ANALYSIS OF CONSTANT PAYMENT MORTGAGES

to review the financial calculations necessary to determine loan amounts, periodic payments (monthly or otherwise), amortization periods, interest rates, outstanding balances, and final payments

Constant payment mortgages

a mortgage loan that is repaid by equal and consecutive instalments that include principal and interest

4 basic financial components in all constant payment mortgage loans

1. Loan Amount: The loan amount (or face value of the mortgage) is the amount the borrower agrees to repay at the interest rate stated in the mortgage contract. In financial terms, the loan amount is the present value of the required payments.

2. Nominal Rate of Interest: The frequency of compounding of the nominal interest rate must match the frequency of the payments. For example, if a loan calls for interest at 10% per annum, compounded semi-annually with monthly payments, the equivalent nominal rate of interest with monthly compounding needs to be calculated.

3. Amortization Period: The amortization period is used to calculate the size of the required payments. The amortization period must be specified in terms of the number of payment periods, so a loan calling for monthly payments over 25 years has 300 (25 × 12) payment periods.

4. Payment: The constant payment required to repay the loan amount over the amortization period is calculated such that, if payments are made regularly, the last payment will repay all remaining principal as well as interest due at the end of the final payment period.

*The calculator also uses a fifth piece of information, the future value. However, the future value is equal to zero when doing basic calculations for constant payment mortgages because these mortgages are always completely paid off (have a future value of zero) at the end of the amortization period.

3 conditions must occur to use the calculator to analyze a constant payment mortgage

1. The present value must occur at the beginning of the first payment/compounding period.

2. The payments must be equal in amount, occur at regular intervals, and be made at the end of each payment period.

3. The rate of interest must be stated as, or converted to, a nominal rate with compounding frequency matching the payment frequency.

Calculation of Loan Amount

-With constant payment mortgage loans, a large portion of each of the early payments is allocated to the payment of interest.

-Increased interest rates reduce the amount of each payment available for principal repayment, making a significant impact on an individual’s ability to borrow a given amount.

-To conform to this provision of the Interest Act, interest rates are typically quoted with semi-annual compounding, but most mortgage loans specify that payments are to be made monthly

*Equivalent interest rates should not be “keyed” into the calculator. Instead, they should be calculated and used directly to avoid errors in re-entering the number, and to retain full accuracy of calculations.

Calculation of Payments to Amortize a Loan

Since borrowers cannot make payments that involve fractions of cents, the payments must be rounded to at least the nearest cent.

*Regular rounding rules apply, unless the facts indicate differently

Calculation of Amortization Period

the maximum amortization period for insured mortgages is 25 years, and 30 to 35 years for uninsured mortgages with a 20% or more down payment.

Calculation of Outstanding Balances (OSB)

-Most vendors want to know how much they will receive from the sale of their property after they have repaid the outstanding balance on their mortgage.

-While mortgage payments are calculated using the amortization period, the actual length of the mortgage contract may be different than the amortization period

-Term: the length of the mortgage contract

-If the mortgage term and amortization period are the same length of time, the mortgage is said to be fully amortized.

-If the mortgage term is shorter than the amortization period, the mortgage is said to be partially amortized

- Since mortgages are typically partially amortized with one to five-year contractual terms, the amount of money that the borrower owes the lender when the contract expires must be calculated.

Calculation of Principal and Interest Components of Payments

-These calculations are important because interest on payments can sometimes be deducted as an expense for income tax purposes.

-borrowers like to know how much principal they have paid off in a single payment or over a series of payments

Final Payments on Fully Amortized Loans

-if payments are rounded up, more principal will be repaid with each payment than is required to amortize the loan, resulting in faster repayment of the loan amount => you are overpaying slightly with each payment.

-Alternatively, if payments are rounded down to the nearest cent, you may in fact be slightly underpaying by a portion of a cent with each payment, meaning an interest adjustment will be owing as part of the final payment – the final payment will be larger than a regular payment => not a common issue

*For the purposes of this course, final payment calculations are not required; however, students are required to understand the concept of final payments.

Calculation of Accelerated Payments

-The more frequent payments can create substantial interest savings and reduce the loan’s amortization period.

-An accelerated payment simply means paying more with each payment than the bare minimum required to fully amortize the loan

-The accelerated biweekly payment is calculated as a monthly payment divided in half – instead of paying once a month, one-half of the monthly payment is paid every two weeks.