How do households finance the purchase of a house?

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# How do households finance the purchase of a house? - PowerPoint PPT Presentation

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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Presentation Transcript
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
• 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
• 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
PV=200,000
• r = (.07/12) = .005833
• n = 30(12) = 360
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
• 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
• 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
• 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.
• 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
• 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?
• 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.
• 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)
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.
• Initial interest rates are typically lower
• If you are buying when mortgage rates are high, but expected to fall in the future
• Greater uncertainty about what future mortgage payments will be
• 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
• Easier to qualify for lower income households
• lower monthly payments early in the mortgage
• 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
• Way to access your home equity without having the burden of repayment
• Creates income
• 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
• Lower monthly payments
• Maybe good for rental properties and/or high-equity growth areas
• 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
• 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
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