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FIN 200: Personal Finance
Topic 11-Housing and Mortgages Lawrence Schrenk, Instructor
Note: Theses slides incorporate material from the slides accompanying Madura. Personal Finance with Financial Planning Software 3rd ed.
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Learning Objectives
1. Find the valuation of a house. ▪
2. Explain and calculate the purchase costs.
3. Explain the features of different mortgages.▪
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Market Value: Yahoo Real Estate
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Sources of Funding
Conventional Loans 80% of Residential Mortgages
Government Loans 20% of Residential Mortgages Federal Insurance or Guarantee
Federal Housing Authority (FHA) Department of Veterans Affairs (VA) Farmer’s Home Administration (FmHA)
Seller Loans
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Transaction Costs
Down Payment (20% typical) Closing Costs
Application Fee Points (percentage of loan amount, deductable)
Trade off with interest rate Appraisal Fee Title Search and Insurance
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Historical Mortgage Rates (30 yr)
30 yr Mortgage Rates
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Fixed Rate Mortgages
Interest Rate Constant until Maturity Current Average (October 2008)
30 yr 5.96% 15 yr 5.67% 30 yr. Fixed Jumbo 7.12%
Higher Rate than Adjustable Not ‘Assumable’ Possible Prepayment Penalties ‘Jumbo’ loans exceed the limit set by Fannie Mae
and Freddie Mac
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Fix Rate Example
Data Loan Amount $200,000 Interest Rate 5.96% Maturity 30 yr
Payments Monthly Payment $1,193.96 Total Monthly Payments $429,826.52 Total Interest Payments $229,826.52 (53.47%) Total Principle Payments$200,000.00 (46.53%)
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Amortization Schedule
$0
$200
$400
$600
$800
$1,000
$1,200
Va
lue
1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
Months
Mortgage Amoritization Schedule
Monthly Interest Principal Repayment
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Adjustable Rate Mortgages (ARMS)
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Adjustable Rate Mortgage (ARM)
Interest Rates Adjust Typically every 6 or 12 months Rate tied to Economic Index Lower Rate than Fixed (at start)
Current Average (October 2008) 5/1 ARM 5.92% 30 yr. Fixed Jumbo 7.12% 5/1 jumbo ARM 6.18%
Potentially Avoid Costs of Refinance Can Be ‘Assumable’
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Rate Adjustment Mechanism
Initial Rate Can be Artificially Low (‘Teaser’) Compare with ‘Fully Indexed Rate’
Index and Margin Adjustment Caps
Periodic Typical 6 Month ± 1%, Annual ± 2%
Lifetime Typical 5-6% above Initial Rate
Always Choose an ARM with a Lifetime Cap!
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Indices and Margins
Common Indices Treasury Hills (T-Bills) Certificates of Deposit (CDs) 11th District Cost of Funds Index (COFI)
Moving Average London Interbank Offered Rate Index (LIBOR)
Check Volatility of Index Margin
Added to Index, e.g., ‘LIBOR + 2’
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ARM MovementARM Rate
6m CD + 2, Annual Adjustment
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Negative Amortization
Positive Amortization: Principal is reduced over the life of the loan
Negative Amortization Monthly payment is less than the interest payment Unpaid interest added to principal Principal increases
On an ARM if the monthly payment is capped, but not the interest rate, then there can be negative amortization
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Hybrid Loans
Hybrid loans mix fixed and adjustable features They start as fixed rate loans, e.g., for 2, 5, or 10 years. A 5/1 ARM (also 3/1 ARM)–Initial interest rate for five years,
and thereafter has an adjustment interval of one year 7/23s–There is a rate adjustment after 7 years
The initial rate will be above an ARM and below 30 yr fixed rate
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Prepay Additional $106.04 $1,193.96 + $106.04 = $1,300.00
Payment Comparison
Interest Payment Savings $50,837.60 Payments end in 24 years 4 months Check for possible prepayment penalty.
Prepayment
No Prepayment Prepayment
Monthly $1,193.96 $1,300.00
Total Monthly $429,826.52 $378,988.92
Total Interest $229,826.52 (53.47%) $178.988.92 (47.23%)
Total Principle $200,000.00 (46.53%) $200,000.00 (52,77%)
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Prepayment
$0
$200
$400
$600
$800
$1,000
$1,200
Va
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1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
Months
Mortgage Amoritization Schedule$200,000, 30 yr, 5.96%
Monthly Interest Principal Repayment
$0
$200
$400
$600
$800
$1,000
$1,200
Va
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1 25 49 73 97 121 145 169 193 217 241 265 289 313 337
Months
Mortgage Amoritization Schedule (Prepayment)$200,000, 30 yr, 5.96%, $1,300
Monthly Interest Principal Repayment
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Refinancing
If interest rates decline, you may choose to ‘refinance’ your house.
Pros Lower interest rate
Cons Refinancing Costs
Points amortized for taxes
Calculate ‘Break-Even’ Point
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Ethical Dilemma
Sarah and Joe own a small home that they would like to sell in order to build their dream home. Their current home has a mortgage and needs extensive repairs to make it marketable. A local loan company is offering home equity loans equal to 125% of the home's value. Since Sarah and Joe have good jobs and can make the additional home equity loan payments, they easily qualify for the 125% equity home loan. It takes the entire home equity loan to complete the repairs and upgrades to the home. To their shock, they find that even after the upgrades they are unable to sell the home for enough to repay the mortgage and the home equity loan. In other words, they have negative equity in the home. a. Comment on the finance company's ethics in making loans in excess
of a home's appraised value. b. What are Sarah and Joe's options in their current situation? Is there a
way they can proceed with building their dream home?
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