1. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Personal Finance SIXTH EDITION Chapter 10 Purchasing and Financing a Home

2. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Chapter Objective (1 of 2) 10.1 Describe the factors that determine how much you can afford when buying a home 10.2 Explain how to select a home to purchase 10.3 Explain how to conduct a valuation of a home 10.4 Describe the transaction costs of purchasing a home 10.5 Describe the characteristics of a fixed-rate mortgage

3. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Chapter Objective (2 of 2) 10.6 Describe the characteristics of an adjustable- rate mortgage 10.7 Show how to compare the costs of purchasing versus renting a home 10.8 Describe special types of mortgages 10.9 Explain the mortgage refinancing decision 10.10 Explain how a mortgage fits within your financial plan

4. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Much Can You Afford? (1 of 3) Usually need 10-20% down payment Typical mortgages are fixed-rate and 30 years Home price should be no more than 2.5 times your total gross annual household income Monthly mortgage payment should not exceed 28% of gross monthly income Monthly debt payments (including the mortgage) should not exceed 40% of gross monthly income

5. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Much Can You Afford? (2 of 3) Affordable down payment –What is the market value of the assets you will convert to cash and use for your down payment? –You also need to allow for closing costs and some liquidity for unanticipated bills Affordable monthly mortgage payments –Refer to your cash flow statement –Your mortgage payment may replace a rent payment but there are other expenses to consider –Allow for continued saving

6. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Much Can You Afford? (3 of 3) –Lessons learned from others’ mistakes  Don’t go for the maximum you can afford  Don’t buy above what you can afford  Home values don’t always rise over time, values can also drop  Consider current economic conditions and job stability

7. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Selecting a Home (1 of 3) Purchasing a home may be the single biggest investment you will ever make and requires serious consideration Decide on a price range and then identify a home you want Compare the cost of buying to the cost of renting Consider a condominium

8. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Selecting a Home (2 of 3) Relying on a real estate agent –Listen to their input, but make your own decisions Using online realtor services –Not available in all areas but may save commissions –www.ziprealty.com is an examplewww.ziprealty.com

9. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Selecting a Home (3 of 3) Criteria used to select a home –Price –Convenient location –Maintenance –School system –Insurance –Taxes–usually between 1% and 2% of market value of home –Homeowner’s Association –Resale value–consider real estate commission –Personal preferences

10. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (1 of 6) Go to www.calculatorweb.comwww.calculatorweb.com This Web site will allow you to estimate how much you could borrow to finance a home, based on your income and other financial information.

11. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (2 of 6) Go to the real estate section of Yahoo.com This Web site provides sales prices of homes on a street in a city that you specify over a recent period. It can also provide a list of homes in the city you specify that sold within a certain price range.

12. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (1 of 7) Market analysis: an estimate of the price of a home based on the prices of similar homes in the area –Usually based on price per square foot –Information can be obtained from a real estate broker or appraiser

13. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (2 of 7) EXHIBIT 10.1 Using a Market Analysis to Purchase a Home House SizePricePrice per Square Foot 1,300 square feet$120,000$120,000/1,300 = $92 1,200 square feet$104,100$104,100/1,200 = $87 1,100 square feet $94,000$94,000/1,100 = $85 Average price per square foot = ($92 + $87 + $85)/3 = $88

14. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (3 of 7) Economic impact on home values –Economic conditions affect the valuation of homes –As demand for homes increase, prices rise –When economic conditions weaken, and demand declines resulting in lower home prices

15. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (4 of 7)

16. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (3 of 6) Go to http://www.realtor.com/http://www.realtor.com/ This Web site provides a listing of homes for sale in an area that you specify and homes in the price and size range that you specify.

17. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (5 of 7) Impact of the financial crisis on home values –Mortgage defaults –Impact on home prices –Resolving the crisis  Housing and Economic Recovery Act of 2008 –Lessons from the crisis –Correcting the mortgage application process

18. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (6 of 7) Effects on business activity and zoning laws –Business activity nearby increases demand for housing in an area –Zoning laws may affect desirability Obtaining a second opinion on your valuation –Remember that brokers represent sellers!

19. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Valuation of a Home (7 of 7) Negotiating a price –Most sellers will accept less than their asking price –Seller may accept your offer, reject it, or suggest a revision –A contract will stipulate the agreed upon price and any other conditions

20. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Transaction Costs of Purchasing a Home (1 of 2) Down payment –Usually 10 to 20 percent –Serves as collateral –Lower down payment may be required for government backed loans  Federal Housing Administration (FHA)  Veterans’ Administration (VA)  Maintenance of an escrow account required –Private mortgage insurance (PMI) may be required if your down payment is less than 20% of the home’s value

21. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Transaction Costs of Purchasing a Home (2 of 2) Closing costs –Loan application fee—from $100 to $500 –Points: a fee charged by the lender when a mortgage loan is provided; stated as a percentage of the mortgage loan amount –Loan origination fee—about 1% of the mortgage amount –Appraisal fee—from $200 to $500 –Title search and insurance

22. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (1 of 9) Fixed-rate mortgage: a mortgage in which a fixed interest rate is specified until maturity Preferred when interest rates are expected to rise May be assumable under some conditions

23. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (4 of 6) Go to the mortgage rate section of Yahoo.com This Web site provides national averages for mortgage rates, as well as average rates for specific regions and states.

24. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (2 of 9) Amortization table –Basis for monthly mortgage payment amount for a fixed-rate mortgage –Allocation of the mortgage payment—each payment represents a partial payment of principal and a partial payment of interest

25. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (3 of 9) EXHIBIT 10.3 Amortization Schedule for a 30-Year (360-Month) Fixed-Rate Mortgage for $100,000 at a 5% Interest Rate MonthPaymentPrincipalInterestBalance 1$537 $120 $417$99,880 2537121416 99,343 10 537125412 98,775 25 537133404 96,841 49 537147390 93,483 100 537173364 87,086 200 537263275 65,822 360537534 3 0 Note: Numbers are rounded to the nearest dollar.

26. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (4 of 9) Impact of the mortgage amount on the monthly payment –The larger the mortgage amount, the larger the mortgage payment Impact of the interest rate on the monthly payment –The larger the interest rate, the larger the mortgage payment

27. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (5 of 9) EXHIBIT 10.4 Allocation of Principal Versus Interest Paid per Year on a $100,000 30-Year Mortgage YearPrincipal Paid in That YearInterest Paid in That Year 1$1,475$4,967 21,5514,890 31,6314,812 41,7134,728 61,8944,548 82,0924,350 102,3124,131 122,5553,888 152,9663,191 173,2783,164 203,8072,635 224,2072,235 244,6291,793 265,1361,286 285,675 767 306,271 171

28. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (6 of 9)

29. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (7 of 9) Impact of the mortgage maturity on the monthly payment –The longer the maturity, the lower the monthly payment –The longer the maturity, the more interest you pay over the live of the loan

30. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (8 of 9) EXHIBIT 10.5 Monthly Mortgage Payments Based on Different Mortgage Amounts (30-Year Fixed-Rate Mortgage; 5% Interest Rate) Mortgage AmountMonthly Mortgage Payment $60,000$322 80,000 429 100,000 537 120,000644 140,000751 160,000859 180,000966

31. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Characteristics of a Fixed-Rate Mortgage (1 of 3) Estimating the monthly mortgage payment –Many mortgage loan Web sites offer mortgage calculators to estimate monthly payments based on a specific mortgage amount, interest rate, and maturity

32. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (5 of 6) Go to the consumer interest rates section of http://www.bloomberg.com http://www.bloomberg.com Consumer interest rates are in the “markets” section This Web site provides the monthly payment on a mortgage based on the loan amount, interest rate, and the loan maturity.

33. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Characteristics of a Fixed-Rate Mortgage (2 of 3) EXHIBIT 10.6 Comparison of Monthly Payments for a 30-Year versus a 15-Year Mortgage of $100,000 Based on Different Interest Rates Monthly Payment on a: Interest Rate30-Year Mortgage15-Year Mortgage 4%$477$740 5 537 791 6600 844 7665 899 8734 956 Note: Payments are rounded to the nearest dollar.

34. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Characteristics of a Fixed-Rate Mortgage (3 of 3) EXHIBIT 10.7 Comparison of Mortgage Balance for a 30-Year versus a 15-Year Mortgage ($100,000 Initial Mortgage Amount; 5% Interest Rate) End of Year Balance on 30-Year MortgageBalance on 15-Year Mortgage 1$98,525 $95,406 2 96,97490,577 3 95,34385,500 4 93,63080,166 5 91,82974,577 6 89,93568,661 7 87,94562,464 8 85,85355,950 9 83,65449,103 10 81,34241,905 11 78,91234,385 12 76,35726,385 13 73,67318,025 14 70,850 9,237 15 67,884 0 Note: Balances are rounded to the nearest dollar.

35. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financing with a Fixed-Rate Mortgage (9 of 9) Adjustable-rate mortgage (ARM): a mortgage where the interest owed changes in response to movements in a specific market- determined interest rate Advantage is that rates could go down; disadvantage is that rates could increase Initial rate—usually relatively low Interest rate index—determines whether mortgage rate goes up Frequency of rate adjustments—varies

36. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Characteristics of an Adjustable-Rate Mortgages (1 of 2) Initial rate is relatively low for a year or so Interest rate index tied to mortgage contract Frequency of rate adjustments –Specified in mortgage contract –Many alternatives available from once a year to every five years

37. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Characteristics of an Adjustable-Rate Mortgages (2 of 2) Caps on adjustable-rate mortgages –Caps: maximum and minimum fluctuations in the interest rate on an ARM  Limits the fluctuations in interest rate –Financing with a fixed- versus an adjustable-rate mortgage  Depends on your expectation of future interest rates

38. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Decision to Own a Home versus Rent Consider financial assessment before considering personal preferences Estimating the total cost of renting and owning –Renting–rent payment, security deposit –Owning–down payment, mortgage payment, closing costs, maintenance, taxes and insurance  Owning also has tax advantages

39. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Exhibit 10.8 Comparing the Total Cost of Renting Versus Buying a Home over a Three-Year Period EXHIBIT 10.8 Comparing the Total Cost of Renting Versus Buying a Home over a Three-Year Period Cost of RentingAmount per YearTotal over Next Three Years Rent ($600 per month)$7,200$21,600 Renter’s insurance0 0 Opportunity cost of security deposit20 60 Total cost of renting$7,220$21,660 Cost of Purchasing Mortgage payment ($791 per month)$9,492$28,476 Down payment8,000 8,000 (first year only) Opportunity cost of down payment160 480 Property taxes 1,500 4,500 Home insurance600 1,800 Closing costs3,100 3,100 (first year only) Maintenance costs1,000 3,000 Total costs before tax benefits $49,356 Total tax savings $325 Equity investment$23,000 Cost of purchasing home over three years$26,031

40. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Special Types of Mortgages (1 of 2) Graduated payment mortgage: a mortgage where the payments are low in the early years and then rise to a higher level over time Balloon payment mortgage: a mortgage where the monthly payments are relatively low, but one large payment is required after a specified period to pay off the mortgage loan

41. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Special Types of Mortgages (2 of 2) Interest-only mortgages –Adjustable-rate mortgages that allow home buyers to pay only interest on the mortgage during the first few years

42. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Mortgage Refinancing Mortgage refinancing: paying off an existing mortgage with a new mortgage that has a lower interest rate Rate modification—may be available to some fixed-rate mortgage holders Refinancing analysis—compare the monthly savings to the cost of refinancing –Must pay additional closing costs

43. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (6 of 6) Go to www.mortgageloan.com and insert the search term “refinance”www.mortgageloan.com This Web site provides information about refinancing loans

44. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How a Mortgage Fits Within Your Financial Plan (1 of 4) Key mortgage loan decisions for your financial plan are: –What mortgage amount can you afford? –What maturity should you select? –Should you consider a fixed-rate or an adjustable-rate mortgage?

45. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How a Mortgage Fits Within Your Financial Plan (2 of 4) EXHIBIT 10.9 How Mortgage Financing Fits Within Stephanie Spratt’s Financial Plan GOALS FOR MORTGAGE FINANCING 1. Limit the amount of mortgage financing to a level that is affordable. 2. Select a short loan maturity if possible, assuming that the payments are affordable. 3. Select the type of mortgage loan (fixed- or adjustable-rate) that is more likely to result in lower interest expenses. ANALYSIS 15-Year Mortgage (5% interest rate) 30-Year Mortgage (5% interest rate) Monthly payment $791 $537 Total interest payments $42,343 $93,256 AdvantagesPay off mortgage in half the time of a 30-year mortgage; pay lower interest expenses on the loan Smaller monthly payment Difference between mortgage payment and rent payment $791 – $600 = $191$537 – $600 = –$63

46. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How a Mortgage Fits Within Your Financial Plan (3 of 4) EXHIBIT 10.9 How Mortgage Financing Fits Within Stephanie Spratt’s Financial Plan DECISIONS Decision on Affording a Mortgage: The monthly interest payment on a $100,000 mortgage loan with a 15- year maturity is $791. My rent is $600 per month, so the difference is $191 per month. Since my monthly cash flows (from my salary) exceed my typical monthly expenses (including my car loan payment) and my purchases of clothes by almost $600, I can afford that difference. I will not save as much money as I planned if I buy a home, but I will be building equity.

47. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How a Mortgage Fits Within Your Financial Plan (4 of 4) EXHIBIT 10.9 How Mortgage Financing Fits Within Stephanie Spratt’s Financial Plan Decision on the Mortgage Maturity: I prefer the 15-year mortgage because I will pay o a larger portion of the principal each year. Decision on the Type of Mortgage Loan: I prefer the fixed-rate mortgage because I know with certainty that the monthly payments will not increase. I am worried that interest rates may increase in the future, which would cause interest expenses to be higher on the adjustable-rate mortgage.