Chapter 8

1. Chapter 8 The Home and Automobile Decision

2. Learning Objectives • Make good buying decisions • Choose housing that meets your needs • Decide whether to rent or buy housing • Calculate the costs of buying a home • Get the most out of your mortgage

3. Smart Buying in Action: Housing • Many people equate home ownership with financial success • On average, housing costs take 34% of a family’s total expenditures • Home ownership is also an investment—biggest investment you will ever make • Use smart-buying approach

4. Your Housing Options • Lifestyle is a major determining factor in housing choice • Kids • Schools • Pets • Privacy • Sociability • Space • Evaluate needs vs. wants in housing choice

5. Your Housing Choices • House • Offers space and privacy • Greater control • Most potential for capital appreciation (increase in value) and building wealth • Will take more work than other options

6. Your Housing Choices • Cooperatives: apartments where the residents are the stockholders • The more valuable the apartment, the more shares you buy • Required to pay a monthly homeowner’s fee • The cooperative corporation pays the taxes and maintenance • Residents do not own their own apartments

7. Your Housing Choices • Condominium – allows for individual ownership of the living space and joint ownership of land, common areas, and facilities • Monthly maintenance fee is required • Planned unit developments (PUDs) • You own your home and land with joint ownership of the development • You pay a monthly fee for common expenses and maintenance

8. Your Housing Choices • Apartments • Affordable, low maintenance • Easy to move • Disadvantages: • may restrict pets • May not be able to remodel • Lack of privacy

9. Smart Buying in Action: Housing Step 1: Differentiate Want From Need • What things are you looking for in a house? • Affordability, location, neighborhood, conveniences, schools, size • Know what you want before you look

10. Smart Buying in Action: Housing Step 2: Do Your Homework • Investigate the potential home and all that goes along with it: • Neighborhood, community lifestyle, meeting needs • www.homefair.com can give you information about cost of living, crime statistics, schools, etc. • How much you can afford to pay?

11. Smart Buying in Action: Housing One-time costs of buying a house: • Down payment – typically 20% of home value • Closing/settlement costs • Points • Loan origination fee • Application fee • Appraisal fee • Title search fee

12. Figure 8.4 Estimated Initial Costs of Buying a Home The Down Payment, Points, and Closing Costs on the Purchase of a $150,000 House, Borrowing $120,000, with 20% Down at a Rate of 6% with 2 Points

13. Smart Buying in Action: Housing Recurring Costs • Monthly mortgage payments • PITI (principal, interest, taxes, and insurance) • Escrow account • the borrower makes a monthly payment into the escrow account (part of the mortgage payment total) • When insurance and taxes are due, the lender pays these costs from the escrow account Maintenance and Operating Costs: • repairs, renovations, upgrades, landscaping

14. Table 8.1 Monthly Mortgage Payments Required to Repay a $10,000 Loan with Different Interest Ratesand Different Maturities

15. Renting Versus Buying • Most of the time, the decision is based on lifestyle • Renting advantages: • Financial and lifestyle flexibility • Compare costs for each alternative • Buying advantages: • Longer stay and appreciation, itemized taxes, forced savings

16. Figure 8.5 Renting Versus Buying

17. Figure 8.6 Worksheet for the Rent-Versus-Buy Decision

18. Determining What YouCan Afford • What is the maximum amount the bank will lend me? • Financial history: lenders will look at FICO score, credit report, steady income • Ability to pay 1: maximum PITI to gross income is 28% (28/36 Rule from Chapter 7) • Ability to pay 2: PITI plus consumer loans to gross income is 36% • Appraised home value -most loans are limited to 80% of home value, so you need a large down payment

19. Determining What You Can Afford • Calculating your mortgage limit • Your mortgage lender will evaluate you on these three standards, then will give you the lowest amount • Should I borrow up to this maximum? • Maybe not – having a large mortgage payment will mean less money for other things • Evaluate how much you can really afford • Remember you are committing your income for many years to come

20. Figure 8.7 Worksheet for calculating the maximum size mortgage loan you qualify for

21. Figure 8.7 Worksheet for calculating the maximum size mortgage loan you qualify for (cont.)

22. Figure 8.7 Worksheet for calculating the maximum size mortgage loan you qualify for (cont.)

23. Figure 8.7 Worksheet for calculating the maximum size mortgage loan you qualify for (cont.)

24. Financing the Purchase—The Mortgage Sources of mortgages: • S&Ls and commercial banks • Credit unions, mutual savings banks • Mortgage bankers • Mortgage brokers

25. Conventional and Government-Backed Mortgages • Conventional loans —from a bank or Savings and Loan, secured by the property • Government-backed loans —loan from traditional lender but insured by government—Federal Housing Administration (FHA) and Veteran’s Administration (VA) loans: • lower interest rate, smaller down payment, less strict financial requirements • more paperwork, higher closing costs, limited funding

26. Fixed-Rate Mortgages • Monthly payment doesn’t change regardless of market interest rate changes • Can lock in low rates for the life of the loan. • An assumable loan can be transferred to a new buyer. • Prepayment privilege allows early cash payments to be applied to principal.

27. Adjustable-Rate Mortgages (ARM) • Interest rate of ARM fluctuates with level of current interest rates. • Initial Rate—”teaser rate”—low for only a short time period (3-24 months), then adjusted upward. • Interest rate index —rates on ARMs are tied to an index not controlled by the lender, such as 6- or 12-month U.S. Treasuries.

28. Adjustable-Rate Mortgages • Margin —the amount over the index rate at which the ARM index rate is set • For example: 2% over the index rate • Adjustment Interval —how frequently the rate can be reset • Rate Cap – sets a limit on how much the interest rate can change

29. Adjustable-Rate Mortgages • Payment Cap —sets dollar limit on how much the monthly payment can increase during any adjustment period. • If interest rates go up, the monthly payment may be too small to cover the interest due—negative amortization(you end up owing more at the end of the month than you did at the beginning) – a big disadvantage • Unpaid interest is then added to the unpaid loan balance, increasing its size.

30. Adjustable-Rate Mortgages ARM Innovations: • Convertible ARM — allows conversion to fixed-rate loan • Reduction-option ARM — allows a one-time opportunity to adjust interest rate • Two-step ARM — combines aspects of fixed-rate and ARM

31. Adjustable-Rate VersusFixed-Rate Mortgages ARMs: • low interest rate in early years • can get larger loan because PITI is lower • If interest rates rise, the reset will push ARM payments upward (disadvantage) Fixed-rate mortgages: • In general, fixed-rate better than ARM • Payments never change • Allows for control and planning

32. Specialty Mortgage Loan Options • Balloon Payment Mortgage Loan — small monthly payments for 5-7 years, then entire loan due. • Graduated Payment Mortgage — payments set in advance, gradually rising for 5-10 years, then level off. • Growing Equity Mortgage — designed to let homebuyer pay off mortgage early by paying a little extra every month

33. Specialty Mortgage Loan Options • Shared Appreciation Mortgage — borrower receives below-market interest rate, lender receives a portion of future appreciation • Generally not issued by traditional mortgage companies • Interest Only Mortgage — the payments are interest only for a set period, then the borrower pays both interest and principal for remainder of loan

34. Specialty Mortgage Loan Options • Option Payment ARM Mortgages — can make different types of mortgage payments each month • Options include: • Amount less than interest due • Interest only • Payment amount that would be required a of 15- or 30-year fixed-rate loan

35. Risks Associated with Specialty Mortgages • Big jump in monthly payments if interest rates rise • Read fine print—know what you are getting into • Know how much your monthly payment could increase, when that could happen, and whether you could afford a higher payment • Penalties could be charged for refinancing

36. Beware of Subprime Mortgages and Predatory Lending • Subprime mortgages — mortgages taken out by borrowers with low credit scores. • Predatory lenders take advantage of these borrowers • Abusive loans — high-cost loans with little chance of paying off • Knowledge is your best defense against predatory lending

37. Figure 8.9 Common Predatory Mortgage Lending Practices

38. Figure 8.8 Status of Nonprime Loans Originated from 2000 through 2007as of December 31, 2009

39. Mortgage Decisions: Length or Term of the Loan • 15- or 30-year maturity on mortgage? • Generally the interest rate on 15 year mortgages is lower than on 30 year mortgages • Prepayment opportunities • You can pay off a 30 year mortgage in 15 years by paying more each month • Size of monthly payment (you make a higher payment but less total interest paid with 15 year loan)

40. Figure 8.10 The Portion of Each Payment That Goes Toward the Principal and Interest on a 30-Year, 8% Fixed-Rate Mortgage for $80,000

41. Table 8.2 Impact of the Loan Term on the Total Interest Paid and Monthly Payment for an $80,000 Fixed-Rate Mortgage at 8%

42. Figure 8.11 Comparing a Shorter- Versus Longer-Term Loan

43. Smart Buying in Action: Housing • Coming up with the down payment • The down payment may be as high as 20% of the home value • Save, get gifts from family and friends • At least 5% of closing costs have to come from homebuyer • If you get money from family, a “gift letter” states that any funds contributed by a family member don’t have to be repaid—it is a gift, not a loan

44. Smart Buying in Action: Housing • Private Mortgage Insurance • Protects the lender in the case of the borrower not being able to make payment • Prequalifying — your lender approves the loan to a set amount before you start home shopping

45. Smart Buying in Action: Housing Step 3:Make Your Purchase • Comparison shop • Traditional real estate agent • The seller pays the agent’s commission, then divides with the buyer’s agent • Never tell your agent your top price • Independent or exclusive buyer-broker • Represents the buyer exclusively • Get it inspected • Make an offer and negotiate

46. Checklist 8.6

47. Smart Buying in Action: Housing • Short sale • Proceeds from the sale is less (short) than the balance owed on the property • Example: you owe $250,000 on your house, but it is only worth $175,000 • The house is sold for $175,000, with no foreclosure • The bank loses the difference • Your credit score is not impacted as much as with a foreclosure • In 2010, 19% of house sales were short sales

48. Smart Buying in Action: Housing • Contract – the legal document binding you to the sale. Be sure all elements are covered • Earnest money – a deposit on the home purchase to assure the seller that the buyer is serious about buying • Closing – when the title is transferred and the seller is paid in full • Settlement or closing statement – a statement showing all the money required at closing

49. Smart Buying in Action: Housing Step 4: Maintain Your Purchase • Refinancing – taking out a new mortgage at a lower interest rate to replace an existing mortgage • Closing costs will be charged again

50. Checklist 8.7