There are many different types of mortgage available with different contractual terms and conditions. You have a hard time choosing on which mortgage would be the most cost-effective one. In this post, I will share with you on Incremental Borrowing Cost. This is a scenario when the interest rate increases when Loan to Value(LTV) ratio increases. You want to find out what is the actual cost of the increase in interest rate.

Incremental Borrowing Cost

Banks are willing to give you a mortgage loan and give you two scenarios.

  1. 90% Loan to Value, 8.5% interest rate, 30 years.
  2. 80% Loan to Value, 8% interest rate, 30 years.

Which one will you choose? How do you calculate the effective interest rate between the two loans? What is the real cost of borrowing MORE money at a higher interest rate?

Case Example Scenario
  • Home value = $150,000
  • Two loan alternatives
    • 90% Loan to Value, 8.5% interest rate, 30 years.
    • 80% Loan to Value, 8% interest rate, 30 years.
Alternative #1 Alternative #2
LTV 90% 80%
i 8.5% 8%
Term 30 Years 30 Years
Down payment  $15,000  $30,000
Loan  $135,000  $120,000
Monthly

Payment

 $1038 $880.52

Let’s take note of the cashflow difference. You managed to borrow $15,000 more. However, you need to pay an additional $157.51 for the monthly loan repayment.

Using TVM calculations

  • PV = $15,000
  • PMT = -$157.51
  • n = 360
  • FV = 0
  • CPT i = 12.28%

To borrow $15,000 more you actually end up paying a 12.28% for the $15,000 instead of the additional 5%.

Things to Consider Before Borrowing

You may want to ask yourself if you are able to earn a 12.28% return on investment on the $15,000 that you have saved by borrowing more. Which means that if you have $15,000 right now will you be able to make a 12.28% investment return? Do you want to wait and save up the $15,000? Can you borrow the $15,000 somewhere else? As long as the interest rate is below 12.28% you are better off.

Make the right calculations so that you can make the right decision to lower your borrowing cost.

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