A Lender is offering a 3% cash back offer on a mortgage providing you sign up for a 5 year term. The mortgage would be closed for 5 years before you would be allowed to renegotiate the interest rate.
Current 5 year interest rates are 8.25% and you need to borrow $100,000. The cashback of 3% would immediately put $3000 in your pocket if you signed (tempting you to buy new appliances, etcetera) or you could direct the cash back immediately to pay down the mortgage to $97,000.
QUESTION: What to do?
Let us assume you did not succumb to temptation and paid the mortgage down by the amount of the cash back, $3,000.
Your monthly payments would be initially calculated to be $779.23 but your cashback reduces the initial mortgage to $97,000 thus after 60 months your outstanding balance is $87,896.43 as shown below;
The Lender could have given you a lower interest rate in order to entice you into signing a five year term and that rate would be 7.453% as shown below. The 7.453% was arrived at by a trial and error technique. You pick a lower rate than 8.25%, recalculate on the amortization period until you zero in on the balance of $87,897.38 after 60 months, which is close enough to $87,896.43
This is a win-win scenario, unfortunately both wins are for the Lender. The Lender achieved two objectives;
Firstly, the Lender got you to sign for 5 years because a $3000 cash back sounds and appears a lot better than lowering the rate from 8.25 down to 7.453, in fact some Lenders will give you up to .75 percent points off the published rates just for asking, especially if you have other business with them (investment vehicles such as Mutual Funds).
Secondly, the Lender has you locked in for 60 months at a rate of 8.25%. If you do decide to payout out the mortgage before the term is over (because rates are dropping) your penalty is based upon the interest rate differential. For example, if after one year, the 4 year term rates are 7 % then the differential is is 1.25 (8.25-7.0) where as if the rate would have been 7.453 the differential would have been 0.453 (7.453-7.0). The larger the differential the larger your IRD "penalty".
Buyer beware! Things are not always what they seem to be.
ALTERNATIVE VIEWPOINT BELOW: Another way of looking at this example is to view it as a DISCOUNTING example. A $100,000 mortgage at 7.453% with a 5 year term.
QUESTION: What price does one have to pay to purchase the mortgage and receive an 8.25% "yield" rather than the 7.453% "yield" over the next 60 months.
ANSWER: $97,000 (see B below in the DISCOUNTING program)
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