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.

Learning Objectives Find the valuation of a house. ▪ Explain and calculate the purchase costs. Explain the features of different mortgages.▪

Valuation

Market Value: Yahoo Real Estate

Yahoo Real Estate (cont’d)

Yahoo Real Estate (cont’d)

Mortgages

Sources of Funding Conventional Loans Government Loans Seller 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

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

Historical Mortgage Rates (30 yr)

Fixed Rate Mortgages

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

Fix Rate Example Data Payments 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%)

Amortization Schedule

Adjustable Rate Mortgages (ARMS)

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’

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!

Indices and Margins Common Indices Check Volatility of Index Margin 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’

ARM Movement

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

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

Prepayment and Refinancing

Prepayment Prepay Additional $106.04 Payment Comparison $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. 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%)

Prepayment

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

Resources Yahoo Real Estate

Project Notes I

Project Notes II

Project Notes III

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?