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 • 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

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

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? • 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) • 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.

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

How do those mortgages stack up?

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

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

How do households finance the purchase of a house?