Chapter 06:

Mortgages: Additional Concepts,

Analysis, and Applications
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Introduction
 This chapter focuses on assessing the
impact of different loan aspects (i.e
difference in loan amounts, origination
fees, early repayment opportunity etc.)
and evaluates how they impact the
ultimate borrowing decision of the
customers.

6-2
 Incremental Borrowing Cost
 Often times, a borrower might have the option to borrow different
amounts from a bank at different rates.
 For example, Mr. A can borrow $80,000 for 25 years (Option A)
at 12% or $90,000 for 25 years at 13% (Option B).
 In this case, the decision regarding which loan to take is not
straightforward as one option has more loan amount but also
higher interest rate and vice versa.
 In such situations, borrowers need to calculate the incremental
borrowing cost to aid their decision. Incremental borrowing cost
refers to the cost of borrowing every additional unit of money.
 In other words, how much does borrowing the extra $10,000
through option B cost the borrower?

6-3
 Incremental Borrowing cost-
Example
 Mr. ABD wants to purchase an apartment for $100,000.
The bank has offered two loan options.
Option A: Bank will give loan at a LTV ratio of 80% for 25
years. The interest rate is 12% per annum to be
compounded monthly.
Option B: Bank will give loan at a LTV ratio of 90% for 25
years. The interest rate is 13% per annum to be
compounded monthly.

Q) The different in interest rate is only 1%. Which option

should Mr. ABD choose?

6-4
 Incremental Borrowing Cost-
Example
Option A Option B Difference
LTV 80% 90% 10%
i 12% 13% 1%
Term 25 Years 25 Years 0
Down payment $20,000 $10,000 $10,000
(equity by
borrower)
Loan $80,000 $90000 $10,000

Monthly $842.58 $1015.05 $172.47

Payment
6-5
Calculating Incremental Borrowing
Cost
 Cash Flow Differences
– Borrow $10,000 more
– Pay $172.47 per month more
PV = $10,000
PMT = $174.47
n = 300
CPT i = 20.57%

6-6
 Incremental Borrowing Cost
 20.57% represents the incremental cost of borrowing the extra
$10,000.

 The decision of the borrower would depend on two factors:

1. By borrowing $10,000 more through option B, the borrower can
save his own equity contribution (down payment) by $10,000 and
can invest it elsewhere. However, if the risk adjusted return from
that investment is less than 20.57% then it wont make sense to take
the additional loan.
2. Alternatively, can the borrower borrow the additional $10,000
elsewhere at a lower cost? If yes, then it should go for Option A.

6-7
 Take-Home Message
The more you borrow, the higher the
interest rate will be.

While we will discuss this in detail later on,

there is a point at which you should not
borrow more money. The interest rate will
be just too high.

It is not economically rational to borrow as

much money as possible.
6-8
 Practice Math 1
 Mr. XYZ wants to purchase an apartment for $50,00,000.
The bank has offered two loan options.
Option A: Bank will give loan at a LTV ratio of 80% for 25
years. The interest rate is 9.5% per annum to be
compounded Semi-annually.
Option B: Bank will give loan at a LTV ratio of 90% for 25
years. The interest rate is 11% per annum to be Semi-
annually.

Q) Which option should Mr. ABD choose?

6-9
 Practice Math 2
 Mr. XYZ wants to purchase an apartment for $50,00,000. The bank
has offered two loan options.
Option A: Bank will give loan at a LTV ratio of 80% for 20 years. The
interest rate is 9% per annum to be compounded Semi-annually.
Option B: Bank will give loan at a LTV ratio of 90% for 20 years. The
interest rate is 9.5% per annum to be Semi-annually.

Q) Mr. XYZ can self fund the extra 500,000. However, Mr. XYZ has an
opportunity to invest in a project for a risk adjusted return of 15%.
Advise Mr. XYZ regarding what his financial decision should be.

6-10
 Practice Math 3
 Mr. XYZ wants to purchase an apartment for $50,00,000. The bank
has offered two loan options.
Option A: Bank will give loan at a LTV ratio of 80% for 20 years. The
interest rate is 8% per annum to be compounded Semi-annually.
Option B: Bank will give loan at a LTV ratio of 90% for 20 years. The
interest rate is 9% per annum to be Semi-annually.

Q) Advise Mr. XYZ regarding what his financial decision should be if he

can also borrow the additional Tk 500000 against his PF at 11%

6-11
 Impact of origination fees on
Incremental borrowing cost
– Analysis would change
 Depending on the points, the cash flow difference
at time zero would change.
 In Example 6-1, the $10,000 difference would
change to $8900.
 Incremental borrowing cost would rise from
20.57% to 23.18% as same interest is now being
paid on less loan amount (net).

6-12
 Practice Math 4
 Mr. XYZ wants to purchase an apartment for $50,00,000.
The bank has offered two loan options.
Option A: Bank will give loan at a LTV ratio of 80% for 25
years. The interest rate is 9.5% per annum to be
compounded Semi-annually. The origination fees is 2%
Option B: Bank will give loan at a LTV ratio of 90% for 25
years. The interest rate is 11% per annum to be Semi-
annually. The origination fees is 3%.

Q) Which option should Mr. ABD choose?

6-13
Effect of Loan-to-Value Ratio on
Loan Cost

6-14
 Effect of Loan-to-Value Ratio on
Loan Cost
 As the loan to value ratio increases, the
level of default risk increases. Thus, the
interest rate charged by the bank will also
increase.

 This means that as LTV ratio increases the

incremental borrowing cost will also increase
and this will pull up the average cost of the
loan as well.
6-15
 Loan Refinancing
 A borrower might get an opportunity to refinance an existing
loan at a lower rate. Before taking any decision, the borrower
must take some considerations
– Terms on the present outstanding loan
– What are the new loan terms?
– What are the fees associated with paying off the old loan
and obtaining a new one?

 The decision will be made through Application of basic capital

budgeting investment decision
– What is our return on an investment in a new loan? In
other words, what is the IRR?

6-16
 Loan Refinancing- Example
– A borrower has secured a 30 year, $80,000 loan at 15% with
monthly payments. Five years later, the interest rate has fallen
and borrower has the opportunity to refinance with a 25 year
mortgage at 14%. However, there is a prepayment penalty fee
of 2% on the outstanding balance. Moreover, the new loan has
an origination fee of $2,500 and recording cost of 25$. Assume
that the borrower has expected rate of return of 12% from other
similar risk investments.

Q1) Should the borrower refinance the loan?

Q2) At what expected rate of return would the borrower have been
against refinancing the loan?

6-17
 Practice Math 5
– A borrower has secured a 30 year, Tk 30,00,000 loan at 15%
with monthly payments. 10 years later, the interest rate has
fallen and borrower has the opportunity to refinance with a 20
year mortgage at 13%. However, there is a prepayment penalty
fee of 3% on the outstanding balance. Moreover, the new loan
has an origination fee of 2%. Assume that the borrower has
expected rate of return of 14% from other similar risk
investments.

Q1) Should the borrower refinance the loan?

Q2) At what expected rate of return would the borrower have been
against refinancing the loan?

6-18
Loan Refinancing-Early Repayment
– A borrower has secured a 30 year, $80,000 loan at 15% with
monthly payments. Five years later, the interest rate has fallen
and borrower has the opportunity to refinance with a 25 year
mortgage at 14%. However, there is a prepayment penalty fee
of 2% on the outstanding balance. Moreover, the new loan has
an origination fee of $2,500 and recording cost of 25$. Assume
that the borrower will repay the entire loan 10 years after
refinancing. The borrower has expected rate of return of 12%
from other similar risk investments.

Q1) Should the borrower refinance the loan?

6-19
 Effective cost of refinancing
 Refinancing decisions can also be taken by calculating
the effective cost of refinancing and comparing it with the
rate of interest on the old loan.

 If the effective rate of interest is less than the rate of old

loan then refinancing would be viable and vice versa.

 In order to calculate effective cost of refinancing, we

treat the cost of refinancing as “fees” and deduct it from
new loan amount to arrive at the “net used amount” and
use it to compute effective cost of refinancing.

6-20
 Example-effective cost of
refinancing
 A borrower has secured a 30 year, $80,000 loan at 15% with
monthly payments. Five years later, the interest rate has fallen and
borrower has the opportunity to refinance with a 25 year mortgage
at 14%. However, there is a prepayment penalty fee of 2% on the
outstanding balance. Moreover, the new loan has an origination fee
of $2,500 and recording cost of 25$. Calculate the effective cost of
refinancing and recommend whether refinancing should be done or
not.

6-21
 Market Value of a Loan
 The amount of loan remaining at any point of time is its
Book value. However, the Market value will be different
from the loan if the market interest rate has changed
after the loan was made and is different from the loan
interest rate.

 The market value of the loan represents how much a

new lender/investor would pay in exchange for receiving
the future payments from the loan.
– The investor is buying the cash flow stream of the loan.
– Discount loan cash flow at the market rate of interest that the
investor can earn on investments of equivalent risk.

6-22
 Market Value of a Loan
 Example :
– $80,000 Loan
– 20 Years
– 10% interest
– Assume market interest rates have risen to
15%.

What is the book value and market value of this

loan after 5 years.
6-23
 Market Value of a Loan
 Solution:
PMT = $772.02
–Five years later, book value = 772.02* PVAF(.10/12,15*12)
= $71,841.95

–Market value = 772.02* PVAF(.15/12,15*12)

= $55,161

This means that after 5 years, the loan will have to be sold at a
discount in the secondary market. The discount is 23% of the face
value/book value of the loan.

6-24
 Effective Cost of Two or More
Loans
 Sometimes a borrower might take two mortgage loans
against a single property. This mainly happens in cases
of assumption of a current mortgage by a new party. In
such case, it becomes necessary to calculate the
combined effective cost. The process of calculating this
is as follows:
 Basic Technique
– Compute the payments for the loans, seperately
– Combine into a cash flow stream
– Compute the effective cost of the amount borrowed, given the
cash flow stream.
– Compare the cost to alternative financing options.

6-25
 Example
 Mr.X bought a property at $100,000. He paid for it by taking $80,000
loan for 25 years at 10% interest (monthly compounding) and paid
the remainder amount from own equity. After 5 years, the property
value has increased to $115,000 and Mr.X became reluctant to
continue the loan and decided to sell of the property to a third party-
Mr. Y. will pay 20% of the property value from own equity, assume
the current mortgage loan and fund the remaining portion by taking
another mortgage loan at 14% for 20 years (Monthly compounding).

Q1) Calculate the combined effective cost of borrowing for Mr. Y.

Q2) Suppose, Mr. Y can purchase similar property directly from the real
estate market by taking a single mortgage loan at 14%. Recommend
should he do so or not.

6-26
 Practice Math 6
 Mr.X bought a property at $100,000. He paid for it by taking $80,000
loan for 30 years at 12% interest (monthly compounding) and paid
the remainder amount from own equity. After 5 years, the property
value has increased to $120,000 and Mr.X became reluctant to
continue the loan and decided to sell of the property to a third party-
Mr. Y. Mr. Y will pay 25% of the property value from own equity,
assume the current mortgage loan and fund the remaining portion by
taking another mortgage loan at 16% for 25 years (Monthly
compounding).

Q1) Calculate the combined effective cost of borrowing for Mr. Y.

Q2) Suppose, Mr. Y can purchase similar property directly from the real
estate market by taking a single mortgage loan at 14%. Recommend
should he do so or not.

6-27