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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.

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how do households finance the purchase of a house
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
basic dimensions of a mortgage
Basic Dimensions of a Mortgage
  • Loan amount (purchase price minus down payment) = PV
  • Interest rate per period = r
  • Time period for the loan = n
  • Pre-payment option
self amortizing fixed rate mortgage
Self-amortizing, Fixed Rate mortgage
  • Interest rate and monthly payment are fixed.
    • Standard, conventional
  • Example (with monthly compounding):
    • loan amount = $200,000
    • interest rate = 7.0%
    • time period = 30 years
slide4
PV=200,000
  • r = (.07/12) = .005833
  • n = 30(12) = 360
slide5
FVP = $1,330.60 per month
  • Please note: this is the PI part of the PITI payment
  • TI will be more every month
interest payments on fixed rate mortgage
Interest Payments on Fixed Rate Mortgage
  • Month 1:
    • interest owed: $200,000(.07/12) = $1166.67
    • principal: $1330.60 - $1166.67 = $163.93
    • new loan balance: = $200,000 - $163.93 = $199,836.07
  • Month 2:
    • interest owed: = $199,836.07(.07/12) = $1165.71
    • principal: $1330.60 – $1165.71 = $164.89
    • new loan balance: $199,836.07 - $164.89 = $199,671.18
economic advantages and disadvantages of fixed rate mortgage
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 mortgage1
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
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
types of mortgages
Types of Mortgages
  • 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
what sparked the creation of alternative mortgage instruments in the late 1970s
What sparked the creation of alternative mortgage instruments in the late 1970s?
  • High rates of inflation made lenders uneasy about locking into a 30-year loan at any fixed interest rate
  • As housing prices rose, first-time home buyers were having difficulty qualifying for the purchase of a home.
self amortizing adjustable rate mortgage arm
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
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 rate1
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)
more about the arm interest rate2
More about the ARM interest rate
  • When the associated index moves and an adjustment period occurs, the lender
    • changes the interest rate by the amount allowed (up or down)
    • recalculates the monthly payments based on the new interest rate and the remaining loan balance.
economic advantages and disadvantages of an adjustable rate mortgage
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
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
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
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
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
slide21
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
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
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
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
is this a good deal
Is this a good deal?
  • Currently 8 years left on a mortgage, paying 7.35% with a payment of $642
  • Refinance to a 15 year mortgage at 5.25% with a payment of $450
  • Answer = NO
  • Under current payment plan, will pay 642(8)(12) = $61,632 over next 8 years
  • Under refinance, will pay 450(15)(12) = $81,000 over next 15 years
  • More out of pocket, and more opportunity costs