Transcript Investing in a Home - University of Utah

How do households finance
the purchase of a house?
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Down payment
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Mortgage
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typically 10% of selling price, but 20% is the
magic number
loan to pay the seller the difference between the
purchase price and the down payment
Mortgage choices impact the economic cost
of a home
Basic Dimensions of a
Mortgage
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Loan amount (purchase price minus down
payment) = PV
Interest rate per period = r
Time period for the loan = n
Pre-payment option
Self-amortizing, Fixed Rate
mortgage
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Interest rate and monthly payment are fixed.
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Standard, conventional
Example (with monthly compounding):
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loan amount = $200,000
interest rate = 7.0%
time period = 30 years
 r 1  r  
FVP  PV 

n
 1  r   1
n
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PV=200,000
r = (.07/12) = .005833
n = 30(12) = 360
 .0058331  .005833360 
FVP  200,000

360
 1  .005833  1 
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FVP = $1,330.60 per month

Please note: this is the PI part of the PITI payment
TI will be more every month
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Interest Payments on Fixed Rate
Mortgage
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Month 1:
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interest owed: $200,000(.07/12) = $1166.67
principal: $1330.60 - $1166.67 = $163.93
new loan balance: = $200,000 - $163.93 =
$199,836.07
Month 2:
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interest owed: = $199,836.07(.07/12) = $1165.71
principal: $1330.60 – $1165.71 = $164.89
new loan balance: $199,836.07 - $164.89 =
$199,671.18
Economic Advantages and
Disadvantages of Fixed Rate Mortgage?
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Advantages:
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future housing costs are known with relative certainty
(only possible changes are property taxes, insurance,
and utilities)
can choose 15-year, 20-year, 25-year, 30-year, 40year, or 50-year loan time
interest deductions from income taxes are high during
the early years of the loan
Economic Advantages and
Disadvantages of Fixed Rate Mortgage?
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Disadvantages:
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more difficult for young households (with lower
incomes) to qualify
Locked in to the fixed rate.
Tax advantages lessen over time (typically at the point
where household income and the marginal tax rate
are both rising)
Fixed rate FHA or VA mortgage
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Federally insured mortgages
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If the borrower defaults, the lender still gets the
money.
Advantages:
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interest rates frequently lower on FHA or VA
mortgages than on conventional mortgages
qualifying is typically easier
FHA/VA loans are assumable
down payment requirements are typically lower
Types of Mortgages
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Disadvantages:
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loan limits (2008 = $729,750 in SLC, Summit, and Tooele
Counties; $323,750 in Utah County; $271,050 most everywhere
else)
insurance fees (1.5% upfront, + 0.50% per year of the loan
amount – can be financed)
typically pay additional points (one-time, fixed costs)
 Rates on 10/30/08
 30 year fixed is 6.46%, with 0.7 points
15 year fixed is 6.19%, with 0.7 points
May take longer to process
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What sparked the creation of alternative
mortgage instruments in the late 1970s?
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High rates of inflation made lenders
uneasy about locking into a 30-year loan
at any fixed interest rate
As housing prices rose, first-time home
buyers were having difficulty qualifying for
the purchase of a home.
Self-amortizing, Adjustable
Rate Mortgage (ARM)
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Interest rate and monthly payment are both
variable (e.g., adjustable).
Example:
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loan amount = $200,000
interest rate = 6.0% initially
time period = 30 years
initial monthly payment: $1199.10
More about the ARM interest
rate
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Index - market interest rate that is not directly
controlled by the lender. It is used to initially set
and periodically adjust the interest rate on the loan
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Spread - the amount that is added to the index to
arrive at the the ARM interest rate.
More about the ARM interest
rate
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Frequency of rate change - how often the
lending institution can change the ARM interest rate.
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Rate cap - limitations on either the increase or the
decrease in the ARM interest rate that can occur at a
point in time.
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Frequency of payment change - how often
monthly payments can change (typically the same as
frequency of rate change -- if not, there is the
possibility of negative amortization)
More about the ARM interest
rate
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When the associated index moves and an
adjustment period occurs, the lender
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changes the interest rate by the amount allowed
(up or down)
recalculates the monthly payments based on the
new interest rate and the remaining loan balance.
Economic Advantages and Disadvantages of
an Adjustable Rate Mortgage?
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Advantages:
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Initial interest rates are typically lower
If you are buying when mortgage rates are high, but
expected to fall in the future
Disadvantages:
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Greater uncertainty about what future mortgage
payments will be
Graduated Payment Mortgage
(GPM)
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Interest rate is fixed but the monthly payment
rises over time -- supposedly as the household’s
income rises.
Example:
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loan amount = $200,000
interest rate = 7.0%
time period = 30 years
monthly payment at first is $800 (rather than
$1330.60)
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After 2 years, payment goes to $1000
After another 2 years, payment goes to $1200
Then payment is $1553.60 for the rest of the loan (24 years)
Interest Payments on a Graduated
Payment Mortgage
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Month 1:
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Month 2:
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payment = $800.00
interest owed: $200,000(.07/12) = $1166.67
loan increased by: $1166.67 - $800 = $366.67
payment = $800.00
interest owed: $200,366.67(.07/12) = $1168.81
loan increased by: $1168.81 - $800 = $368.81
This is an example of negative amortization
Economic Advantages and Disadvantages of a
Graduated Payment Mortgage?
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Advantages:
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Easier to qualify for lower income households
lower monthly payments early in the mortgage
Disadvantages:
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Loan amount is larger than with a conventional, fixed
rate mortgage
Payments will be higher in the later stages of the loan
(must be confident that income will rise or else this
may present a problem)
Reverse Equity Mortgages (REM)
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A reverse mortgage is a loan against your home that
you do not have to pay back for as long as you live
there.
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It can be paid to you all at once, as a regular monthly
advance, or at times and in amounts that you choose.
You pay the money back plus interest when you die, sell
your home, or permanently move out of your home.
Reverse mortgage loans typically require no
repayment for as long as you live in your home.
Your house must be paid off (or close to it)
You must be over 62
REMs
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Advantages:
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Way to access your home equity without having
the burden of repayment
Creates income
Disadvantages:
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Reduces the value of your estate
Your home must be sold after your death to repay
the REM, if liquid assets are not available to pay
off the REM
Interest Only
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Your payment only covers the interest owed on the loan
 Then you have a balloon payment after a specified # of years
(e.g. 7 or 12) with the principal balance due
 Or your loan will amortize over a shorter amount of time
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E.g. 40 yr IO – pay IO for 10 years, and then amortized over 30 yrs
Advantages:
 Lower monthly payments
 Maybe good for rental properties and/or high-equity growth areas
Disadvantages:
 Negative amortization may occur
 No gain in equity from principal reduction
 Very risky
How do those mortgages stack
up?
Loan Type Interest
Rate
Monthly
Pmt
5/1
Interest
Only
$1,572.50 ($367.32)
$94,350
$0
15-yr fixed 6.32%
$2,583.73 $643.91
$84,415
$70,609
30-yr fixed 6.72%
$1,939.82 $0
$97,922
$18,467
40-yr fixed 6.97%
$1,857.76 ($82.06)
$103,220
$8,245
50-yr fixed 6.97%
$1,798.18 ($141.64)
$103,908
6.29%
Compared r pd in 5
to a 30-yr yrs
Equity
created in
5 yrs
$3,983
Summary: Economic Costs and Economic Benefits of
Various Mortgage Instruments Depend Upon...
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Life cycle stage
Business cycle stage
Risk tolerance
Liquidity needs
How to reduce the amount of
interest paid on your mortgage
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Pay extra principal every month
Pay next month’s principal this month
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Pay bi-weekly
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Pays off a 30-year mortgage in about 15 years and 8
months
Pay 26 half payments a year, or 13 monthly payments
Cuts about 7 years off of 30 year mortgage
Pay semi-monthly
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Pay 24 half payments a year
Cuts about 5 years off of 30 year mortgage, without ever
paying extra
Is this a good deal?
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Currently 8 years left on a mortgage, paying 7.35%
with a payment of $642
Refinance to a 15 year mortgage at 5.25% with a
payment of $450
Answer = NO
Under current payment plan, will pay 642(8)(12) =
$61,632 over next 8 years
Under refinance, will pay 450(15)(12) = $81,000
over next 15 years
More out of pocket, and more opportunity costs