Economic: Investment and Pension Funds Essay

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Jessie is a freelance sales person and has just teamed up with Walt, a chemistry teacher, to launch a new business they hope will provide some extra income for their old age and rainy days. They are aiming to buy a warehouse to store their production equipment and have found an adequate conversion on offer on the residential market for £150,000.
However they also realise that annual residential property price inflation in their city is at
10%. General inflation rate is at 3% annually. Both rates are expected to remain the same on average in the foreseeable future and they know they can get fixed interest rates on their mortgage.

1 Briefly explain the difference between nominal and real interest rates on mortgage loans. (2 marks)

Nominal interest rates refer to the rate charged by financiers so as to take into account the inflation and also to give them a return. On the other hand, real interest rates do not take into account the inflation levels. For instance, Jessie should note that the nominal interest rate should be a sum of the real rate and the inflation rate of 3 percent.

2 One possibility is to build up a 20% deposit over five years. Using the inflation tool, calculate how much they would need to save assuming the relevant inflation rate (and that the warehouse conversion would still be on sale).(3 marks)

Price of property in five years time can be calculated by multiplying the current price of £150,000 with the future value of annuity as follows

Price = £150,000 *1.2^5 = £373,248
The deposit of 20% per year at the inflation rate of 3 percent should be adequate to meet the price of the warehouse at the end of year 5. The amount to be deposited is determined by dividing the future value of the warehouse with the present value of annuity at 3 percent for five years.

Deposit = £373,248/ (PVIFA 3%, 5) = £373,248/ 4.58 = £81,500

They would need to save £81,500 per year for five years so as to afford the warehouse.

3(a) Using the Saving and borrowing calculator, what rate of return would be needed to reach their nominal target if they jointly put aside £500 monthly and invested
Walt’s £7500 cash as lump sum investment as well? (4 marks)

Nominal target is £373,248

$373,248 = $500* FVIFA, r/12, 5*12 + £7,500 * FVIF, r, 5

Using the financial calculator, the rate (r) is 64%

(b) Briefly explain which types of financial products could be used to achieve this goal and discuss whether this is a realistic option. (4 marks)

This goal could be achieved through the use of time deposits with financial institutions, purchase of common stocks to be sold after five years, use of government securities such as treasury bills to be rolled over and treasury bonds to be liquidated after five years, investment in commercial papers and corporate bonds. This is not a realistic option since the rate of return required (64%) is quite ambitious to expect to earn it from the available investment options.

4 Jessie is considering another option: instead of staying (rent free) with his aunt as at present, he would buy a home in which to live and work. He manages to negotiate with a bank to get a mortgage for 95% of the value of the house (estimated at the same amount as the warehouse). They would use the basement for their activities.
Walt would not move in but his cash could pay for the deposit now. They are considering whether to take up a repayment mortgage but are also attracted by the lower periodic repayment of an interest-only mortgage. Both would require a 5% fixed interest rate for 20 years. Using the Mortgage calculator, fill in the table below and discuss the feasibility of each type of mortgage repayment and the associated financial risks.

Interest-only
Repayment
Mortgage value

£142,500
Total repaid

£161,349.05
Total interest
£61,349.05

Monthly repayment

£2,689.15

Mortgage value = £150,000 * 0.95% = £142,500

Interest rate = 5%
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