Information for the Question/ Task: In the years leading up to the COVID-19 pandemic, interest rates...

Information for the Question/ Task: In the years leading up to the COVID-19 pandemic, interest rates have already been on a declining trend. Harry is currently planning to borrow $300,000 to buy a house. Banks are offering monthly and fortnightly repayment terms, and home loans can range from 20 to 30 years in duration. Assume Harry will sign up for a variable rate home loan, which means that the interest rate of his home loan will change in the same direction of market interest rates.

Tasks:

First, explain the impact of interest rates on present values.
But if interest rates rise instead, this will affect the terms of Harry's home loan contract. Discuss two components of his home loan contract that can change (and explain the impact of these changes), in order to repay a $300,000 home loan.

(60 – 80 words)

Expert Solution

Because of the pandemic COVID-19, many Central Banks are reducing the interest rates. Reason? With less interest rates, borrowing cost for the funds would be less and that would boost the businesses.

1. While calculating the cost of capital, we take tax-adjusted interest rate. i.e. interest rate*(1-tax rate)

Thus, with decreasing interest rate, cost of capital will go down.

We calculate present value by dividing value by (1+Cost of capital), as the cost of capital goes down, the Present Value will go up.

2. Harry is taking $300000 home loan with a variable rate. Means if the interest rates go up, the interest he will pay will go up and vice versa. So, in the current situation of COVID-19, its a really good deal. But if the interest rate goes up, he will have to pay more interest and ultimately more EMI on his loan.

Two components that will change are Interest and EMI,

With increase in Interest rate, interest to pay and EMI will go up

With decrease in Interest rate, interest to pay and EMI will go down.

jeff jeffy answered 1 year ago

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