Overview
This lecture explains two ways to create amortization schedules for a loan, focusing on calculating and tracking principal and interest components over time.
Loan Parameters
- Loan has four equal payments, received at the end of each year for four years.
- Total payments over four years equal $4,000.
- Payments are discounted to present value using a 10% interest rate.
- Present value of the payments (principal) is $3,170.
- The difference between total payments and present value ($830) is total interest over the loan.
Amortization Schedule Method 1
- Start with a beginning balance equal to loan principal ($3,170).
- Calculate annual interest as 10% of the beginning balance.
- Add interest to the beginning balance before subtracting the payment.
- Subtract the fixed payment amount ($1,000) to get the ending balance.
- The ending balance becomes next year’s beginning balance.
- This method does not show principal reduction directly; principal reduction = payment minus interest.
Amortization Schedule Method 2
- Begin with the same starting balance ($3,170).
- Payment amount includes both principal and interest.
- Calculate the interest as 10% of beginning balance.
- Subtract interest from the payment to find principal reduction each year.
- This method explicitly shows the principal reduction and is more intuitive.
Tips and Key Points
- Always distinguish between principal and interest in each payment.
- Carefully read problem setups to identify if you need to calculate principal or interest.
- Understand both methods, as questions can use either schedule format.
Key Terms & Definitions
- Amortization Schedule — A table showing payments, interest, principal reduction, and remaining balance for a loan over time.
- Principal — The original amount of the loan, or the present value of payments.
- Interest — The cost of borrowing, calculated as a percentage (rate) of the outstanding principal.
- Principal Reduction — The part of each payment that reduces the outstanding loan balance.
Action Items / Next Steps
- Practice creating both types of amortization schedules for sample loans.
- Review how to calculate principal and interest portions of each payment.
- Be prepared to identify principal and interest in varying amortization schedule formats.