Prosperous Bank (PB) has received an application from an existing customer for a housing loan of $900,000. There is no adverse comment and/or unfavourable experience for this customer over last 5 years. The property has to be mortgaged with the Bank as collateral. It would be a 10-year term loan. After reviewing all financial and non-financial analysis the credit manager has recommended that the loan is granted.

You have been tasked to calculate the rate of interest to be charged on this loan before it is formally approved by the board of directors.

You notice from the working papers that default and recovery rates for this loan have been estimated to be 3% and 90% respectively. Monitoring cost of this loan is estimated to be $25,000 per year. Interest on deposits is currently paid at 2.5% per year. 6% liquidity is required on lending assets which fetch a return of 5.2% per year. For the purpose of capital adequacy ratio (CAR), mortgage loans are weighted at 50% with capital requirement set at 8%.

PB has a return on equity (ROE) target of 15% and its current tax rate is 25%.

Required:

Calculate the rate of interest to be charged for this housing loan. [Note: For the benefit of board members, you need to show detailed calculations, step-by-step, AND provide brief explanation in support of these calculations.] (20 marks)