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Topic 6 : Loans

Example 1
Sloth Ltd borrows $100,000 for 10 years as an interest only loan. Interest is
payable monthly at the fixed rate of 12% p.a. compounded monthly.
(a)

Describe the payments made by Sloth Ltd under this loan.

(b)

Sloth plans to accumulate the amount to be repaid by making level


monthly payments into a sinking fund earning 10% p.a. compounded
monthly. Determine the size of the sinking fund instalment.

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Solution
(a) Monthly Interest = 1% $100,000 = $1,000 .
Sloth pays:

$1,000 at the end of each month for 10 years.


A further $100,000 at the end of the 10th year.

(b) The sinking fund instalment is $x where


100,000 = x s120 at
x = 488.17

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10
12

%.

Example 2
A loan of $10,000 is repaid by 5 annual instalments of $2,504.56, interest
being charged at 8% p.a.
Loan
outstanding
Year
at start of
year
1
10,000.00
2
8,295.44
3
6,454.52
4
4,466.32
5
2,319.07

Principal
Interest
repaid
800.00
663.64
516.36
357.31
185.53

1,704.56
1,840.92
1,988.20
2,147.25
2,319.03

Loan
outstanding
at end of
year
8,295.44
6,454.52
4,466.32
2,319.07
0.04

(a)

Verify the numbers for the first two years of the schedule.

(b)

If we increased the instalment by 1c, the final loan outstanding


changes from 4c to 4c. Do we care that it isnt exactly 0 at the end?
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Solution

(a)

Interest = 8% Loan O/S at start of year


Principal Repaid = Instalment Interest
Loan O/S at end = Loan O/S at start Principal Repaid

(b)

Each customer should see their final balance being exactly zero. The
person (accountant?) specifying the computer programs to generate
individual customers loan records will care.
The person (actuary?) testing the overall profitability of a lenders
loan products probably doesnt care, since errors balance out over
different loans.

Note that over time, the loan outstanding reduces, so the interest reduces,
so the principal repaid each year increases.

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Example 3
A loan of $10,000 is repaid by annual instalments, interest being charged at
8% p.a. The first instalment is $2,350 and subsequent instalments increase
at 7% p.a., with a reduced instalment in the final year.
If the instalment varies, it is best to create a column for it in the schedule.
Loan
Loan
outstanding
Principal outstanding
Year
Instalment Interest
at start of
at end of
repaid
year
year
1
10,000.00 2,350.00 800.00 1,550.00
8,450.00
2
8,450.00 2,514.50 676.00 1,838.50
6,611.50
3
6,611.50 2,690.52 528.92 2,161.60
4,449.90
4
4,449.90 2,878.86 355.99 2,522.87
1,927.03
5
1,927.03 2,081.19 154.16 1,927.03
0.00
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(a)

Verify the numbers for the first two years of the schedule.

(b)

If you were building this schedule on a spreadsheet, how would you


determine the length of the loan and the size of the final instalment?

Solution

(a)

The formulae from the previous example still hold.

(b)

Extend the schedule to the first time period with a final loan
outstanding that is negative. For that time period, reset:
Final instalment = Loan o/s at start + Interest.

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Algebraic Manipulation of Reducing Balance Loans


1.
Loan amount = Present value at the outset of the repayments.
2.

The loan outstanding equals the accumulated value of the loan less
the accumulated value of the repayments made to date. (The
retrospective method.)

3.

The loan outstanding is also the present value of the future


repayments still to be made. (The prospective method.)

1.
2.

L0 = vR1 + v R2 + ... + v Rn = v t Rt
2

Lt = L0 (1 + i ) R1 (1 + i )
t

t 1

= L0 (1 + i ) Rs (1 + i )
t

s =1

3.

t =1

+ R2 (1 + i )

t 2

t s

n t

Lt = vRt +1 + v Rt +2 + ... + v Rn = v s Rt + s
2

n t

s =1

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+ ... + Rt

t = 1, 2,3,..., n
t = 0,1, 2,..., n 1

Example 4 Level Repayments


A loan of $120,000 is repayable by level monthly instalments over 30
years. Interest is charged at 12% p.a. compounded monthly.
(a)

Determine the monthly instalment. (Round to the nearest cent.)


The monthly instalment is $x where
$120,000 = $ x a360 at 1%
x = 1, 234.34

(b)

Determine the loan outstanding at the end of the 5th year


(immediately after the instalment then due) by the prospective
method.
Loan o/s after 5 years
= $ x a300 at 1%
= $117,196.33
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(c)

Check the above answer using the retrospective method. (If the check
fails, the error could be in (a), (b) or (c).)
Loan o/s after 5 years

= $120,000 (1 + i ) $ x s60 at 1%
60

= $117,195.46
(d)

The answers to (b) and (c) differ slightly (less than $1) due to
rounding. Given they differ, which one is right?
Both retrospective and prospective methods are approximations. The
true answer comes from the loan repayment schedule, which may
match neither of these since it individually rounds each interest
payment. (If it didnt round the interest but used the rounded
instalment, it would match the retrospective method, so perhaps that
method is less wrong.)

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(e) If the (prospective) loan outstanding at the end of the 4th year of the
loan is $117,898.38, determine the amount of interest charged during
the 5th year of the loan.
Interest charged in 5th year of loan
= Total instalments paid in 5th year principal repaid over 5th year
= 12 $ x ( Loan o/s after 4 years loan o/s after 5 years )
= 12 $1, 234.34 ( $117,898.38 $117,196.33)
= $14,110.03
(f)

At the end of the 5th year of the loan, the interest rate falls to 11% p.a.
compounded monthly. Determine the new monthly instalment which
will repay the loan in the original term. Use the prospective loan
outstanding. (If a question doesnt specify which loan outstanding to
use, you can use either.)
The new monthly instalment is $ y where
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$117,196.33 = $ y a300 at

11
12

% or 0.916%

y = 1,148.66
(Check: Interest rate Instalment .)
(g) If the borrower continues paying the original instalment under the
new interest rate, determine the new term of the loan and the final
smaller instalment. Perform a reasonableness check on the final
instalment.
Assume the loan is exactly repaid by n further instalments of $x.
(Highly unlikely!) Then

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$117,196.33 = $1, 234.34 an at 0.916%

1 1.00916 n
= 94.946554

0.00916
1.00916 n = 7.712682
n ln1.00916 = ln 7.712682
n 223.88
That is there will be 223 further full instalments plus a final smaller
instalment of $z where

$117,196.33 = $1, 234.34 a + $ z v 224 at 0.916%


223

z = 1,084.34

a223 = 94.832781
224 + 60 = 284 . The new term of the loan is 284 months.
Checks: 0 < z < x .
284 < 360 . Interest rate Fewer Instalments.
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(h)

The following question is not suitable for an ACST202/851 exam.


Explain why.
At the end of the 5th year the borrower decides to increase the
instalment to $1,400 for the rest of the loan, and the lender decides to
increase the interest rate in such a way that the loan is exactly repaid
at the end of the originally planned term. What is the new interest
rate?
1. Its unrealistic. Lenders adjust interest rates in line with market
forces, not to achieve some desired outcome for one particular loan.
2. Look at the equation:
$117,196.33 = $1400 a300 at i
1 (1 + i ) 300
= $1400
i
We cant easily solve for i . Its more efficient to use a spreadsheet.
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Example 5 Geometrically increasing repayments


A loan of $300,000 is being repaid by geometrically increasing quarterly
instalments. The interest rate is 8% p.a. compounded quarterly. The first
instalment is $7,000. Each subsequent instalment is 0.5% greater than the
previous instalment, except for the final instalment which extinguishes the
loan.
(a)

Find the term of the loan and the size of the final instalment. Perform
a reasonableness check on the final instalment.

(b)

Find the loan outstanding after 5 years using both retrospective and
prospective methods.

(We can also do the same types of alterations as done in the previous
question, but this doesnt require any new skills, so well stop here.)

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Solution

If the loan is exactly repaid by n instalments following the GP pattern,


$300,000 = $7,000

1
1.02

n
1 ( 1.005

1.02 )
$7,000
= 1.02

1.005
1 1.02
n
1 ( 1.005

1.02 )
= $7,000

1.02
1.005

1.005 n
1.02

+ 1.005
+ (n terms)
1.022

= .357143

n ln 1.005
1.02 = ln.357143
n = 69.50

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20

21

7,0001.00568

7,0001.005
2

7,0001.00520

7,000
1

7,0001.00519

300,000
0

69

70

Thus there are 69 instalments following the GP, plus a final smaller
instalment of $x where
69
1 ( 1.005

$x
1.02 )
$300,000 = $7,000
+

70
1.02
1.005
1.02

x = 4,936.65.
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Check: 0 < x < 7000 1.00569 = 9875.44 . That is, the 70th instalment must
be smaller than what it would have been had it followed the GP pattern.
(b)

Retrospective loan outstanding after 5 years


= $300, 000 1.0220 $7, 000 {1.0219 + 1.005 1.0218 + + 1.00519 }
1.005 20

20
19 1 ( 1.02 )
= $300, 000 1.02 $7, 000 1.02

1.005
1 1.02
20
20

1.02

1.005
20
= $300, 000 1.02 $7, 000

1.02

1.005

= $267,960.04

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Prospective loan outstanding after 5 years


1.00520 1.00521
1.00568
$x
= $7, 000
+
+ +
+
2
49
50
1.02
1.02
1.02
1.02

1.005 49

1.005
$x
1 ( 1.02 )
=$7, 000

+
1.005
1.02 1 1.02 1.0250

20

1.005 49

$4,936.65
20 1 ( 1.02 )
= $7, 000 1.005
+
50
1.02

1.005
1.02

= $267,960.04

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Example 6 Monthly instalments, annual increases


A loan of $150,000 is repayable over 20 years by monthly repayments with
annual increases at 2% compound. (That is, repayments are constant within
each year, but increase by 2% compound at the end of each year of the
loan.) Interest is charged at 6% p.a. compounded monthly. Determine the
initial monthly loan instalment.
Solution

0.5% per month = 6.167781% p.a.


Let the initial monthly instalment be $x.
Pretend there are annual repayments of $12 x,$12 x (1.02 ) ,$12 x (1.02 ) ,...,
i
for 20 years, and then adjust to monthly by multiplying by (12) .
i
2

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150,000 = 12 x {v + 1.02v 2 + + 1.0219 v 20 }

i
i

(12)

20
1.02

12 x 1 ( 1+i ) i
=
at 6.167781%

1.02
1 + i 1 1+i .06

20
1 ( 1.02

1+i ) i
= 12 x
at 6.167781%

i .02 .06
x = 919.61

Flat rate loans are extinct in Australia


Read the unit notes.

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at 6.167781%

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