ACST202/ACST851 : Mathematics of Finance

Tutorial Solutions 6 : Loans

Question 1
(a) The instalment is $x where:
x a240 = 100, 000 at 1%
x = 1,101.0861
≈ 1,101.09
(b) The loan outstanding at the end of the 43rd month, immediately after the instalment, with 197
instalments still to come, is
1%
$1,101.09a197 = $94,602.56

(c) The interest due in the 44th month is

1% × $94,602.56 = $946.03
The principal repaid is:
$1,101.09 − $946.03 = $155.06
Loan outstanding at the end of the 44th month is
$94, 602.56 − $155.06 = $94, 447.50
Hence the relevant section of the repayment schedule is:
Month Loan O/S at Interest Principal Loan O/S at
beginning Repaid end
44 94,602.56 946.03 155.06 94,447.50

Check: Loan outstanding at end of 44th month, with 196 repayments to go, is
1%
$1,101.09a196 = $94, 447.49

Copyright  2016 Macquarie University.

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Question 2
(a) The initial instalment is $x where:
250, 000 = x {v + 1.005v 2 + 1.0052 v 3 + ... ( 360 terms )} at 0.75%

x 1 − ( 1.0075 )
1.005 360

=
1.0075 1 − 1.0075
1.005

1 − ( 1.0075 )
1.005 360

=x
0.0025
x = 1,057.258 741
which we would normally round to get an initial instalment of $1,057.26, but we’ll use the
unrounded values in (c).
(b) Interest for 1st month = 0.75% × $250, 000 = $1875 > $1,057.26
The loan was used to buy a house, which can be expected to increase in value over time. If the
increase in the house value over the month exceeds the increase in the loan outstanding, the
borrower is getting ahead.
(c) 1/4/2027 is 201 months into the loan, with 159 months remaining.
Retrospective loan outstanding at 1/4/2027

= $250,000 × (1 + i )
201
{
− $ x (1 + i )
200
+ 1.005 (1 + i )
199
}
+ ... + 1.005200 at 0.75%

1 − ( 1.0075 )
1.005 201

= $250,000 × (1.0075) − $ x (1.0075)

201 200

1 − 1.0075
1.005

(1.0075) − (1.005)
201 201

= $250,000 × (1.0075) − $x
201

0.0025
= $376,089.63
Prospective loan outstanding at 1/4/2027
1.005201 1.005202 1.005359 
= $x  + 2
+ ... + 
 1.0075 1.0075 1.0075159 
1.005201 1 − ( 1.0075 )
1.005 159

= $x ×
1.0075 1 − 1.0075 1.005

1 − ( 1.0075 )
1.005 159

= $ x ×1.005 201
×
0.0025
= $376, 089.63
That is, if we eliminate the rounding errors, the two loans outstanding match to the cent.
In reality, the actual loan outstanding might still be a few cents different from this number,
since in practice every instalment and every amount of interest would be rounded to a whole
number of cents.

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(d) The one-off extra payment reduces the outstanding loan to $356,089.63. If the loan is exactly
repaid by n further instalments increasing in G.P, then

$356, 089.63 = $ x × (1.005 )

200
{1.015v + (1.015v ) 2
+ ... + (1.015v )
n
} at 1%
1.015 1 − ( 1.015
1.01 )
n

= $ x × (1.005 )
200

1.01 1 − 1.015
1.01

1 − ( 1.015
1.01 )
n

= $ x × (1.005 ) × 1.015 ×
200

−0.005
( )
1.015 n
1.01
= 1.611 885
n ln ( 1.015
1.01 )
= ln1.611 885
n ≈ 96.67
That is there will be 96 instalments following the GP, and a final smaller instalment of $y
where
1 − ( 1.015
1.01 )
96

$356,089.63 = $ x × (1.005) + $ y × (1.01)

−97
× 1.015 ×
200

−0.005
y = 8,184.73

Check 0 < y < x × (1.005) × 1.01597 = 12,150.66

200

So the loan is finally extinguished by a final smaller instalment of $8,184.73 occurring 97

months after 1/4/2027, which is on 1/5/2035.

Copyright  2016 Macquarie University.

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Question 3
Let the monthly instalment in the first year be $x.
Method 1
Adopt a time period of years.
1% per month effective = 12.6825% p.a. effective.
If the first year’s 12 instalments of x were replaced by an instalment of 12x at the end of the year,
with the similar replacement being done in each subsequent year, the present value of the
repayments would be
12 xv + 12 ×1.03 xv 2 + 12 × 1.032 xv3 + ... + 12 × 1.039 xv10 at 12.6825%
We can then adjust the payments from annually in arrears to monthly in arrears by applying a factor
i
of (12) . Hence
i

100, 000 = 12 x {v + 1.03v 2 + 1.032 v3 + ... + 1.039 v10 }

i
(12)
at 12.6825%
i
1 − (1.03v ) 0.12685
10

= 12 xv at 12.6825%
1 − 1.03v 0.12
1 − (1.03v ) 0.12685
10

= 12 x at 12.6825%
1 + i − 1.03 0.12
x = 1, 287.88
Each monthly instalment in the first year is $1287.88.
Method 2
(This is less efficient, but we’ve included this solution since some students try this approach.)
Adopt a time unit of months. All compound interest symbols in this solution are at 1%, the effective
monthly interest rate.
100, 000 = x {v + v 2 + v3 + ... + v12 }
+1.03 x {v13 + v14 + v15 + ... + v 24 }
+1.032 x {v 25 + v 26 + v 27 + ... + v36 }
+...
+1.039 x {v109 + v110 + v111 + ... + v120 }
= x {v + v 2 + v3 + ... + v12 }{1 + 1.03v12 + 1.032 v 24 + ... + 1.039 v108 }

1 − (1.03v12 )
10

= xa12
1 − 1.03v12
x = 1287.88

Copyright  2016 Macquarie University.

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Question 4
0.07
(a) Monthly interest = $250, 000 × = $1, 458.33
12
Ferret will make 96 payments of $1,458.33 monthly in arrears, and repay the $250,000 at the
end of the 8 years.
(b) The sinking fund instalment is $x where
250, 000 = xs96 at 0.5%
x = 2, 035.36

Copyright  2016 Macquarie University.

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Question 5
Assume the loan is exactly repaid by n instalments of $3,000.
The interest rate is 1.14% per month effective.
$265, 476 = $3, 000 an at 1.14%
1 − 1.0114− n $265, 476
=
0.0114 $3, 000
1.0114 n = −113.52284
Then, when we try to take the log of both sides of the equation, we can’t evaluate the log of the right
hand side since it is negative. (More accurately, we can take the log of a negative real, but the
answer isn’t real, so the resulting value for n is also not real.)
In the first line, we have also assumed implicitly that there is a positive real value of n which allows
the loan to be repaid. Since we failed to find a valid answer, this assumption is false.
If Ann pays $3,000 per month in perpetuity, the present value of her repayments is
= $3, 000 a∞ at 1.14%
$3, 000
= = $263,157.89 < $265, 476
0.0114
That is, even if she pays this instalment in perpetuity, it won’t be enough to repay the loan.
The other way to explain this is to consider the next month of the loan. The interest charged will be
1.14% × $265, 476 = $3, 026.43
That is, her repayment of $3,000 doesn’t cover the interest of $3,026.43, so the loan outstanding at
the end of the next month increases by $26.43. This means the interest charged in the following
month is larger than $3,026.43, leaving an even greater shortfall, and so the loan outstanding will
increase each month thereafter.
While this situation sounds bad, the repayment very nearly covers the interest, so for the next few
months the loan outstanding will be increasing very slowly. Hence the lender (the bank) may agree
to the proposal for 2 reasons.
1. They may expect Ann’s future salary to grow with inflation, and in the short term it may grow
faster than inflation as she acquires new skills making her more valuable to her new employer.
Hence it’s likely that in a year or two she will be able to increase the instalment to a level that
covers the interest, and the loan outstanding will start reducing.
2. Since the initial loan amount was about 90% of the value of the house, the value of the house
will probably be increasing in value faster than the loan outstanding. In the worst case
scenario where Ann defaults on the loan, the bank can sell the house to reclaim the
outstanding loan.
Question 6
Check against the lecture notes.

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 Solutions to Additional Exercises 6 : Loans
Question 1
The instalment is $R where
Ra360 = 120,000 at 1%
R = 1, 234.34
Loan outstanding at 30/6/02 immediately after payment then due
= $ Ra357 at 1%
= $119,896.43
Loan outstanding at 30/6/03 immediately after payment then due
= $ Ra345 at 1%
= $119, 447.78
Principal Repaid in 2002/2003 tax year
= $119,896.43 − $119,447.78
= $448.65
Interest Paid in that tax year
= 12 × $1,234.34 − $448.65
= $14,363.43
Question 2
At the end of each year we pay the interest of i that has accumulated over the year, and at the end of
n years we also repay the loan amount of 1.
1

i i i i

0 1 2 n-1 n

Equating the initial loan to the present value of the repayments gives:
1 = i an + v n
1 − v n = i an
1 − vn
an =
i
We have achieved a cute method for deriving the standard formula for an .

Copyright  2016 Macquarie University.

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Question 3
(a) At the start of month t, the number of instalments remaining is n − ( t − 1) . Hence, using the
prospective loan outstanding:
Loan O/S at start of month t = X an −t +1

(b) Interest for month t

= i × X an −t +1
1 − v n −t +1
=i×X
i
= X (1 − v n −t +1 )

Principal repaid for month t

= X − X (1 − v n −t +1 )
= X v n −t +1
Loan outstanding at end of month t
= X an −t +1 − X v n −t +1
= X ( v + v 2 + v 3 + ... + v n −t +1 ) − X v n −t +1
= X ( v + v 2 + v 3 + ... + v n −t )
= X an − t

(c) If we don’t want to assume knowledge of the prospective loan outstanding formula used in
(a), we can use mathematical induction instead. Part (b) contains all the algebra we need for
the induction step. The equation L = X an gives the loan outstanding at the start of the first
month, and so provides the starting point for the induction process. Alternatively, if you want
to prove the result at an even lower level and assume we don’t even know the equation
L = X an , then use the fact that the loan outstanding at the end of line n of the schedule must
be 0, and run the induction step in reverse to work backwards through the schedule.
(d) We do the principal repaid column first, working from the bottom up, which involves
successively multiplying by v. All other columns could then be found by simple additions and
subtractions.
Or to take it a step further, we could develop tables of log10 v n = n log10 v , for every interest
rate we require and use that to develop the Principal Repaid column for any required loan.
Given the availability of computers, we now calculate schedules, working left to right
successively along each row from top to bottom, since this is the most logical sequence and
hence it is the sequence least prone to error.
It’s interesting to reflect on how tedious mathematical work was before calculating machines
were invented. Various professions would develop their own tables to try to make the
calculations more efficient. Actuaries had tables of all the standard compound interest
functions like annuities, and their logs, for all the useful interest rates. A former staff member
of the Department of Actuarial Studies reckoned that in the early days of Macquarie
University, a 3 hour exam in ACST229 (a former version of ACST202) contained about 1
hour of real maths of finance and 2 hours of arithmetic.

Copyright  2016 Macquarie University.

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(e) Total principal repaid
= Xv n + Xv n −1 + Xv n −2 + ... + Xv
= X an

either by summing the GP or more simply by recognising the summation for an . But we also
know that X an = L . That is, the total principal repaid must equal the initial principal, a
statement which should be self-evident.
(f) Required interest
= X (1 − v n − a ) + X (1 − v n − a −1 ) + X (1 − v n − a − 2 ) + ... X (1 − v n −b +1 )
= ( b − a ) X − X ( v n − a + v n − a −1 + v n − a − 2 + ... + v n −b +1 )
= ( b − a ) X − X ( v n − a + v n − a −1 + v n − a − 2 + ... + v )
+ X ( v n −b + v n −b −1 + v n −b − 2 + ... + v )
= ( b − a ) X − ( Xan − a − Xan −b )
This is equal to the instalments paid less the change in the loan outstanding, the latter being
equal to the principal repaid.

Question 4
(a) Lt +1 = Lt (1 + i ) − Rt +1 t = 0,1, 2,..., n − 1. (1)

(b) Define the statement

t
{
St : Lt = L0 (1 + i ) − R1 (1 + i )
t −1
+ R2 (1 + i )
t −2
+ ... + Rt } t = 1, 2,3,..., n

Hence S1 alleges:

S1 : L1 = L0 (1 + i ) − R1

Since this arises from equation (1) with t = 0 , it is true. (That is, it simply states what happens
in the first line of the loan repayment schedule.)
Assume S j is true for some j ∈ {1, 2,3,..., n − 1} . (Make sure you understand why the upper
limit is n − 1 , not n.) We will attempt to prove that S j +1 is true.

L j +1
= L j (1 + i ) − R j +1 from (1)


j
{
=  L0 (1 + i ) − R1 (1 + i )
j −1
+ R2 (1 + i )
j −2

}
+ ... + R j  (1 + i ) − R j +1

using the assumption that S j is true

= L0 (1 + i )
j +1
{
− R1 (1 + i )
j +1−1
+ R2 (1 + i )
j +1− 2
+ ... + R j (1 + i ) + R j +1 }
That is, if S j is true for some j ∈ {1, 2,3,..., n − 1} , then S j +1 is true.

Hence, by mathematical induction, St is true for t = 1, 2,3,..., n .

Copyright  2016 Macquarie University.
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 That is, property 2 is true.
(c) Property 2 with t = n gives:
n
{
Ln = L0 (1 + i ) − R1 (1 + i )
n −1
+ R2 (1 + i )
n −2
}
+ ... + Rn = 0 since the loan is repaid at time n.

L0 (1 + i ) = R1 (1 + i ) + R2 (1 + i )
n −1 n −2
+ ... + Rn
n

L0 = vR1 + v R2 + ... + v Rn
2 n

This proves property 1.

(d) Substitute the expression for L0 from Property 1 into the expression for Lt from property 2.
t
{
Lt = L0 (1 + i ) − R1 (1 + i )
t −1
+ R2 (1 + i )
t −2
+ ... + Rt }
= {vR1 + v 2 R2 + ... + v n Rn }(1 + i ) − R1 (1 + i )
t
{ t −1
+ R2 (1 + i )
t −2
+ ... + Rt }
{
= R1 (1 + i )
t −1
+ R2 (1 + i )
t −2
+ ... + Rt + vRt +1 + v 2 Rt + 2 + ... + v n −t Rn }
− {R (1 + i ) + R2 (1 + i ) }
t −1 t −2
1 + ... + Rt
= vRt +1 + v 2 Rt + 2 + ... + v n −t Rn
This proves property 3.
As noted in the question, the above proofs can be written more elegantly using summation notation
if you wish.

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Question 5
(a) Assume at first that the loan is repaid by exactly n instalments following the prescribed
pattern. Then at 10%
$100, 000 = $1, 000 ( Ia )n
( Ia )n = 100

We’ve got no easy way to solve this by calculator. You could open the spreadsheet you built
to calculate annuity values in an earlier topic and use trial and error with that, but it will be
easier to just construct the loan repayment schedule in (b).
(b) The loan outstanding becomes negative at year 42. This implies there are 42 instalments, the
final instalment being smaller than normal.
Checking using the equation in (a), we find at 10%
( Ia )41 = 99.555 125 < 100
( Ia )42 = 100.322 056 > 100

This confirms the answer.

(c) Let the final smaller instalment be $x.
100, 000 = 1, 000 ( Ia ) 41 + xv 42 at 10%
x = 24,363.01
That is, the 42nd instalment is $24,363.01.
Check: It’s less than the $42,000 that would have occurred on the prescribed pattern.
(d) The spreadsheet output is shown on the next page. The simple method of finding the final
instalment is to set it to the sum of the loan outstanding at the start of the period and the
interest for the period.
(e) Retrospective loan outstanding at the end of the 5th year

= 100, 000 (1 + i ) − 1, 000 ( Is )5 at 10%

5

= 161, 051 − 1000 × 17.156 100

= 143,894.90
This exceeds the initial loan outstanding, but this is reasonable since the first 5 repayments are
all less than the 10% interest on the initial loan. The 10th instalment is the first to reach the
first year’s interest, (by which time the annual interest has increased further) so the loan
outstanding will be increasing for at least the first 10 years of the loan. (The spreadsheet
shows it peaks at the end of the 25th year.)
(f) Prospective loan outstanding at the end of the 5th year
= 5, 000a36 + 1, 000 ( Ia )36 + 24,363.01v 37 at 10%
= 5000 × 9.676 508 + 1000 × 94.795 883 + 24, 363.01v37 at 10%
= 143,894.90
Parts (e) and (f) demonstrate that it is possible to determine loans outstanding by calculator when
the instalments vary in arithmetic progression. However, since the evaluation of the increasing
annuities is time consuming, it’s preferable to use a spreadsheet.

Copyright  2016 Macquarie University.

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Year Loan O/S Interest Instalment Principal Loan O/S
at beginning Repaid at end

1 100000.00 10000.00 1000.00 -9000.00 109000.00

2 109000.00 10900.00 2000.00 -8900.00 117900.00
3 117900.00 11790.00 3000.00 -8790.00 126690.00
4 126690.00 12669.00 4000.00 -8669.00 135359.00
5 135359.00 13535.90 5000.00 -8535.90 143894.90
6 143894.90 14389.49 6000.00 -8389.49 152284.39
7 152284.39 15228.44 7000.00 -8228.44 160512.83
8 160512.83 16051.28 8000.00 -8051.28 168564.11
9 168564.11 16856.41 9000.00 -7856.41 176420.52
10 176420.52 17642.05 10000.00 -7642.05 184062.58
11 184062.58 18406.26 11000.00 -7406.26 191468.83
12 191468.83 19146.88 12000.00 -7146.88 198615.72
13 198615.72 19861.57 13000.00 -6861.57 205477.29
14 205477.29 20547.73 14000.00 -6547.73 212025.02
15 212025.02 21202.50 15000.00 -6202.50 218227.52
16 218227.52 21822.75 16000.00 -5822.75 224050.27
17 224050.27 22405.03 17000.00 -5405.03 229455.30
18 229455.30 22945.53 18000.00 -4945.53 234400.83
19 234400.83 23440.08 19000.00 -4440.08 238840.91
20 238840.91 23884.09 20000.00 -3884.09 242725.00
21 242725.00 24272.50 21000.00 -3272.50 245997.50
22 245997.50 24599.75 22000.00 -2599.75 248597.25
23 248597.25 24859.73 23000.00 -1859.73 250456.98
24 250456.98 25045.70 24000.00 -1045.70 251502.67
25 251502.67 25150.27 25000.00 -150.27 251652.94
26 251652.94 25165.29 26000.00 834.71 250818.23
27 250818.23 25081.82 27000.00 1918.18 248900.06
28 248900.06 24890.01 28000.00 3109.99 245790.06
29 245790.06 24579.01 29000.00 4420.99 241369.07
30 241369.07 24136.91 30000.00 5863.09 235505.98
31 235505.98 23550.60 31000.00 7449.40 228056.58
32 228056.58 22805.66 32000.00 9194.34 218862.23
33 218862.23 21886.22 33000.00 11113.78 207748.46
34 207748.46 20774.85 34000.00 13225.15 194523.30
35 194523.30 19452.33 35000.00 15547.67 178975.63
36 178975.63 17897.56 36000.00 18102.44 160873.19
37 160873.19 16087.32 37000.00 20912.68 139960.51
38 139960.51 13996.05 38000.00 24003.95 115956.57
39 115956.57 11595.66 39000.00 27404.34 88552.22
40 88552.22 8855.22 40000.00 31144.78 57407.44
41 57407.44 5740.74 41000.00 35259.26 22148.19
42 22148.19 2214.82 24363.01 22148.19 0.00

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Question 6
(a) Let the increase be $x, so the repayments are:
$10, 000, $10, 000 + x, $10, 000 + 2 x,...,$10, 000 + 19 x
Then
100, 000 = (10, 000 − x ) a20 + x ( Ia ) 20 at 8%
= (10, 000 − x ) × 9.818 147 + x × 78.907 938
x = 26.321
To the nearest cent, the increase is $26.32
(b) Prospective loan outstanding after 5 years, in dollars
= (10, 000 + 4 x ) a15 + x ( Ia )15 at 8%
= 10,105.28 × 8.559 479 + 26.32 × 56.445143
= 87,981.57
(c) Retrospective loan outstanding after 5 years, in dollars

= 100, 000 × (1 + i ) − {(10000 − x ) s5 + x ( Is )5 } at 8%

5

= 100, 000 × 1.085 − {( 9973.68 ) × 5.866 601 + 26.32 × 16.699 113}

= 87,981.69

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