Loan Pricing -- Discount Point and Prepayment Calculations to create EY for lender.

Effective Yield (EY) for a lender can be targeted with the proper charging of discount point
(finance fee) and pre-payment penalty.

Suppose, a lender wants an EY = 7.25% and expects an average loan payoff of six years.
However, a particular borrower wants to borrow $500,000 for 30 years at 7.0%. How many
points must the lender charge to generate this EY?

Find Payment
INPUTS 360 .07/12 $500,000 $0
N I/YR PV PMT FV
OUTPUTS $3,326.51

P/Y = 1

Find Balance in 6 years

INPUTS 72 .07/12 $500,000 $3,326.51
N I/YR PV PMT FV
OUTPUTS $463,457.76

P/Y = 1

There exists a present value (net borrowed amount) that will create the desired EY for the lender.

Find PV that will create EY = 7.25%

INPUTS 72 .0725/12 $3,326.51 $463,457.76
N I/YR PV PMT FV
OUTPUTS $494,120.34

P/Y = 1

Thus, the difference between loan amount ($500,000) and the calculated Net Borrowed amount
($494,120.34) equals the dollar amount of $5,879.66 in finance fees that needs to be charged in
order to create the desired EY of 7.25%. If we were quoting discount points necessary to create
the desired EY, the calculation would be:

(Loan Amount−Net Borrowed)

Discount Points=
Loan Amount

($ 500,000−$ 494,120.34)
Discount Points=
$ 500,000
Discount Points=1.176 %

What prepayment penalty (without charging discount points) will create an EY = 7.25%? In
order to calculate the prepayment penalty to create an EY = 7.25%, repeat payment and balance
calculation and then find FV (mortgage payoff amount) that will create the desired EY.

Find Payment
INPUTS 360 .07/12 $500,000 $0
N I/YR PV PMT FV
OUTPUTS $3,326.51

P/Y = 1

Find Balance in 6 years

INPUTS 72 .07/12 $500,000 $3,326.51
N I/YR PV PMT FV
OUTPUTS $463,457.76

P/Y = 1

Find FV (loan payoff amount) that will create an EY = 7.25%

INPUTS 72 .0725/12 500,000 $3,326.51
N I/YR PV PMT FV
OUTPUTS $472,529.77

P/Y = 1

Taking the difference between the loan balance amount ($463,457.76) and the loan payoff
amount ($472,529.77) necessary to create the desired EY indicates that a prepayment amount of
$9,071.78 as a prepayment penalty will create the lender’s desired EY.

Thus, there are multiple ways to create a lender’s desired EY using a combination of finance fees
at closing and prepayment penalty amounts when the loan is paid off.