Question

Question #6

After lunch, Nancy Williams calls up her personal banker to ask about two things. One, she wants a 1-year education loan of $20,000 for her son, Phil and two, she is looking to take out a mortgage loan of $200,000. The banker offers the following choices:

1. Education loan of $20,000: A simple loan to be repaid after a year along with an interest of 10% p.a. or an amortized loan at an interest rate of 10% p.a. to be repaid through 12 equal monthly instalments.

2. Mortgage loan of $200,000: A 9% p.a. loan for 25 years without any discount points or an 8.5% p.a. loan for 25 years with 1 discount point.

Nancy decides to go for a simple loan because, well, it is simple instead of being complex. She also decides to avail the discount point facility, assuming that she is unlikely to repay the loan before time.

Question 6
Did Nancy take a correct decision regarding taking a simple loan for her son’s education? Support your answer with relevant computations and reasoning.

Answer 1

In a simple loan, the principal amount along with the interest is repaid at the end of the loan term.

Nancy has taken a simple loan for her son's education to be repaid after a year.

The interest on the loan = Principal time period interest rate

Interest = $ 20000 1 0.10 = $2000

Total amount repaid at the end of 1 year = $ 22000

In a fully amortized loan, the monthly payment on the loan is calculated using the following equation

Monthly payment on the loan = $ 1758.32

Total repayment on the loan = $ 1758.32 12 months

Total repayment on the fully amortized loan = $ 21,099.84

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Nancy's decision to take the simple loan was not a correct decision because the fully amortized loan works out cheaper than the simple loan.

By taking the fully amortized loan, Nancy could have saved $ 900.16 in interest. ( $ 22000 - $ 21099.84)