This issue has three parts.
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.com 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?