Consider the following scenario: John buys a house for $150,000 andtakes out a f

Question

Consider the following scenario: John buys a house for $150,000 andtakes out a five year adjustable rate mortgage with a beginningrate of 6%. He makes annual payments rather than monthlypayments.

Unfortunately for John, interest rates go up by 1% for each of thefive years of his loan (Year 1 is 6%, Year 2 is 7%, Year 3 is 8%,Year 4 is 9%, Year 5 is 10%).

Calculate the amount of John's payment over the life of his loan.Compare these findings if he would have taken out a fix rate loanfor the same period at 7.5%. Which do you think is thebetter deal?

Explanation / Answer

Option (1) Year Annual CashOutflows InterestRate PVFactors PV of Cashoutflows 1 $30,000.00 6% 0.9434 $28,302.00 2 $30,000.00 7% 0.8734 $26,202.00 3 $30,000.00 8% 0.7938 $23,814.00 4 $30,000.00 9% 0.7084 $21,252.00 5 $30,000.00 10% 0.6209 $18,627.00 Total Present Value of CashOutflows $118,197.00
Option(2) Calculating Present Value of CashOutflows: (Using Ms-Excel "PV" Function): InterestRate (Rate) 7.50% Number ofPeriods (Nper) 5 AnnualPayment Amount (PMT) -$30,000 Present Value of CashOutflows $121,376.55 Note: Comparing these two Options, Option (1) has lowestCash outflows i.e $118,197. Thus, Option (1) is the betterdeal.                   $121,376.55< $118,197 Option (1) Year Annual CashOutflows InterestRate PVFactors PV of Cashoutflows 1 $30,000.00 6% 0.9434 $28,302.00 2 $30,000.00 7% 0.8734 $26,202.00 3 $30,000.00 8% 0.7938 $23,814.00 4 $30,000.00 9% 0.7084 $21,252.00 5 $30,000.00 10% 0.6209 $18,627.00 Total Present Value of CashOutflows $118,197.00

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