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Economic Analysis Team Project. TEAM 3. Home Financing Options. Team Members. From left to right Jason de la Guerra – Organizer Michael Jauregui – Summarizer Jerry Lessley – Techie Kevin Navares – Techie. You’re in the market to purchase a home. What type of loan should you choose?
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Economic Analysis Team Project TEAM 3 Home Financing Options
Team Members From left to right Jason de la Guerra – Organizer Michael Jauregui – Summarizer Jerry Lessley – Techie Kevin Navares – Techie
You’re in the market to purchase a home. What type of loan should you choose? What is the difference between an FRM and an ARM? The Big Questions???
FRM (Fixed Rate Mortgage) Rate is constant for 30 years Current Rate 5.36 ARM (Adjustable Rate Mortgage) Fixed rate for 7 yrs then indexed for 23 years Fixed rate 4.36 Adjustable rate index of 2.25 – 3.0 Definitions ** Both require a FICO score of 700 or above
Analysis Assumptions • Loan amount of $400,000 • Down payments are equal to 10% of loan • Payment is based on a 30 year term • Options of selling at 7 and 10 years • Average tax benefit of 28% • All rates are based on current market values and historical trends
Future Value • Assuming a Conservative California Average growth of 10% • FV of a $400,000 would be $716,339.08 in 10 years • FV of a $400,000 would be $601,452.10 in 7 years • Combined with monthly payments and our initial down payment the amount owed at the end of 10 years would be: FRM $296,646 ARM $273,871 • For 7 year FRM $113,181 ARM $124,120
Benefit Cost Ratio The most beneficial option will have the highest ratio. B/C = (sale benefit + tax benefit) / (down payment + total of amount paid) • 10 yr FRM B/C = (316339+61280)/(40000+241503) = 1.34 • 10 yr ARM B/C = (316339+58531)/(40000+241503) = 1.33 • 7 yr FRM B/C = (201452+48271)/(40000+169052) = 1.19 • 7 yr ARM B/C = (201452+37332)/(40000+169052) = 1.14
Rate Of Return FRM Interest 5.36% Arm Interest 4.36%,5.51%,6.66%,7.81% ROR based on initial down payment of $40,000 less our annual tax benefit and equity earned at sale of the home FRM ARM ROR at 10 years 31% 30% ROR at 7 years 36% 35%
Principal vs. Interest Contribution Principal and interest sum = total yearly payment of $24,150 for both FRM and ARM
Fixed Rate Mortgage (FRM) Benefits • Predictable cash flows for term of loan • Higher tax benefits • The rate of return after 10 years with no sale is higher. • Greater investment return at 7 year sale • Higher profit than ARM after 10 year sale.
Adjustable Rate Mortgage (ARM) Benefits • Initial interest rate is lower than FRM • Interest rate paid will generally decrease as prevailing interest go down. • Typically offer lower down payment option • Generally easier qualification criteria • Competitive ARM market coupled with low rates increase affordability.
Conclusions • FRM overall better alternative given analysis assumptions • Long term home-owners receive greater benefit form FRM • Assuming the same FRM and ARM payment the FRM has greater return on investment. • Short Term home-owners benefit from ARM due to lower initial costs and higher payments to principle. • Current market provides ARM advantage through affordability and competitive markets
Resources • www.myfico.com • www.cnnmoney.com • www.hud.gov • www.lendingexpo.net • D. Newnan, J. Lavelle, and T. Eschenbach. (2002). “Essentials of Engineering Economic Analysis” Oxford University Press, Oxford, NY.
