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The Home Decision II: Answers to Questions Updated 2012-02-13

Personal Finance: Another Perspective. The Home Decision II: Answers to Questions Updated 2012-02-13. Objectives. 1. How are mortgage brokers paid? 2. How do I know when to refinance my home? 3. What happens when good credit marries bad credit?

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The Home Decision II: Answers to Questions Updated 2012-02-13

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  1. Personal Finance: Another Perspective The Home Decision II:Answers to QuestionsUpdated 2012-02-13

  2. Objectives • 1. How are mortgage brokers paid? • 2. How do I know when to refinance my home? • 3. What happens when good credit marries bad credit? • 4. What about prepayment penalties? What should I know? • 5. What’s the lowdown on buying down or paying discount points?

  3. Objectives (continued) • 6. How do I make sure that brokers give what they promise, i.e., no bait and switch? • 7. How much of a percentage should I pay for a down payment? • 8. Should I pay off the loan early or stick to the loan schedule? • 9. Is a 15 or 30 year loan better? • 10. Do I have to pay Private Mortgage Insurance (PMI)?

  4. Objectives (continued) • 11. How do I know whether to rent or buy? • 12. How easy is it to refinance a home with an interest only loan? • 13. If a person is upside down in their mortgage (i.e., they owe more than the house is worth) and they would like to sell their house, what can they do? This is called a short-sell. • 14. If a person is upside down in their mortgage, can they still refinance?

  5. Objectives (continued) • 15. What do you think about purchasing distressed properties out of state? • 16. If you move from your first house, do you recommend keeping it as a rental? • 17. If the offer is not accepted, is the earnest money returned? • 18. What is your recommendation on your first house? • 19. Can you review the Home Buying process?

  6. Objectives (continued) • 20. What type of account should you use to save for a down payment (e.g., ETF, stocks, bonds, money market, etc.)? • 21. With home values depressed, home values are bound to increase. How do we weigh this in the decision to purchase a home? Should we accelerate the purchase so we can buy when the market is low? • 22. How do we balance our current home size need with the fact that our family will be growing?

  7. 1. How do Mortgage Brokers get Paid? Principle: Stewardship Logic: If you understand how people are paid, you can use that knowledge to your advantage in getting a lower interest rate Mortgage brokers are out to provide a service and make money They generally work with similar lenders with similar rates They are done with you after your loan—there is no follow up Your goal is to minimize your interest rate received with the fewest discount points (if any) 7

  8. Mortgage Brokers (continued) Mortgage brokers make money three ways: Origination fees: These are the costs and profits on making the loan Discount Points: These are payments you make to lower the loan interest rate Backend bonus: These are bonuses paid to the mortgage broker if they get a higher interest rate than what the lender requires There is a relationship between discount points you pay and the broker’s backend bonus Your goal is to minimize the interest rate and the discount points you pay. It will likely reduce the broker’s backend bonus as well.

  9. Mortgage Brokers (continued) • How do I estimate the Lenders required rate or return for mortgage loans? • Logic: Broker’s earnings are origination fees, discount points and backend bonus • Find out how low (the interest rate and points) they will let you buy-down to, i.e., 4.75% with 3 points • This may be close to the lender’s rate, as they will not let you buy-down below the lender’s required rate • Use this information in your negotiations

  10. The Underwriting Process The Underwriting Process From http://upload.wikimedia.org/wikipedia/commons/0/08/Borrowing_Under_a_Securitization_Structure.gif on 7Oct08 10

  11. 2. How do I know when to Refinance my home? • Principle: Stewardship • Logic: Determine the costs you would pay before refinancing and the costs you will pay during and after refinancing, including any prepayment penalties • Calculate an internal rate of return on your savings, which takes into account the time value of money • Calculate a breakeven analysis and a total cost analysis as well • These are all inputs into your decision

  12. Refinancing (continued) Calculate: A. Current monthly principal and interest costs B. Refinance monthly principal and interest costs C. Monthly savings from the refinance D. Total new fees/costs, including origination fees, discount points, and other fees from the refinance. In addition, be sure to include all new costs that will be incurred in taking out of the new loan including prepayment penalties Note that costs that are the same for both loans, i.e., escrow or reserve accounts, do not need to be included in these calculations

  13. Refinancing (continued) To determine if refinancing makes sense, look at three calculations: 1. Internal Rate of Return, 2. Breakeven Analysis and 3. Total Costs If all are reasonable, then do it. If only one calculation makes sense, I would likely not do it

  14. Refinancing (continued) • 1. Internal Rate of Return • Outflows: • A. Calculate all costs and fees for the loan • Inflows: • B. Calculate the monthly savings • C. Determine the number of months savings • Note: Set the number of months on the new load equal to the number of months remaining on the old loan • Recommendation: • Set PV = - A, PMT = B, N = C, solve for I • If your IRR is greater than your risk-free rate, then refinance

  15. Refinancing (continued) • 2. Breakeven Analysis • Calculate: • A. All new costs and fees for the new loan • B. Savings in principle and interest over the old loan • Recommendation: • Divide all new costs (A) by monthly savings (B) which will give you your breakeven point in months (C) • If your breakeven point (C) is: • Less than 4 years, it may be a good idea • If 5-7 years, it might be considered • Greater than 7 years, be careful • You may likely move before 7 years

  16. Refinancing (continued) • 3. Total Costs Analysis (no Time Value of Money) • Calculate: • A. Your total new costs and fees from the loan until it is paid off • B. Your total current monthly principal and interest costs remaining without refinancing • C. Your total refinance monthly principal and interest costs • Recommendation: • If you will be paying less overall, think about it • If A + C < B, it may make sense. • If A + C = B, it may not make sense • If A + C > B, it does not make sense

  17. Case Study #1 Data • Steve has a $150,000 30 year 6% fixed rate loan that he has paid on for 10 years, and he owes $125,529 on the loan. He is looking to refinance. He has found a 20 year 5.25% loan with origination fees of $1,500, and $2,500 in other fees. His risk-free rate is 8%. Calculations: Calculate the three types of refinance analysis for this new loan: IRR, Breakeven and Total Cost Analysis. Application: Should Steve refinance with this loan?

  18. Steve has a $150,000, 30 year, 6% fixed rate loan that he has paid on for 10 years ($125,539 remaining). He has found a 5.25% loan with a $1,500 origination fee and $2,500 in other fees. Calculate Steve’s Breakeven and Total Cost calculations. Should Steve refinance with this loan? 1. IRR Analysis • A. Calculate all costs for the new Loan? $4,000 • B. Calculate the monthly savings: Old versus New • Old: -$150,000=PV, N = 360, I = 6%, PMT = ? • PMT = $899.33 • New: -$125,539 PV, N = 240, I = 5.25%, PMT = ? • PMT = $845.87 • Monthly Savings = $899.33 - $845.87 = $53.46 • C. Months on the new loan N = 240 • Recommendation: Calculate the IRR • PV = -4,000, PMT = $53.46, N = 240, solve for I? I = 15.27%. Compare this to their risk-free rate

  19. Steve has a $150,000, 30 year, 6% fixed rate loan that he has paid on for 10 years ($125,539 remaining). He has found a 5.25% loan with a $1,500 origination fee and $2,500 in other fees. Calculate Steve’s Breakeven and Total Cost calculations. Should Steve refinance with this loan? 2. Breakeven Analysis • A. Calculate new costs and fees • $1,500 + $2,500 = $4,000 • B. Calculate monthly savings • Current principal and interest: PMT = $899.33 • Refinance principal and interest: PMT = $845.87 • Monthly Savings: $53.46 • Recommendation: Calculate the Breakeven in Months • Divide the total costs (A) by the monthly savings (B). The Breakeven is $4,000 / $53.46 = 74.8 months / 12 = 6.2 years. Not a great payback period

  20. Steve has a $150,000, 30 year, 6% fixed rate loan that he has paid on for 10 years ($125,539 remaining). He has found a 5.5% loan with a $1,500 origination fee and $2,500 in other fees. Calculate Steve’s Breakeven and Total Cost calculations. Should Steve refinance with this loan? 3. Total Cost Analysis • A. Calculate new costs and fees for new loan until paid off: 240 * $845.87 = $203,008 • B. Total costs without refinancing: 240 * 899.33 = $215,838 • C. Costs to refinance: $4,000 • Recommendation: Total Cost Savings • Since $203,008 + 4,000 = 207,008 < $215,838, the savings are positive (they would save $8,830), I would think about refinancing • Summary: Since the IRR is greater than their risk free rate of 8%, and since they will save $8,830, they likely should refinance.

  21. 3. What Happens when Good Credit Marries Bad Credit Principle: Stewardship Logic: Determine the cheapest way of getting the highest credit score so you can pay the lowest interest on your loan There are five main options: 1. Buy the house as co-owners and co-borrowers 2. Have “good-credit” buy the house alone 3. Have “good-credit” buy the home using a “no-income verification” mortgage (if available) 4. Have a third party with good credit replace the “bad-credit” as the co-borrower 5. Improve “bad-credit’s” credit score

  22. Good Marries Bad Credit (continued) 1. Buy the house as co-owners and co-borrowers Bad credit will result in bad credit for the loan and a higher interest rate This is what you want to avoid 2. Have “good-credit” buy the house alone This is the preferred option However, this may limit the size of the loan to the income that good-credit can support Do not buy a house on two incomes when you know you will drop to one income in the future—it is a recipe for disaster

  23. Good Marries Bad Credit (continued) 3. Have “good-credit” buy the home using a “no-income verification” mortgage This would be OK, but these mortgages are much harder to get These mortgages also require higher down payments of 25-30% of the property value 4. Have a third party with good credit replace the “bad-credit” as the co-borrower Co-signers are hard to find Usually, only a parent would be willing to do this

  24. Good Marries Bad Credit (continued) • 5. Improve “bad-credit’s” credit score • Suggestions include: • Put “bad-credit” on joint accounts with “good-credit” spouse. This can improve history and score • Call bank to increase the available credit limits on “bad credit” • Pay bills twice a month to reduce amount used for “bad credit” to reduce percentage of credit • Pay off debt as quickly as “bad credit” can

  25. 4. What about Prepayment Penalties? What should I know? • Principle: Stewardship • Logic: Understand what you are getting into before you sign the Loan papers • Mortgage lenders usually do not require a prepayment penalty on a first mortgage, but they do require it on a 2nd, 3rd, or subprime loan • If mortgage brokers get a prepayment penalty on a loan, they may make more money • Make sure there is no prepayment penalty on your first mortgage

  26. Prepayment Penalties (continued) There are two main types of prepayment penalties: soft and hard Both have: 1. A stated period of time, i.e., 1, 2, or 3 years the prepayment penalty is in effect 2. A maximum pay down percentage (MPP), i.e., 6% of the principal per year, and 3. The prepayment penalty if you sell it before, i.e., 6 months interest

  27. Prepayment Penalties (continued) Soft Prepayment: You cannot within the stated period of time without penalty: Refinance at all Sell the loan to family members Pay down more than your MPP each year The only way to get out of a soft prepayment penalty is to sell the property to an unrelated party

  28. Prepayment Penalties (continued) Hard Prepayment: You cannot within the stated period of time without penalty: Refinance at all Sell the loan to anyone Pay down more than your MPP each year There is no way to get out of a hard prepayment penalty before the defined period without paying the penalty

  29. 5. What is the Low Down on Buying Down (Points)? Principle: Stewardship Logic: You can reduce your loan interest rate by paying discount points (these points go to the mortgage broker—not the mortgage lender) The longer you actually stay in the home the more valuable the discount points as those costs are allocated over more years Since the average homeowner is in their homes only 5-7 years, the savings from the discount points should break even before that time is up

  30. Buying Down (continued) There are two different analyses for determining whether you should buy down your interest rate: 1. Internal Rate of Return Analysis Outflows: A. Calculate all costs for the new loan Inflows: B. Calculate the monthly savings C. Determine the number of months savings Recommendation: Set PV = - A, PMT = B, N = C, solve for I If your IRR is greater than your risk-free rate, then refinance

  31. Buying Down (continued) 2. Breakeven Analysis • A. Calculate your monthly payments: • 1. Without the discount points, and • 2. With the discount points • B. Calculate the savings between options 1 and 2 • C. Calculate the cost of the discount points • Recommendation: • Calculate your breakeven point in months by dividing the cost of your discount points (C) by your monthly savings (B). If your breakeven is less than 4 years, it may be a good idea, 4-7 years, be careful, and greater than 7 years, it is likely very questionable

  32. Buying Down (continued) Before you pay the points, ask yourself: Will you be refinancing soon? If so: There may be better uses for your money than to buy down a tax-deductible interest rate Better uses may include: Paying down higher-rate debt Saving for retirement in tax-eliminated or deferred accounts Building your emergency fund

  33. Case Study #2 Data: Mark is looking into a $250,000 6.0% fixed 30 year mortgage for his new house. The broker offers him 6.0% with 1 origination point (loan A). He also says that he can buy down the loan to 5.5% with 1 additional buy down points (loan B with 2 points total). Mark’s risk-free rate is 8%. Calculation: Calculate the IRR and Breakeven Analysis for Loan B. Application: Assuming Mark will take one of these two loans, which loan should he take?

  34. Mark is looking into a $250,000 6.0% fixed 30 year mortgage for his house. The broker offers him 6.0% with 1 origination point (A). He also says that he can buy down the loan to 5.5% with 1 additional buy down point (B). IRR Analysis: • A. Calculate the monthly payments for both loans • Loan A: PV=-$250,000 , I = 6%, N=360, Pmt = ? • PMT = $1,498.88 • Loan B: PV=-$250,000 , I = 5.5%, N=360, Pmt = ? • PMT = $1,419.47 • B. Monthly savings: $1,498.88 - $1,419.47 = $79.40 • C. Cost of discount points: 2%* $250,000 = $5,000 • IRR • PV=-$5,000, PMT =$79.40, N=360, solve for I? • IRR = 19.0%

  35. Mark is looking into a $250,000 6.0% fixed 30 year mortgage for his new house. The broker offers him 6.0% with 1 origination point (loan A). He also says that he can buy down the loan to 5.5% with 1 buy down points (loan B). Breakeven Analysis: • A. Calculate the monthly payments for both loans • Loan A: $1,498.88, Loan B: $1,419.47 • B. Monthly savings: $1,498.88 - $1,419.47 = $79.40 • C. Calculate the cost of the discount points • 2 points * $250,000 = $5,000 Breakeven • Divide the cost by the monthly savings • $5,000 / $79.40 = 63 months or 5.25 years • Since the breakeven point is greater than 4 years and less than 7 years, I would recommend they buy down the loan

  36. Mark is looking into a $250,000 6.0% fixed 30 year mortgage for his new house. The broker offers him 6.0% with 1 origination point (loan A). He also says that he can buy down the loan to 5.5% with 2 buy down points (loan B). Recommendation • Their IRR is 19%, substantially higher than the 8% risk-free rate • Their breakeven analysis is 5.3 years. Since their breakeven is less than 7 years, it may be a good idea • Since the breakeven for this loan is less than 7 years, I would recommend Mark to think about it • I would use this as a negotiating tool. • Go back to the mortgage broker and tell them that if they can do the same interest rate with 1-1.5 points, I would do it because my breakeven is 2.6 years at 1 point and 4 years at 1.5 points.

  37. 6. How Do I Get the Best Deal with Mortgage Brokers? Principle: Accountability Logic: You can reduce your overall costs by shopping around and holding mortgage brokers accountable for what they say. Following are a few ideas to help you in this process 1. Work with a number of brokers to find the lowest interest rate and fees 2. Research the reputation and background of potential lenders. Check with the BBB

  38. Dealing with Mortgage Brokers (continued) • 3. Beware of the “bait and switch” routine. They should follow through with what they promise. • 1. Hold them accountable for their closing and other costs by seeing the complete (not summary) Good Faith Estimate and comparing it to final closing costs • 2. Hold them accountable for the interest rate that they promise by having them show you their “Rate Lock Commitment sheet” to make sure it is consistent with what they promise.

  39. Dealing with Mortgage Brokers (continued) • 4. Beware of lenders who advertise “no closing costs” or “no origination fee.” Generally, they will either raise the interest rates, call it a processing fee, or add the costs to the principal of your loan. There are costs to processing the loan • 5. If your lender promises a short turn around or processing period for your loan (7-14 days), ask to confirm that their underwriter is in the same state (or in the same building). Sending data to underwriters out of state can result in loans that take much longer to process.

  40. 7. How much of a down payment should you make? Principle: Stewardship Logic: First, fulfill the covenants of the loan, and second, make sure you have an adequate Emergency Fund after all closing costs are paid Having a buffer the first few years are important in case of job loss or other concerns Once you have this buffer in place, you can pay as a down payment amount any additional funds you have saved However, I recommend you both pay down your loan and save for your other goals at the same time (not just pay down the loan) Have a balanced plan for your goals 40

  41. 8. Should you pay off the loan early? Principle: Stewardship Logic: While there are some tax benefits, you are paying interest instead of earning it with a mortgage even after tax benefits We have been counseled to buy a modest home, fix it up, and pay it off as soon as we can We should use wisdom in all that we do I recommend to both pay off principal and save for your other goals at the same time (diversification) Maintain a balanced plan for your goals

  42. 9. Is a 15 year or 30 year loan better? • Principle: Stewardship • Logic: While there are some tax benefits to a mortgage, you are paying interest instead of earning it. My inclination is to pay it off sooner. • The inputs into the decision for a 15 versus 30 year mortgage are: • Monthly cash flow and budget under both rates • Stability of your job and job outlook • Interest rate differences between 15 and 30 year • Realize you can also take out a 30 year mortgage and pay it off in 15 years as well (see TT19: Prepayments) if you have other concerns

  43. 10. Do I Have to Pay PMI? • Principle: Stewardship • Logic: Pay PMI only if required, and then get rid of it as soon as your equity in your home is greater than 20% • PMI is generally required if your down payment is less than 20% of the appraised value of the home. This can be due to: • Principal being paid down • Home value appreciation, or • Both • PMI may be avoided through “piggy-back” loans if available, but these are as well

  44. Eliminating PMI • Once your principal is reduced to 80% of the value of the loan: • Contact the loan servicer • Request information on cancellation of PMI • Often, they will require a new appraisal to determine the Loan to Value ration (LTV) • Once the appraisal is completed and documentation is provided (at your cost), PMI will no longer be required.

  45. 11. How do I know whether to rent or buy? • Principle: Stewardship • Understand what you are trying to do before you do it. • There are a number of rent versus buy calculators on the internet. • One student sent this one to me. It looks only at monthly rent, home price, down payment, mortgage interest rate, and annual property taxes. • It does not take into account what you spend on landscaping, appliances, repair, etc. • http://www.nytimes.com/interactive/business/buy-rent-calculator.html

  46. 12. How Easy is it to Refinance a Home with an Interest Only Loan? • Principle: Stewardship • Refinancing with an interest only loan is the same as with a traditional fixed or ARM • It is a fixed or ARM loan with an interest only option • You will follow the same steps as if you were refinancing a traditional mortgage • It is easy

  47. 13. What is a Short-sell? • A short-sell is where a lender allows a property to be sold for less than the amount owed on a mortgage and takes a loss • A short sell requires: • A borrow who wishes to sell the property • A lender who decides that selling at a moderate loss is a preferable alternative to pressing the borrower into foreclosure and incurring the risks and costs from that process

  48. Short-sell (continued) • A short sell allows: • Borrower to avoid foreclosure, which involves hefty fees for the bank and poorer credit outcome for the borrower • Lender to make “less” of a loss on the property and to not enter foreclosure • A short sell does not: • Necessarily release the borrower from the obligation to pay the remaining balance of the loan (called the “deficiency”)

  49. 14. If a person is upside down in their mortgage, can they still refinance? • That depends: • If the entire mortgage is a first mortgage, then the answer is likely no • However, if there is both a first and second mortgage, and the first mortgage is significantly less than the market value of the home, you may be able to refinance the first mortgage because the first mortgage has first claim on the home and it must be paid before the second is paid

  50. 15. What Do You Think About Purchasing Distressed Properties Out of State? • Principles: Stewardship and Accountability • 1. Can you adequately assess the quality of rental properties from out of state? • Generally no. You would need to trust someone else’s opinion as to the quality of the investment • Be very careful about advertisements that state you can buy rental properties at 85% off retail • If it was that good, they would buy it themselves

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