Amortization and Sinking Funds

Module

4
4.1 Amortization

Amortization is a debt-repayment scheme wherein the original amount loaned is repaid by making equal
payments in equal periods of time.

Objectives

At the end of this module, you should be able to

• Define what an amortization is
• Determine the amount of regular payment in an amortization problem
• Determine the outstanding debt at the and of any given period
• Find out which part of the periodic payment goes to interest payment and which part is
for principal repayment
• Construct an amortization schedule

Key Concepts

• The formula for determining the regular payment R is given by

Ai
R= −n
1−1i
where
A is the amount loaned
i is the interest rate per period
n is the total number of payment periods
• We have two formulas for determining the outstanding balance OB k at the end of any
period k :

OB k = R[ 1−1i− n− k
i ]
and

OB k = A1i −R
k
[ 1ik −1
i ]
The first formula is used when n is known. You use the second if n is not known or
n is not exact.

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 • The part of the k th regular payment which goes to the payment of interest is given by

IP k = OB k−1 i

while the portion which goes to principal repayment is

PRk =R−IP k

Problem

A Php15,000 loan at 12% compounded quarterly is to be amortized every 3 months for 1.5
years. Find the quarterly payment and construct an amortization table.

Solution

First, we get R.

Ai
R =
1−1i−n
15,000.03
= −6
1−1.03
=2768.96
Next, we construct the amortization schedule.

Step 1: Prepare the table. (Recall that we have 6 periods).

Period Periodic Payment Interest Payment Principal Repayment Outstanding Balance

Step 2: Place the original debt and the periodic payments.

Period Periodic Payment Interest Payment Principal Repayment Outstanding Balance

0
1 2768.96

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 2 2768.96
3 2768.96
4 2768.96
5 2768.96
6 2768.96

Step 3:
• Get the interest payment for the first period: (15,000)(.03) = 450.
• Subtract this from the regular payment to get the principal repayment for the first
period: 2768.96 – 450 = 2318.96.
• Finally, deduct the principal repayment 2318.96 from the debt to get the outstanding
balance at the end of the first period: 15,000 – 2318.96 = 12681.04.
• Place these values on the table.

Period Periodic Payment Interest Payment Principal Repayment Outstanding Balance

0 15000
1 2768.96 450 2318.96 12681.04
2 2768.96
3 2768.96
4 2768.96
5 2768.96
6 2768.96

Step 4: Repeat the Step 3 for the other rows to get the following:

Period Periodic Payment Interest Payment Principal Repayment Outstanding Balance

0 15000
1 2768.96 450 2318.96 12681.04
2 2768.96 380.43 2388.53 10292.51
3 2768.96 308.78 2460.18 7832.33
4 2768.96 234.97 2533.99 5298.34
5 2768.96 158.95 2610.01 2688.33
6 2768.96 80.65 2688.31 0 (.02)

The outstanding balance at the end of the term (end of 6th period) is 0.

Problem

A Php25,000 debt at 18% converted quarterly will be discharged by quarterly payments over 6.5
years.

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 a) Find the quarterly payment.
b) Find the outstanding balance after the 13th payment.
c) How much of the 16th payment goes to interest payment?
d) How much of the 16th payment is repayment of principal?
e) Find the total interest charged on the loan.

Solution

a) The quarterly payment is R .

Ai
R = −n
1−1i
25,000.045
= −26
1−1.045
=1650.53

b) This is denoted by OB 13 . Solving, we have

[ ]
− 26−13
1−1.045
OB 13 =1650.53
.045
=15981.84

c) This is IP 16 . Substituting the known values in the formula, we have

IP 16 =OB 15.045

{ [ ]}
− 26−15
1−1.045
= 1650.53 .045
.045
= 633.48

d) This is PR 16 . From the given formula, we have

PR 16 = R−IP 16
=1650.53−633.48
=1017.05
e) Total interest = Total payments – Total debts. Here, we have 26 regular payments of
1650.53 and a debt equal to 25,000. Hence

Total interest = Total payments – Total debts

= 261650.53−25,000
=17913.78

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 Exercises

1. A loan of Php80,000 is to be repaid with equal quarterly payments for two years with
an interest rate of 4% compounded quarterly. Find the quarterly payment.
2. Semi-annual payments of Php96,000 each are used to repay a loan for 4 years at 5%
compounded semi-annually. Find the amount of the loan.
3. A loan of Php400,000 with interest at 6% payable semi-annually is to be amortized by
equal payments at the end of each 6 months for 5 years.
a) Find the periodic payment.
b) How much of the 8th payment is interest payment and how much is for repayment
of principal?
4. A loan is to be amortized by equal payments of Php50,000 each at the end of six
months for 10 years. If the interest is based on 7% compounded semi-annually, find:
a) the present value of the loan;
b) outstanding principal just after the 8th payment;
c) the remaining liability after 8 years.

4.2 Amortization With Final Irregular Payment

Objectives

At the end of this module, you should be able to

• Determine the number of regular payments it will take to repay a debt
• Determine the final irregular payment

Key Concepts

• The formula for determining the total number of payment periods n is given by

n=

log 1−
Ai
R 
−log 1i

• To find the amount of the final irregular payment x , we can either use equation of
values or the formula

x=OB LR 1i

where OB LR is the outstanding balance as of the end of the last regular payment
period

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 Problem

An Php8,000 debt at 15% interest compounded semi-annually is to be amortized at Php1,250

every 6 months. A final smaller payment is to be made after the last regular.
a) How many regular payments are needed?
b) When will the final smaller payment be due?
c) How much is the final payment?

Solution

First, we get n.

n =

log 1−
Ai
R 
−log 1i

=
[
log 1−
8000.075
1250 ]
−log 1.075
= 9.04
a) Hence, there will be 9 regular payments of Php1,250 plus a final irregular payment.
b) The final payment will be due on the 10th period. (Note: Generally, we assume that
the final payment is due one period after the last regular payment).
c) The final payment, which we denote by x , is given by:

x = OB 9 1.075

{ [ ]}
9
9 1.075 −1
= 80001.075 −1250 1.075
.075
= 54.39

(Note that we had to use the retrospective formula because n is not exact).

Problem

A man obtains a Php7,800 loan to be repaid in annual payments of Php1,500. If the lender
charges an effective interest rate of 8%
a) how many regular payments will be required?
b) find the outstanding liability in 5 years.
c) how much of the 6th payment is for the principal?
d) how much interest will be paid to discharge the loan?

Solution

a) Solving for n , we have

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 n =

log 1−
Ai
R 
−log 1i

=
[
log 1−
 7800.08
1500 ]
−log 1.08
= 6.99
Hence, 6 regular payments are required.
b) This is denoted by OB 5 . Solving, we have

[ ]
5
5 1.08 −1
OB 5 =7800 1.08 −1500
.08
= 2660.86

c) This is PR 6 .

PR 6 = R− IP 6
= 1500−OB 5i
= 1500−2660.86.08
= 1287.13
d) Total interest = Total payments – Total debts. Here, we have 6 regular payments of
1500 and one (still unknown) final irregular payment. The debt is equal to P7,800.
The final irregular payment is given by

x = OB 6 1.08

{ [ ]}
6
6 1.08 −1
= 7800 1.08 −1500 1.08
.08
= 1483.62
Hence

Total interest = Total payments – Total debts

=[615001483.62]−7800
= 2683.62

Exercises

1. A debt of Php450,000 will be amortized by semi-annual payments of Php58,000 for as

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 long as necessary. If interest is paid at 5 ½% compounded semi-annually, find:
a) the number of full payments;
b) the final or concluding payment.
2. A loan of Php60,000 with interest at 6% converted quarterly is to be amortized by
payments of Php2,000 at the end of each three months for as long as necessary. Find
a) the outstanding balance at the end of 4 years;
b) the remaining liability just after the 30th payment;
c) the final or concluding payment.

4.3 Sinking Funds

A sinking fund is one which is generated by making periodic deposits. The deposits may be regular or irregular.
However, in this discussion, we assume that the amount of any sinking fund deposit is the same, that is, they
form an ordinary annuity.

Key Concepts

• The amount in the fund after any k th deposit is given by:

[ ]
k
1i s  −1
S k =D
is

where
D is the the sinking fund deposit
i s is the interest rate earned by the sinking fund
• Any fund increase on the k th deposit is given by:

INC k =S k −S k −1=D1i s k−1

• The interest earned in the k th deposit period is given by IE k =S k−1 i s .

• If the debtor pays interest 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
sinking fund method. Under this method,
• the interest and principal are paid separately;
• the total periodic cost is given by

is A
C=i A A n
1i s −1

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 Exercises

1. In order to have Php800,000 in 5 years, a man deposits each year in a sinking fund
earning 6% effective. Find the annual deposit and construct a sinking fund schedule.
2. To pay for plant expansion, a factory manager estimates that Php25M will be needed in
6 ½ 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 deposit date?
d) How much will the fund increase be on the 10th deposit date?
3. A Php200,000 loan at 8% effective interest rate is to be repaid in 5 years through a
sinking fund. Equal deposits are made each year into a fund that earns 7% effective.
Find the total annual cost of the loan.
4. A Php100,000 loan is to be repaid in lump sum in 8 years. The lender charges 10%
interest payable semi-annually. The debtor decides to pay the interest semi-annually
and to repay the principal by creating a sinking fund.
a) How much is the debtor’s semi-annual expense if the fund is invested at 9%
compounded semi-annually?
b) How much will be in the fund after the 10th deposit?

Comparing Amortization and Sinking Fund Methods

i A=i s R=C If the interest rate on the loan is the same as the rate on the sinking
fund, the periodic costs of the two methods are equal.
i Ai s RC When the debtor pays an interest rate higher than the earning rate on
the sinking fund, the periodic cost in the amortization method is less
than that in the sinking fund method.

Choose the amortization method.

i Ai s RC When the debtor pays a loan interest at a rate lower than that at which
he is earning on the sinking fund, then the periodic cost in the
amortization method is greater than that in the sinking fund method.

Choose the sinking fund method.

Exercises

1. A Php500,000 loan at 16% interest rate payable semi-annually is to be discharged in 10

years. Find the semi-annual expense if
a) the loan is to be amortized every 6 months;
b) the loan is repaid by a sinking fund earning at 15% compounded semi-annually.

Also, find which method is cheaper and how much the debtor can save semi-annually
by choosing it.

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