Hidden Costs in Home Loans ©2002 Dr. Bradley C. Paul

The Home Loan Payments Game  We found that Herby’s mortgage payments will be pretty small compared to rent payments  The payments consider  Principle (paying off part of the debt each month)  Interest (paying investors each month for the gratification they are giving up by keeping money in Herby’s House)  Banks Charge Other Fees as part of the payments.

The Escrow Costs  There is that homeowners insurance payment $600 per year including a chunk right up front  There is the private mortgage insurance $280 per year (first year was covered in closing)  There is property tax  The bank doesn’t trust you to save this money so they charge it to you each month  They stash it in an escrow account (where they usually make the interest)

The Insurance Costs  Insurance $280 + $600 = $880  12 payments = $880/12 = $73.33

The Property Tax Game  Illinois (and most states) try to baffle people with convoluted formulas to keep them too confused to fuss  In Illinois You first compute “Fair Market Value”  Many communities estimate low  You think your getting a deal so your less likely to fuss  If the state ever wishes to use eminent domain to buy you out they have a basis for a lower value  If property taxes are ever frozen, they can keep the tax rate and jack up the property value

Herby’s Property Tax  DeSoto values Herby’s house at $27,000  Next you get the “Assessed Valuation”  By law in Illinois - this is 1/3rd of fair market value  $9,000  (People really think they’re getting a deal when the realize they are only paying taxes on this little amount - never mind the tax rate is about 3 times as high as in states that don’t do this step)

Figuring Herby’s Property Tax  Apply the tax rate to the “Assessed Valuation”  Tax rate about 9.78%  rates can be high is Southern Illinois because of a weak industrial base  They can be high in Chicago suburbs because suburban school districts and governments are very very good at spending money  Apply and let dry  $9,000 * = $ per year

The Escrow Account  Insurance monthly payments were $73.33  Taxes $880.2/ 12 = $73.35  The Total = $  Wrong  Banks usually charge you 1.5 times the estimated amount to accumulate money in the escrow account  Official reason - so if rates go up there is money there  Unofficial reason - since they get to collect the interest on the account it gives them more of your money to make extra money on.  $220/month

More on Escrow  Banks adjust escrow payments each year based on actual tax and insurance rates  They don’t charge 1.5 times forever but they do get the amount up to about twice the actual experience before they back off on overcharging you  Escrow payments can drastically alter what you thought your mortgage was  30 year internet mortgage is $ $220 = $377.49/month

Herby Looks at Later Year Mortgage Payments  In order to know what escrow payments will be the second year - Herby has to know how much tax and insurance will take out of his escrow account.  On the insurance - Herby will pay that for the first year (or 6 months) when he gets the loan.  He’ll accumulate escrow for a year and then pay it again.

Herby’s Insurance  Herby has Private Mortgage Insurance  Usually stays the same - in fact lenders risk is declining as you get more paid off  $280  Herby has homeowners insurance  say goes up about with inflation 4%/year  $600*1.04 = $624  Herby’s escrow account will pay out $904 for insurance at the end of the first year (note this won’t be a Herby cash flow item because Herby makes monthly escrow and the banker worries about the insurance premiums)

Herby’s Taxes and Escrow  Taxes are paid “in arrears”  That means that in 2001 you pay property tax for year 2000  This can be a problem for buying because you will get a tax bill for when you didn’t own the house  Solved by giving you a “credit” at closing (adjusts your loan amount)  may adjust exact mortgage amount but we already found which loan was best

Payments Out of Herby’s Escrow  Taxes at end of year will be the previous years amount $  Insurance at the end of the year $904  Money out of account  $1,  Money into account  $220 * 12 = $2640  Balance in account $855.20

Billy Banker Reviews Next Years Tax and Insurance Cost  Insurance was $  Taxes  $ this year  Each year the State estimates the increase in property value around the state  When real estate sells have to fill out a report form to the government  (Also used by appraisers)  State Issues a multiplier  say (1.05)

The State Multiplier Strikes Again  Periodically the county also reappraise all the property (usually do a roving system so it won’t be all at once)  County makes any changes they see, supervisor of assessments reviews, then multiply by state multiplier  Get a new assessed valuation  Last year $9,000*1.05 = $9450  Next Years Tax $9,450* = $924.21

Figuring Year II Escrow  Taxes will be $  Insurance will be $904  Total Payout estimated for end of year II  $1,  Billy Banker Would Like twice that in account  about $3,657  Billy Banker has $ in there now

Setting Next Years Escrow  $ = $2802  $2802/12 months = $ for Escrow  Mortgage Principle and Interest is  $  Add Escrow  $ next years mortgage payment  During Year #1 pay $  During Year #2 pay $390.99

Estimating Escrow for Later Years  Escrow account has now built up the bankers interest free extra money - now they’ll just have Herby pay as he goes  Assume PMI (Private Mortgage Insurance) stays same - Home owners goes up 4% per year  Assume taxes up 5% per year

Taxes and Insurance  Year #3 homeowners insurance  Year #2 was $624  Year #3 $624*(1.04) = $649  Year #4 $649*(1.04) = $675  Year #5 $675*(1.04) = $702  Year #6 (until house sells) $702*1.04 = $730  PMI stays the same at $280  Taxes will go up 5% each year

Taxes and Escrow  Year 2 taxes were $  Year 3 taxes $924.21*1.05 = $  Year 4 taxes $970.42*1.05 = $1,  Year 5 taxes $1,018.94*1.05 = $1,  Year 6 taxes $ *1.05 = $

Future Years Escrow  Year 3 $280 + $649 + $ = $  Year 4 $280 + $675 + $1, = $  Year 5 $280 + $702 + $1, = $  Year 6 $280 + $730 + $1, = $

Important Inflation Features  Note that the Taxes and Insurance Payments are just going up by 3.9% over-all each year  Many Times in Inflation Scenarios you see a cost that grows and compounds with inflation  If the costs grow at a steady rate through each compounding period you have something like an annuity with inflation  can’t use P/A or A/P because payment amount changes

The Geometric Gradient  In some engineering econ problems we see what would be an annuity except that it grows at a steady rate each compounding period.  Some equipment maintenance expenses behave this way  Most common source is inflation in the cash flow (ie - its an annuity with inflation)  The tax and insurance expense is behaving this way

Special Features for Special Problems  We’ve met P/A  They really don’t do anything for us that can’t be done with a large number of different P/F values  We got P/A because it let us treat an obnoxious series of numbers as one cash flow element that can be dealt with all at once  Now we have an annuity almost except its growing  Without help it’s a large number of P/F problems

Another Super Hero  P/A g,i,n  Looks very similar to our old friend P/A only this one has 3 numbers  The first two numbers look like interest rates  Actually what you have is a rate of inflation or cost escalation, and an interest rate, and a number of payments or compounding periods

Super Hero Formula  Look in the front of the book “Geometric Series Present Worth”  In our case we won’t be able to use the hero because Herby’s escrow payments are made monthly, while the growth is yearly  Why introduce the Geometric Series Present Worth this way?  Example illustrates how inflation commonly produces these growing annuities  Also I don’t like inflation in engineering cash flow analysis and so I’m not putting out a lot of emphasis

Back from the Detour  Annual Escrow Payments  Year #3 $1,899.42/12 = $  Year #4 $ /12 = $  Year #5 $ /12 = $  Year #6 $ /12 = $177.78

Adjusting the Mortgage Payments  Basic Loan will be for $25,200  The Bank also charges points  (an up front premium in exchange for a lower interest rate - or a good way for bankers to make their loan look like a better deal and still make the same money )  $378  But Herby gets credit for last years taxes (since he’ll end up paying them)  $880.20

Herby’s Loan with Tax Adjustment  $25,200 + $378 - $880.2 = $24,698  A/P is for 360 payments with 6.25% annual interest (divided by 12 for monthly compounding)  $24,698* = $  Mortgage Payments  Year #1 - $ $220 = $  Year #2 - $ $ = $  Year #3 - $ $ = $  Year #4 - $ $ = $  Year #5 - $ $ = $  Year #6 - $ $ = $329.84

Building the Home Buy Cash Flow $2,800 Down Payment $1,260 Loan Initiation Fees $600 Homeowners Insurance Bank also charged $378 in “Points that rolled into loan $372.06/mo.$385.56/mo. $ $ $ $ $ $ $ $ $ $ $132$139 $146$153$161$169