Discuss the options available for rented and owned housing and whether renters or owners pay more for housing. Determine how much buyers can afford for housing. Discuss the various mechanisms for financing a home. Objectives
Identify the numerous costs of buying a home, including principle, interest, and closing costs. List and describe the steps in the home-buying process. Identify some important concerns in the process of selling a home. Objectives
Housing Decision Young Single • Rental housing has limited maintenance and offers mobility. • Purchase a home or a condominium for financial and tax benefits. • Single Parent • Rental housing can provide suitable environment for children and some degree of housing security. • Purchase low-maintenance housing to meet financial and social needs of family. • Young Couple, No Children • Rental housing offers convenience and flexibility of lifestyle. • Purchase housing for financial benefits and to build long-term financial security. • Couple, Children No Longer At Home • Rental housing for convenience, flexibility for changing needs and financial situation. • Purchase housing that requires minimal maintenance and meets lifestyle needs. Couple, Young Children • Rental housing can provide facilities for children in a family-oriented area. • Purchase a home to meet financial and other family needs. • Retired Person • Rental housing meet financial, social, and physical needs. • Purchase housing that requires minimal maintenance, offers convenience, and provides needed services.
Renting Your Residence • Advantages • Mobility • Fewer responsibilities • Lower costs initially • More amenities • Disadvantages • Few financial benefits • Restricted lifestyle • Cost of renting - deposits • Legal concerns of a lease
Largest Physical Capital Investment Made by a Family is a HOUSE. • Home Ownership rates 2012: • US = 65.4% (lowest since 1997) • Utah = 71.5% • Since 1900, home ownership has been in excess of 40% in the U.S.
Housing Prices are determined by Supply & Demand • Demand • Average household size down • Average income up • Availability of substitutes down • Life cycle stage of housing • Childhood home, apartment, starter home, family home, empty nest home, retirement home, institutionalization or back to family, burial vault • Supply • Business cycle
Advantages of Owning • Pride of ownership • American dream/norm • Reduced income taxes • deduct property taxes • deduct mortgage interest
Advantages of Owning (continued) • Build an equity • pay down the loan • price appreciation • Builds your credit rating • Forced savings-portion of mortgage payment goes toward building up equity. • Hedge against inflation • Lifestyle flexibility • can express your individuality
Disadvantages of Owning • Financial risk • need down payment • home prices could drop • Opportunity cost of money tied up in purchase. • Limited mobility • can take time to sell • Higher living costs • maintenance • repairs & improvements • utilities & insurance • real estate taxes
Based on cash flow, renters appear to win After taxes and appreciation, owners usually win Renting vs. Owning Your Home • WHO PAYS MORE:
A Cost-Benefit Approach (CBA) to the home ownership decision • 1. What is the time period over which the household plans to own/rent? • 2. What are the one-time fixed costs associated with purchasing the home? • down payment • closing costs (e.g., points, fees) • Do you pay these costs if you are renting?
A Cost-Benefit Approach (CBA) to the home ownership decision • 3. What are the recurring (i.e., monthly) NET costs associated with owning compared to renting? • How much more does it cost you to own than to rent every single month? You want to get that money back at the end… • Sum of owning costs (mortgage payment, property taxes, hazard insurance, operating and maintenance expenses) minus tax savings • Sum of renting costs (rent, operating expenses) • 4. What will the outstanding loan balance be at the end of the time period? • You have to pay off your loan when you sell • 5. What will the estimated selling costs be at the end of the time period? • You need to pay a realtor, and you want to get those dollars back
A Cost-Benefit Approach (CBA) to the home ownership decision • 6. Place all of these costs into future value dollars using 3% real interest rate • Remember, all of our dollars have to be at one point in time – we are putting all of our dollars in to the future • One-time costs (because these costs are one-time costs): FV=PV(1+r)n • Recurring costs (because these costs happen every single month): • Loan balance (already in future dollars; do not need to use a formula): • Selling costs: • Add up the one-time costs, recurring costs, loan balance, and selling costs, for the total costs expressed in future value terms • This equals the minimum required future value of the home, or the break even price • This is how much you have to sell your home for in the future in order to get back all of the dollars that you have spent
A Cost-Benefit Approach (CBA) to the home ownership decision • 7. Compute the interest rate • This interest rate is the annual rate of appreciation that will have to occur if you are to break even on purchasing a house rather than renting for n years. • This converts the dollar amount into an interest rate, so that you can compare your housing investment with other types of investments
DECISION RULE - • If the forecasted rate of housing appreciation is greater than the calculated interest rate, then economic benefits of home ownership outweigh the economic costs. • So, buy the house • If the forecasted housing appreciation rate is less than the calculated interest rate, then the economic costs of home ownership outweigh the economic benefits. • So, rent
Example • Original Purchase Price = $100,000 • 1. Time period = 8 years • 2. One-time fixed costs: • Down Payment = $10,000 • Closing Costs = $3,000 • Total = __________ • 3. Recurring Net costs • Sum of owning costs – tax savings = $1200 • Sum of renting costs = $900 • Net Costs = $1200 - $900 = _______ • 4. Loan balance: $81,900 (get from amortization table) • 5. Selling Costs: $6,000
6. FV of one-time costs = FV=13000(1+.03)8 FVA of recurring costs (with monthly compounding) = =$16,468 = $32,504 Example
Example • 6. Now, add up all of the future costs: • FV • FVA • Loan Balance • Selling Costs • = $136,872 ($16,468 + $32,504 + $81,900 + $6,000)
Example • 7. • = 0.04 or 4%
Example • Decision = • if forecasted housing appreciation rates are higher than 4%, you should buy this house
Renting versus Buying Place of Residence Comparing an apartment with $1,250 of monthly rent and a home that cost $200,000. A 28% tax rate is assumed.
Housing Options for Home Buyers • Single-family dwelling • tract housing • built on speculation by builder • built to your specifications • previously lived in home • manufactured home • mobile home
Home Buying Process Step 1: Determine Ownership Needs • How much you can afford • down payment • loan amount • size and quality • handyman’s special • sweat equity
Home Buying Process Step 2: Finding and Evaluating a Property to Purchase • Select a location • Zoning laws • Covenants, codes and restrictions • Using a real estate agent • Property appraisal • Conducting a home inspection 9-15
Home Buying Process Step 3: Pricing the Property • Determining the price to offer • Negotiating the purchase price • seller’s or buyer’s market • earnest money • Contingency clauses • home passes structural inspection • able to get a loan
Estimating Mortgage Loan Payments for Principal and Interest Estimating Mortgage Loan Payments for Principal and Interest (Monthly Payment per $1,000 Borrowed) Note: To use this table to calculate a monthly mortgage payment, divide the amount borrowed by 1,000 and multiply by the appropriate figure in the table where the interest rate and the time period for the loan intersect. For example, a $150,000 loan for 30 years at 9 percent would require a payment of $1,206.93 [($150.000/1,000) x 8.0462]; over 15 years it would require a payment of $1,521.41.
Effect of Down Payment Effect of Down Payment Size on Monthly Payment for a $150,000 Home (7 Percent Mortgage Loan for 30 Years)
How do households finance the purchase of a house? • Down payment • typically 10% of selling price, but 20% is the magic number • Mortgage • loan to pay the seller the difference between the purchase price and the down payment • Mortgage choices impact the economic cost of a home
Type of Mortgages • Conventional • fixed rate, amortized • 5, 10 or 20 percent down • 15, 20 or 30 years of fixed payments • Government guaranteed • Veterans Administration • Federal Housing Administration • Adjustable rate mortgages • varies with the prime rate but has a rate cap
Type of Mortgages (continued) • Graduated payment • payments start lower and go up • for persons whose income will increase • Balloon • fixed monthly payments plus one large payment, usually after 3, 5 or 7 years • Growing equity • payment increases to allow loan to be paid off more quickly
Type of Mortgages (continued) • Shared appreciation • borrower agrees to share appreciated value of the home with the lender • Home equity loans • a second mortgage • home is collateral and interest may be tax deductible • Reverse • a loan based on the home equity • Refinancing
Economic Advantages and Disadvantages of Fixed Rate Mortgage? • Advantages: • future housing costs are known with relative certainty (only possible changes are property taxes, insurance, and utilities) • can choose 15-year, 20-year, 25-year, 30-year, 40-year, or 50-year loan time • interest deductions from income taxes are high during the early years of the loan
Economic Advantages and Disadvantages of Fixed Rate Mortgage? • Disadvantages: • more difficult for young households (with lower incomes) to qualify • Locked in to the fixed rate. • Tax advantages lessen over time (typically at the point where household income and the marginal tax rate are both rising)
Fixed rate FHA or VA mortgage • Federally insured mortgages • If the borrower defaults, the lender still gets the money. • Advantages: • interest rates frequently lower on FHA or VA mortgages than on conventional mortgages • qualifying is typically easier • FHA/VA loans are assumable • down payment requirements are typically lower
Fixed rate FHA or VA mortgage • Disadvantages: • loan limits (2008 = $729,750 in SLC, Summit, and Tooele Counties; $323,750 in Utah County; $271,050 most everywhere else) • insurance fees (1.5% upfront, + 0.50% per year of the loan amount – can be financed) • typically pay additional points (one-time, fixed costs) • Rates on 10/30/08 • 30 year fixed is 6.46%, with 0.7 points • 15 year fixed is 6.19%, with 0.7 points • May take longer to process
Self-amortizing, Adjustable Rate Mortgage (ARM) • Interest rate and monthly payment are both variable (e.g., adjustable). • Example: • loan amount = $200,000 • interest rate = 6.0% initially • time period = 30 years • initial monthly payment: $1199.10
More about the ARM interest rate • Index - market interest rate that is not directly controlled by the lender. It is used to initially set and periodically adjust the interest rate on the loan • Spread - the amount that is added to the index to arrive at the the ARM interest rate.
More about the ARM interest rate • Frequency of rate change - how often the lending institution can change the ARM interest rate. • Rate cap - limitations on either the increase or the decrease in the ARM interest rate that can occur at a point in time. • Frequency of payment change - how often monthly payments can change (typically the same as frequency of rate change -- if not, there is the possibility of negative amortization)
Economic Advantages and Disadvantages of an Adjustable Rate Mortgage? • Advantages: • Initial interest rates are typically lower • If you are buying when mortgage rates are high, but expected to fall in the future • Disadvantages: • Greater uncertainty about what future mortgage payments will be
Graduated Payment Mortgage (GPM) • Interest rate is fixed but the monthly payment rises over time -- supposedly as the household’s income rises. • Example: • loan amount = $200,000 • interest rate = 7.0% • time period = 30 years • monthly payment at first is $800 (rather than $1330.60) • After 2 years, payment goes to $1000 • After another 2 years, payment goes to $1200 • Then payment is $1553.60 for the rest of the loan (24 years)
Interest Payments on a Graduated Payment Mortgage • Month 1: • payment = $800.00 • interest owed: $200,000(.07/12) = $1166.67 • loan increased by: $1166.67 - $800 = $366.67 • Month 2: • payment = $800.00 • interest owed: $200,366.67(.07/12) = $1168.81 • loan increased by: $1168.81 - $800 = $368.81 • This is an example of negative amortization
Economic Advantages and Disadvantages of a Graduated Payment Mortgage? • Advantages: • Easier to qualify for lower income households • lower monthly payments early in the mortgage • Disadvantages: • Loan amount is larger than with a conventional, fixed rate mortgage • Payments will be higher in the later stages of the loan (must be confident that income will rise or else this may present a problem)
Reverse Equity Mortgages (REM) • A reverse mortgage is a loan against your home that you do not have to pay back for as long as you live there. • It can be paid to you all at once, as a regular monthly advance, or at times and in amounts that you choose. • You pay the money back plus interest when you die, sell your home, or permanently move out of your home. • Reverse mortgage loans typically require no repayment for as long as you live in your home. • Your house must be paid off (or close to it) • You must be over 62
REMs • Advantages: • Way to access your home equity without having the burden of repayment • Creates income • Disadvantages: • Reduces the value of your estate • Your home must be sold after your death to repay the REM, if liquid assets are not available to pay off the REM
Interest Only • Your payment only covers the interest owed on the loan • Then you have a balloon payment after a specified # of years (e.g. 7 or 12) with the principal balance due • Or your loan will amortize over a shorter amount of time • E.g. 40 yr IO – pay IO for 10 years, and then amortized over 30 yrs • Advantages: • Lower monthly payments • Maybe good for rental properties and/or high-equity growth areas • Disadvantages: • Negative amortization may occur • No gain in equity from principal reduction • Very risky
Summary: Economic Costs and Economic Benefits of Various Mortgage Instruments Depend Upon... • Life cycle stage • Business cycle stage • Risk tolerance • Liquidity needs
How to reduce the amount of interest paid on your mortgage • Pay extra principal every month • Pay next month’s principal this month • Pays off a 30-year mortgage in about 15 years and 8 months • Pay bi-weekly • Pay 26 half payments a year, or 13 monthly payments • Cuts about 7 years off of 30 year mortgage • Pay semi-monthly • Pay 24 half payments a year • Cuts about 5 years off of 30 year mortgage, without ever paying extra