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Chapter 6

Chapter 6. Residential Financial Analysis. Overview. Incremental Borrowing Cost Loan Refinancing Effective Cost of Multiple Loans Below Market Financing Cash Equivalency. Incremental Borrowing Cost. Compare financing alternatives

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Chapter 6

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  1. Chapter 6 Residential Financial Analysis

  2. Overview • Incremental Borrowing Cost • Loan Refinancing • Effective Cost of Multiple Loans • Below Market Financing • Cash Equivalency

  3. Incremental Borrowing Cost • Compare financing alternatives • What is the real cost of borrowing more money at a higher interest rate? • Alternatively, what is the required return to justify a lower down payment? • Basic principle when comparing choices: What are the cash flow differences?

  4. Incremental Borrowing Cost – Continued • Example: • Home Value = $150,000 • Two Financing Alternatives: • #1: 90% Loan-to-Value, 8.5% Interest Rate, 30 Years • #2: 80% Loan-to-Value, 8.0% Interest Rate, 30 Years • It appears there is only a 50bp interest rate difference, but…

  5. Incremental Borrowing Cost – Continued

  6. Incremental Borrowing Cost – Continued • 20.57% represents the real cost of borrowing the extra $10,000 • Can you earn an equivalent risk adjusted return on the $10,000 that is not invested in the home? • Alternatively, can you borrow the additional $10,000 elsewhere at a lower cost?

  7. Incremental Borrowing Cost – Early Repayment

  8. Incremental Borrowing Cost – Origination Fees

  9. Incremental Borrowing Cost – Second Mortgage • In the first case we compared 80 and 90% LTV loans • By borrowing $90,000, cost of additional $10,000 was 20.57% • What if we borrow $80,000 (80% LTV) and shop for loan for $10,000 with 25 year term • If we can borrow that $10,000 at a cost less than 20.57% then we would have loan with a lower cost than 90% LTV loan. • Suppose a lender can loan us that $10,000 at 18% • Composite cost of borrowing would be • ($80,000 / $90,000) × 12% + ($10,000 / $90,000) × 18% • This is 12.66% • It is clear that break-even rate for second mortgage is 20.57%

  10. Incremental Borrowing Cost – Maturity Differences

  11. Loan Refinancing • Borrower consideration • Lower interest rates in the market than on the current loan • The borrower can secure lower monthly payments • There is a cost to refinance • Application of basic capital budgeting investment decision: • What is our return on an investment in a new loan?

  12. Loan Refinancing for Remaining Term of Original Loan

  13. Loan Refinancing – Early Repayment of New Loan

  14. Borrowing the Financing Costs

  15. Effective Cost of Multiple Loans • Basic Technique • Compute the payments for the loans • Combine into a cash flow stream • Compute the effective cost of the amount borrowed, given the cash flow stream • Compare the cost to alternative financing options

  16. Effective Cost of Multiple Loans – Continued • Example: • You need a $500,000 financing package. • $100,000 at 7.0%, 30 Years • $200,000 at 7.5%, 20 Years • $200,000 at 8.0%, 10 Years

  17. Effective Cost of Multiple Loans – Continued

  18. Below Market Financing • A seller with a below market rate assumable loan may increase the home price • All else equal, a buyer is paying a higher price for lower payments • Similar to other problems, we compute interest rate and compare it to other equivalent risk investments

  19. Below Market Financing – Continued • The buyer can secure below market financing by paying $5,000 more for an identical home • The below market financing results in a monthly payment of $85.63 less than if regular financing was used • The buyer earns 19.41% on the $5,000 investment by reducing the monthly payment by $85.63

  20. Cash Equivalency • How much more a borrower would be most willing to pay for a property with an assumable loan? • This is same as PV of payment savings discounted at the rate a new loan could be obtained

  21. Cash Equivalency – Continued • Together with the financing premium, a buyer could be willing to pay $107,534 for this property to receive the benefit of below-market financing • Does this mean the house is worth more than $100,000? • Need to separate the value of the property with and without the effects of financing • Note that the amount of cash invested in this property would be $100,000 if you take away the assumable loan benefit

  22. Cash Equivalency - Smaller Loan Balance • Need for additional borrowing due to relatively low balance on the assumable loan reduces the financing premium on the property

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