Fundamentals of Financial Instruments. Sunil K. Parameswaran
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Thus, in the case of such loans, the initial installments will consist largely of interest payments. As we approach the maturity of the loan, however, the corresponding installments will consist largely of principal repayments.
AMORTIZATION WITH A BALLOON PAYMENT
Julie Tate has taken a loan of $25,000 from First National Bank. The loan requires her to pay in eight equal annual installments along with a terminal payment of $5,000. This terminal payment that has to be made over and above the scheduled installment in year eight is termed as a balloon payment. The interest rate is 8% per annum on the outstanding principal. The annual installment may be calculated as follows.
Obviously the larger the balloon, the smaller will be the periodic installment payment for a given loan amount. The amortization schedule may be depicted as shown in Table 2.7.
TABLE 2.7 Amortization with a Balloon Payment
| Year | Payment | Interest | Principal Repayment | Outstanding Principal |
|---|---|---|---|---|
| 0 | 25,000 | |||
| 1 | 3,880.2950 | 2,000.00 | 1,880.30 | 23,119.70 |
| 2 | 3,880.2950 | 1,849.58 | 2,030.72 | 21,088.99 |
| 3 | 3,880.2950 | 1,687.12 | 2,193.18 | 18,895.81 |
| 4 | 3,880.2950 | 1,511.66 | 2,368.63 | 16,527.18 |
| 5 | 3,880.2950 | 1,322.17 | 2,558.12 | 13,969.06 |
| 6 | 3,880.2950 | 1,117.52 | 2,762.77 | 11,206.29 |
| 7 | 3,880.2950 | 896.50 | 2,983.79 | 8,222.50 |
| 8 | 8,880.2950 | 657.80 | 8,222.50 | 0.00 |
THE EQUAL PRINCIPAL REPAYMENT APPROACH
Sometimes a loan may be structured in such a way that the principal is repaid in equal installments. Thus, the principal component of each installment will remain constant; however, as in the case of the amortized loan, the interest component of each payment will steadily decline, on account of the diminishing loan balance. Therefore, the total magnitude of each payment will also decline.
We will illustrate the payment stream for an eight-year loan of $25,000, assuming that the interest rate is 8% per annum (Table 2.8).
TABLE 2.8 Equal Principal Repayment Schedule
| Year | Payment | Interest | Principal Repayment | Outstanding Principal |
|---|---|---|---|---|
| 0 | 25,000 | |||
| 1 | 5,125 | 2,000 | 3,125 | 21,875 |
| 2 | 4,875 | 1,750 | 3.125 | 18,750 |
| 3 | 4,625 |
|