Question

Rent Versus Buy. Alex Guadet of Nashville, Tennessee, has been renting a two-bedroom house for several years. He pays $900 per month in rent for the home and $300 per year in property and liability insurance. The owner of the house wants to sell it, and Alex is considering making an offer. The owner wants $160,000 for the property, but Alex thinks he could get the house for $150,000. Alex has talked to his banker and could get a 5 percent mortgage loan for 25 years to finance the remainder of the purchase price. The banker advised Alex that he would reduce his principal by $1,700 during the first year of the loan. Property taxes on the house are $1,400 per year. Alex estimates that he would need to upgrade his property and liability insurance to $1,200 per year and would incur about $3,000 in costs the first year for maintenance and improvements. Property values are increasing at about 3 percent per year in the neighborhood. Alex will have to pay $50 a month for private mortgage insurance. He is in the 25 percent marginal tax bracket.
b. Considering his reduction in principal the first year, how much interest would Alex pay during the first year of the loan?

Answer 1

Answer:

Rent Versus Buy. Alex Guadet of Nashville, Tennessee

b. Computation of Interest payable by Alex during the first year of the loan:

Interest = Net Mortgage amount x rate of interest

= ($148,300 x 5%)

= $7,415

Explanation:

a) Data and Calculation:

Mortgage amount = $150,000

Principal Reduction         1,700

Net Mortgage          $148,300

b) Mortgage Interest is calculated as the Mortgage amount minus any reduction in the principal amount, multiplied by the interest rate.  The interest represents the cost of capital that Alex pays for taking a mortgage on the property.  For the bank, the interest represents the benefit for lending the mortgage loan to Alex.