CHAPTER 5 S&S AIR’S MORTGAGE

1. The payment for a loan repaid with equal payments is the annuity payment with the
loan value as the PV of the annuity. So, the 30-year loan payment will be:

PVA = C({1 – [1/(1 + r)] t } / r)

$35,000,000 = C{[1 – 1 / (1 + .061/12) 360] / (.061/12)}
C = $212,098.17

And the monthly payments for the 20-year loan will be:

PVA = C({1 – [1/(1 + r)] t } / r)

$35,000,000 = C{[1 – 1 / (1 + .061/12) 240] / (.061/12)}
C = $252,774.22

2. The interest payment is the beginning balance times the interest rate for the period,
and the principal payment is the total payment minus the interest payment. The ending
balance is the beginning balance minus the principal payment. The ending balance for a
period is the beginning balance for the next period. The amortization table for an equal
payment is:

Year Beginning Total Interest Principal Ending

Balance Payment Payment Payment Balance
1 $35,000,000.00 $212,098.17 $177,916.67 $34,181.51 $34,965,818.49
2 34,965,818.49 212,098.17 177,742.91 34,355.26 34,931,463.23
3 34,931,463.23 212,098.17 177,568.27 34,529.90 34,896,933.32
4 34,896,933.32 212,098.17 177,392.74 34,705.43 34,862,227.89
5 34,862,227.89 212,098.17 177,216.33 34,881.85 34,827,346.04
6 34,827,346.04 212,098.17 177,039.01 35,059.17 34,792,286.88
3. The bi-weekly payment is one-half of the 30-year traditional mortgage payment, or:

Bi-weekly payment = $212,098.17 / 2

Bi-weekly payment = $106,049.09

Now we have the present value of an annuity, the interest rate, and the number of
payments. We
need to find the number of periods of the annuity payments. Note that if you make a
payment every
two weeks, you will make 52/2 = 26 payments per year. So, we can solve the present
value of an
annuity equation for the number of periods as follows:
PVA = C({1 – [1/(1 + r)]t} / r)
$35,000,000 = $106,049.09{[1 – 1 / (1 + .061/26)t] / (.061/26)}

Now we solve for t:

1/1.00235t= 1 – [($35,000,000)(.00235) / ($106,049.09)]
1.00235t= 1/.2384 = 4.1950
t = ln 4.1950 / ln 1.00235
t = 635.24 periods

Since they are 26 bi-weekly periods in a year, the time necessary to pay of the bi-
weekly mortgage will be:

Bi-weekly payoff = 635.24 / 26

Bi-weekly payoff = 24.43 years

The bi-weekly payments pay off the loan quicker for two reasons. First, one-half of the
payment gets
to the bank quicker each month, which reduces the interest that accrues each month.
Second, the
company is actually making 13 full payments each year (26 bi-weekly periods amounts
to 13
monthly payments).

The traditional answer on how much the company saves is as follows: The total
payments under the
30-year traditional mortgage will be:
30-year total payments = 360 × $212,098.17
30-year total payments = $76,355,342.98

And the total payments on the bi-weekly mortgage will be:

Bi-weekly total payments = 635.24 × ($106,049.09/2)
Bi-weekly total payments = $67,366,136.74

So, the traditional answer for how much the bi-weekly mortgage saves is the difference
between
these two answers. Unfortunately, this calculation is very misleading. This is actually a
“pseudo
interest” savings, which is caused by the different maturities of the loans. If the actual
interest rate is
6.1 percent, the present value of the two cash flows is still $35 million. More interest
accrues in the
30-year traditional mortgage because of the longer length, but the present value is still
the same as
the present value of the bi-weekly mortgage, so the two mortgage cash flow streams
are equivalent.
In actual fact, the bi-weekly mortgage is more expensive. We can see this by examining
the EAR for
the two loans. The EAR of the monthly mortgage is:
EAR = [1 + (APR / m)]m– 1
EAR = [1 + (.061/12)]12– 1
EAR = .0627 or 6.27%

And the EAR of the bi-weekly mortgage is:

EAR = [1 + (APR / m)]m– 1

EAR = [1 + (.061/26)]26– 1
EAR = .0628 or 6.28%

The bi-weekly mortgage is actually more expensive with the same APR because there
are more N N compounding periods in a year under this option.

4. The loan payments for the first 59 months are the same as the traditional 30-year
mortgage, which is
$212,098.17. This mortgage payment will be made in the 60th month as well, but the
company will
also make the bullet payment. The bullet payment can be found by using an
amortization table, but
the easier method is to find the present value of the remaining loan payments. The
present value of
the remaining loan payments in month 60 will be:
PVA = C({1 – [1/(1 + r)]t} / r)
PVA = $212,098.17{[1 – 1 / (1 + .061/12)300] / (.061/12)}
PVA = $32,609,016.11
So, the total payment in month 60 will be:
Month 60 payment = $212,098.17 + 32,609,016.11
Month 60 payment = $32,821,114.28

5. The interest-only loan requires only interest payments each month, which will be:
Monthly interest payments = $35,000,000(.035/12)
Monthly interest payments = $102,083.33
The company will make these payments for the first 119 months, and then repay the
principal and interest on the 120th payment. So, the 120th payment will be:
Last payment = $35,000,000 + 102,083.33
Last payment = $35,102,083.33

6. The best loan is the interest-only loan because it has the lowest interest rate. One
risk of the loan is
that the company may not pay off the principal before maturity, which could mean it may
refinance
at a higher rate in the future. Of course, the rate in the future could be the same, or
even lower, but
there is still a refinancing risk. One way to show that the interest-only loan is the better
option is to
consider what happens if the company makes the same payments as it would if took out
the
traditional 30-year mortgage. If the company makes these payments, it would pay off
the interestonly
loan in:
PVA = C({1 – [1/(1 + r)]t} / r)
$35,000,000 = $212,098.17{[1 – 1 / (1 + .035/12)t] / (.035/12)}

Now we solve for t:

1/1.00292t= 1 – [($35,000,000)(.00292) / ($212,098.17)]
1.00292t= 1/.5737 = 1.7431
t = ln 1.7431 / ln 1.00292
t = 225.39 months
or:
225.39 / 12 = 18.78 years