Tom Is About To Make An Investment Assuming He Had To Choose
Tom Is About To Make An Investment Assuming He Had To Choose Betwe
Tom is about to make an investment, assuming he had to choose between an ordinary annuity and an annuity due. Which of these two types of payment would you recommend for Tom assuming all else being equal, and why?
Give examples of when a person might need to calculate the following:
- Present value
- Loan balance
What is the accrual rate and payment rate on a mortgage loan? What happens when the two are different?
Discuss two elements affecting the increase in house prices.
Paper For Above instruction
Introduction
The decision between choosing an ordinary annuity and an annuity due is crucial for financial planning and investment strategies. Both investment options involve periodic payments, but their timing differs, which has significant implications on the present value and overall benefits. This paper aims to analyze which payment structure would be more advantageous for Tom, provide real-world examples of calculations for present value and loan balance, elucidate the concepts of accrual rate and payment rate on mortgages, and discuss the major elements influencing house price increases.
Comparison Between Ordinary Annuity and Annuity Due
An ordinary annuity involves payments made at the end of each period, whereas an annuity due involves payments made at the beginning of each period. The key difference affects the present value calculations because payments made earlier (as in an annuity due) are discounted less, resulting in a higher present value compared to an ordinary annuity, assuming all other factors are equal (Brigham & Ehrhardt, 2014). For investors like Tom, choosing an annuity due would typically be advantageous if the goal is to maximize the present value of the investment, as payments or benefits received upfront increase the value today.
However, when considering investment returns, risk, and liquidity needs, the choice may vary. If Tom expects to receive payments before payments are due or prefers immediate cash flows, an annuity due would be preferable. Conversely, if he plans for the payments to aggregate at the end of the period, an ordinary annuity might suit his needs better.
When and Why to Calculate Present Value and Loan Balance
Calculating the present value (PV) is essential for understanding the current worth of a stream of future cash flows, which assists in investment comparisons and decision-making. For example, an investor considering an annuity investment will evaluate its PV to determine if the future payments justify the initial investment (Ross, Westerfield, & Jordan, 2016). Similarly, individuals calculating loan balances understand how much they owe at any given point after partial repayments, which helps in managing debt repayment strategies.
Understanding Mortgage Rates: Accrual Rate and Payment Rate
The accrual rate of a mortgage loan is the interest rate used to calculate the interest accrued on the outstanding balance, often quoted annually. The payment rate refers to the amount paid periodically towards the principal and interest components of the loan (Mishkin & Eakins, 2018). When these rates differ—such as when the accrual rate is higher than the actual payment rate—the unpaid interest may either accrue as unpaid interest (leading to negative amortization) or be deferred, potentially increasing the total amount owed over time. Managing these rates is vital for borrowers to prevent unexpected increases in debt and to plan repayments effectively.
Factors Affecting House Prices
Several elements influence the escalation of house prices. Two primary factors are:
- Interest Rates: Lower interest rates reduce mortgage costs, increasing demand for houses and driving up prices (Case, Quigley, & Shiller, 2018). When borrowing is cheaper, more buyers enter the market, elevating property prices.
- Economic Growth and Employment Rates: A robust economy with high employment levels boosts household income and confidence, encouraging investment in real estate, thereby elevating house prices (Glaeser & Gyourko, 2018).
Conclusion
The choice between an annuity due and an ordinary annuity depends on the specific financial goals and cash flow preferences. Calculations of present value and loan balances are foundational to sound financial decision-making. Understanding mortgage interest rates and their differences is crucial for borrowers to manage their debt effectively. Finally, economic factors like interest rates and economic growth significantly influence house prices, shaping the housing market's dynamics. A comprehensive understanding of these elements can greatly improve personal investment strategies and market analysis.
References
- Brigham, E. F., & Ehrhardt, M. C. (2014). Financial Management: Theory & Practice. Cengage Learning.
- Case, K. E., Quigley, J. M., & Shiller, R. J. (2018). The Dynamics of Housing Prices. Brookings Papers on Economic Activity, 2018(1), 203-262.
- Glaeser, E. L., & Gyourko, J. (2018). The Impact of Building Restrictions on Housing Affordability. FRB of Boston Working Paper.
- Mishkin, F. S., & Eakins, S. G. (2018). Financial Markets and Institutions. Pearson.
- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2016). Fundamentals of Corporate Finance. McGraw-Hill Education.