Thursday, June 13, 2019

Interest expenses over the life of a mortgage


This post looks at potential interest savings from moving from a 30-year FRM to a 15-year FRM.    We also consider issues pertaining to a strategy of keeping the 30-year FRM with its higher interest rate while making the 15-year FRM payment.

Question:    A person is purchasing a house and is considering two financing options.  The first option is a 30-year loan at 3.43%.  The second option is a 15-year loan at 2.65%.   The loan balance for both the 15-year and 30-year FRM is $200,000.  What is the total interest expense over the life of the loan for the two options? 

What is the outstanding balance on the loan if you make the monthly payment consistent with a 15-year loan at 2.65% but you are actually charged 3.43% interest?

Answer:  The interest cost calculation involves three steps.

Step One: Calculate monthly payments for the two mortgages.  Inputs for the 30-year FRM are r=0.343/13, N=360, and P=$200,000.  Inputs for the 15-year FRM are r=0.0265, N=180, and P=$200,000.  We get $890.29 for the 30-year FRM and $1347.75 for the 15-year FRM.   

Step Two:   Calculate total payments over the life of the loan (360 x $890.20  = $320,505) for the 30-year loan and  (180 x $1346.75 = $242,594.40) for the 15-year loan. 

Step Three: we subtract the $200,000 initial loan balance from the total payment calculations and get total interest payments of $120,505 for the 30-year FRM and $42,594 for the 15-year FRM.

These calculations are laid out in the table below.


Total Interest Costs Over the Life of Two Loans
30 year
15 year
Interest Rate
0.0343
0.0265
# of Monthly Payments
360
180
Loan Balance
200000
200000
Monthly Payment
($890.29)
($1,347.75)
Total Payments over the life of the loan
($320,505.37)
($242,594.40)
Total Interest Payments
($120,505.37)
($42,594.40)



Now for the second part of the problem:

A person chooses to take out the 30-year FRM because he is fearful that he cannot maintain the higher payment on the 15-year loan.    He continues to make the 15-year payment on time for 15 years but he is charged the 30-year rate of 3.43%.   What is the outstanding loan balance after 15 years of payments?

We use the FV function in Excel with inputs of r=0.0343/12 (the 30-year rate) N=180 (the number of months in a 15-year loan) and $1347.75 (the required payment for a 15-year FRM assuming r=2.65%).

After 15 years on this payment plan the borrower would owe $17,658.




Loan balance with 15-year payment but 30-year interest rate
30-year interest Rate
0.0343
# of Months
180
Actual Payment on 15-year FRM
($1,347.75)
Loan amount
$200,000
Future Value of Loan
($17,657.49)



The post presented here was solved using Excel finance function.   Students of finance can learn a lot by evaluating the formulas used in the Excel functions.   One of the first blog and most highly read postson Daily Math Problem studied this issue.  Interested readers should go here.

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