Chapter 9: The Housing Expenditure
Dec 22, 2015
Objectives
Discuss the options available for rented and owned housing and whether renters or owners pay more for housing.
Determine how much buyers can afford for housing.
Discuss the various mechanisms for financing a home.
Objectives
Identify the numerous costs of buying a home, including principle, interest, and closing costs.
List and describe the steps in the home-buying process.
Identify some important concerns in the process of selling a home.
Housing Decision
Young Single•Rental housing has limited maintenance and offers mobility.•Purchase a home or a condominium for financial and tax benefits.
Single Parent•Rental housing can provide suitable environment for children and some degree of housing security.•Purchase low-maintenance housing to meet financial and social needs of family.
Young Couple, No Children•Rental housing offers convenience and flexibility of lifestyle.•Purchase housing for financial benefits and to build long-term financial security.
Couple, Children No Longer At Home•Rental housing for convenience, flexibility for changing needs and financial situation.•Purchase housing that requires minimal maintenance and meets lifestyle needs.
Couple, Young Children•Rental housing can provide facilities for children in a family-oriented area.•Purchase a home to meet financial and other family needs.
Retired Person•Rental housing meet financial, social, and physical needs.•Purchase housing that requires minimal maintenance, offers convenience, and provides needed services.
Renting Your Residence
Advantages Mobility Fewer responsibilities Lower costs initially More amenities
Disadvantages Few financial benefits Restricted lifestyle Cost of renting - deposits Legal concerns of a lease
Largest Physical Capital Investment Made by a Family is a HOUSE.
Home Ownership rates 2012: US = 65.4% (lowest since 1997) Utah = 71.5%
Since 1900, home ownership has been in excess of 40% in the U.S.
The Percentage of Families Owning Homes Over Time
46.7 45.7 45.6 47.843.6
5561.9 62.9 64.4 64.2
67.4 68.866.9
0
10
20
30
40
50
60
70
1900 1920 1940 1960 1980 2000 2010
%
Housing Prices are determined by Supply & Demand
Demand Average household size down Average income up Availability of substitutes down Life cycle stage of housing
Childhood home, apartment, starter home, family home, empty nest home, retirement home, institutionalization or back to family, burial vault
Supply Business cycle
Advantages of Owning
Pride of ownership American dream/norm
Reduced income taxes deduct property taxes deduct mortgage interest
Advantages of Owning
Build an equity pay down the loan price appreciation
Builds your credit rating Forced savings-portion of mortgage payment
goes toward building up equity. Hedge against inflation Lifestyle flexibility
can express your individuality
(continued)
Disadvantages of Owning Financial risk
need down payment home prices could drop Opportunity cost of money tied up in
purchase. Limited mobility
can take time to sell Higher living costs
maintenance repairs & improvements utilities & insurance real estate taxes
Renting vs. Owning Your Home
Based on cash flow, renters appear to win
After taxes and appreciation, owners usually win
WHO PAYS MORE:
1. What is the time period over which the household plans to own/rent?
2. What are the one-time fixed costs associated with purchasing the home? down payment closing costs (e.g., points, fees)
Do you pay these costs if you are renting?
A Cost-Benefit Approach (CBA) to the home ownership decision
3. What are the recurring (i.e., monthly) NET costs associated with owning compared to renting?
How much more does it cost you to own than to rent every single month? You want to get that money back at the end…
Sum of owning costs (mortgage payment, property taxes, hazard insurance, operating and maintenance expenses) minus tax savings
Sum of renting costs (rent, operating expenses) 4. What will the outstanding loan balance be at the end of the time
period? You have to pay off your loan when you sell
5. What will the estimated selling costs be at the end of the time period? You need to pay a realtor, and you want to get those dollars back
A Cost-Benefit Approach (CBA) to the home ownership decision
6. Place all of these costs into future value dollars using 3% real interest rate Remember, all of our dollars have to be at one point in time – we are putting all of our
dollars in to the future One-time costs (because these costs are one-time costs):
FV=PV(1+r)n
Recurring costs (because these costs happen every single month):
Loan balance (already in future dollars; do not need to use a formula): Selling costs:
Add up the one-time costs, recurring costs, loan balance, and selling costs, for the total costs expressed in future value terms This equals the minimum required future value of the home, or the break even price This is how much you have to sell your home for in the future in order to get back all of the
dollars that you have spent
r
rPVFVA
n 11
A Cost-Benefit Approach (CBA) to the home ownership decision
7. Compute the interest rate This interest rate is the annual rate of
appreciation that will have to occur if you are to break even on purchasing a house rather than renting for n years. This converts the dollar amount into an interest
rate, so that you can compare your housing investment with other types of investments
1
1
n
PV
FVr
A Cost-Benefit Approach (CBA) to the home ownership decision
DECISION RULE -
If the forecasted rate of housing appreciation is greater than the calculated interest rate, then economic benefits of home ownership outweigh the economic costs. So, buy the house
If the forecasted housing appreciation rate is less than the calculated interest rate, then the economic costs of home ownership outweigh the economic benefits. So, rent
Example
Original Purchase Price = $100,000 1. Time period = 8 years 2. One-time fixed costs:
Down Payment = $10,000 Closing Costs = $3,000 Total = __________
3. Recurring Net costs Sum of owning costs – tax savings = $1200 Sum of renting costs = $900 Net Costs = $1200 - $900 = _______
4. Loan balance: $81,900 (get from amortization table) 5. Selling Costs: $6,000
6. FV of one-time costs =
FV=13000(1+.03)8
FVA of recurring costs (with monthly compounding) =
=$16,468
= $32,504
0025.
10025.1300
96
FVA
Example
6. Now, add up all of the future costs: FV FVA Loan Balance Selling Costs
= $136,872 ($16,468 + $32,504 + $81,900 + $6,000)
Example
Decision = if forecasted housing appreciation rates
are higher than 4%, you should buy this house
Example
Renting versus Buying Place of Residence
RENTAL COSTS EXAMPLE YOUR FIGURES
Annual Rent Payments $15,000
Renter’s Insurance 210
Interest Lost on Security Deposit (amount of security deposit times after-tax savings account rate) 36
Total annual cost of renting $15,246
Annual mortgage payments $15,168
Property taxes (annual) 4,800
Homeowner’s insurance (annual) 600
Estimated maintenance and repairs (1%) 2,000
After-tax interest lost on down payment and closing costs 750
Less financial benefits of home ownership
Growth of equity (1,120)
Tax savings for mortgage interest (annual mortgage interest times tax rate) (3,048)
Tax savings for property taxes (annual property taxes times tax rate) (1,344)
Estimated annual appreciation (1.5%) (3,000)
Total annual cost of buying $14,806
Comparing an apartment with $1,250 of monthly rent and a home that cost $200,000. A 28% tax rate is assumed.
Housing Options for Home Buyers
Single-family dwelling tract housing built on speculation by builder built to your specifications previously lived in home manufactured home mobile home
Home Buying Process Step 1: Determine Ownership Needs
How much you can afford down payment loan amount size and quality handyman’s special sweat equity
Home Buying Process Step 2: Finding and Evaluating a Property to Purchase
Select a location Zoning laws Covenants, codes and restrictions Using a real estate agent Property appraisal Conducting a home inspection
9-15
Home Buying Process Step 3: Pricing the Property
Determining the price to offer Negotiating the purchase price
seller’s or buyer’s market earnest money
Contingency clauses home passes
structural inspection able to get a loan
Estimating Mortgage Loan Payments for Principal and Interest
Estimating Mortgage Loan Payments for Principal and Interest(Monthly Payment per $1,000 Borrowed)
Payment Period (Years)
InterestRate (5)
15 20 25 30
4.5 $7.6499 $6.3265 $5.5583 $5.0669
5.0 7.9079 6.5996 5.8459 5.3682
5.5 8.1708 6.8789 6.1409 5.6779
6.0 8.4386 7.1643 6.4430 5.9955
6.5 8.7111 7.4557 6.7521 6.3207
7.0 8.9883 7.7530 7.0678 6.6530
7.5 9.2701 8.0559 7.3899 6.9921
8.0 9.5565 8.3644 7.7182 7.3376
8.5 9.8474 8.6782 8.0523 7.6891
9.0 10.1427 8.9973 8.3920 8.0462
9.5 10.4422 9.3213 8.7370 8.4085
10.0 10.7461 9.6502 9.0870 8.7757
Note: To use this table to calculate a monthly mortgage payment, divide the amount borrowed by 1,000 and multiply by the appropriate figure in the table where the interest rate and the time period for the loan intersect. For example, a $150,000 loan for 30 years at 9 percent would require a payment of $1,206.93 [($150.000/1,000) x 8.0462]; over 15 years it would require a payment of $1,521.41.
Effect of Down Payment
Effect of Down Payment Size on Monthly Payment for a $150,000 Home(7 Percent Mortgage Loan for 30 Years)
DownPayment
AmountOf Loan
MonthlyPayment
$5,000 $145,000 $964.69
10,000 140,000 931.42
15,000 135,000 898.16
20,000 130,000 864.89
25,000 125,000 831.63
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
Conventional fixed rate, amortized 5, 10 or 20 percent down 15, 20 or 30 years of fixed payments
Government guaranteed Veterans Administration Federal Housing Administration
Adjustable rate mortgages varies with the prime rate but has a rate cap
Type of Mortgages
Type of Mortgages
Graduated payment payments start lower and go up for persons whose income will increase
Balloon fixed monthly payments plus one large
payment, usually after 3, 5 or 7 years Growing equity
payment increases to allow loan to be paid off more quickly
(continued)
Type of Mortgages Shared appreciation
borrower agrees to share appreciated value of the home with the lender
Home equity loans a second mortgage home is collateral and interest may be tax
deductible Reverse
a loan based on the home equity Refinancing
(continued)
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
Fixed rate FHA or VA mortgage
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
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)
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
Summary: Economic Costs and Economic Benefits of Various Mortgage Instruments Depend Upon...
Life cycle stage Business cycle stage Risk tolerance Liquidity needs
How do those mortgages stack up?
Loan Type
Interest Rate
Monthly Pmt
Compared to a 30-yr
r pd in 5 yrs
Equity created in 5 yrs
5/1 Interest Only
6.29% $1,572.50 ($367.32) $94,350 $0
15-yr fixed 6.32% $2,583.73 $643.91 $84,415 $70,609
30-yr fixed 6.72% $1,939.82 $0 $97,922 $18,467
40-yr fixed 6.97% $1,857.76 ($82.06) $103,220 $8,245
50-yr fixed 6.97% $1,798.18 ($141.64) $103,908$3,983
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
Determine the amount of down payment mortgage insurance
Qualifying for a mortgage can be pre-qualified based on income, assets,
debts, credit history and length of loan purpose of “points” (prepaid interest)
The home loan application process fixed or adjustable rate mortgage locking in an interest rate - search Web
Home Buying Process Step 4: Obtaining Financing
Qualifying for a Mortgage
Amount available for down payment Amount of income Amount of other debts Credit rating Current mortgage rates Length of loan desired
Title insurance and search fee Attorney’s and appraisers fees Property survey Recording fees; transfer taxes Credit report Termite inspection Lender’s origination fee Tax and insurance reserves Pre-paid interest Real estate commission
Home Buying Process Step 5: Closing the Purchase Transaction
Closing Costs
The Main Elements of Buying a Home
Location Down payment Mortgage application Points Closing costs TIPI (taxes, insurance, principal, interest) Maintenance costs
Selling Your Home
Preparing your home Determining the asking price
Appraiser Realtor
For sale by owner or use a broker Listing with a real estate agent
Make Sure Security Deposit Is Returned
1. List damages/defects before moving in unit. 2. Maintain unit and promptly notify landlord of
any problems. 3. Give proper written notice of intent to move. 4. List all damages/defects after moving out of
unit. 5. Use certified mail to request return of
security deposit. 6. Use small claims court, if necessary.