Amortization formula derivation

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Amortization formula derivation

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One of the most useful arithmetic formulas in mathematics is the monthly payment for

an amortized loan. Here are some standard questions that apply whenever you borrow

money to buy a car or a house:

payments, then what is the monthly payment M ?

2. After m monthly payments of $ M , what is your balance due? Of what you have

€ paid in interest?

paid, how much of the loan have you paid off and how much have you

3. How do you create an amortization chart that shows how much goes to interest, how

€

much goes to principal, and the remaining balance after each payment.

4. If an additional fixed amount A is paid each month to help reduce the principal, then

what will be you balance after m monthly payments?

€

For a principal balance of P with fixed interest rate r (in decimal), the amount due each

month to pay off the loan in n monthly payments is given by

€ P × ( r12 )

M = −n .

1 − (1 + r12 )

r 12M r

k k

€

Bk = P1+ + 1− 1+

12 r 12

Let B0 be the initial balance and let Bi the balance after the i th payment.

€

The interest on i th payment is given by Ii = Bi −1 × r / 12 .

€

The balance after the i th payment is Bi = Bi−1 – Pi .

€

Finally, the umber of months required to pay off balance B with monthly checks of C is

€ B r€

−log1−

12C

m=

log(1+ r /12)

€

Example 1. Suppose you are buying a house. After your downpayment, closing costs,

etc., you are to finance $125,000 at 5.25% to be paid back over 30 years.

(b) How much will you pay over the course of 30 years? How much goes to interest?

(c) On the first few payments, show how much of your payment goes to interest, how

much goes to principle, and the balance due.

(i) How much have you paid in? (ii) What is the balance due?

(iii) How much of the loan have you paid off?

(iv) How much of your payments have gone to interest?

(v) You decide to try to pay off the balance 12 more years of payments. Compute the

monthly payment that would be required to pay off the balance B from (d) in 12 years at

5.25% interest.

(vi) On second thought, you decide to start paying $1500 a month after the initial 10

years of payments. How many more payments will be required? Also express the

result as xx years, yy months (e.g. finish in 9 yrs, 3 months of payments).

Solution. (a) For 30 years, there are 360 payments. The monthly payment is

M = −360 = = $690.25.

1 − (1 + .052512 ) 1 − (1.004375 )−360

(b) After 30 years, or 360 payments, you will pay $690.25 × 360 = $248,490. The amount

paid to interest is $248,490 – $125,000 = $123,490.

So the amount to principal is $690.25 – $546.88 = $143.37, which gives a balance of

$124,856.63.

Payment To Interest To Principal Balance

– – – $125,000

3. $690.25

4. $690.25

Notes: (a) If your downpayment is at least 20%, or when your balance drops below

80% the value of the house, then you no longer have to escrow your property taxes and

insurance. If you do escrow, then your monthly payment is actually higher than M , but

this additional amount is only for insurance and taxes and does not affect the loan.

(b) Due to the rounding of M to the nearest cent, the last payment may not actually be

$690.25. If you make a complete amortization chart of the process, then the last

payment actually will be $694.02, which makes the total payment $248,493.77.

(d) (i) After 10 years, or 120 payments, you have paid in $690.25 × 120 = $82,830.

.0525 120 12 × 690. 25

B120 = 125, 000 × 1 + + × (1 − (1+.0525 / 12 )120 )

12 . 0525

12 × 690.25

= 125, 000 × 1.004375120 + × 1 − 1.004375120

( )

.0525

= $102, 436. 08 .

(v) For 12 years, there are 144 payments. The monthly payment for a balance of

$102,436.08 is now

(

102436.08 × .052512 ) 448.15785

M = −144 = 1− 1.004375 −144 = $960.32.

(

1− 1+ .052512 ) ( )

(vi) If you start paying $1500 a month after the initial 10 years of payments, then the

number of remaining payments is €

€

Br 102436.08 ×.0525

−log1− −log1−

12C 12 ×1500 −log(1− .2987719)

m= = = = 81.3

log(1+ r /12) log(1+ .0525 /12) log(1.004375)

€

Exercises

1. You are buying a car and you must finance $22,000 at 4.8% over a five-year period.

(b) How much will you pay over the course of 5 years? How much goes to interest?

(c) For the first two payments, show how much of your payment goes to interest, how

much goes to principle, and the balance due.

(i) How much have you paid in? (ii) What is the balance due?

(iii) How much of the loan have you paid off?

(iv) How much of your payments have gone to interest?

(e) If you pay an extra $150 per month from the start, then what is your balance due

after two years of payments?

2. You are buying a house and you must finance $150,000 at 5.4% over a 30-year period.

(b) How much will you pay over the course of 30 years? How much goes to interest?

(c) For the first two payments, show how much of your payment goes to interest, how

much goes to principle, and the balance due.

(i) How much have you paid in? (ii) What is the balance due?

(iii) How much of the loan have you paid off?

(iv) How much of your payments have gone to interest?

(v) You decide to try to pay off the balance 8 more years of payments. Compute the

monthly payment that would be required to pay off the balance B from (d) in 8 years at

5.4% interest.

(vi) On second thought, you decide to start paying $1300 a month after the initial 10

years of payments. How many more payments will be required? Also express the

result as xx years, yy months (e.g. finish in 9 yrs, 3 months of payments).

Solutions

22000 × 0. 048 / 12 88

−60 = −60 = $413.15;

. 048 1 − 1.004

1 − 1 +

12

New Balance after 1st payment = 22,000 – 325.15 = $21,674.85.

$326.45. Balance after 2nd payment = 21,674.85 – 326.45 = $21,348.40.

(ii) The balance due is

.048 24 12 × 413.15

B24 = 22, 000 × 1 + +

× (1 − (1+. 048 / 12)24 )

12 . 048

= 22, 000 × 1.004 24 + 103287.5 × 1 − 1.00424

( )

= $13 ,826. 68 .

(e) If you pay $563.15 per month (an extra $150), then after 24 payments the balance

due is

.048 24 12 × 563.15

B24 = 22, 000 × 1 + +

× (1 − (1+. 048 / 12 )24 )

12 . 048

= 22, 000 × 1.004 24 + 140787.5 × 1 − 1.00424

( )

= $10 ,056.12 .

2. (a) There are 360 monthly payments over 30 years. The payment is

−360 = = $842.30.

. 054 1 − 1. 0045−360

1 − 1 +

12

$167.30. New Balance after 1st payment = 150,000 – 167.30 = $149,832.70.

Payment 2 – To interest: 149, 832. 70 × 0.054 / 12 = $674.25; To principle: 842.30 – 674.25

= $168.05. Balance after 2nd payment = 149,832.70 – 168.05 = $149,664.65.

(d) (i) You have paid in 120 × 842.30 = $101,076 after 10 years.

B120 = 150,000 × 1 +

+ × (1 − (1+ .054 / 12 )120 )

12 .054

= 150,000 × 1. 0045120 + 187177.78 × 1 − 1.0045120

( )

= $123 , 457. 69 .

(iv) So 101,076 – 26,542.31 = $74,533.69 has gone to interest after 10 years of payments.

(v) For 8 years, there are 96 payments. The monthly payment for a balance of

$123,457.69 is now

(

123457.69 × .054 12 )

555.559605

M = −96 = −96 = $1586.58.

1− (1.0045)

(

1− 1+ .054 12 )

(vi) If you start paying $1300 a month after the initial 10 years of payments, then the

number of remaining payments is €

€

Br 123457.69 ×.054

−log1− −log1−

12C 12 ×1300 −log(1− .4273535423)

m= = = = 124.16448

log(1+ r /12) log(1+ .054 /12) log(1.0045)

€

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