Loans
Learning Outcomes
- Calculate the balance on an annuity after a specific amount of time
- Discern between compound interest, annuity, and payout annuity given a finance scenario
- Use the loan formula to calculate loan payments, loan balance, or interest accrued on a loan
- Determine which equation to use for a given scenario
- Solve a financial application for time
Conventional Loans
In the last section, you learned about payout annuities. In this section, you will learn about conventional loans (also called amortized loans or installment loans). Examples include auto loans and home mortgages. These techniques do not apply to payday loans, add-on loans, or other loan types where the interest is calculated up front.
Loans Formula
- P0 is the balance in the account at the beginning (the principal, or amount of the loan).
- d is your loan payment (your monthly payment, annual payment, etc)
- r is the annual interest rate in decimal form.
- k is the number of compounding periods in one year.
- N is the length of the loan, in years.
When do you use this?
The loan formula assumes that you make loan payments on a regular schedule (every month, year, quarter, etc.) and are paying interest on the loan.- Compound interest: One deposit
- Annuity: Many deposits
- Payout Annuity: Many withdrawals
- Loans: Many payments
Example
You can afford $200 per month as a car payment. If you can get an auto loan at 3% interest for 60 months (5 years), how expensive of a car can you afford? In other words, what amount loan can you pay off with $200 per month?Answer: In this example,
d = $200 | the monthly loan payment |
r = 0.03 | 3% annual rate |
k = 12 | since we’re doing monthly payments, we’ll compound monthly |
N = 5 | since we’re making monthly payments for 5 years |
Example
You want to take out a $140,000 mortgage (home loan). The interest rate on the loan is 6%, and the loan is for 30 years. How much will your monthly payments be?Answer: In this example, we’re looking for d.
r = 0.06 | 6% annual rate |
k = 12 | since we’re paying monthly |
N = 30 | 30 years |
P0 = $140,000 | the starting loan amount |
Try It
Janine bought $3,000 of new furniture on credit. Because her credit score isn’t very good, the store is charging her a fairly high interest rate on the loan: 16%. If she agreed to pay off the furniture over 2 years, how much will she have to pay each month?Answer:
d = unknown
r = 0.16 16% annual rate
k = 12 since we’re making monthly payments
N = 2 2 years to repay
P0 = 3,000 we’re starting with a $3,000 loan
Solve for d to get monthly payments of $146.89
Two years to repay means $146.89(24) = $3525.36 in total payments. This means Janine will pay $3525.36 - $3000 = $525.36 in interest.
Calculating the Balance
With loans, it is often desirable to determine what the remaining loan balance will be after some number of years. For example, if you purchase a home and plan to sell it in five years, you might want to know how much of the loan balance you will have paid off and how much you have to pay from the sale.
Example
If a mortgage at a 6% interest rate has payments of $1,000 a month, how much will the loan balance be 10 years from the end the loan?Answer: To determine this, we are looking for the amount of the loan that can be paid off by $1,000 a month payments in 10 years. In other words, we’re looking for P0 when
d = $1,000 | the monthly loan payment |
r = 0.06 | 6% annual rate |
k = 12 | since we’re doing monthly payments, we’ll compound monthly |
N = 10 | since we’re making monthly payments for 10 more years |
- Calculating the monthly payments on the loan
- Calculating the remaining loan balance based on the remaining time on the loan
Example
A couple purchases a home with a $180,000 mortgage at 4% for 30 years with monthly payments. What will the remaining balance on their mortgage be after 5 years?Answer: First we will calculate their monthly payments. We’re looking for d.
r = 0.04 | 4% annual rate |
k = 12 | since they’re paying monthly |
N = 30 | 30 years |
P0 = $180,000 | the starting loan amount |
d = $858.93 | the monthly loan payment we calculated above |
r = 0.04 | 4% annual rate |
k = 12 | since they’re doing monthly payments |
N = 25 | since they’d be making monthly payments for 25 more years |
Solving for Time
Recall that we have used logarithms to solve for time, since it is an exponent in interest calculations. We can apply the same idea to finding how long it will take to pay off a loan.Try It
Joel is considering putting a $1,000 laptop purchase on his credit card, which has an interest rate of 12% compounded monthly. How long will it take him to pay off the purchase if he makes payments of $30 a month?Answer:
d = $30 The monthly payments
r = 0.12 12% annual rate
k = 12 since we’re making monthly payments
P0 = 1,000 we’re starting with a $1,000 loan
We are solving for N, the time to pay off the loan
Solving for N gives 3.396. It will take about 3.4 years to pay off the purchase.