1. Residential Financial Analysis
Chapter 6
Residential Financial Analysis

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

3. 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?

4. 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…

5. Incremental Borrowing Cost – Continued

6. 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?

7. Incremental Borrowing Cost – Early Repayment

8. Incremental Borrowing Cost – Origination Fees

9. 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%

10. Incremental Borrowing Cost – Maturity Differences

11. 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?

12. Loan Refinancing for Remaining Term of Original Loan

13. Loan Refinancing – Early Repayment of New Loan

14. Borrowing the Financing Costs

15. 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

16. 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

17. Effective Cost of Multiple Loans – Continued

18. 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

19. 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

20. 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

21. 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

22. 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