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ARE144_chap_04_bf13ed_v2_KEY

# ARE144_chap_04_bf13ed_v2_KEY - 1 Managerial Economics(ARE...

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1 Managerial Economics (ARE) 144 University of California, Davis Instructor: John H. Constantine KEY—Handout: Chapter 4, Fixed Rate Mortgage Loans NOTES: (1) You should practice using your FINANCIAL CALCULATOR on many of these problems. (2) Many answers have Excel printouts. These are provided to show you how you can use Excel to solve these problems. BUT , you are expected to be able to solve all problems using the given formulas. Detailed answers are provided for many of the questions. In the cases where a full answer is not given, then you can look to a previous answer to get the process to solving. (1) What are the major differences between the CAM, and CPM loans? What are the advantages to borrowers and risks to lenders for each? What elements do each of the loans have in common? CAM - Constant Amortization Mortgage: Payments on constant amortization mortgages are determined first by computing a constant amount of each monthly payment to be applied to principal. Interest is then computed on the monthly loan balance and added to the monthly amount of amortization to determine the total monthly payment. CPM - Constant Payment Mortgage: This payment pattern simply means that a level, or constant, monthly payment is calculated on an original loan amount at a fixed rate of interest for a given term. CAM: Lenders recognized that in a growing economy, borrowers could partially repay the loan over time, as opposed to reducing the loan balance in fixed monthly amounts. CPM: At the end of the term of the mortgage loan, the original loan amount or principal is completely repaid and the lender has earned a fixed rate of interest on the monthly loan balance. However the amount of amortization varies each month. When both loans are originated at the same rate of interest, the yield to the lender will be the same regardless of when the loans are repaid (ie, early or at maturity). (2) Define amortization. Amortization is the process of loan repayment over time. (3) Why do the monthly payments in the beginning months of a CPM loan contain a higher proportion of interest than principal repayment? The reason for such a high interest component in each monthly payment is that the lender earns an annual percentage return on the outstanding monthly loan balance. Because the loan is being repaid over a long period of time, the loan balance is reduced only very slightly at first and monthly interest charges are correspondingly high.

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