Question

You are considering to buy a $250,000 property with a 80% LTV ratio and have two mortgage choices: a FRM or a FRM with an IO period. The lender offers the following two loans: Loan 1: 30 year FRM, fully amortizing monthly payments; 4% interest Loan 2: 30 year FRM with 4 year IO period, fully amortizing monthly payments; 4.15% interest Check all the true statements: If I want to save on interest payments, I would choose Loan 2 If I want to minimize the payments in the first few years, I would choose Loan 2 If I'd like to pay off the loan sooner, I'd choose Loan 1 If I want my payments to remain the same for the duration of the loan, I would pick Loan 1

Answer 1

Answer:

Statement # 1: False

Statement # 2: True

Statement # 3: False

Statement # 4: True

Explanation:

Lets look at each statement provided in the question and determine which of them is true or false.

Statement # 1 is false. First things first, the interest on this loan amount is higher which is at 4.15%. This is compared to the interest of 4% applicable on loan option 1. Secondly, there is a four year interest only option. This means that for 4 years there will be no repayments of the principal amount which means that the interest of 4.15% will continue to apply on the entire loan amount for these 4 years. In loan 1 however, principal repayments will reduce the principal amount after the 1st year which would further reduce the interest payment in the second year.

Statement # 2 is true. Loan 2 has an interest only period for the first 4 years. During this year you will only pay the 4.15% interest whereas in loan option 1, you will pay 4% interest AND the principal amount. The effect would offset once principal payments start in loan 2 but it would still mean that payments would be minimized in the first few years.

Statement # 3 is false. One of the advantages of having a loan with an interest free clause is that you can pay it off faster than a conventional loan. Since both the loans are fully amortizing, the principal payments would be different but would both result in the principal being repaid in the full 30 year tenor. Any extra payment that you wish to make would be counted towards principal payment in each loan option. However, for loan 1, the total monthly payments you make would remain the same. For loan 2, the extra payments that you make will continue to lower the monthly payments in way of interest which would allow you to save up more to pay more off in principal. The interest only period will also allow you to arrange extra funds during the IO period and repay the principal further. With loan 1, you will continue to make the same monthly payment until the end.

Statement # 4 is true. A fixed payment is being made each year by way of interest and principal repayments and will remain the same till the loan is fully amortized at maturity. In loan 2 on the other hand, a larger balloon payment will start 4 years later since only interest is paid in the first 4 years. So basically you may lower in the first 4 years and more in the remaining years.