Annuity curves for portfolio management

In my previous article on annuity curves, I used them to set initial loan amounts within the bounds of affordability but they also serve as a good illustration of why top-up campaigns, and to a lesser degree payment holidays, can be a value portfolio management tool.

The annuity curve describes the exponential drop of the principal balance, but it is important to not forget that monthly instalments are stable from day one to the end. This means that the drop in principal balances is also a drop in the ratio of interest generated per euro received over time.

So, let’s revisit the €25 000 loan we used in that previous article, charged with a 10% interest rate. In that article, the loan was paid over one year, but while the relationship is the same in all loans, the impact is easier to see in larger loans, so let’s now assume it will be paid over 36 months.

With these new terms, the monthly repayment would be €807.

In the first month, the repayment will be split with €208 going to interest and €598 going to reduce the balance. Or, in other words, 26% of the money coming in is income. By the last payment, although the same amount is received, only €7 is going to interest, or 1%. In fact, by the midway point of the loan term, nearly three quarters of all the interest the loan will generate has already been earned.

And that’s why loan top-ups can be so effective from a profitability point of view. After 18 months of regular repayments, the outstanding loan balance will be down at €13 434. If the loan is left to paydown as per the original agreement, a further €1 094 in interest will be generated in the next 18 months. However, if the loan is topped-up back to the original €25 000 and the term extended accordingly, those same 18 months will generate nearly three times as much interest. And indeed, you could reasonably expect to top-up the loan to a large amount given the extra data you now have on hand (albeit perhaps at a lower rate).

In the chart above, I’m showing the ratio of interest to payment received as it decreases from 26% to 1% over the original life of the loan, but then also as bounces back when the loan is topped-up midway. Even if that top-up is a once-off, it would be enough to raise the average % of payments going to interest from 14% to 16% over the extended life of the loan.

Finding the perfect time to offer a top-up can be tricky, though, thanks to the exponential nature of that underlying relationship. On the one hand, top-ups offered early in a loan’s life keep the average interest earnings highest, but on the other had loans in the early stages of the life haven’t yet create much headroom, nor indeed much extra payment data.

A similar but lesser impact can be achieved with a payment holiday. Most recently, payment holidays have come to the fore as an accommodation for consumers experiencing through temporary financial difficulty, but in better times they can be used by lenders to give their customers a temporary boost cash flow – say around Christmas when they know spend will be high.

Payment holidays flatten the downward curve rather than raise it, but you can see how the same mechanics are at play.