Question #7

After lunch, Nancy Williams calls up her personal banker to ask about two things. One, she wants a 1-year education loan of $20,000 for her son, Phil and two, she is looking to take out a mortgage loan of $200,000. The banker offers the following choices: 1. Education loan of $20,000: A simple loan to be repaid after a year along with an interest of 10% p.a. or an amortized loan at an interest rate of 10% p.a. to be repaid through 12 equal monthly instalments. 2. Mortgage loan of $200,000: A 9% p.a. loan for 25 years without any discount points or an 8.5% p.a. loan for 25 years with 1 discount point. Nancy decides to go for a simple loan because, well, it is simple instead of being complex. She also decides to avail the discount point facility, assuming that she is unlikely to repay the loan before time.

At home, she gets into an uneasy argument with her husband. Her husband says that she did not make the correct decision to commit to such a long term mortgage loan. According to him, they would now have to make primarily interest payments for a long time before their instalments begin to reduce the principal that they owe. He suggests that they should not keep the loan for too long and prepay it as early as year 2 but Nancy does not agree. The arguments heat up when they notice their daughter Shelly quietly watching them. They decide to postpone this discussion to the next morning. They would eventually proceed to sit back-to-back next morning after sending Shelly off to school and do their math to prove their point. Nancys husband would decide to prepare a statement for the first nine months of the first year so that Shelly could see how the bank was interested in collecting primarily interest and Nancy would evaluate the merit of repaying the loan after 2 years.

Question 7 (15 marks)

a) Was Nancy right in availing the discount point facility for her mortgage loan, keeping in mind that when she made the decision, there was no intent to prepay the loan? Support your answer through relevant computations. (5 marks)

b) Assuming yourself to be first Nancys husband and then Nancy, prepare an amortization schedule for the first nine months in the first year of the mortgage loan and show the merit/demerit of paying off the loan after 2 years. Who do you think is the eventual winner of the argument? Why?

(10 marks)