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Week 2
Financial Mathematics Review
 Part 2
Financial Mathematics:
Present Value and Mortgage Mathematics
 Time value of money calculations
 Present value of a single sum or annuity payment
 Future value of a single sum or annuity
 Mortgage loan constants
 Mortgage balance calculations
 Point charges and their effects on borrowing costs or yields
 Annual Percentage Rate
 Effective Cost of Borrowing
 Net present value and IRR calculations
 Refinancing decisions
 Adjustable Rate Mortgage or ARM Calculations
 Price Level Adjusted Mortgage
 Reverse Annuity Mortgages (Future Value of Annuity)
 Supportable mortgage calculations

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 Introduction to the Time Value of Money
 Understanding of financial mathematics is one of the core
working tools in finance.
 In terms of this course it helps us understands both
capacity and well and loan conditions.
 A dollar today is worth more than a dollar received in
future
 In most economies we expect a return on money or capital
related to the productivity of things capital can buy
• This is the fundamental source of the real returns (not
just inflationary increases)
 The required returns are cumulatively known as the
opportunity cost of capital
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 Present & Future Value of a Single Sum

 PV = FV / (1+r)
 FV = PV (1+r)
 PV is the present value
 FV is future value
 r is the total expected rate of return
 r includes the risk free and risk premium rates
 r is called “discount rate” when solving for PV
 r is called “rate of return” when solving for FV
 FV>PV assuming i > 0

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 PV & FV over Multiple Periods of Time
 General formula for PV and FV across multiple periods:
N
 PV = FV / (1+r)
N
 FV = PV (1+r)

 N is the number of periods between FV and PV

 If FV and PV are known the rate of return can be found by the formula:
1/N
r = (FV/PV) –1

Note that you must adjust r (as appropriate) for the frequency of
compounding

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 PV of an Annuity
 Annuity: stream of regular payments of equal amounts
 E.g.: monthly rental payments, mortgage payments

⁄
PV = PMT

 ‘PMT’: equal payments occurring at the end of each of the consecutive equal
length periods of time
 ‘N’ is the number of payments
 ‘r’ is the interest rate per period of time, compounded at the end of each
period
 Note that it is critical to adjust r and n for the frequency of compounding
per annum.
 If the interest rate is 12% per annum, compounding monthly for a 10
year loan, then r is 1% and n is 120

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 PV of Annuity (Contd.)
 For payments in advance the PV formula changes to:
⁄
PV = PMT (1+r)
 Expressed in simple interest annual rate terms, the annuity
formula assumes the forms:
⁄ ⁄
PV = PMT ⁄

⁄
PMT = PV
⁄ ⁄

Where: i = nominal interest rate per annum, T = number of years, m

= number of compounding periods per annum

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 Mortgage Constant
‘MMC’ is the monthly mortgage constant
It is the monthly payment per dollar of loan and it includes
both interest and principal amortization.
⁄
MMC =
⁄ ⁄

Here N & r are in months

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 Calculating a Loan Balance
 Outstanding Loan Balance (OLB) equals the present value of
the remaining loan payments
 Original mortgage was for ‘T’ years at a rate of ‘i’
 If ‘q’ payments have been made, the formula will be:

⁄ ⁄
OLB = PMT ⁄

 If there are monthly payments and monthly compounding of

interest (the usual case), them m = 12.
⁄
OLB = PMT

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 Calculating the Principal and Interest components of a
Mortgage
 Example: A $150,000 30yr mortgage at 9%

Point to note: as the loan matures the interest component of each payment
declines and the principal repaid increases. The payment does not change.

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 Future Value of an Annuity

 The FV of an annuity is the result of equal payments

compounding over time at a given interest rate
 Used in RAM (Reverse Annuity Mortgage)
 Formula:

FV = PMT
 ‘PMT’ is the payment every month
 ‘r’ is the interest per period (month)
 ‘n’ is the number of months

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 More mortgage calculations on a financial
calculator

Inputs:
 PV = $240,000 (Amount of Loan)
 I = 8% (divide by 12, and input 0.6666667)
 N = 360 (30 year loan x 12 months/year)
 Solve for PMT
 Result
 PMT = ($1,761.03)

Note: make sure that you have cleared the values from your
previous calculation!!

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 Effective Yield Calculation
Loan Amount is $240,000 with 1.5 points and prepayment expected in 10 years
without penalty
Points: The fees etc from establishing the mortgage, deducted from the
mortgage before disbursement to the borrower, expressed as a percent

Step 1: Calculate actual loan amount

Loan Amount Disbursed
= $240,000 – 1.5%(240,000)
= $236,400 net dollars

Step 2: Calculate loan balance due at end of 10

Years (using the PMT from the previous slide)
PMT = ($1,761.03)
I = 8% (convert to monthly divide by 12 and enter 0.666667 )
N = 240 (Months Remaining on the loan)
Compute
PV = $(210,539) (Use as FV input)
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 Effective Yield Calculation (cont’d)

Step 3: Calculate the lender's yield on the amount disbursed,

considering early repayment
Enter PV = $ 236,400
Enter PMT = $(1,761.03)
Enter N = 120 (The expected time until prepayment)
Enter FV = $ (210,539)
Compute i = 0.6859 per month or 8.23% per annum

This is the effective cost of borrowing

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 Annual Percentage Rate (APR)

 When loans are held over the full amortization term the
effective borrowing costs are based on APR for annual
percentage rate
 Truth in lending Act requires disclosure
 If there are no point charges, APR is equal to effective
borrowing costs
 APR is the yield which brings the future payment stream back
to present value such that it exactly equals the net cash
disbursed by the lender

PV = Mortgage – Points = [1-{1/(1+APR12)N}/APR/12]* PMT

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 Points – A tool to increase Yield

 Lender’s perspective: Decrease contract rate (looks attractive to

borrower) and increase points to compensate for it
 Question: How many points are needed to bring a mortgage yield
up, given the contract rate is lower than required yield?
 Steps (using business calculator)
 Find monthly payment and input as PMT
 Find mortgage balance (considering payout) input as FV
 Input monthly interest rate (Required yield/12)
 Input the number of periods
 Compute for PV
 Loan amount – PV will give the points

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 Mortgage Pricing (Contd.)

 Which loan is best for a borrower depends on the expected tenure or time
they expect to hold the loan
 The 7.5% loan with 7 points is better if the borrower is fairly certain they will
hold the loan for more than 10 years and if they don’t believe rates will come
down, allowing them to refinance before 10 years
 If the borrower is uncertain about holding periods or future rates, the 8.6%
loan is the best choice with the lowest cost for anything under a 10 year hold

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 ARM and FRM

 Fixed Rate Mortgage (FRM), where the rate of interest charged remains
constant throughout the term
 More common in the US
 Adjustable Rate Mortgage (ARM), where the rate of interest and hence
the mortgage payment is variable due to the link with an index
 More common in Australia and NZ
 Spread is the amount above the index that is added to determine the
new contract rate of interest
 Typically ARMs are priced at significantly lower interest rates as much
of the future interest rate risk is borne by the borrower

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 ARM and FRM
 Annual rate caps is the maximum increase in the rate that is
possible per year
 Life time caps is the maximum total increase in the rate that is
possible during the loan term
 A 1.0% to 2.0% annual rate cap is common
 Typical life caps are 5% or 6% over the course of the loan, so a
loan that starts at 6% can never be higher then 11% if the life
cap is 5%
 To calculate the new payment we first need to calculate the
balance of the loan at the time of the change in interest and
then we use this balance over the remaining term or N to
calculate payments at the new rate
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 Choosing b/w FRMs and ARMs
 With FRM interest rate risk is borne by lender
 With ARMs much of the interest rate risk is borne by the borrower
 Borrowers who are just able to qualify for the mortgage with little
excess in their budget to manage the risk of higher payments will
often opt for the FRM, while wealthier borrowers with few liquidity
concerns will often opt for the ARMS
 Rather than lower aspirations (buy a cheaper house) many
households will start to consider taking on the risk of an ARM as rates
rise and the spread in the market between FRMs and ARMs increases
 Some commentators have argued that increased levels of ARMs
being given to less sophisticated and less financially able
borrowers was an important element of the GFC

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 Refinancing
 Refinancing can save the borrower money if there is
a drop in mortgage interest rates
 Situations when refinancing is not advisable:
 Remaining term of the loan is short or expected
tenure of the new loan is short
 Mortgage rates are expected to fall further
 Prepayment penalties are higher than benefits
 Deciding whether refinancing is profitable or not:
 If the NPV of expected savings exceeds the cost
of refinancing then it is advisable and vice-versa

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