Skip main navigation

New offer! Get 30% off one whole year of Unlimited learning. Subscribe for just £249.99 £174.99. New subscribers only T&Cs apply

Find out more

Application I: Fundamentals of a Loan (Cont.)

Application I: Fundamentals of a Loan (Cont.)
Welcome back. We are on Application I. I call it mega and particularly useful to understand finance because it has all the components. It has time value of money. It has moving forward, moving backwards, and then you'll see very cool stuff now. So what are the patterns we've observed in what we call the amortization table? Which by the a bank can print it out and should print out for you if you so desire. If not you can ask for it. So it basically shows you how a loan works. So quickly, let's capture the main elements. How many components of a payment? So our payment was about $23,739. And the answer is two. One is what?
Interest, which you pay on the beginning of the period balance, not the end. Pay interest for the usage of time and money. And the second is whatever remains goes and pays off part of the principle. Which component decreases over time? If you're paying off part of the principle, the component that is decreasing, given that your payment is fixed, has to be interest. So interest drops and which one increases? The repayment increases such that the last repayment is exactly equal to the beginning of the period balance. Because if that's not the case, you're still keeping on paying some interest and so on and so forth.
So what I'm going to next is ask you some simple questions to show you the power of finance. So how would you figure out, for example, the outstanding balance after the second payment? So let me just ask the following question. So here's the plan. And I'm asking you this, you have 1, 5, the payment you're making every year is 23,739.64. I'm asking you the following question, at time 2, after you've made the second payment, how much do you still owe?
As I said, these are snippets I'm doing with you and complex problems, and I keep going because you become a genius now in finance. Now, you could do it the long way which we just did. You could start at times 0 and work your way forwards, but this is the awesomeness of finance. Finance, one of the main elements of finance is that it looks forward, it doesn't look back. It makes life very simple by recognizing the value of anything is the present value of the future. Value of anything today is the present value of the future. So watch the Matrix, time travel to time 2. And ask yourself, how much do you owe?
That's the question, given you make two payments. Think for a second the answers pretty straightforward, but very complex if you don't know finance. And it is, it has to be the present value of what you owe the bank. So how do you do PV? You know interest is 0.06.
You know the payment is 23,739.64. But you want to know N now. How many N are left? 3. When you do this you get the answer of 63,456.34. Isn't that cool? So the one thing I've told you now is a very deep lesson of finance or of thinking of value. Value comes from the future. And looking forward and then remember, you've gotta discount, because of time value of money. But where you look forward from is dictated by the problem you're trying to solve. Trick question, if you were standing at time 0 and I asked you, what is the present value?
What would change here? This 3 would become, 5. But what answer should you get and this is one of the most profound realizations of People when they figure it out. You don't need to do this. You should know the answer. It has to be 100,000. So one of the things we realized down the road is that finance itself cannot have value in present value terms because it's just an exchange of money. Value creation where you make more than what you've put in comes from real ideas. It comes from producing something like an iPhone which is very popular and people seem to value a lot, rather than just exchanging money.
So let's do one more question, and then what I'll do is I'll keep taking breaks within this first mega-problem. Because as I said, it's pretty complex. I may do it in other mega-problems, too. But I will do one more question before we take a break. How would you figure out the interest component of the third payment? So now I'm asking a very simple question. You made a third payment, how do you figure out the interest component? Now, if you remember your basics, that the interest you pay in any period is a function of two things. The dollar and amount. The interest rate, and the amount you owe at the beginning of the period.
Do we know the amount we owe at the beginning of the third period? Which is also time period 2 after you made, yes we just calculated it, It was 63, 456.34. So I'm asking you what is the third payment's interest component? We know the third payment was what? Also 23,739.64. I'm asking, what is the interest component of this? Very simple. Multiply it by 0.06, and I think the answer works out to be 3,807.38.
You see how simple this is. So you can basically do anything you want even if there are a zillion periods to pay off the loan. So if you took a 30 year mortgage. Mortgage is a loan against a house and you paid monthly payments. How many periods do you have? 360. You're gonna not figuring out the amortization table. We're going to take a brake and kinda go in that direction to show you the real power of the first mega problem.
This article is from the free online

Finance for Everyone: Smart Tools for Decision-Making

Created by
FutureLearn - Learning For Life

Reach your personal and professional goals

Unlock access to hundreds of expert online courses and degrees from top universities and educators to gain accredited qualifications and professional CV-building certificates.

Join over 18 million learners to launch, switch or build upon your career, all at your own pace, across a wide range of topic areas.

Start Learning now