CH. 18
interest only vs. amortizing loans
Borrowers and lenders both like amortizing loans • Easy to budget for • If it's fixed-rate, you know the payment each month • Greater chance of payment when something is due each month • When combined with insurance, it's a safer bet for the lender
EX) Prepayment
Example: • A 30 year loan • With an original loan amount of $133,000 • At 7.5% annual interest • Requires monthly payments of $929.96 • At the end of the fifth year of this loan (60 months), the amount outstanding of the original principal amount is $125,841.19 n=300 ((30-5) x 12) i=7.5/12 PV=? 125,841 PMT=929.96 FV=0
amortizing loans
The borrower makes periodic payments of both interest and principal so the loan balance gradually declines to zero over the life of the loan
interest only loans
The borrower makes periodic payments of interest, then pays the loan balance in full at the end of the loan in a lump sum payment
alternatives to the fixed-rate mortgage
Two-step mortgages Adjustable Rate Mortgages
adjustable rate mortgages
loans in which the interest rate is adjusted at the end of each year to match current market rates • Usually capped
Two Step Mortgages "reset mortgages"
loans in which the interest rate is adjusted to match current market rates at the end of the fifth or seventh year• Usually capped • Might be attractive if you're not going to own the property to the re-set point • Might be attractive if your earnings are anticipated to increase by the re-set point
fixed-rate mortgage
most common mortgage loan, which interest rate is fixed at the time or origination
effective interest rate
refers to actual cost of borrowing funds form a lender, expressed as an annual rate, after consideration of discount points and origination fees
understanding prepayment
• Most people don't own a property for the full term of the mortgage • Thus, they would 'prepay' the mortgage when they sell the property • To find the amount needed to prepay (repay before the full term of the loan expires) a loan, use the present value of an annuity formula to find the present value of the remaining payments
two-step mortgage example
• A 30-year mortgage for $110,000 • The initial interest rate on this loan is 6% • The loan contract calls for an interest rate adjustment at the end of year seven to 2% above the ten-year U.S. Treasury Bond yield at that time • Assuming that the Treasury yield is 6.9%, the new interest rate for the remaining 23 years of this loan will be 8.9% • What is the monthly payment during the first seven years of this loan? • $659.51 n=30x12 i=6/12 pv=110000 PMT=? Find amount still owed at year 7? n=23x12 i=6/12 PV=? PMT=-659.1 • What is the monthly payment during the last 23 years of this loan? • $840.68 n=23x12 i=8.6/12 PV=-98603 PMT=?
mortgages
• Because most real estate commitments are for long periods of time and lots of money • Most of us don't have enough cash to purchase a property outright • So we look for 3rd party finacing
understanding refinancing
• Borrowers can take advantage of declining mortgage interest rates by refinancing existing loans at the prevailing market rate • You're basically taking out a new loan to pay off the existing loan • Remember though, new loan usually equals fees! • Refinancing the loan at the lower rate reduces borrowing cost by either reducing the payment amount or reducing the number of payments required to amortize the loan.
Discount Points and Effective Interest Rates
• Many lenders charge discount points and/or origination fees to increase their yield on mortgage loans • It makes the APR look better, but they still get money AND they get it up front! • One discount point equals 1% of the loan amount • Discount points do lower your interest rate • 1 point usually lowers the interest rate on the loan by 0.125% for a 30-year mortgage • Points and fees are paid at origination of the loan. • From the borrower's perspective, points and fees increase the effective interest rate on the loan • *****The decision whether to buy a point depends on how long you hold the mortgage******
discount points and effective interest rates
• Repeating this analysis for other loans with different interest rate and discount point combinations allows comparison of the effective interest rates being charged in each loan • Unfortunately, APR alone isn't enough
constructing an amortization schedule
• The following notation will prove useful: • It = interest due in period t • AOt = amount outstanding at the end of period t • PMT = mortgage payment • i = periodic interest rate • Pt = principal paid in period t • Amortization: Period One • It = AOt-1 x i = 10,000 = 100,000 x .10 • Pt = PMT - It= 6,274.54 = 16,274.54 - 10,000 • AOt = AOt-1 - Pt = 93,725.46 = 100,000 - 6,274.54co
understanding the amortization process
• The total amount that you pay stays constant BUT the portions of each payment going to interest and principal vary greatly over time. • The interest portion of each payment decreases over time • The bank gets its money up front • The principal portion of each payment increases over time • The longer you pay, the greater percentage gets paid off each month • The amount outstanding declines to zero at the end of the loan term.
effective interest rates w/ discount points and prepayment
• When a borrower expects to prepay a loan before it is due (as most borrowers do), discount points paid at origination may have a dramatic impact on the effective interest rate of the loan ******• The earlier a loan with discount points is prepaid, the greater the effective interest rate for the loan!*****
