Question

If Melody wants to purchase a house for $120,000 and finance $100,000 with either a 4%, 30-year mortgage or a 6%, 20-year mortgage. a. What is the effective interest rate on each of the above alternatives? b. Which alternative would you recommend and why

Answer 1

Part a
Effective interest rate = (1+ rate/m)^m)-1
m = number of periods per year
Nominal interest rate = 4%
Effective interest rate = (1+4%/12)^12-1
Effective interest rate = 4.07%
Nominal interest rate = 6%
Effective interest rate = (1+6%/12)^12-1
Effective interest rate = 6.17%
Part b
Calculating Monthly payment
Excel function for monthly payment	Monthly Payment
=PMT(4%/12,30*12,-100000,0,0)	477.42
Total Payment = 477.42 * 12 * 30
Total Payment = 171,871.20
Excel function for monthly payment	Monthly Payment
=PMT(6%/12,20*12,-100000,0,0)	716.43
Total Payment = 716.43 * 12 * 20
Total Payment = 171,943.20