Understanding the Arithmetic of Private Finance
The listing of what number of completely different types of prepayment penalties will be contrived is limitless. Listed here are a number of examples I’ve encountered:
1. Six months’ curiosity on 80% of the steadiness. Trying on the rule of 78 instance proven in Determine 5.2, after 5 years, the remaining steadiness is approximately $236,000. Eighty % of that is roughly $189,000, and 6 months’ curiosity on that is about $7,560. That is significantly higher than the rule of 78 prepayment penalty however nonetheless some huge cash.
0 20 40 60 80 100 120 140 160
Determine 5.3 Comparability of various penalties for numerous prepayment penalty formulation (massive loan instance).
2. A flat 2% of the excellent steadiness. Within the above instance, this may be about $3,600. That is nonetheless quite a bit, however we’re getting higher.
3. Three % of the steadiness for the primary yr of the loan, 2% for the second yr, 1% for the third yr, then 0 for the rest of the loan time period. That is very costly for the primary yr of the loan ($9,000) however clearly not of concern after the third yr.
4. Innumerable variations on the above. That’s, a declining penalty that goes to 0 after some cheap (i. e., quick) time period. The lender’s aim right here is to maintain you from leaping ship if charges drop earlier than the lender has recovered at the least an inexpensive piece of the up-front bills.
Determine 5.3 exhibits the rule of 78 prepayment penalty and in addition the primary three of the above prepayment penalties (labeled PP1, PP2, and PP3). Apparently sufficient, very early within the loan, the rule of 78 penalty is the perfect of the group (finest = lowest penalty). For many of the loan, that is roughly from 36 to 145 months; the rule of 78 penalty is the worst of the group.
Many loans, notably mortgages, enable for a reasonably substantial partial prepayment, with the accompanying drop in curiosity quantity, with out triggering a prepayment penalty (if there’s one). Additionally, many state legal guidelines have one thing to say about prepayment penalties on mortgages. One other level: Some prepayment penalties are triggered both by the sale of the house or the prepayment of the mortgage with out the sale, and a few are triggered solely by the prepayment of the mortgage. You’ll have to perform a little research to search out out what applies to you. Please do all of those the day earlier than you signal the loan contract, not the day after. Additionally, keep in mind that you’re the client; if you take a loan—negotiate.
1. Think about a $25,000, 5-year auto loan with a set rate of interest of seven.6%.
(a) After which month-to-month fee does the worst case rule of 78 prepayment penalty happen and the way a lot is that this penalty?
(b) In case you haven’t made the month-to-month fee but, utilizing your solutions from downside 1a, how a lot would it not price you to repay this loan?
(c) Once more utilizing your reply from downside 1a, what’s the payoff penalty as a operate of the unpaid steadiness, each earlier than and after you’ ve made the common twenty – first fee?
(d) Once more utilizing your reply from downside 1a, what’s the penalty primarily based on 3 months’ curiosity on the remaining steadiness (after the month-to-month fee is made)? How does this examine to the rule of 78 penalty?
2. Assume that you’ve a financial savings account that pays 7.00% annual proportion fee (APR), compounded month-to-month, with $100,000 in it on the day you purchased your automotive. The most effective cashmanaging philosophy would have been to take the cash out of your financial savings account and to purchase your automotive with money since you are paying extra in your loan than your cash was incomes.1 For no matter cause, you took the loan and are making your funds by withdrawing cash out of your financial savings. You now determine that you simply made a mistake and need to repay the loan. In each the prepayment penalty examples proven above and in addition the case of no prepayment penalty, when is the perfect time to repay your loan?
3. Repeat the identical downside however with a financial savings rate of interest of 8.0%.
I’m ignoring delicate points akin to inflation and taxation on this downside.
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