Question

Order these loans from highest monthly payment to lowest monthly payment. (Enter 1 as your answer to designate loan with highest payment, 2 as loan with second highest payment, and so on up to 5 to designate loan with lowest payment.) Each of the following loans is for $300,000 and is a fixed rate mortgage with a 3.5% interest rate.
(a) Balloon payment of S500,000 is due at maturity
(b) Balloon payment of $250,000 is due at maturity
(c) The loan is fully repaid at maturity
(d) Interest-only payments for the duration of the loan
(e) Balloon payment of S100,000 is due at maturity

Answer 1

Answer:

(a) 5

(b) 3

(c) 1

(d) 4

(e) 2

Explanation:

The way to answer this question is actually simple and does not necessarily require complicated calculations, or computations of amortization schedules etc. You can answer the question by looking at it intuitively. Now, lets see how the mortgage works in practical life (given the information presented in the question). The loan amount is $300,000 with an interest rate of 3.5% per year. You would be paying a certain amount of interest on this loan on a monthly basis. This is calculated by multiplying the loan amount by one-twelfth of the interest rate since the quoted rate is on a yearly basis. So the first month's interest payment would be $875(300,000 x 3.5% / 12). Now, along with interest payments, you may a certain amount of money towards reducing the principal loan amount as well. So, we see that the first month's interest payment was $875 but the actual monthly payment (as per the loan agreement) might be higher because you are paying a bit off the principal as well. So, over the life of the loan, the principal payments will go up and interest payments would go down with the total monthly payments remaining the same until, at the end of the loan tenor, the loan is completely settled.

Now, some of the options mention a balloon payment. This balloon payment refers to a loan in which not all of the principal amount is run down by the maturity date. Which means, a certain portion of the principal amount (lets say $ 50,000) is remaining. This is referred to as a balloon payment since this is a payment, that is considerably larger than the monthly payments you were making, that needs to be paid in one go at the maturity date. We can see both logically and mathematically, that the higher the amount of the balloon payment, the lower the amount paid in monthly principal payments, and therefore, the lower monthly payment amount overall.

Now, out of the options presented, option (c) would have the highest number of monthly payments because the loan is being fully settled at maturity. This means that the monthly principal repayment component would be higher compared to the other loan options.

Option (d) would have the one of the lowest monthly payment since only interest is being paid on the monthly basis. The entire principal will be repaid at maturity (in a balloon payment of $300,000).

Option (a) would have the LOWEST monthly payment because, the loan amount is $300,000 whereas a considerably larger amount of $500,000 is being made in a balloon payment on maturity. This means that there is zero principal payment being made on a monthly basis AND the interest payment is lower as well. So, while the interest rate is the same as in the other loans (3.5%), the interest is being accumulated rather than being paid of on a monthly basis, and will be paid along with the entire principal payment in one massive balloon payment at the end of the loan tenor. Which means, this option would have the lowest monthly payments.

The rest of the options (b and e) come in between  with option e having higher monthly payments than option d since the balloon payment amount is larger.

out of the options presented, most of them involve a balloon payment at maturity.