Loans and amortization schedules
The single-lender loan: interest computed on the outstanding balance, three repayment modes (bullet, constant principal, constant payments), the constant payment, the amortization schedule and the cost of credit.
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Outstanding balance: what is it?
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The part of the borrowed sum not yet repaid at a given date; it is what the next period's interest is computed on.
It falls at each payment by the amount repaid. That is why a loan's interest falls over time, even when the payment stays constant.
A €10,000 loan at 5% a year is repaid in constant payments of €2,820.12. How is the first payment split?
- €500 of interest and €2,320.12 of principal
- €705.03 of interest and €2,115.09 of principal
- €2,500 of principal and €320.12 of interest
- €500 of principal and €2,320.12 of interest
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€500 of interest and €2,320.12 of principal
Interest = 10,000 × 5% = €500, principal = 2,820.12 − 500 = €2,320.12, remaining balance €7,679.88. Swapping interest and principal is a misreading of the schedule.
The interest on a payment is computed on the … balance at the start of the period, never on the amount originally ….
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The interest on a payment is computed on the outstanding balance at the start of the period, never on the amount originally borrowed.
Computing on the starting principal would overstate the cost: after several payments, part of the sum has been returned and no longer earns the lender anything.