Finite Math

5.3 Notes

Name_______________________

5.3 Amortization and Sinking Funds

Amortization of Loans
Amortization the paying off of debt with a fixed repayment schedule in
regular installments over a period of time; for example with a mortgage or a
car loan.
By thinking of the monthly loan repayments R as the payments in an
annuity, we see that the original amount of the loan is given by P, the
present value of the annuity.
n
1( 1+i )
P=R
i

A question a financier might ask is: How much should the monthly
installment be so that a loan will be amortized at the end of the term of the
loan? To answer this question, we simply solve equation above for R in terms
of P, obtaining
R=

Pi
n
1( 1+i )

Example 1 Amortization of Loans

A sum of $50,000 is to be repaid over a 5-year period through equal
installments made at the end of each year.
If an interest rate of 8% per year is charged on the unpaid balance and
interest calculations are made at the end of each year, determine the size of
each installment so that the loan (principal plus interest charges) is
amortized at the end of 5 years.
Verify the result by displaying the amortization schedule.
Solution:
P=

r
i= =
m

, and n =

We plug it into
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R=

5.3 Notes

Name_______________________

Pi
n
1( 1+i )

1+

1
( )()
R=
Thus, the required yearly installment (payment) would be $
.
We calculated the required yearly installment (payment) to be $12,522.82.
Now we create the table displaying the amortization schedule below.

To get the interest charged, multiply the outstanding principal by 0.08 (the
interest rate on the unpaid balance).
Example: (50,000.00)(0.08)=4,000.00

To get the payment toward principal, subtract the interest charged from the
repayment made.
Example: $12,522.82 - $4,000.00 = $8,522.82.

To get the outstanding principal, use the outstanding principal balance before
it and subtract the payment toward principle.
Example: $50,000.00 - $8,522.82 = $41,477.18.

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5.3 Notes

Name_______________________

The outstanding principal at the end of 5 years is, of course, zero.(The figure
of $0.01 in Table 4 is the result of round-off errors.)
Observe that initially the larger portion of the repayment goes toward
payment of interest charges, but as time goes by, more and more of the
payment goes toward repayment of the principal.

Financing a Home
Example: Home Mortgage Payments
The Blakelys borrowed $120,000 from a bank to help finance the purchase of
a house.
The bank charges interest at a rate of 5.4% per year on the unpaid balance,
with interest computations made at the end of each month.
The Blakelys have agreed to repay the loan in equal monthly installments
over 30 years. How much should each payment be if the loan is to be
amortized at the end of the term?
Solution:
P=

r
i= =
m

, and n =

We plug it into
R=

Pi
1( 1+i )n

1+

1
( )()
R=
Thus, the required yearly installment (payment) would be $
.
Example: Home Affordability
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5.3 Notes

Name_______________________

The Jacksons have determined that, after making a down payment, they
could afford at most $2000 for a monthly house payment.
The bank charges interest at the rate of 6% per year on the unpaid balance,
with interest computations made at the end of each month.
If the loan is to be amortized in equal monthly installments over 30 years,
what is the maximum amount that the Jacksons can borrow from the bank?
Solution:
R=

r
i= =
m

, and n =mt =

We plug it into
P=R

1( 1+i )
i

]
1+
]
(
1

P=

Thus, the Jacksons can borrow at most $333,583.23.

Sinking Funds
Sinking funds are another important application of the annuity formulas.
Sinking fund is an account that is set up for a specific purpose at some future
date.
For example,

An individual might establish a sinking fund for the purpose of

discharging a debt at a future date.
A corporation might establish a sinking fund in order to accumulate
sufficient capital to replace equipment that is expected to be obsolete
at some future date.

Example: Want to purchase a truck in 2 years time

The proprietor of Carson Hardware has decided to set up a sinking fund for
the purpose of purchasing a truck in
2 years time.
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5.3 Notes

Name_______________________

It is expected that the truck will cost $30,000. If the fund earns 10% interest
per year compounded quarterly, determine the size of each (equal) quarterly
installment the proprietor should pay into the fund.
Verify the result by displaying the schedule.
Solution:
The problem at hand is to find the size of each quarterly payment R of an
annuity, given that its future value is S = 30,000, the interest earned per
r 0.1
conversion period is i= m = 4 =0.025 and the number of payments is n =
mt = (4)(2) = 8.
S=R

The formula for an annuity is

And we solve for R to get

R=

( 1+i )n1
i

Si
( 1+i )n1

We plug in the information to get

1+

( )()
R=

Thus, the installment (payment) would be of $

.

We calculated the required quarterly installment (payment) to be $3,434.02.

Now we create the table displaying the schedule below.

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5.3 Notes

Name_______________________

To get the interest earned, multiply the accumulated amount in fund by

0.025 (the interest earned on the accumulated fund).
Example: (3,434.02)(0.025)=85.8505=85.85

To get the addition to fund, add the deposit made to the interest earned.
Example: $3,434.02 + $85.85 = $3,519.87

To get the accumulated amount in the fund, use the accumulated amount in
fund before it and add the addition to fund.
Example: $3,434.02 + $3,519.87 = $6,953.89.

SUMMARY OF FORMULAS DEVELOPED

1. Simple and compound interest; annuities
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5.3 Notes

Name_______________________

2.

Effective rate of interest

3. Amortization

Periodic payment

Amount amortized
4. Sinking Fund

Periodic payment taken out