UCLA ECON 103 - Chap004 (1) (21 pages)

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Chap004 (1)



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Chap004 (1)

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Pages:
21
School:
University of California, Los Angeles
Course:
Econ 103 - Introduction to Econometrics
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Chapter 04 Fixed Interest Rate Mortgage Loans Solutions to Questions Chapter 4 Fixed Interest Rate Mortgage Loans Question 4 1 What are the major differences between the CAM and CPM loans What are the advantages to borrowers and risks to lenders for each What elements do each of the loans have in common CAM Constant Amortization Mortgage Payments on constant amortization mortgages are determined first by computing a constant amount of each monthly payment to be applied to principal Interest is then computed on the monthly loan balance and added to the monthly amount of amortization to determine the total monthly payment CPM Constant Payment Mortgage This payment pattern simply means that a level or constant monthly payment is calculated on an original loan amount at a fixed rate of interest for a given term CAM lenders recognized that in a growing economy borrowers could partially repay the loan over time as opposed to reducing the loan balance in fixed monthly amounts CPM At the end of the term of the mortgage loan the original loan amount or principal is completely repaid and the lender has earned a fixed rate of interest on the monthly loan balance However the amount of amortization varies each month When both loans are originated at the same rate of interest the yield to the lender will be the same regardless of when the loans are repaid i e early or at maturity Question 4 2 Define amortization Amortization is rate at which the process of loan repayment occurs over the loan term Types of amortization are fully partially zero negative and constant rates of amortization Question 4 3 Why do the monthly payments in the beginning months of a CPM loan contain a higher proportion of interest than principal repayment The reason for such a high interest component in each monthly payment is that the lender earns an annual percentage return on the outstanding monthly loan balance Because the loan is being repaid over a long period of time the loan balance is reduced only very slightly at first and monthly interest charges are correspondingly high Question 4 4 What are loan closing costs How can they be categorized Which of the categories influence borrowing costs and why Closing costs are incurred in many types of real estate financing including residential property income property construction and land development loans Categories include statutory costs third party charges and additional finance charges Closing costs that do affect the cost of borrowing are additional finance charges levied by the lender These charges constitute additional income to the lender and as a result must be included as a part of the cost of borrowing Lenders refer to these additional charges as loan fees Question 4 5 In the absence of loan fees does repaying a loan early ever affect the actual or true interest cost to the borrower No the true interest rate always equals the contract rate of interest Question 4 6 Why do lenders charge origination fees especially loan discount fees Lenders usually charge these costs to borrowers when the loan is made or closed rather than charging higher interest rates They do this because if the loan is repaid soon after closing the additional interest earned by the lender as of the repayment date may not be enough to offset the fixed costs of loan origination Question 4 7 What is the connection between the Truth in Lending Act and the annual percentage rate APR Truth in Lending Act the lender must disclose to the borrower the annual percentage rate being charged on the loan The APR reflects origination fees and discount points and treats them as additional income or yield to the lender regardless of what costs the fees are intended to cover The APR is always calculated assuming that the loan is repaid at maturity 4 1 Chapter 04 Fixed Interest Rate Mortgage Loans Question 4 8 What is the effective borrowing cost rate This differs from the contract rate because it includes financing fees points origination It differs from the APR because the latter is calculated assuming that the loan is repaid at maturity When calculating the effective cost the expected repayment or payoff date must be used The latter is usually sooner than the maturity date Question 4 9 What is meant by the nominal rate on a mortgage loan This rate is usually quoted as an annual rate however the time intervals used to accrue interest is generally not quoted explicitly Further the rate generally does not specify the extent of any origination fees and or discount points Question 4 10 What is the accrual rate and payment rate on a mortgage loan The accrual rate is usually the nominal rate divided by the number of periods within a year that will be used to calculate interest For example if interest is to be accrued monthly the nominal rate is divided by 12 if daily the nominal rate is divided by 365 The payment rate or pay rate is the of the loan to be paid at time intervals specified in the loan agreement This rate is used to calculate payments which are usually made monthly but could be quarterly semi annual etc If the pay rate exceeds the accrual rate this indicates that some loan repayment amortization is occurring When it is equal to the accrual rate amortization is not occurring etc Question 4 11 An expected inflation premium is said to be part of the interest rate what does this mean In general the nominal interest rates for a specified period say 10 years is said to be a composite of three things a real return such as the growth rate in real GDP underlying economic growth in the economy b expected inflation and c premium for risk For example if a lender quotes a 6 rate on a mortgage loan at a time when 10 year U S government bonds are yielding 3 6 then the risk premium would be 2 4 If at that same time growth in real GDP is 2 0 and is expected to continue at that rate for 10 years then expected inflation can be estimated to be 1 6 or 6 2 4 2 0 1 6 Alternatively if 10 year U S Government Bonds that are indexed for inflation TIPs are currently yielding 2 0 and 10 year Treasuries not indexed for inflation are yielding 3 6 the difference or 3 6 2 0 or 1 6 is an estimate of expected inflation Question 4 12 A mortgage loan is made to Mr Jones for 30 000 at 10 percent interest for 20 years If Mr Jones has a choice between a CPM and a CAM which one would result in his paying a greater amount of total interest over the life of the mortgage Would one of these mortgages be likely to have a higher interest rate


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