Residential Financial Analysis Chapter 6 Residential Financial Analysis

Overview Incremental Borrowing Cost Loan Refinancing Effective Cost of Multiple Loans Below Market Financing Cash Equivalency

Incremental Borrowing Cost Compare financing alternatives What is the real cost of borrowing more money at a higher interest rate? Alternatively, what is the required return to justify a lower down payment? Basic principle when comparing choices: What are the cash flow differences?

Incremental Borrowing Cost – Continued Example: Home Value = $150,000 Two Financing Alternatives: #1: 90% Loan-to-Value, 8.5% Interest Rate, 30 Years #2: 80% Loan-to-Value, 8.0% Interest Rate, 30 Years It appears there is only a 50bp interest rate difference, but…

Incremental Borrowing Cost – Continued

Incremental Borrowing Cost – Continued 20.57% represents the real cost of borrowing the extra $10,000 Can you earn an equivalent risk adjusted return on the $10,000 that is not invested in the home? Alternatively, can you borrow the additional $10,000 elsewhere at a lower cost?

Incremental Borrowing Cost – Early Repayment

Incremental Borrowing Cost – Origination Fees

Incremental Borrowing Cost – Second Mortgage In the first case we compared 80 and 90% LTV loans By borrowing $90,000, cost of additional $10,000 was 20.57% What if we borrow $80,000 (80% LTV) and shop for loan for $10,000 with 25 year term If we can borrow that $10,000 at a cost less than 20.57% then we would have loan with a lower cost than 90% LTV loan. Suppose a lender can loan us that $10,000 at 18% Composite cost of borrowing would be ($80,000 / $90,000) × 12% + ($10,000 / $90,000) × 18% This is 12.66% It is clear that break-even rate for second mortgage is 20.57%

Incremental Borrowing Cost – Maturity Differences

Loan Refinancing Borrower consideration Lower interest rates in the market than on the current loan The borrower can secure lower monthly payments There is a cost to refinance Application of basic capital budgeting investment decision: What is our return on an investment in a new loan?

Loan Refinancing for Remaining Term of Original Loan

Loan Refinancing – Early Repayment of New Loan

Borrowing the Financing Costs

Effective Cost of Multiple Loans Basic Technique Compute the payments for the loans Combine into a cash flow stream Compute the effective cost of the amount borrowed, given the cash flow stream Compare the cost to alternative financing options

Effective Cost of Multiple Loans – Continued Example: You need a $500,000 financing package. $100,000 at 7.0%, 30 Years $200,000 at 7.5%, 20 Years $200,000 at 8.0%, 10 Years

Effective Cost of Multiple Loans – Continued

Below Market Financing A seller with a below market rate assumable loan may increase the home price All else equal, a buyer is paying a higher price for lower payments Similar to other problems, we compute interest rate and compare it to other equivalent risk investments

Below Market Financing – Continued The buyer can secure below market financing by paying $5,000 more for an identical home The below market financing results in a monthly payment of $85.63 less than if regular financing was used The buyer earns 19.41% on the $5,000 investment by reducing the monthly payment by $85.63

Cash Equivalency How much more a borrower would be most willing to pay for a property with an assumable loan? This is same as PV of payment savings discounted at the rate a new loan could be obtained

Cash Equivalency – Continued Together with the financing premium, a buyer could be willing to pay $107,534 for this property to receive the benefit of below-market financing Does this mean the house is worth more than $100,000? Need to separate the value of the property with and without the effects of financing Note that the amount of cash invested in this property would be $100,000 if you take away the assumable loan benefit

Cash Equivalency - Smaller Loan Balance Need for additional borrowing due to relatively low balance on the assumable loan reduces the financing premium on the property