1. Personal Financial Management Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.ukg.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.ukp.a.collier@ex.ac.uk

2. Reading Callaghan: Chapter 6 McRae: Chapter 3

3. Investing in Real Assets The three major real assets purchased are: Housing Cars Leisure goods Second homes Yachts, planes, motorhomes, The link between these is typically the need to finance the purchase using a loan In addition each has unique features

4. Real Assets and the Portfolio In financial planning all real assets should be counted as part of the investment portfolio They contribute to wealth Real assets have returns and risks For most people their house is the major asset they own Evaluation of return should include use value (proxied by rental rate) less maintenance costs

5. Housing Risks: the risk from housing is derived mainly from variations in prices The housing market has been very cyclical in the past In the past this has lead to “negative equity” Such cycles cannot occur for a financial asset Housing Data

6. House Finance Repayment Mortgages Each monthly payment covers the interest and reduces the outstanding capital Initially mostly interest is paid but towards the end of the mortgage mostly capital is paid Variety comes through alternative interest structures Fixed Rate: rate fixed for some or all of life of mortgage Variable Rate: rate changes usually in line with base rate Capped Rate: place an upper limit on rate Flexible mortgages: some flexibility in reducing/increasing payments

7. House Finance Interest Only Mortgages The monthly mortgage payment only pays the interest on the loan Alongside the mortgage an investment policy is purchased The investment policy is planned to repay the capital These mortgages were popular until recent failure of investment policies to deliver

8. House Finance This is a complete account A-Z of mortgages

9. Repayment Mortgage Consider repaying 100 over 3 years at 5% interest Let the yearly payment be x End of year 1: 100(1.05) – x End of year 2: (100(1.05) – x )(1.05) – x End of year 3: ((100(1.05)– x )(1.05) – x )(1.05) – x = 0 or 100(1.05) 3 – x (1+ (1.05) + (1.05) 2 ) = 0 The yearly payment is x = £36.72

10. Over n years with interest rate r and with monthly payments this generalizes to: So Repayment Mortgage

11. For example, a £100,000 loan over 25 years at 6% The calculation of this value requires the sum of 25 terms in the denominator Repayment Mortgage

12. Interest-Only Mortgage Interest is paid but no principal For a £100,000 loan at 6%, interest is £6000 per annum, so monthly payment is £500 Payments can also be made into an investment policy Assume investment return of 7% then annual payment solves So monthly payment is £123.13 Total cost is £500 + £123.13 = £623.13

13. Issues An interest-only mortgage with a savings policy is often called an endowment mortgage A repayment mortgage is certain to repay An endowment mortgage is not For the example: 4% gives £63,9965% gives £74,046 6% gives £85,930 7% gives £100,000 8% gives £116,660 9% gives £136,41 Alternatively: an FT100 of 1000 in 1979 would need to be 5427 now

14. Tax treatment made endowment mortgages popular Mortgage interest payments were tax deductible (MIRAS) but this has now been eliminated Many holders of endowment mortgages are left with a shortfall at the end of the term Issues

15. Purchasing a Car There are two major distinctions between cars and houses Cars loans are not viewed as being as safe as house mortgages so the interest rate tends to be about 3-5% above base rate Houses tend to rise in line with wages but cars depreciate A 2005 BMW 760 cost £78000 new. In 3 years it will be worth only 39% of its new value - £30420 This is a monthly loss of £1321 Currently worth £15000

16. Other Assets Boats These can be purchased on mortgages “Balloon mortgages” are available: payments are low (not enough to pay off mortgage) so unpaid capital and interest “inflate” to end of mortgage The outstanding sum can be financed by sale of asset Hence turns ownership into rental Marine Mortgages