Mortgages and Other loans:

APR:

“APR” stands for “annual percentage rate” and is the legal definition for expressing an interest
rate in a contract. The value of the APR (say 12%) can be adjusted to a monthly rate by dividing
the APR rate by 12 (e.g. 12% ÷ 12 = 1% monthly). Similarly, 12% APR can be adjusted to a
quarterly rate of 3% ( 3% = 12% ÷ 4) or a semi-annual rate of 6% ( 6% = 12% ÷ 2).

However, when paying/earning interest on a monthly, quarterly, or semi-annual basis, the annual
interest rate is not equal to the APR rate because compounding occurs more frequently than on
an annual basis. For example, let $100.00 earn 12% APR on a monthly basis (i.e. 1% every
month):

12
$ 112.68=$ 100.00 × (1+1 % )

Notice, the actual interest earned over the year is 12.68%. In these circumstances, the actual
interest you earn annually is called the equivalent annual rate (EAR) or the annual percentage
yield (APY).

A general formula for the EAR or APY when there are “M” periods of compounding within a
year is:

M
APR rate
EAR∨ APY = 1+ ( M ) −1
Following this formula assuming 12% APR, the EAR or APY for quarterly compounding is
12.55% and the EAR or APY for semi-annual compounding is 12.36%.

Mortgage:

A mortgage is a loan specifically for the purchase of real estate. Generally, a mortgage is repaid
with monthly payments. If the mortgage is a fixed rate mortgage (FRM), the interest rate is the
same throughout the life of the mortgage and the monthly payment is also the same throughout
the life of the mortgage. If the mortgage is an adjustable rate mortgage (ARM), the mortgage
rate will change at some future point in time (usually after the first five years). While a
particular rate is being applied, the monthly mortgage payment will be the same every month.
However, because the interest rate changes in an ARM, a new monthly mortgage payment is
calculated every time the interest rate changes.

1
To introduce the type of calculations that are associated with mortgages, look at the following
FRM-type mortgage for $150,000.00:

Mortgage: $150,000
Maturity: 30 years (N = 30 × 12 = 360 months)
Rate: 6% APR (k = 6% ÷ 12 = 0.5% monthly)

A mortgage is a type of PV-annuity in which the monthly payment is the constant cash flow
(CF):

CF 1 CF CF CF
k [
1−
( 1+ k ) N
]
= 1
+
( 1+ k ) ( 1+ k ) 2
+ …+
( 1+ k )N

“k” is the periodic interest rate

“N” are the number of periods…note: the amount of time between each cash flow must be of the
same length.

With a mortgage, we actually know the value of the annuity. What we do not know is the
monthly payment (CF):

CF 1
$ 150,000=
0.5 %
1−
[
( 1+0.5 % )360 ]
We can solve for the monthly payment (CF):

$ 150,000 × 0.5 %
$ 899.33=CF=
1
[1−
]
( 1+0.5 % )360

2
Excel template available: MORTGAGE-CALC.xlsx

The template requests 3 of 4 pieces of “Information” (orange cells): the mortgage (i.e. the
amount), interest rate (as an APR), payment (monthly), and maturity (in years). Whatever piece
of information is missing, type in “X” and the template will compute the missing piece of
information based on the other three pieces of information.

As an example, view the template for computing the above mortgage payment (in cell E4).

A B C D E F
1 Information: Answer:
2 Mortgage: $150,000.0 Mortgage: #VALUE!
0
3 Interest: 6.00% APR Interest: #VALUE! APR
4 Payment: X monthly Payment: $899.33 monthly
5 Maturity: 30 years Maturity: #VALUE! years
6

3
Mortgage Schedule:

Each monthly payment is a combination of interest and loan repayment. A mortgage schedule
demonstrates how the interest and repayment portion of the mortgage payment changes through
time. This can be demonstrated for the first three payments.

Payment: Amount Owed: Interest Paid: Loan Repayment:

1st payment: $150,000.00 $750.00 $149.33
initial amount of the interest rate × amount owed monthly payment less the
mortgage interest paid

=0.5% × $150,000.00 =$899.33 - $750.00

2nd payment: $149,850.67 $749.25 $150.08

previous amount owed less interest rate × amount owed monthly payment less the
the loan repayment from last interest paid
month

=$150,000.00 - $149.33 =0.5% × $149,850.67 =$899.33 - $749.25

3rd payment: $149,700.59 $748.50 $150.83

previous amount owed less interest rate × amount owed monthly payment less the
the loan repayment from last interest paid
month

=$149,850.67 - $150.08 =0.5% × $149,700.59 =$899.33 - $748.50

Notice, the interest portion of the mortgage payment decreases through time with each payment
because the amount of the mortgage owed is decreasing with each payment. Correspondingly,
the loan repayment portion increases through time with each payment. Towards the end of the
mortgage, most of the mortgage payment will be applied to repaying the loan with interest being
a small part of the payment. However, this will take quite some time.

How much interest will you pay over the life of the mortgage?

Multiply the number of payments by the amount of the monthly payment:

$899.33 × 360 = $323,758.80

Next, subtract the amount of the mortgage:

$323,758.80 - $150,000.00 = $173,758.80

This is how much you pay in interest over the life of the mortgage.

4
How much of the mortgage has been paid after twenty years?

The mortgage schedule can be continued for twenty years (i.e. 240 payments), but that takes too
long to execute. Instead, figure out how much you still owe: 10 years (120 months) of $899.33
monthly payments…you can use the PV-annuity to calculate this with CF = $899.33, k = 0.5%,
and N = 120:

$ 899.33 1
$ 81,005.76=
0.5 % [
1−
(1+ 0.5 % )120 ]
Be very aware that the amount you owe is based on the remaining monthly payments and
NOT on the monthly payments you have already paid.

How much you have paid is the amount of the mortgage less what you still owe on the mortgage:

$150,000.00 - $81,005.76 = $68,994.24

Excel template: What you owe is the value of a 10-year mortgage with monthly payments of
$899.33, and an interest rate of 6.00% APR

A B C D E F
1 Information: Answer:
2 Mortgage: X Mortgage: $81,005.78
3 Interest: 6.00% APR Interest: #VALUE! APR
4 Payment: $899.33 monthly Payment: #VALUE! monthly
5 Maturity: 10 years Maturity: #VALUE! years
6

NOTE: there is some rounding error, however, the template calculation is actually more accurate.

5
What happens if I pay more than the monthly payment…say $920.00 instead of $899.33?

You will pay off the mortgage faster. To find out how much faster, the PV-annuity will need to
be solved for “N”:

k × loan
N=− ( [
ln 1−
CF ])
ln ( 1+k )

“ln” is the natural logarithm function

Do this in parts:

k ×loan 0.5 % × $ 150,000.00

[
A= 1−
CF ][
= 1−
$ 920.00 ]=0.18478

B=ln ( A )=ln ( 0.18478 ) =−1.68859

C=ln ( 1+k )=ln ( 1+0.5 % )=0.00499

N=−( B ÷ C )=−(−1.68859 ÷ 0.00499 )=338.39

Round “N” up to 339 months…in other words, the mortgage will be repaid in 339 months rather
than 360 months.

How much in interest will you pay over the life of the mortgage by making $920.00 monthly
payments?

Multiply the number of payments by the amount of the monthly payment:

$920.00 × 339 = $311,880.00

Next, subtract the amount of the mortgage:

$311,880.00 - $150,000.00 = $161,880.00

Notice, the extra $20.67 each month eliminates 21 months of payments and eliminates
$11,878.80 (= $173,758.80 - $161,880.00) in interest over the life of the mortgage.

6
Excel template: the mortgage is for $150,000.00, the monthly payment is $920.00 and the
interest rate is 6.00% APR

A B C D E F
1 Information: Answer:
2 Mortgage: $150,000.0 Mortgage: #VALUE!
0
3 Interest: 6.00% APR Interest: #VALUE! APR
4 Payment: $920.00 monthly Payment: #VALUE! monthly
5 Maturity: X years Maturity: 28.2132 years
6

Convert years to months by multiplying by 12:

28.2132 × 12 = 338.56…NOTE: there is some rounding error, however, the template calculation
is actually more accurate.

7
Suppose I can afford to pay $850.00 each month for a mortgage. How large of a mortgage
can I have (assume FRM)?

First, find the interest rate for the mortgage term that you find will best suit your needs. For this
example, assume it is a thirty-year mortgage at 3.6% APR.

Mortgage: ??
Maturity: 30 years (N = 30 × 12 = 360 months)
Rate: 3.6% APR (k = 3.6% ÷ 12 = 0.3% monthly)

Find the present value of 360 payments of $850.00 over the next thirty years:

$ 850.00 1
$ 186,958.91=
0.3 % [
1−
( 1+0.3 % )360 ]
You can afford a mortgage of approximately $187,000.00, but will more than likely have a
mortgage for $184,000.00 to $185,000.00 to allow for fees that may occur.

Excel template: the monthly payment is $850.00, the mortgage is for 30 years, and the interest
rate is 3.60% APR

A B C D E F
1 Information: Answer:
2 Mortgage: X Mortgage: $186,958.9
1
3 Interest: 3.60% APR Interest: #VALUE! APR
4 Payment: $850.00 monthly Payment: #VALUE! monthly
5 Maturity: 30 years Maturity: #VALUE! years
6

8
What if I start with a 30-year $200,000.00 FRM-type mortgage at 4.8%APR and then five
years later decide to refinance with a 15-year 3.0% APR FRM-type mortgage?

Initially:

Mortgage: $200,000
Maturity: 30 years (N = 30 × 12 = 360 months)
Rate: 4.8% APR (k = 4.8% ÷ 12 = 0.4% monthly)

Find the monthly payment:

$ 200,000× 0.4 %
$ 1,049.33=
1
[1−
( 1+0.4 % )360 ]
After five years, determine how much is still owed on the mortgage (i.e. the present value of the
remaining 300 payments of $1,049.33):

$ 1,049.33 1
$ 183,130.12=
0.4 % [
1−
( 1+ 0.4 % )300 ]
This is the value that is to be refinanced. Treat $183,130.12 just like any other 15-year mortgage
and find the new monthly payment.

Mortgage: $183,130.12
Maturity: 15 years (N = 15 × 12 = 180 months)
Rate: 3.0% APR (k = 3.0% ÷ 12 = 0.25% monthly)

Find the new monthly payment:

$ 183,130.12× 0.25 %
$ 1,264.66=
1
[
1−
( 1+0.25 % )180 ]
What if I want the same monthly payment of $1,049.33on the fifteen year mortgage?

This will require paying down some of the existing mortgage during the refinancing phase.

First, find the present value of 180 payments (i.e. fifteen years of monthly) of $1,049.33 at 3.0%
APR (this is the fifteen year rate, making k = 3.0% ÷ 12 = 0.25% monthly).

9
 $ 1,049.33 1
$ 151,948.73=
0.25 % [1−
( 1+0.25 % )180 ]
When refinancing, pay $31,181.39 (= $183,130.12 - $151,948.73) to reduce the mortgage
principle to $151,948.73. This will make the monthly mortgage payment equal to $1,049.33.

If you are uncertain about this result, compute the fifteen year monthly mortgage for
$151,948.73 and see that the result is correct:

Mortgage: $151,948.73
Maturity: 15 years (N = 15 × 12 = 180 months)
Rate: 3.0% APR (k = 3.0% ÷ 12 = 0.25% monthly)

Find the monthly payment:

$ 151,948.73 × 0.25 %
$ 1,049.33=
1
[ 1−
( 1+0.25 % )180 ]

10
How does an adjustable rate mortgage (ARM) work?

Assume a 30-year mortgage for $200,000.00 at 4.8% APR. Calculate the monthly payment in
the same manner as an FRM-type mortgage:

Mortgage: $200,000
Maturity: 30 years (N = 30 × 12 = 360 months)
Rate: 4.8% APR (k = 4.8% ÷ 12 = 0.4% monthly)

Find the monthly payment:

$ 200,000× 0.4 %
$ 1,049.33=
1
[1−
( 1+0.4 % )360 ]
Generally, an ARM will re-calibrate at 5 years. Consequently, the amount of the remaining
mortgage must be found after five years of payments (i.e. present value of the remaining 300
payments of $1,049.33):

$ 1,049.33 1
$ 183,130.12=
0.4 % [
1−
( 1+ 0.4 % )300 ]
Based on the new APR (assume it increases to 5.4% APR making k = 0.45% = 5.4% ÷ 12),
calculate the new monthly payment as if the mortgage is for $183,130.12 for 25-years (N = 300
= 25 × 12):

Mortgage: $183,130.12
Maturity: 25 years (N = 25 × 12 = 300 months)
Rate: 5.4% APR (k = 5.4% ÷ 12 = 0.45% monthly)

Find the new monthly payment:

$ 183,130.12× 0.45 %
$ 1,113.67=
1
[
1−
( 1+ 0.45 % )300 ]
Note: the monthly mortgage payment increases because the APR increased. If the APR had
decreased, the monthly payment would also have decreased. The amount the APR can move up
or down has to be within a certain range (i.e. it has a “floor” and a “cap”). However, there is no
way to know what will happen with interest rates in the future. To make ARMs more appealing,

11
the initial APR rate is generally substantially below the equivalent FRM APR rate (usually by
0.5% to 0.75%).

What can happen with an ARM is that people will find a monthly payment value that they are
comfortable with, assume it is $850.00, and then base the amount of mortgage they can afford on
the initially low ARM APR rate. The problem with this logic, is that the monthly ARM payment
can increase, like in the example above, and suddenly the monthly payment jumps to a value that
does not fit within the household budget.

If you are considering an ARM, be aware that the monthly payment can increase at a designated
point in the future and be ready to adjust to the possibility of a higher monthly payment. With an
FRM, there is no danger in the monthly payment changing because it is set initially and does not
change throughout the life of the mortgage.

12
What other fees and payments can I expect with a mortgage?

There are fees associated with the loan itself which are generally proportionate with the
mortgage (sometimes called “points”). Such fees are somewhat negotiable, but are generally
inevitable.

There are fees associated with buying the property. These are called “closing costs” which
include commissions for real estate brokers and other costs.

If you do not pay for 20% of the sale price with your own money (i.e. have equity in the property
of 20%), you will be requested to have “private mortgage insurance” (PMI). PMI is paid
monthly and is included with your mortgage payment. Upon building 20% equity into your
property through making mortgage payments over the life of the loan or through property
appreciation, you may be able to request eliminating the PMI.

Property taxes will be included in your mortgage payment and held in escrow until due.
Consequently, while making mortgage payments, you generally do not pay much attention to
property tax, but it will become a payment you make annually after the mortgage is finished.

When getting the mortgage, it is not uncommon to make the first payment at that time and then
the next payment is not due until two months. You may choose not to do this, but unless you
request to do something different, this is somewhat of a standard policy.

Note: whether you are refinancing or starting a mortgage, bring a check to the closing for any
incidental overages that can occur. Although all parties try their best to have every fee included
in the mortgage, it is not uncommon for a fee to be missed. Also, expect a good 90 minutes of
paper signing.

13
Other types of loans:

Car loan:

A car loan is very similar to a mortgage in structure, but are usually much shorter in duration
(less than five years) and are being applied to an asset that depreciates very quickly.

Like a mortgage, the monthly payment is calculated in a similar fashion. Assume the car loan is
for $20,000.00 at 3% APR (i.e. k = 3% ÷ 12 = 0.25% monthly) for three years ( N = 36 = 3 years
× 12). The monthly payment is:

$ 20,000.00 × 0.25 %
$ 581.62=
1
[1−
]
( 1+0.25 % )36

The car loan schedule also works the same way as the mortgage schedule;

Payment: Amount Owed: Interest Paid: Loan Repayment:

1st payment: $20,000.00 $50.00 $531.62
initial amount of the loan interest rate × amount owed monthly payment less the
interest paid

=0.25% × $20,000.00 =$581.62 - $50.00

nd
2 payment: $19,468.38 $48.67 $532.95

previous amount owed less interest rate × amount owed monthly payment less the
the loan repayment from last interest paid
month

=$20,000.00 - $531.62 =0.25% × $19,468.38 =$581.62 - $48.67

rd
3 payment: $18,935.43 $47.34 $534.28

previous amount owed less interest rate × amount owed monthly payment less the
the loan repayment from last interest paid
month

=$19,468.38 - $532.95 =0.25% × $18,935.43 =$581.62 - $47.34

What can happen with car loans is that the borrower becomes “upside-down” on the loan. This
means the amount still owed on the loan is higher than the value of the car. For example, after
two years, assume the car is now worth $6,500.00. The amount still owed on the car two years
into the future is the present value of the remaining twelve payments over the last year of the
loan (i.e. what you owe is not based the 24 payments you have already made, but it is based on
the 12 future payments you still have to make):

14
 $ 581.62 1
$ 6,867.33=
0.25 % [
1−
( 1+0.25 % )12 ]
Notice, the car is worth $6,500.00, but the loan is worth $6,867.33 making the car owner
“upside-down” on the loan.

Generally, three year loans on new cars do not create upside-down situations. However, this is
not uncommon if the car is used or if the loan term is five years or more.

Leasing a car:

Leasing is a popular option that is often difficult to assess because the car may not actually be
purchased at any point in time.

One method to evaluate a lease is to determine what the car will be worth at the end of the lease.
For example assume the lease term is for three years, any number of websites can provide the
value of the current 3-year old version of the car. Based on the value of the 3-year old version of
the car, assume the car is expected to depreciate to 60% of its original value.

If the car is currently worth $22,000.00, then the residual value on the car after three years is
$13,200.00 ($13,200.00 = 60% × $22,000.00)

Based on a three-year car loan rate of 3.6% APR ( i.e. k = 3.6% ÷ 12 = 0.3% monthly), monthly
lease payments of $500.00, and a residual value for the car of $13,200.00, perform the following
calculation:

Determine the present value of the monthly lease payments:

$ 500.00 1
$ 17,037.88=
0.3 %
1−
[
( 1+0.3 % )36 ]
Determine the present value of the residual value of the car:

$ 13,200.00
$ 11,850.60=
( 1+0.3 % )36

Add the two values together to get an approximate value of what is being paid for the car via
leasing:

$28,888.48 = $17,037.88 + $11,850.60

15
Your eyes are not deceiving you, you are paying approximately $7,000.00 more than the car is
worth. The next question becomes: Why do people lease cars?

First, look at the monthly payment if you plan to finance the purchase with a three year car loan:

$ 22,000.00× 0.3 %
$ 645.62=
1
[1−
(1+ 0.3 % )36 ]
The monthly loan payment is much higher than the monthly lease payment. Consequently, a
lease can allow someone to drive a more expensive car than what their budget can allow for
when purchasing a car. Like renting a property, one forgoes ownership of the asset, but may feel
that this is an acceptable compromise.

From the car dealer’s perspective, leases are quite valuable. Consequently, you should expect
car dealerships to offer and promote leasing options extensively (particularly on higher priced
vehicles).

Credit cards:

Credit cards are a type of loan that accrues interest on a monthly basis like a mortgage (at rates
of approximately 18% to 20% APR) unless the amount owed is paid in full when billed.

Many times, people will carry a loan on the credit card over a number of months by making
minimum allowable payments (e.g. $10.00 minimum for amounts under $500.00).

To illustrate how long it will take to pay off a credit card balance of $500.00 making $10.00
minimum payments, set CF = $10.00, loan = $500.00, and k = 1.5% (= 18% APR ÷ 12) and
perform the following calculation:

k × loan
N=− ( [
ln 1−
CF ])
ln ( 1+k )

“ln” is the natural logarithm function

Do this in parts:

16
 k ×loan 1.5 % × $ 500.00
[
A= 1−
CF ][
= 1−
$ 10.00 ]
=0.2500

B=ln ( A )=ln ( 0.2500 ) =−1.38629

C=ln ( 1+k )=ln ( 1+1.5 % ) =0.01489

N=−( B ÷ C )=−(−1.38629 ÷ 0.01489 )=93.10

Round “N” up to 94 months…in other words, it will take 7.83 (= 94 ÷ 12) years to repay the
credit card.

How much will you pay in interest?

Amount paid: 94 × $10.00 = $940.00

Loan amount: $500.00

Interest paid: $440.00 = $940.00 - $500.00 = Amount paid less Loan amount

Why does it take so long to pay off the credit card?

There are two reasons:

First, the APR on credit cards are high (up to 30.00% APR in some cases) relative to other forms
of loans which makes the interest accrue very quickly.

Second, the minimum payment is very low. Look at the interest that accrues in our example over
one month on $500.00:

$7.50 = 1.5% × $500.00

The minimum payment of $10.00 does not allow for much of the $500.00 loan to be repaid. In
fact, if the minimum payment was less than $7.50, the credit card would never be repaid.

Note: Many times very high APR credit cards (30.00% APR is not uncommon) are disguised
with promotions that allow you to buy an item for 0% financing over a period of time (12 – 24
months is common). Assuming you pay for the item within the 0% financing period, you will
not be subject to the high APR. However, your next purchase on that credit card will be subject

17
to the high APR. Consequently, after taking advantage of the 0% financing offer, it may be best
to then close that credit card account to eliminate any potential purchases at the high APR rate.

18