Reginald just entered the workforce and his parents have pressured him to take advantage

of the low interest rates and longstanding property boom to purchase a property.
Thus, he borrows $500 000 to purchase a 1 bedroom apartment in Chatswood for $650 000,
with the help from his parents on the first deposit. The bank charges interest at 4.25% p.a.
compounded monthly.
Reginald plans to repay the loan in 25 years time making monthly payments in arrears.
a.) Draw a time diagram showing the cash flows. Include the effective rate of interest.
b.) What is the monthly instalment that Reginald pays? Give your answer correct to the
nearest cent.
27 months after the inception of the loan, the market crashed when the Federal Reserve was
forced to raise interest rates from 0.375% p.a. to 4% p.a. The bank, in turn, increased the
interest rate to 7.8% p.a. compounded monthly.
c.) Find the loan outstanding at the time the bank raises interest rates, after the 27 months.
Give your answer correct to the nearest cent.
d.) If Reginald wants to repay the loan completely without delay, calculate the monthly
instalment required.
Reginald has just lost his job and times are tough, so he is unable to make additional
repayments. He hopes to try and keep repaying the loan using the amount calculated in b.).
e.) Calculate how much longer it would take to repay the loan. Comment on your answer.

Solutions
a.) There will be 300 monthly instalments. The effective monthly interest rate is:

i=

0.0425
per month
12

b.) At t = 0:

Value of loan = PV of future loan repayments

0.0425 300

1 1 +
12
$500 000 = R
0.0425

12
$500 000

300

0.0425
0.0425
= R 1 1 +

12
12

0.0425
12
R=
300
0.0425

1 1+

12

= $2 708.69
$500 000

c.) After 27 months, we need to calculate the amount of the loan outstanding using the
retrospective method. That is, we calculate the accumulated value of the loan to the end
of 27 months, less the accumulated value of the repayments made for the first 27
months. The prospective method of taking the present value of the future repayments
using the new interest rate is not valid, since that will understate the loan outstanding,
and it is also illogical.
27

0.0425
1
+
1
27

0.0425
12

Loan outstanding = $500 000 1 +

$2 708.69
0.0425
12

12
= $473 476.83

d.) Use the prospective method. At t = 27,

273

0.0785

1 1 +
12
$473 476.83 = R2
0.0785

12
R2 = $3 725.56

So, Reginald has to increase his monthly repayments from $2 708.69 to $3 725.56. The
market has just crashed, so do you think he will easily afford this? Consider what
happens if he loses his job? Also, consider the effects of inflation!
e.) Again, use the prospective method, but this time, we do not know how many
instalments will be needed. So set up the following equation at t=27:
n

0.0785
1

1
+


12
$473 476.83 = $2 708.69
0.0785

12
0.0785
n
$473 476.83
12 = 1 1 + 0.0785


$2 708.69
12

0.0785
n
$473 476.83
0.0785
1+
= 1
12

12
$2 708.69

$473 476.83 0.0785

0.0785
12
n ln 1 +
= ln 1

12
$2 708.69

$473 476.83 0.0785

12
ln 1

$2 708.69

n=
0.0785
ln 1 +

12

= Cannot be determined
The reason for this is because if you calculate the monthly interest due on the
outstanding loan of $473 476.83 at the end of the 27 months, that amounts to $3 097.33.
That exceeds the monthly instalment.
Notice how most newspapers only tout a rising property market, and do not anticipate
the risk of a combination of a falling property market leading to a failing jobs market?
When it happens, they call it a perfect storm. But this occurs also because they never
thought to take an umbrella, or to have been sailing without noticing that the seas were
getting rough. Beware normalcy bias!