Suppose a property owner named Smith has an existing loan with a balance of $90,000 and monthly payments of $860.09. The interest rate on the loan is 8 percent and the remaining loan term is 15 years. From the time Smith originally obtained this loan, the property has risen in value to $150,000. Smith’s current loan balance is 60 percent of the current value of the property. He would like to borrow an additional $30,000, which would increase his debt to $120,000, or 80 percent of the property value. Assume that the current effective interest rate on a first mortgage with an 80 percent loan-to-value ratio is 11.5 percent with a term of 15 years, and the current effective interest rate on a second mortgage for an additional20 percent of value ($30,000) would be 15.5 percent for a term of 15 years. A lender different than the holder of Smith’s existing loan is willing to make a wraparound loan for $120,000 at a 10 percent rate for a 15-year term. Payments on this loan would be $1,289.53 per month. If Smith makes this loan, the wraparound lender will take over the payments on Smith’s current loan; that is, Smith will pay $1,289.53 to the wraparound lender, and the wraparound lender will make the $860.09 payment on the original loan. Thus, Smith’s payment would increase by $429.44 ($1,289.53 – $860.09) per month. Because the wraparound lender is taking over the payments on the old loan, Smith will actually receive only $30,000 in cash (the $120,000 amount for the wraparound loan less the $90,000 balance of Smith’s current loan). Is the wraparound loan a desirable alternative for Smith to obtain an additional $30,000?
19 What is the cost of the incremental $30,000? This is analogous to determining the
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