Cost of Funds Advanced to the Borrower

Cost of Funds Advanced to the Borrower (COFA) – Fully Amortized Loan

-the borrower would want to calculate the rate of interest charged on the mortgage loan amount after all fees have been deducted

-another measure of the cost of borrowing that can be compared against the contract interest rate

Cost of Funds Advanced to the Borrower – Partially Amortized Loan

-Although the contract indicates that the borrower is to pay interest at a nominal rate of j12 = 7%, the borrower pays a higher rate of approximately j12 = 17.06% on the funds received. Why?

-The borrower is making payments on a larger amount of money ($110,000) than the cash received ($100,000). The cost of funds advanced to the borrower is j12 = 17.057527% and j1 = 18.456345%.

-The rate calculated for the partially amortized loan (j12 = 17.057527%) is higher than the rate calculated if the loan were fully amortized (j12 = 8.262175%).

-The difference is a result of the fact that since the loan is partially amortized, the bonus is repaid over a shorter period.

-In other words, with a bonus of a given size, all other terms being equal, the effective rate/the cost of funds advanced paid by the borrower increases dramatically as the term of the loan is shortened.

Yield to the Lender

-Today, mortgage brokers are increasingly involved with conventional financing, and in most of these conventional deals, it is the lender, not the borrower, who pays the brokerage fee.

-this fee is usually a percentage of the face value of the loan

-This means the cost of borrowing is the same as the contract rate on the loan.

-However, the return to the lender is diminished by these fees – the lender advances a larger amount, and when fees are deducted upfront, the lender receives back a smaller amount over time.

Investment Yield

-The two calculations that may flow from this situation are:

1. Given the investor’s desired yield, what price should the investor pay?

2. Given the price the investor is willing to pay, what yield will the investor earn on the investment?

-Perhaps the most common application for this situation would be an investor who provides a “buy-out” for a lender who has originated a mortgage loan but does not wish to be a long-term mortgage holder.

*Note that the calculations illustrated below are not restricted to mortgage loans – they would be the same for any investment where cash flows occur in equal amounts at regular intervals and where a discount is involved.

PREPAYMENT PENALTIES

lenders do typically allow prepayment of the remaining outstanding balance but with a penalty of the greater of three months’ interest or the interest rate differential (IRD)

*Monthly Interest Penalty = OSB × imo × Number of Months

Interest rate differential (IRD)

the difference between the contract rate of interest and the current rate of interest over the remaining term, which the borrower may have to pay the lender when fully prepaying an outstanding balance

-The IRD calculation is an attempt by the lender to recover the loss of interest that will occur as a result of allowing prepayment.

-When interest rates decline, lenders lose the benefit of the higher contractual rate if they allow prepayment.

*IRD Penalty = OSB × Interest Rate Difference × Length of Time Remaining in the Term

-Each lender will differ in the rate used to determine the actual IRD rate.

-Other penalties may also be used, at the lender’s discretion