Amortization and Sinking Funds

i) Amortization
If a loan is repaid on installment (usually in equal amounts), then the loan
to be repaid by the amortization method. Under this method, each installm
includes the repayment of principal and the payment of interest. The payme
form an annuity whose present value is equal to the original loan.
1) Finding the periodic payment:

Example 1:
A debt of 12,500 with interest at 8%, compounded quarterly, is to be amo
by equal payments at the end of each 3 months for 5 years. Find the size of
quarterly payment.

Example 1:
A debt of 12,500 with interest at 8%, compounded quarterly, is to be amo
by equal payments at the end of each 3 months for 5 years. Find the size of
quarterly payment.
Solution:
Given:
A = 12,500
i = j/m = 0.02
n = 5(4) = 20
Find: R
= = = 764.46
Example 2: A 5,000 loan is being repaid in 10 yearly payments. If interest
effective, find the annual payment.

Example 2: A 5,000 loan is being repaid in 10 yearly payments. If interest

effective, find the annual payment.
Solution:
Given:
A = 5,000
i = 0.08
n = 10
Find: R
= = = 745.15

Example 3: A 40,000 loan, with interest at 9%, compounded monthly, will

amortized over a period of 3 years with the first payment due now. What is
the size of the monthly payment?

Example 3: A 40,000 loan, with interest at 9%, compounded monthly, will b

amortized over a period of 3 years with the first payment due now. What is
the size of the monthly payment?
Solution:
Given:
A = 40,000
i = j/ m = 0.0075
n = 3(12) = 36
Find: R
R = = = = 1,262.52

Example 4: A man buys a cellphone worth 8,000. He is to pay it in 6 monthl

installments starting next month. If the interest rate is 15% compounded
monthly, find the monthly payment.

Example 5: A housewife buys jewelry worth 75,000. She pays 20,000 and
the balance on monthly installment for 5 years. If the interest rate is 15%(m
find the monthly payment.

2) Finding
the Outstanding Principal:

Suppose that a loan is to be repaid in n payments. After making a few paym

the borrower wants to pay off the rest of the loan in one lump sum. How muc
would he pay?
Any remaining debt is called the outstanding principal (sometimes called ou
standing balance or outstanding liability).
Two methods are used in finding the outstanding principal: the prospective
method and the retrospective method.
Under the prospective method, the outstanding principal is the present valu
all the payments still to be made. Suppose that a loan is to be repaid in n pay
the outstanding balance after the kth payments, denoted by is
=
Time Diagram:
k payments already made
R
R
R
R
0

k1
k
n
(n k payments still to be made)

Example
1: A 20,000 debt is to be repaid on installment every 6 months
5 years. Find
a) the semi-annually payment; and
b) the outstanding balance after the 4th payment. Assume that mone
worth 12% compounded semi-annually.
Solution:
Given: A = 20,000
i = j/m = 0.06
n = 5(2) = 10
a) Find: R
= 2,717.36
b) With k = 4, the outstanding balance after the 4th payments is
= = 2,717.36 = 13,362.14
Diagram:
20,000

R
0

R
1

R
2

R
3

R
4

R
5

R
6

R
9

10

Another
method to find the outstanding balance:

If the number of payments is not known, then the prospective method is no

applicable. In such case, the outstanding balance is obtained by using the
payments as basis. This method is called the retrospective method. For ins
a loan A is amortized by payment R. Under the retrospective method, the
outstanding balance after the kth payment, denoted by , is obtained
through an equation of value with comparison date at kth payment.
Diagram:
A

k
k past payments
CD
The equation of value, with k as CD is
= (accumulated value of A at k) (accumulated value of k past payments)
=

Example 2: Refer to example 1 above and solve b:

A 20,000 debt is to be repaid on installment every 6 months for
5 years. Find (b) the outstanding balance after the 4th payment. Assume tha
worth 12% compounded semi-annually.
=
=
= 20,000(1.262477) 2,717.36(4.3746167
= 25,249.54 11, 887.408
= 13,362.13
Notice that = . This is generally true. The retrospective and
prospective methods give the same results.

The methods can be differentiated simply. The prospective method arrives at th

outstanding principal by using future payments, the retrospective method usin
past payments.

Example 3: A debt of 32,500 with interest at 9%, payable bimonthly, will be

discharged by equal payments at the end of each 2 months for 5 years.
a) Find the outstanding principal just after the 9th payment.
b) What part of the payment at the end of 3 years is a payment of principal
Solution:
Given: A = 32,500
m = bimonthly = every 2 months = 6
i = j/m = 0.09/6 = 0.015
n = 5(6) = 30 periods
R=?
=

a) Outstanding balance after the 9th payment:

= = 1,353.27= 24,223.72
b) The payments at the end of 3 years pays interest on the outstanding princip
the end of 2 years and 10 months (n = 30 17 = 13).
= = 1,353.27= 15,875.93

The interest on regular payment: 15,875.93(0.015) = 238.14

The payment of principal on regular payment : 1,353.27 238.14 = 1,115.1

Example 3: A 22,000 debt is to be amortized in 15 payments every 6 month

Find the semi-annual payment and the outstanding balance after the 7 th paym
Money is worth 13% converted semi-annually.
Example 4. Allan borrows 30,000 at 9% effective interest. The debt is to be
annually in 18 years. Find the outstanding principal after the 10 th payment.

Example 5: A 7,500 loan is amortized annually at 800. The interest is 10%

effective. Find the outstanding principal after the 5th payment. (Note: The
prospective method cannot be applied in this problem.)

Example 6: A loan is amortized annually at 1,800. If the outstanding princip

4 years is 10,000, find the original loan.

3) Amortization
Schedule:

An amortization schedule shows how each regular payment is distributed int

interest payment and reduction principal. It also shows the outstanding prin
at the beginning of each interval.

Example 1: Construct an amortization schedule for a 2,000 loan to be repaid

5 semi-annual payments if the interest charged is 16% converted semi-annu
Solution:
Given: A = 2,000
n=5
i = j/m = 0.08
R= = =

Amortization Schedule:
Perio
d
(k)

Regular Interest Due

Paymen at the End
t
of
(R)
Interval
I=

Repayment
of
Principal at
the End of
Interval
PR = R - 1

Outstanding Principal
at the Beginning of
Interval
(OB)

2,000

500.91
3

160=2000*0. 340.913
08

1,659.087 =2000
-340.913

500.91
3

132.727

368.186

1,290.901

500.91
3

103.272

397.641

893.26

4
500.91 71.461
429.452
463.808 =893.26 The outstanding
is equal to the differen
3 principal at the end of the first period
429.452
between the outstanding principal at the beginning of the first period and th
5
500.91 37.105
463.808
0
principal repaid. That is, 1,659.087 =2000 -340.913
3
=
The rest of the entries can be constructed by repeating the procedure.
463.808*0.0

Example 2: A debt of 7,500, with interest at 8%, payable quarterly, is to be

discharged by 6 equal payments and reduction principal. It also shows the
outstanding principal at the beginning of each interval.
Solution:
R = = = = 1,338.94
Schedule:
Perio
d
(k)

Regular
Paymen
t
(R)

Interest Due
at the End of
Interval
I=

Repayment
of
Principal at
the End of
Interval
PR = R - 1

Outstanding
Principal at the
Beginning of
Interval
(OB)

1,338.9
4

150
=7500*0.02

1,188.94

7,500

1,338.9
4

126.22

1,212.72

6311.06 =7500 1188.94

1,338.9
4

101.97

1,236.97

5,098.34

1,338.9
4

77.23

1,261.71

3,861.37

1,338.9

51.99

1,286.95

2,599.66

The amortization
schedule shows these relationships:

1. The total repayments on the principal equal the original loan

2. At the end of the term, the total payment is equal to the total interest paid
the original loan.
3. The outstanding principal at the beginning of the term is the original loan.
4. The outstanding principal at the end of the term is equal to zero. But it may
be shown to be equal because fractions have been rounded off to 3 decimal p
5. Interest payments decrease as payments on principal increase.
6. It is possible to find each entry without constructing the entire amortization
schedule. For instance, the outstanding balance after each period can be
determined by the prospective or retrospective method.

Example 3: Without constructing the amortization table of Example 1, determ

the outstanding balance after the 3rd payment. Use the prospective method.
Solution:
Given: n = 5, k = 3, R = 500.913
= = 500.913 = 893.26

Example
4: Given the problem in Example 1, find
a) how much of the 4th payment goes to pay the interest
b) how much goes to repay the principal.
Solution:
The interest in the 4th payment is
I = = 893.26(0.08) = 71.461
The repayment on principal is
PR = R 1 = 500.913 71.461 = 429.452

Example 5: A 15,000 loan at 12% compounded quarterly is to be amortize

every 3 months for 1.5 years. Find the quarterly payment and construct an
amortization schedule.

Example 6: A 25,000 debt at 18% converted quarterly will be discharge by

quarterly payments over 6.5 years.
a) Find the quarterly payment.
b) Find the outstanding balance after the 15th payment.
c) How much of the 16th payment is interest?
d) How much of the 16th payment is repayment of principal?
e) Find the total interest charged on the loan.

Assignment:
Page: 95
Items: 1 and 10
Book: Mathematics of Investment by Victoria C. Naval, et.,al.
Topic: Amortization

ii) Sinking Funds

If a person sees the need to have a certain sum at some future date, he mi
accumulate a fund by making periodic deposits. Such a fund is called a sinkin
The deposits may be irregular, that is, varied amounts deposited at irregula
intervals. But in our class, we assumed that the amount of any sinking fund d
is the same and that is deposited at regular intervals. In such a case, the equ
periodic deposits from an ordinary annuity. Thus, the amount in the fund afte
kth deposit, denoted by S, is the amount of the k payments, or
S=

A sinking fund schedule shows how the fund accumulates and how much inter
the fund earns at any time.

Example 1: A man expects to buy a government subsidized condominium wor

100,000 in 3 years. He decides to put his savings every 6 months in a fund
earns 8% converted semi-annually.
a) How much should he put in semi-annually?
b) How much is in the fund after the 4th deposit?
c) Construct a sinking fund schedule.

Example 1: A man expects to buy a government subsidized condominium w

100,000 in 3 years. He decides to put his savings every 6 months in a fund
earns 8% converted semi-annually.
a) How much should he put in semi-annually?
b) How much is in the fund after the 4th deposit?
c) Construct a sinking fund schedule.
Solution:
Given: S = 100,000
n = 3(2) = 6
k=4
i = j/m = 0.04
a) R = = = = 15,076.19
b) S = = 15,076.19 = 15,076.19(4.246465) = 64,020.51

c) Sinking Fund Schedule

Perio
d

1
1
2
2
3
3
4
4
5

Amount in
Fund at the
Beginning of
the Period

Interest
Earned
on Sinking
Fund
at End of
Period
I = (i)

0.00
0.00

0.00
0.00
15,076.19
603.05
15,076.19
603.05
30,755.43
1,230.22
30,755.43
47,061.84
47,061.84
64,020.50

1,230.22
1,882.47
1,882.47
2,560.82

Sinking
Fund
Deposit at
End of
Period
R

Amount in
Fund at
End
of Period
= +I +R

15,076.19

15,076.19
15,076.19

15,076.19

15,076.19
30,755.43

15,076.19
15,076.19
15,076.19
15,076.19

30,755.43
47,061.84
47,061.84
64,020.50

15,076.19
64,020.50
15,076.19
81,657.51
5
64,020.50
2,560.82
15,076.19
81,657.51
6
81,657.51
3,266.30
15,076.19 100,000.00
Note that the amount in the fund after 6 periods equals the total interest pl
6
81,657.51
3,266.30
15,076.19
100,000.00
Total

the total
sinking fund deposit.
9,542.86
90,457.14
Total

9,542.86
90,457.14

Any fund
increase on the kth deposit date equals the difference between the
total fund after and before the kth deposit. The latter is expressed as the
(k -1)th deposit. Or
Increase in fund =
An alternate solution is:

The fund increase on the kth deposit date equals the interest earned on the
previous fund balance plus the sinking fund deposit.
Increase in fund = (amount in the fund after (k -1) deposit)(i) + R
=
=

Example 2: A father wishes to have 10,000 in 5 years. He sets up a sinking

depositing a sum every 3 months in a bank that pays 12% interest converte
quarterly.
a) Find his quarterly sinking fund deposit.
b) Find the interest earned in the 10th quarter.
c) Find the fund increase on the 8th deposit date.
Solution:
Given: S = 10,000;

n = 5(4) = 20;

i = 0.12/4 = 0.03

a) Find : R
R = = = = 372.16

b) The interest earned in the 10th quarter is equal to the results of multiplying
previous balance by the interest rate per period.
The total fund after the 9th deposit:
S = = 372.16 = 3,780.81 (fund after 9th deposit)
Interest Earned in the 10th deposit: = (fund after 9th deposit)X(interest rate
I = 3,780.81(0.03) = 113.42

c) The fund increase on the 8th deposit date is:

Increase in fund =
=372.16
= 372.16(8.8923367 7.6624633)
=457.71
Another solution:
=
= 372.16
= 372.16[7.6624633(0.03) + 1]
= 457.71

Example 3: In order to have 8,000 in 5 years, a man deposits each year in a

sinking fund earning 6% effective. Find the annual deposit and construct a si
fund schedule.

Example 4: To pay for plant expansion, a factory manager estimates that 25

will be needed in 6.5 years. He decides that the factory should invest a sum
every 3 months in a fund. Interest is earned at 12% converted quarterly.
a) How much is the quarterly investment?
b) How much will be in the fund after the 10th deposit?
c) How much interest is earned on the 8th deposits date?
d) How much will the fund increase be on the 10th deposit date?

iii) Sinking
Fund Method of Discharging a Debt

In amortizing a loan, the debt is paid on installment. If the debtor pays intere
periodically and the principal in one lump-sum payment at the end of the term
from a sinking fund, then he is said to have discharged the loan by the sinkin
fund method. Under this method, the interest and principal are paid separate
It should be noted that the interest earned by the sinking fund is in no way
to the interest paid on the loan. Unless otherwise stated, the sinking fund de
and the payment of interest on the loan are made at the same time.
Under the sinking fund method, the total periodic cost (or expense) of the lo
consists of the following:
a) Periodic interest paid on the loan:
I = A(
b) Periodic deposit in the sinking fund to repay the principal:
R=
c) The total periodic cost C is the sum of the periodic interest charge and the
sinking fund deposit:
C=I+R

C = total periodic cost (expense) of the loan

A =original loan
= interest rate per period paid on the loan n =loan term (expressed in peri
= interest rate per period earned on the sinking fund.

Example 1: A 5,000 loan is to be repaid in 3 years at the rate of 16% payab

semi-annually. The creditor agrees that the interest shall be paid semi-annu
and the principal in one lump sum. Find the total semi-annual cost of the loa
the borrower deposits semi-annually in a sinking fund that 15% converted
semi-annually.
Solution:
Given: A = 5,000
=
= 0.075
n=6
The semi-annual interest charge: I = A( = 0.08(5,000) = 400
The semi-annual sinking fund deposit:
R = = = 690.22

The total semi-annual cost of the loan is: C = I + R = 400 + 690.22 = 1,090

To repay the loan, the borrower must save 1,090.22 semi-annually for 3 yea
400 for the payment of interest on the loan semi-annually and 690.22 for t
deposit to the fund semi-annually so that the fund wll contain 5,000 in 3 ye

Example2: A loan of 20,000 due in 4 years is to be discharged in a single

installment by building up a sinking fund. If the debt bears interest at 9%,
compounded monthly, and the sinking fund accumulates at 7 % converted m
find (a) the monthly payment to the sinking fund and the total monthly charg
(b) the amount in the sinking fund at the end of 2 years; and (c) the book valu
the debt at the end of 1.5 years.
Solution:
Given:
A = 20,000
=
= 0.00583
n = 4(12) = 48
(a) The monthly interest charge: I = A( = 20,000(0.0075) = 150
The monthly payment in the sinking fund to repay the principal:
R = = = 362.29
The total monthly charges(Cost): C = I + R = 150 + 362.29 = 512.29

(b) The
amount in the sinking fund at the end of 2 years:
S = = 362.29 = 362.29(25.68) =9,303.61

(c) The book value of a debt at any given time is the difference between t
principal of the debt and the amount in the sinking fund at the time.
The amount in sinking fund at the end of 1.5 years:
S = = 362.29 = 362.29(18.92) = 6,854.53
Book value of the debt = 20,000 6,854.53 = 13,145.47
Assignment:
Pages: 101 and 102 : Sinking Fund
Items: 2, 3, 6, and 9
Book: Mathematics of Investment by Victoria C. Naval, et.,al.