A marketing innovation is the “cash-back mortgage” wherein the lender gives the borrower an up-front bonus cash payment. For example, if you borrow $100,000 on a 3% cash-back mortgage loan, the lender will give you $3000 in addition to the $100,000 loan. You pay back only the $100,000 principal over the amortization period. The $3000 can be immediately applied as a prepayment to reduce the principal balance (to $97,000) or it can be used for any other purpose. You must keep your mortgage with the lender for at least five years.
The cash-back mortgage seems like a good deal but there is more you need to know about advertised mortgage interest rates. The rates you see posted in your local financial institution are just a starting point for negotiations. You can get 1/4% knocked off just by asking for it. With some firm negotiating, you can probably get a 1/2% reduction. If the institution really wants your business, you can get a 3/4% or even 1% reduction. However, if you take advantage of some other promotion such as a cash-back offer, you will not get any rate discount. So the cash-back offer is not as good as it initially appears.
Which of the following loans should be chosen by the borrower?
• A standard $100,000 mortgage loan at 6.5% compounded semiannually?
• A 3% cash-back mortgage loan for $100,000 at 7.25% compounded semiannually?
In both cases, the interest rate is for a five-year term and the payments are based on a 25-year amortization. For the cash-back mortgage, assume that the $3000 cash bonus is immediately applied to reduce the balance to $97,000. (Since the monthly payments are based on the $100,000 face value, the prepayment will shorten the time required to pay off the loan.) Assume money can earn 4.8% compounded monthly.