Question

Option 1: First Mortgage loan for $170,000 with an effective interest cost of 9%. Option 2: First Mortgage loan for $150,000 with terms: 6%, 30 years & Second Mortgage loan for $20,000 with terms: 12% 10 years. The holding period is 5 years (note: The procedure varies slightly with the holding period selection). Mathematically demonstrate using PV analysis which option should be selected. Indicate whether option 1 or 2 should be taken.

C. Decision: Which Option should be selected and reason for the selection.

Answer 1

In option 2,

Total yearly payment = $14,437.02

Amount required to pay off after 5 years = $152,064.30

Calculation as follows:

With these amounts, effective interest cost during the holding period of 5 years= 6.6447% as follows

Effective interest cost of Option 1 is given as 9%. Since the interest cost in option 2 is lower at 6.64%, option 2 is selected.