Business Finance Project - HOME MORTGAGE COMPARISON
Mark and Alicia Story, recently married, have decided that they want to buy a $800,000 house. They are planning to give 20% down payment and finance the rest with a mortgage. Mark and Alicia are now ready to meet with Chris Vaughan, the loan officer for First United National Bank. The meeting is to discuss the mortgage options available to the company to finance the property.
Chris begins the meeting by discussing a 30-year mortgage. The loan would be repaid in equal monthly installments. Because of the previous relationship between Mark and the bank, there would be no closing costs for the loan. Chris states that the APR of this loan would be 4.0 percent. Alicia asks if a shorter mortgage loan is available. Chris says that the bank does have 25-year, 20-year and 15-year mortgages available 3.75, 3.5 and 3.375 percent respectively.
Mark decides to ask Chris about a "smart loan" he heard about from a friend. A smart loan works as follows: Every two weeks a mortgage payment is made that is exactly one-half of the traditional monthly mortgage payment. Chris informs him that the bank does have smart loans. The APR of smart loan would be the same as the APR of the traditional loans. Mark nods his head. He then asks whether this is the best mortgage option available to him in order to save interest payments.
Chris suggests that a bullet loan, or balloon payment, would result in the greatest interest savings. At Alicia's prompting, she goes on to explain a bullet loan. The monthly payments of a bullet loan would be calculated using a 10-year traditional mortgage at a rate of 3.25 percent. In this case, there would be a 5-year bullet. This would mean that the Storys would make the mortgage payments for the traditional mortgage for the first five years, but immediately after they make the 60th payment, the bullet payment would be due. The bullet payment is the remaining principal of the loan. Chris then asks how the bullet payment is calculated. Chris tells him that the remaining principal can be calculated using an amortization table, but it is also the present value of the remaining 5 years of mortgage payments for the 30-year mortgage.
Alicia has also heard of an interest-only loan and asks if this loan is available and what the terms would be. Chris says that the bank offers an interest-only loan with a term of 10 years and an APR of 3.125 percent. She goes on to further explain the terms. Mark would be responsible for making interest payments each month on the amount borrowed. No principal payments are required. At the end of the 10-year term, the Storys would repay the amount they borrowed. However, the Storys can make principal payments at any time. The principal payments would work just like those on a traditional mortgage. Principal payments would reduce the principal of the loan and reduce the interest due on the next payment.
Mark and Alicia are satisfied with Chris's answers, but they are still unsure of which loan they should choose. They have asked Chris to answer the following questions to help them choose the correct mortgage.
QUESTIONS -
1. What are the monthly payments for the 4 traditional mortgages, the bullet and the IO loans? If the Storys want the lowest monthly payment, which alternative is the best?
2. Assuming that they plan to live in the house only for five years and that they are only interested in monthly payments, prepare an amortization table for the first five years for the 6 alternative loans. Calculate the total amount paid, the total interest paid, the total principal paid and the remaining balances after 60 months.
Which alternative has the lowest amount of interest paid in those 5 years? Which alternative has the highest amount of principal paid (the lowest remaining balance)? Which alternative has the lowest total cost to cancel (service & pay off) the loan?
3. Assume the Storys get paid biweekly and are really interested in the smart loans. How long would it take to pay off the 4 traditional mortgages if they choose the smart payments plan? How much money do they save by doing smart loans compared to traditional mortgages?
4. Which of the 10 options (4 traditional, 4 smart, bullet and IO) would be chosen by a house flipper? Which of the 10 options would be best for someone that plans to retire and die in that house?
5. Is there a mortgage option that is best for everyone? Explain advantages and disadvantages (in term of payments and risks) of the "best" alternatives identified in the previous question.
HINTS: Use one Excel sheet for each loan mentioned in the case (10 sheets). Once all numbers are available, create tables to compare all options in order to answer the case questions.