Question

Mark Sexton and Todd Story, the owners of S&S Air, Inc., were impressed by the work Chris had done on financial planning. Using Chris’s analysis, and looking at the demand for light aircraft, they have decided that their existing fabrication equipment is sufficient, but it is time to acquire a bigger manufacturing facility. Mark and Todd have identified a suitable structure that is currently for sale, and they believe they can buy and refurbish it for about $68 million. Mark, Todd, and Chris are now ready to meet with Christie Vaughan, the loan officer for First United National Bank. The meeting is to discuss the mortgage options available to the company to finance the new facility.

Christie begins the meeting by discussing a 30-year mortgage. The loan would be repaid in equal monthly install- ments. Because of the previous relationship between S&S Air and the bank, there would be no closing costs for the loan. Christie states that the APR of the loan would be 3.19 percent. Todd asks if a shorter mortgage loan is available. Christie says that the bank does have a 20-year mortgage available at the same APR.

Mark decides to ask Christie about a “smart loan” he discussed with a mortgage broker when he was refinancing his home loan. A smart loan works as follows : Every two weeks a mortgage payment is made that is exactly one-half of the traditional monthly mortgage payment. Christie informs him that the bank does have smart loans. The APR of the smart loan would be the same as the APR of the traditional loan. Mark nods his head. He then states this is the best mortgage option available to the company since it saves interest payments.

Christie agrees with Mark, but then suggests that a bullet loan, or balloon payment, would result in the greatest interest savings. At Todd’s prompting, she goes on to explain a bullet loan. The monthly payments of a bullet loan would be calculated using a 30-year traditional mortgage. In this case, there would be a 5-year bullet. This would mean that the company would make the mortgage payments for the traditional 30-year mortgage for the first five years, but immediately after the company makes the 60th payment, the bullet payment would be due. The bullet payment is the remaining principal of the loan. Chris then asks how the bullet payment is calculated. Christie tells him that the remaining principal can be calculated using an amortization table, but it is also the present value of the remaining 25 years of mortgage payments for the 30-year mortgage.

Todd has also heard of an interest-only loan and asks if this loan is available and what the terms would be. Christie says that the bank offers an interest-only loan with a term of 10 years and an APR of 2.95 percent. She goes on to further explain the terms. The company would be responsible for making interest payments each month on the amount borrowed. No principal payments are required. At the end of the 10-year term, the company would repay the $68 million. However, the company can make principal payments at any time. The principal payments would work just like those on a traditional mortgage. Principal payments would reduce the principal of the loan and reduce the interest due on the next payment.

Mark and Todd are satisfied with Christie’s answers, but they are still unsure of which loan they should choose. They have asked Chris to answer the following questions to help them choose the correct mortgage.

  

Questions

What are the monthly payments for a 30-year traditional mortgage? What are the payments for a 20-year traditional mortgage ?

Prepare an amortization table for the first six months of the traditional 30-year mortgage. How much of the first payment goes toward principal ?

How long would it take for S&S Air to pay off the smart loan assuming 30-year traditional mortgage payments ? Why is this shorter than the time needed to pay off the traditional mortgage ? How much interest would the company save ?

Assume S&S Air takes out a bullet loan under the terms described. What are the payments on the loan?

What are the payments for the interest-only loan?

Which mortgage is the best for the company? Are there any potential risks in this action?

HINT : Use one Excel sheet for each loan mentioned in the case. Once all numbers are available, create tables to compare all options in order to answer the case questions.

Answer 1

1.) 30 Years traditional mortgage consist loan payments that are equal to 360 monthly payments . For calculate monthly payment , we use present value of Annuity formula :

PMT = amount of each annuity payment  = c

r = interest rate  = 3.19%/12 = 0.27%

n = number of periods in which payments made = 360

PVA = Present Value of Annuity = 68,000,000

C = $295,562.22

Monthly Payments for 30 years mortgage loan is $295,562.22.

20 Years traditional mortgage consist loan payments that are equal to 240 monthly payments . For calculate monthly payment , we use present value of Annuity formula :

PVA = PMT * PVIFA ( 0.27%,240)   { value of pvifa from pvifa table or pvifa calculator }

68,000,000 = C * 176.46

C = 68,000,000 / 176.46

C = $385,356.45

Monthly Payments for 20 years mortgage loan is $385,356.45.

Note : we can calculate in both ways first way as in 30year and second way in 20year.

2.) We will split payment of $295,562.22 in two parts interest and principal companent. For this we use excel IPMT and PPMT function.

amortization table for the first six months of the traditional 30-year mortgage.

​ $183,600 of the first payment goes towards principal. At the end of 6th month ending balance is $67,323,645.67.

3.) Smart Loan allow Mark and Todd to make payments bi-weekly (once in every two week), which will save interest payments at the end.

Firstly we have to split monthly payments in two biweekly payments. $295,562.22 / 2 = $147,781.11

A month has four week, biweekly payments means once in two week i.e., 2 payments in a month.

52 weeks in a year, So, 52 weeks / 2 = 26 payments in a year

The monthly payments allowed in a year is 12 and bi-weekly payments in a month is 2 per month. Simply means 12 * 2 = 24 payments in a year, but this is not true.

We can make 26 payments in a year on the basis of bi-weekly payments that means 2 ( 26 - 24 ) payment extra in every year. This will decrease the time to pay-off of the loan.

Interest Rate = 3.19% * (2/52) = 0.123% bi-weekly interest rate.

4.) Condition of a bullet loan would 30 years traditional mortgage loan , resulting in 5-year bullet. There are 12 payments in a year. So, total number of Payments 5 * 12 = 60 required payments.

The payments would be the same as 30 year loan, only difference is that at the end of 60th payment, the principal balance is due is $60,717,835.90 (you can calculate through amortisation table as calculate above in point 2. )

= = = =    = $60,720,302.48