Financial Markets and Institutions (2-downloads)

Mortgage Interest Rates

Long-Term

Treasury

Rates

F I G U R E   1 4 . 1

Mortgage Rates and Long-Term Treasury Interest Rates, 1985–2009

Source: Federal Reserve Bulletin, various issues, Table 1.53 Line 7 and Table 1.35 Line 23.

C A S E

The Discount Point Decision

Suppose that you are offered two loan alternatives. In the first, you pay no discount

points and the interest rate is 12%. In the second, you pay 2 discount points but

receive a lower interest rate of 11.5%. Which alternative do you choose?

To answer this question you must first compute the effective annual rate with-

out discount points. Since the loan is compounded monthly, you pay 1% per month.

Because of the compounding, the effective annual rate is greater than the simple

annual rate. To compute the effective rate, raise 1 plus the monthly rate to the

12th power and subtract 1. The effective annual rate on the no-point loan is thus

Because of monthly compounding, a 12% annual percentage rate has an effective

annual rate of 12.68%. On a 30-year, $100,000 mortgage loan, your payment will be

$1,028.61 as found on a financial calculator.

Now compute the effective annual rate if you pay 2 discount points. Let’s assume

that the amount of the loan is still $100,000. If you pay 2 points, instead of receiving

Effective annual rate

⫽ 11.012

12

⫺ 1 ⫽ 0.1268 ⫽ 12.68%

---

Chapter 14 The Mortgage Markets

327

TA B L E   1 4 . 2

Effective Rate of Interest on a Loan at 12% with 2 Discount Points