In this section, we will understand how loan payments work and what can you calculate if you know certain
parameters of a loan.
So let us first understand how a loan works.
Suppose you take a loan from a bank or any financial institute.
When a loan is sanctioned, you get a sum of money, which is known as the principal amount.
This money, you have to return to the bank by doing certain payments over time.
And apart from the principal amount, you will be paying some interest to the bank.
So before taking the loan, you will also see that there is some interest rate given by the bank.
The payments are usually of equal value and these payments are made over a period of time, for example,
10 years, 20 years or even 30 years.
And whenever you make a payment, there are two parts to that payment.
The first part is the payment of interest that you have accrued in the last period of time.
So, for example, in the first year, with the interest rate of 10 percent, there be some interest
amount also accrued.
So that interest will be paid at the end of the first year.
So that will be first part.
The second part will be the payment of some part of the principal amount.
So suppose the period of time for which you have to make payments is 10 years and you are making a payment
at the end of each year.
So at the end of the year, your principal amount should be zero.
Over the period of 10 years, you'll be paying some amount which will be reducing the principal amount.
So each payment that you make.
Will have to part one is the payment of the interest and second is repayment of some part of the principal
amount.
Let us look at an example to understand this further.
So suppose you have taken a loan of one hundred thousand dollars from a bank which is offering this
amount at an interest rate of 10 percent.
The tone here means that this loan is to be paid within three years.
You'll be making a payment at the end of each year, so the total number of payments you will be making
is three.
The payment that you make each year is of equal value.
So when you calculate this value and we will see how to calculate it in Excel, when we calculate this
value, you will find that the payment value comes out to be forty thousand two hundred eleven.
So this is the payment that you have to make it to the bank.
Out of this, 40 thousand two hundred eleven.
And is the interest for the first year?
You can calculate this also.
The interest rate is 10 percent.
The principal amount is one hundred thousand.
So 10 percent of hundred thousand is 10000.
Sort of forty thousand two hundred eleven thousand is interest and the rest?
Thirty thousand two hundred eleven will reduce the principal amount.
That is the one hundred thousand loan that you have taken out of that thirty thousand two hundred eleven
will be deducted.
So the net balance of the loan would be sixty nine thousand seven hundred eighty nine.
Similarly, in the next year, you'll make another payment of forty thousand two hundred eleven.
This time, the interest is on the balance of last year, which was sixty nine thousand two hundred
eighty nine, 10 percent of this comes out to be six thousand nine hundred seventy nine.
So this part is the interest the rest of the thirty three thousand two hundred thirty three is the payment
towards the principal.
You subtract this payment from the balance of the year and you get thirty six thousand five hundred
fifty six as the remaining principal balance.
And the last payment that you make of fourteen thousand two hundred eleven will have to part interest
will be only three thousand six hundred fifty six, which is 10 percent of the balance.
And the remaining is the principal balance from last year.
So at the end of the third year, the principal will be completely paid along with the interest, what,
three years?
So this is the concept of loan repayment.
You have four main values here.
The first is principal amount that you have taken.
Second is the rate of interest that is being charged on that loan to reduce the number of payments you
will be making.
And the is the amount of payment that you will be making in each item.
Now, let us go to our software tool and see how this is implemented.