TYPES OF LOANS

INTEREST ONLY LOANS

INTEREST ONLY LOAN: the borrower receives the money
today and agrees to pay the lender interest periodically over
the loan term and the principal (the original loan amount) at
the end of the loan term.
Example: you borrow $10,000 today and agree to pay interest
annually at the annual rate of 9% and repay the principal at
the end of five years. What is your annual interest payment?

Interest

= 0.09 x $10,000

= $900

TYPES OF LOANS
CONSTANT PAYMENT LOANS

FIXED RATE OF INTEREST

FIXED LOAN TERM
FULLY AMORTIZING
FIXED PERIODIC PAYMENTS

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Computing the equal periodic payment for amortized loans:
PMT = Loan Amount

where
CR
n
k
PMT

1
nk

CR t
t 1 (1
)
k
=
=
=
=

the annual contract rate of interest

the number of years in the loan term
the number of payments per year
the equal periodic payment necessary to fully
amortize the Loan Amount with nk payments.

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Compute the monthly payment necessary to fully amortize a
30 year, 8% annual interest (compounded monthly), $100,000
loan.
PMT =

$100,000
=
360
1

0.08 t
t 1 (1
)
12

Annual debt service (DS)

$ 733.76

= 12 x PMT = $8,805.12

TYPES OF LOANS
CONSTANT PAYMENT LOANS
For a fixed rate, fixed term, fixed payment, fully amortizing
loan, the mortgage balance (book value of the loan) is simply
the present value of the remaining stream of payments
discounted at the periodic contract rate.
Let

MBs

= mortgage balance at the end of period s

nk s

= PMT

CR t
t 1 (1
)
k

TYPES OF LOANS
CONSTANT PAYMENT LOANS
What is the mortgage balance in five years for a $100,000, 30
year, 8% annual interest rate, monthly payment loan?
The mortgage balance in five years is the present value of the
300 (360-60) remaining monthly payments discounted at the
monthly rate of 0.08/12.
300

MB60

1
= $733.76
= $ 95,069.26
0.08 t
t 1 (1
)
12

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Alternatively, the mortgage balance is the future value (FV)
in:
s

1
MBs
PV PMT

CR t
CR s
t 1 (1
) (1
)
k
k
60

1
MBs
$100,000 $733.76

0.08 t
0.08 60
t 1 (1
) (1
)
12
12

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Amortization schedules separate the periodic payment into
interest and principal:

Periodic interest payment = beginning balance x periodic rate

or Is = MBs-1
Periodic principal

CR
k
= periodic payment - periodic interest

or Ps = PMT - Is

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Separate the $733.76 monthly payment into interest and
principal for the first two months of the $100,000, 30 year, 8%
annual interest rate loan.
Month 1:
Interest
= $100,000.00 x 0.0066667 = $666.67
Principal = $733.76 - $666.67
= $ 67.09
MB1
= $100,000.00 - $67.09 = $99,932.91
Month 2:
Interest
= $99,932.91 x 0.0066667 = $666.22
Principal = $733.76 - $666.22
= $ 67.54
MB2
= $99,932.91 - $ 67.54
= $99,865.37

TYPES OF LOANS
CONSTANT PAYMENT LOANS
How would you calculate the amount of interest you paid
during the fifth year of a conventional mortgage?
You could separate the monthly payments into interest and
principal for the 12 months of the fifth year and add the
monthly interest payments.
Fortunately, theres an easier way:
Principal paid between months s and t = MBs - MBt
Interest paid = PMT (t - s) - Principal paid

TYPES OF LOANS
CONSTANT PAYMENT LOANS
Compute the principal and interest paid during the fifth year of
a $100,000, 30 year, 8% annual rate, monthly payment
mortgage.
312

MB48

1
= $733.76
0.08 t
t 1 (1
)
12

= $96,218.44

300

MB60 = $733.76

0.08 t
t 1 (1
)
12

= $95,069.26

Year 5:
Principal paid: $96,218.44 - $95,069.26 = $1,149.17
Interest paid: $733.76 x 12 - $1,149.17 = $7,655.95

TYPES OF LOANS
CONSTANT PAYMENT LOANS
In what month is one half of the loan repaid?

1
$50,000
$100,000 $733.76

0.08 t
.08 s
t 1 (1
) (1
)
12
12
s = 269 (the 5th month of year 22)

Constant Payment Mortgages:

Yields
The lenders expected yield or borrowers true borrowing
cost is the IRR on the expected mortgage cash flows.
Let

Fee
= loan origination fee,
Points = discount points in dollars (points are usually
expressed as a percent of the loan amount),
S
= month that the loan is repaid,
PP
= the dollar amount of the prepayment
penalty (a percent of the mortgage balance),
NLA = net loan amount
= Loan Amount - Fee - Points
y
= the discount rate -- the lenders yield, the
borrowers borrowing cost.

Constant Payment Mortgages:

Yields
Computing Lenders Yield (or Borrowers Borrowing Cost)

There are 3 cases to consider:

(1)

The loan is held to maturity;

(2)

the loan is repaid prior to maturity without

penalty;

(3)

the loan is repaid prior to maturity with a

prepayment penalty.

Constant Payment Mortgages:

Yields
Computing Lenders Yield (or Borrowers Borrowing Cost)

1)

If the loan is held to maturity, solve for y in:

nk

1
NLA PMT
t
(
1

y
/
12
)
t 1

Constant Payment Mortgages:

Yields
Example: compute the lenders expected yield (or the
borrowers borrowing cost) for a $100,000, 30 year,
monthly payment mortgage that has a 7.5% annual contract
rate of interest if the lender charges a $1,000 loan
origination fee, 2 discount points, and expects the borrower
to hold the loan to maturity.
NLA = $100,000 - $1,000 - $2,000
PMT =

360

= $97,000.00

1
=
$100,000 /
0.075 t
t 1 (1
)
12

$699.21

Constant Payment Mortgages:

Yields
Example (continued): the lenders expected yield (or the
borrowers true borrowing cost) is the IRR (or discount rate y)
in the following:
360

$97,000 $699.21
t 1

y = 7.81%

1
y t
(1 )
12

Constant Payment Mortgages:

Yields
Computing Lenders Yield (or Borrowers Borrowing Cost)
(2)

If the loan is repaid prior to maturity without penalty,

solve for y in:
s

MBS
NLA PMT

y t
y s
t 1 (1
) (1 )
12
12

Constant Payment Mortgages:

Yields
Example: compute the lenders expected yield (or borrowers
borrowing cost) in the previous example if the lender expects
the borrower to repay the loan, without penalty, at the end of
four years.
312

1
MB48 $699.21
$95,860.00
0
.
075
t 1 (1
)t
12
Solve for y = 8.40% in:
48

$95,860.00
$97,000 $699.21

y
y 48
t
t 1 (1
)
(1 )
12
12

Constant Payment Mortgages:

Yields
Computing Lenders Yield (or Borrowers Borrowing Cost)
(3)

If the loan is repaid prior to maturity with a prepayment

penalty, solve for y in:

MBS PPS
NLA PMT

y t
y s
t 1 (1
)
(1 )
12
12
s

Prepayment penalties are computed as a percent of the

outstanding mortgage balance.

Constant Payment Mortgages:

Yields
Example: compute the lenders expected yield (or borrowers
borrowing cost) in the previous example if the lender expects
the borrower to repay the loan, with a 2% prepayment penalty,
at the end of four years.

$95,860.00 $1,917.20
$97,000 $699.21

y t
y
t 1 (1
)
(1 )48
12
12
48

FV = $97,777.20 and y = 8.82%

Constant Payment Mortgages:

Yields
Relationship between mortgage yields and prepayment (with no
prepayment penalty) for a 7.5%, 30 year, constant payment
mortgage with a $1,000 loan fee and 2 discount points.
Year of Prepayment
1
2
3
4
5
10
20
30

Mortgage Yield
10.69%
9.16%
8.65%
8.40%
8.25%
7.96%
7.83%
7.81%

Constant Payment Mortgages:

Yields

The Annual Percentage Rate (APR) on a loan is the lenders

yield (or borrowers borrowing cost) computed assuming the
loan is held to maturity rounded to the nearest one-eighth.

The APR for the loan in the previous example is

3
4

Constant Payment Mortgages:

Yields
Charging Points to Achieve a Desired Yield
If a lender has a required yield of y, then the points the lender
must charge to obtain the required yield are computed by
solving for Points in:

MB s PPs
1
Loan Amount Points Fee PMT

y
y s
t
t 1
(1 )
(1 )
12
12
s

Constant Payment Mortgages:

Yields
Example: compute the points a lender must charge to earn a
9% required yield on a $100,000, 30 year, 7.5% annual
interest rate, monthly payment mortgage if the lender
charges a $1,000 loan origination fee and expects the
borrower to repay the loan, without penalty, at the end of
four years.
48

1
$95,860.00
$100,000 Points $1,000 $699.21

0.09 t
0.09 48
t 1
(1
) (1
)
12
12

$99,000 - Points = $95,066.75;

Points = $3,933.25