Application of time value of money principles can help you make decisions on loan alternatives. This exercise requires you to compare three mortgage alternatives using various combinations and points. Points on a mortgage refer to a payment that is made up front to secure the loan. A single point is a payment of one percent of the amount of the total mortgage loan. If you were borrowing $200,000 a single point would require an upfront payment of $2,000.
When you are evaluating alternative mortgages, you may be able to obtain a lower rate by making an upfront payment. This comparison will not include an after-tax comparison. When taxes are considered, the effective costs are affected by interest paid and the amortization of points on the loan. This analysis will require you to compare only before-tax costs.
Bloomberg provides a mortgage calculator that allows you to compare the effective costs on alternative mortgages. You are considering three alternatives for a $250,000 mortgage. Assume that the mortgage will start in December, 2002. The mortgage company is offering you a 6% rate on a 30-year mortgage with no points. If you pay 1.25 points, they are willing to offer you the mortgage at 5.875%. If you pay 2 points, they are willing to offer you the mortgage at 5.75%.
1. What are the mortgage payments under the three alternatives?
2. Which alternative has the lowest effective cost?
3. Can you explain how the effective rate is being calculated?