1. Some Events in Both Personal and Business Life are Measured by the Cost of Something Needed, Rather than by Profit Example - Herby Housing needs a place for his family to live while he goes to school at SIU. Herby is debating whether to rent an apartment or buy a house (he has military benefits and his wife Hanna will be working). Herby finds that the cost of renting will be $650/month. Herby does some house shopping and finds he can get a house in DeSoto for $28,000. Herby expects to take 5 years for school and wants to know what his housing is really going to cost?

2. Herby Builds a Cash Flow $650 Rent $650 Deposit $650 Rent$730 Rent $650 Deposit Refund 0 1 2 3 4 5 6 7 854 55 56 57 58 59 60 61 Cash Flow for Renting Scenario Herby assumes rent will go up $20/year with inflation The NPV of this cash flow will surely be negative - does that mean no go?

3. Herby Studies Buying The house will cost Herby $28,000. (Herby will finance that) Herby needs a 10% down payment $2,800 Herby discovers that there are “Closing Costs” when you buy a house –Appraisal fee $250 –Flood Determination Letter $150 –Credit Report $25 –Dead Registration $15 –Mortgage Registration $15 –Private Mortgage Insurance $280

4. Herby’s first time home buyers adventure continues Herby will need to get Home Owners Insurance $600/year Herby discovers that banks also like to charge their little “fees” for starting up a loan Herby can get a local loan from Union Shafters Bank –Union Shafters will simply recover closing costs –Union Shafters will charge 8% annual interest compounded monthly over 15 years Herby could also get a loan over the internet from Inter Your Pocket Mortgage Lenders –5% of face amount loan initiation - covers all closing costs –1.5 points (rolled into the mortgage) –6.25% annual interest compounded monthly over 30 years

5. Herby Compares Loans Union Shafters –Closing Costs $735 –Down Payment $2,800 –Needs $3,535 now Mortgage Payments –Loan Amount $28,000 - $2,800 (down payment) = $25,200 –Loan over 15 years at 8% interest - How do I get the Payments?

6. Enter Our Super Hero I need to convert a present value amount into an annuity –A/P * Present Loan = Annuity of Loan Payments cancellation of units checks out What is the value of n? 15 years * 12 months/year = 180 What is the value of i?

7. Oh NO You Don’t We is smart students. We know that interest rate did not match the compounding period. Annual interest is 8% But it is compounded monthly Get the monthly rate –8%/12 = 0.00667 Plug and Crank –{ 1.00667 180 * 0.00667}/{1.00667 180 -1} = 0.009559 –$25,200 * 0.009559 = $240.88/month

8. Now Check Out the Internet Bank Loan Amount $25,200 –5% initiation fee $25,200*0.05 = $1,260 Whats this point business –Lenders discount interest rate on the loan for an up front payment of a percentage of the loan amount. A point is a catchy way of saying what percent of the loan amount they will charge (they often roll it into the loan) –$25,200 * 0.015 = $378 –Loan amount is $25,578

9. Get Our Monthly Payments What is n (30 year loan) n= 360 Watch out for i compounding period mismatch trick –6.25%/12 = 0.0052083 Plug and Crunch –A/P 0.0052083, 360 = 0.006157 –$25,578 * 0.006157 = $157.49

10. Some Initial Statistics Action Up Front Cost Monthly Cost –Rent $1,300 $650 –Buy with US $3,535 $240.88 –Buy with IYP $4,060 $157.49 Buying is looking really good right now except for those scary up front costs. Which loan should Herby get if he does buy the house?

11. Building some cash flows ………………………... 0 1 2 3 4 5 6 7 8 9 Resell the House Interest is tax deductible but the loans have different interest rates Loans have different terms so one loan will be more paid-off when the house sells (they will build “equity” faster) 69 months (assumed takes 9 months to sell house)

12. The tax deduction and equity problem The handy magic numbers are designed to sweep cash in standard positions into the pot. We can always get questions they really weren’t designed to answer –This case - how much is interest and how much is building equity Enter another answer - the spreadsheet

13. Setting Up Our Spreadsheet A speadsheet is a series of cells into which we type words, numbers or formulas. It will calculate the values for us automatically (it’s a nice little calculator). Because we can copy formula’s around it can help us avoid key punch errors or redo our homework quickly if we find we have made just one little mistake. I often use convention of coloring cell yellow where I want someone to put in a number.

14. Putting in a Formula I entered formula =c3/100/12 Each cell in the spreadsheet has a name. I can tell my formula to look in a specific cell for a value. This is how I can build formulas that refer to information I can change. (Remember I have two bank loans to work with). In Excel I have to start a formula with = The / sign means divide just like on a calculator.

15. Copy Formula Trick I entered 1 in cell a7 I entered =a7+1 into cell a8 I will click on that cell and copy it to the cells below. When I copy the formula each cell will refer to the one above it. (ie- cell a12 will say = a11 + 1)

16. Developing the Spreadsheet You can see what happened when I copied the formula I entered = b7*c4 I entered =c7-d7 I entered =b7-e7

17. More Formula Copying I entered =c7 in cell c8 and then copied. Thus each cell simply copies the one above it. What if I want to refer to the same cell each time and copy a formula? My interest cell multiplies the outstanding principle by c4 the monthly interest rate and I want to keep the same interest. Lets Change formula in cell d7. Right now it says = b7*c4 In Excel, putting a dollar sign in front of part of a cell name makes it stay the same when copied. In this case I want the 4 part of c4 to stay the same = b7 * c$4 We’ll make next periods principle equal to what was left from the time before. = f7

18. Copy the Formulas Notice that with time the amount of money going to Principle increases and interest decreases as the debt is paid-off. Equity is the difference between what the house is worth and what the unpaid load is. Enter formula =b$7-f7 and copy the formula

19. Magic at the End In year #1 Herby will pay $1983.21 in potentially tax deductible interest In year #2 Herby has $1907.90 in deductions In year #3 $1826.34 In year #4 $1738.01 In year #5 $1642.35 In year #6 (before the house is resold) $1164.23 When the house resells - Herby will have $6358.68 in equity The question of whether Herby gets a deduction depends on whether his itemized deductions exceed the standard deduction.

20. Tax Assumption Lets assume Herby can deduct his interest, but that he is only in the 15% tax bracket The money Herby saves on his taxes may be a positive flow into his pocket as a refund check –Year #1 $1983 * 0.15 = $297.48 –Year #2 $1907.9 * 0.15 = $286.19 –Year #3 $1826.33 *0.15 = $273.95 –Year #4 $1738.01 * 0.15 = $260.70 –Year #5 $1642.35 * 0.15 = $246.35

21. Cash Flow for Buying with Local Loan 0 1 - 12 13 - 24 25 - 36 37 - 48 49 - 60 61 - 69 73 $3,535 $240.88 per month $6,358.68 $297.48$286.19$273.95$260.70 $246.35 $174.63

22. Can do the Same Thing for the Internet Loan Note that with the spreadsheet I just retyped the 3 numbers in yellow and it did my whole interest, tax, and equity problem for me instantly

23. Cash Flow for Internet Loan 0 1 - 12 13 - 24 25 - 36 37 - 48 49 - 60 61 - 69 73 $4,060 $157.49 per month $238.52$235.64$232.55$229.27$225.79$166.92 $1630.95

24. Herby Must Now Compare Herby is comparing two alternatives that will both cost him money One often used technique is to subtract one alternative from the other and look at the incremental value of choosing one alternative over the other –This then becomes a question of how much you gain (or loose by choosing one alternative over the other)

25. Application Need to first decide which alternative we think we want to choose. - Oh yes the loan with the lower payments. $3,535-$4,060= -$525 $240.88 - $157.49 = 83.39 / month $238.52 - $297.48 = -$58.96 -$50.56 -$41.40 -$31.43 -$20.56 -$7.71 $1630.95 - $6358.68 = -$4,727.73

26. Now What Should Herby Do? He has a cash flow that represents the value of choosing the loan with the lower payments and interest rate Naturally he could discount it back to his decision point (when he goes to bank or signs on the internet) –But What Rate?

27. Herby’s Interest Rate Dilemma Herby hopes to save some money by picking the lower monthly payments and interest rate –What will he do with the money he saves? May very well use it for school. Herby may be looking at student loans for what ever he and wifey can’t get together –Herby’s incremental cost of money may be what student loans would cost Herby may be playing the market on the side –What could Herby get on the market if he were to invest

28. More on Herby’s Dilemma Herby might not know what the heck his cost or value of money is Lets suppose Herby is clueless With spreadsheet Herby can try different interest rates and see what the resulting flow is.

29. Lets identify our cash flow elements -$50.56 -$41.40 -$31.43 -$20.56 -$7.71 What an element is depends on where the pot is (remember the annuity problem) We have a Present Value that needs no magic number

30. Spreadsheet

31. Another Case

32. Observations Notice that even where something is going to cost you money that subtracting one alternative from another will show an NPV for the value of picking one alternative instead of the other. –If somethings going to cost you you usually have choices. This technique allows you to measure the value of one choice vs. the other –If you have only one choice you can still get the NPV of what it will cost you.

33. More Observations In this case one of the reasons for choosing the spreadsheet was we were unsure of what interest rate to use. Many activities and needs cost money. Freeing up money from the activity brings other opportunities –They may be to eliminate debt or the need for debt –They may be to invest.

34. A Personal Life Interest Rate Herby may have several things that cost him money (look for where your additional margin of dollars go and what interest rate or forgone interest rate opportunities there are) –School - if you can’t pay as you go you have student loans –Credit Cards - if you have needs you are going to charge (or a credit card debt from previous needs) –If you have investment opportunities –If you could put money into CDs or a money market account –If you have an interest bearing checking account it may have a rate –The home loan itself has an interest rate - and most allow extra payment directly against principle.

35. Notes about NPV The NPV of picking the internet loan over the local loan is positive for any positive rate of interest –(just cash flow total was positive) –The higher the interest the more discounted the home equity at the end is and the greater the savings on monthly payments and interest expenses.

36. Conclusion Herby should pick the internet loan Notice that this kind of calculation can be done to decide when to refinance a house or to choose between various borrowing options. We’ve now decided which loan is best for the house - but not whether Herby should buy or rent.

37. The Home Loan Payments Game We found that Herby’s mortgage payments will be pretty small compared to rent payments The payments consider –Principle (paying off part of the debt each month) –Interest (paying investors each month for the gratification they are giving up by keeping money in Herby’s House) Banks Charge Other Fees as part of the payments.

38. The Escrow Costs There is that homeowners insurance payment $600 per year including a chunk right up front There is the private mortgage insurance $280 per year (first year was covered in closing) There is property tax The bank doesn’t trust you to save this money so they charge it to you each month –They stash it in an escrow account (where they usually make the interest)

39. The Insurance Costs Insurance $280 + $600 = $880 12 payments = $880/12 = $73.33

40. The Property Tax Game Illinois (and most states) try to baffle people with convoluted formulas to keep them too confused to fuss In Illinois You first compute “Fair Market Value” –Many communities estimate low You think your getting a deal so your less likely to fuss If the state ever wishes to use eminent domain to buy you out they have a basis for a lower value If property taxes are ever frozen, they can keep the tax rate and jack up the property value

41. Herby’s Property Tax DeSoto values Herby’s house at $27,000 Next you get the “Assessed Valuation” –By law in Illinois - this is 1/3rd of fair market value $9,000 (People really think they’re getting a deal when the realize they are only paying taxes on this little amount - never mind the tax rate is about 3 times as high as in states that don’t do this step)

42. Figuring Herby’s Property Tax Apply the tax rate to the “Assessed Valuation” –Tax rate about 9.78% rates can be high is Southern Illinois because of a weak industrial base They can be high in Chicago suburbs because suburban school districts and governments are very very good at spending money Apply and let dry –$9,000 * 0.0978 = $880.20 per year

43. The Escrow Account Insurance monthly payments were $73.33 Taxes $880.2/ 12 = $73.35 The Total = $146.78 Wrong –Banks usually charge you 1.5 times the estimated amount to accumulate money in the escrow account Official reason - so if rates go up there is money there Unofficial reason - since they get to collect the interest on the account it gives them more of your money to make extra money on. –$220/month

44. More on Escrow Banks adjust escrow payments each year based on actual tax and insurance rates –They don’t charge 1.5 times forever but they do get the amount up to about twice the actual experience before they back off on overcharging you Escrow payments can drastically alter what you thought your mortgage was –30 year internet mortgage is $157.49 + $220 = $377.49/month

45. Herby Looks at Later Year Mortgage Payments In order to know what escrow payments will be the second year - Herby has to know how much tax and insurance will take out of his escrow account. On the insurance - Herby will pay that for the first year (or 6 months) when he gets the loan. –He’ll accumulate escrow for a year and then pay it again.

46. Herby’s Insurance Herby has Private Mortgage Insurance –Usually stays the same - in fact lenders risk is declining as you get more paid off –$280 Herby has homeowners insurance –say goes up about with inflation 4%/year –$600*1.04 = $624 Herby’s escrow account will pay out $904 for insurance at the end of the first year (note this won’t be a Herby cash flow item because Herby makes monthly escrow and the banker worries about the insurance premiums)

47. Herby’s Taxes and Escrow Taxes are paid “in arrears” –That means that in 2001 you pay property tax for year 2000 This can be a problem for buying because you will get a tax bill for when you didn’t own the house –Solved by giving you a “credit” at closing (adjusts your loan amount) may adjust exact mortgage amount but we already found which loan was best

48. Payments Out of Herby’s Escrow Taxes at end of year will be the previous years amount $880.20 Insurance at the end of the year $904 Money out of account –$1,784.20 Money into account –$220 * 12 = $2640 Balance in account $855.20

49. Billy Banker Reviews Next Years Tax and Insurance Cost Insurance was $904.00 Taxes –$880.20 this year –Each year the State estimates the increase in property value around the state When real estate sells have to fill out a report form to the government –(Also used by appraisers) –State Issues a multiplier say (1.05)

50. The State Multiplier Strikes Again Periodically the county also reappraise all the property (usually do a roving system so it won’t be all at once) County makes any changes they see, supervisor of assessments reviews, then multiply by state multiplier –Get a new assessed valuation –Last year $9,000*1.05 = $9450 Next Years Tax $9,450*0.0978 = $924.21

51. Figuring Year II Escrow Taxes will be $924.21 Insurance will be $904 Total Payout estimated for end of year II –$1,828.21 Billy Banker Would Like twice that in account –about $3,657 Billy Banker has $855.20 in there now

52. Setting Next Years Escrow $3657-855.20 = $2802 $2802/12 months = $233.50 for Escrow Mortgage Principle and Interest is –$157.49 –Add Escrow –$390.99 next years mortgage payment During Year #1 pay $377.49 During Year #2 pay $390.99

53. Estimating Escrow for Later Years Escrow account has now built up the bankers interest free extra money - now they’ll just have Herby pay as he goes Assume PMI (Private Mortgage Insurance) stays same - Home owners goes up 4% per year Assume taxes up 5% per year

54. Taxes and Insurance Year #3 homeowners insurance –Year #2 was $624 –Year #3 $624*(1.04) = $649 –Year #4 $649*(1.04) = $675 –Year #5 $675*(1.04) = $702 –Year #6 (until house sells) $702*1.04 = $730 PMI stays the same at $280 Taxes will go up 5% each year

55. Taxes and Escrow Year 2 taxes were $924.21 Year 3 taxes $924.21*1.05 = $970.42 Year 4 taxes $970.42*1.05 = $1,018.94 Year 5 taxes $1,018.94*1.05 = $1,069.89 Year 6 taxes $1069.89*1.05 = $1123.38

56. Future Years Escrow Year 3 $280 + $649 + $970.42 = $1899.42 Year 4 $280 + $675 + $1,018.94 = $1973.94 Year 5 $280 + $702 + $1,069.89 = $2051.89 Year 6 $280 + $730 + $1,123.38 = $2133.88

57. Important Inflation Features Note that the Taxes and Insurance Payments are just going up by 3.9% over-all each year Many Times in Inflation Scenarios you see a cost that grows and compounds with inflation –If the costs grow at a steady rate through each compounding period you have something like an annuity with inflation can’t use P/A or A/P because payment amount changes

58. The Geometric Gradient In some engineering econ problems we see what would be an annuity except that it grows at a steady rate each compounding period. –Some equipment maintenance expenses behave this way –Most common source is inflation in the cash flow (ie - its an annuity with inflation) The tax and insurance expense is behaving this way

59. Special Features for Special Problems We’ve met P/A –They really don’t do anything for us that can’t be done with a large number of different P/F values –We got P/A because it let us treat an obnoxious series of numbers as one cash flow element that can be dealt with all at once Now we have an annuity almost except its growing –Without help it’s a large number of P/F problems

60. Another Super Hero P/A g,i,n –Looks very similar to our old friend P/A only this one has 3 numbers –The first two numbers look like interest rates Actually what you have is a rate of inflation or cost escalation, and an interest rate, and a number of payments or compounding periods

61. Super Hero Formula Look in the front of the book “Geometric Series Present Worth” In our case we won’t be able to use the hero because Herby’s escrow payments are made monthly, while the growth is yearly Why introduce the Geometric Series Present Worth this way? –Example illustrates how inflation commonly produces these growing annuities –Also I don’t like inflation in engineering cash flow analysis and so I’m not putting out a lot of emphasis

62. Back from the Detour Annual Escrow Payments –Year #3 $1,899.42/12 = $158.29 –Year #4 $1973.94/12 = $164.50 –Year #5 $2051.89/12 = $170.99 –Year #6 $2133.88/12 = $177.78

63. Adjusting the Mortgage Payments Basic Loan will be for $25,200 The Bank also charges points –(an up front premium in exchange for a lower interest rate - or a good way for bankers to make their loan look like a better deal and still make the same money ) –$378 But Herby gets credit for last years taxes (since he’ll end up paying them) –$880.20

64. Herby’s Loan with Tax Adjustment $25,200 + $378 - $880.2 = $24,698 A/P is 0.006157 for 360 payments with 6.25% annual interest (divided by 12 for monthly compounding) $24,698*0.006157 = $152.06 Mortgage Payments –Year #1 - $152.06 + $220 = $372.06 –Year #2 - $152.06 + $233.50 = $385.56 –Year #3 - $152.06 + $158.29 = $310.35 –Year #4 - $152.06 + $164.50 = $316.56 –Year #5 - $152.06 + $170.99 = $323.05 –Year #6 - $152.06 + $177.78 = $329.84

65. Building the Home Buy Cash Flow $2,800 Down Payment $1,260 Loan Initiation Fees $600 Homeowners Insurance Bank also charged $378 in “Points that rolled into loan $372.06/mo.$385.56/mo. $310.56 $316.56 $323.05 $329.84 $230.31 $227.52 $224.55 $221.39 $218.03 $161.18 $132$139 $146$153$161$169

66. Maintenance Costs Home owners have regular repair costs DeSoto house needs some initial repairs –about $5,000 for materials plus some personal “sweat equity” Herby could get a personal loan from the bank for 5 years at 8% interest with a $200 loan application fee Herby’s could just use his credit card at 15% interest There are routine things that break down - Herby figures about $75/month

67. Herby’s Big Kicker Herby is getting the house pretty cheap but The roof will probably fail in 4 years –This will likely cost about $4,200 –Herby is concerned about whether he will be able to get additional money on loans at a critical time like that.

68. How Should Herby Deal With This? $75/month maintenance is just an annuity in the cash flow. The loan vs. credit card choice is another of those spreadsheet comparison jobs –Figure the cash flow from each –Pick a preferred alternative –Subtract one alternative from the other to define a cash flow of costs and benefits from choosing your favorite –Discount cash flow back and see if your preferred alternative saved you enough.

69. The Roof Herby sees a big expense coming and can’t risk ability to get credit when it hits Answer is a business device called a sinking fund –Save up money just like Fursee Foresight –Money is saved up as a series of regular savings at the end of each compounding period - ie. Its an annuity.

70. The Sinking Fund Discounted Cash Flow was developed in Mining –Got its name from the practice of saving money to sink a new mine shaft Trick here is that we are trying to find an annuity that will reach a set amount of money at some time in the future –P/A and A/P deal with present values –F/A converts and annuity to a future value

71. Enter a New Super Hero A/F Check to make sure she can do the job –A/F * Future Cost of Re-roofing Need to know n –re-roof in 4 years (but we’re on a monthly schedule) 4*12 = 48 Need to know i –What ever Herby can get on his savings

72. Herby Builds a Sinking Fund for His Roof Herby will put money into a money market account at 5% interest (compounded monthly) Using the formula –Just F/A flipped –( i / {[1 + i ] n -1}) = A/F for i= 0.05 /12 = 0.004167 and n=48 A/F = 0.018863

73. Herby’s Monthly Cost for the Roof 0.018863 * $4,200 = $79.22 Herby now has monthly maintenance costs of –$75/month routine maintenance –$79.22/month sinking fund to replace the roof –Herby still needs to deal with the $5,000 in initial repairs

74. Herby’s Personal Loan Choice $5,000 in initial repairs The Bank Loan Option –$200 loan application fee –8% compounded monthly –5 year amortization Convert a present loan amount into an annuity of payments in the future –A/P * Present Loan Amount check

75. A Bank Loan for Herby A/P –n = 60 = 5 years * 12 months per year –i = 8% per year/ 12 months per year = 0.00667 –A/P 0,00667, 60 = 0.020278 Monthly cost for initial repairs –0.020278 * $5000 = $101.39 Also an initial fee of $200

76. Herby’s Credit Card Credit cards usually do not charge a fixed monthly payment (except for some minimum usually around $10 to $15) –Instead they charge a fixed percentage of the outstanding balance will produce a declining monthly payment like a reverse geometric gradient going down We have no super hero for that We do have a spreadsheet

77. Working with Credit Cards Credit Cards usually compound interest monthly, but they use a “Daily Periodic Rate” so that months with more days have a higher monthly rate. Credit Cards frequently play games with the rate. They quote an annual rate, charge interest for each day, but divide the annual rate by a number of days smaller than 365. Credit cards usually charge 2% or 3% of your outstanding balance as a minimum payment.

78. Developing the Spreadsheet The Monthly Rate is Calculated by taking the number of days in the billing cycle (month) * the daily periodic rate.

79. A Spreadsheet for Credit Cards Credit Cards Charge a fixed % of the outstanding balance or a minimum monthly payment. The minimum payment cell contains an if statement =if(c11*f$6/100>f$7, c11*f$6/100, f$7)

80. The Payoff Interest is the average daily balance * the monthly rate. Principle paid is of course the monthly payment minus the interest. New balance is the old balance minus the payment against the principle.

81. Or Is It Credit Card Monthly Payments Decline over time But so does your payment against principle - unlike loans which pay down faster over time.

82. In Fact If Herby pays minimum payments on his credit card it will take him 27 years 11 months to pay off the credit card.

83. The Game Afoot Why are credit cards so hard to pay-off –The minimum payments are generally set to be competitive with signature loans at banks –But the modest payment hides a high interest rate and results in slow payment of the debt The Declining Payment - Why? –Official Answer - to better service the customer by minimizing demands made upon him

84. Its A TRAP By directing a high percentage of your payments to interest and then slowly declining those payments - credit card debt takes a long time to pay-off The Credit Card Company’s bet you a life time of debt that if you ever get a good credit card debt - you won’t be able to avoid using your card again for 25 years - You'll recharge the debt.

85. Other Credit Card Games Credit Cards have “Cash Advance Fees” –Credit Card Checks or getting cash from an ATM is considered a “Cash Advance” –Cash advances are usually 3% of the amount advanced (or a minimum fee of $5 or $10) some cards do have a maximum fee also If Herby gets a cash advance on his credit card he will pay –$5,000 * 0.03 = $150 so much for getting out of that loan initiation fee

86. More Games If Herby Charges supplies at Lowe’s or Home Depot he does not pay a cash advance fee. –But the credit card company charges a couple percent to the merchant (hidden in higher prices) Reason some gas stations have a higher price for credit cards than cash Reason that not every store takes credit cards

87. Cash Advance vs. Purchase In addition to cash advance fee credit cards charge a higher interest rate for cash advances than purchases –purchases are often 9.9% to 18.9% –cash advances are typically 18.9 to 24% If you get a cash advance on your credit card - all your payments will go to cover purchases (lower rate) until the low rate stuff is paid off (never if you fall in the declining payment trap) –About the only way to get a cash advance off your back is to pay-off the entire card.

88. The Promotional Offer Many credit cards offer promotional interest rates –They last around 3 to 12 months depending on the card - And then they jump to a higher interest rate The idea is to get you to run up a balance that you won’t be able to dig out of Often they will charge a cash advance fee with a promotional interest rate check

89. The Grace Period Most cards offer a grace period –If you pay-off your balance in full each month there is no interest BUT Many credit cards are shortening grace period from 25 days to 20 –They wait about a week to 10 days after your “statement date” to send the bill –Takes about 3 or 4 days in the mail –They warn you in fine print that it may take 3 to 5 days to credit your payment –Takes you about 3 or 4 days to get payment to their office –Result - you may have only a day or two to have the money in your checking account ready to pay them.

90. Bankers Grace If your payment doesn’t make it on time ( I wonder how much hustle they put into processing your payment if its close - I wonder how you’d prove it) –Credit Cards Charge a late fee (usually $29) in addition to interest –If they can catch you several times, most will raise the interest rate that they charge on your account (after all you’re a bad credit risk because you don’t pay on time)

91. Billing Cycle Tricks Some credit cards change the way the calculate the “average daily balance” –They do the average daily balance as a two cycle average (ie the average over two months instead of each billing cycle) Results –If you try to take a promotional offer and then pay off the balance before the rate goes up - they get to zap you even after the balance is paid. –They can continue to charge you interest on purchases after they are paid off –You have to keep your credit card paid off for many months straight to stop monthly interest charges.

92. Back to Herby Choosing a Personal Loan or Credit Card Assume that Herby will buy the supplies at Lowe’s so he will not be on a credit card cash advance. How do we compare two financial alternatives to the same problem when both will cost you money?

93. The Cash Flow Comparison Trick I have a hunch Herby would rather have the bank loan to fix up his house so I will get the cash flow from choosing the bank loan instead of the credit card Herby pays a $200 loan application fee $0 - $200 Bank loan payments stay the same while the credit card payments go down with time. They start at -$1.39 and end at -$36.87 After the bank loan is paid off Herby would still have credit card bills so now Herby is saving money by having the bank loan instead of the credit card. Savings start at $64.05 and decline to $60.35 when the house sells We’ll assume Herby would pay off the credit card when the house sold. By having the bank loan instead of the credit card, Herby keeps money he would otherwise have to use to pay off the credit card $3,017.62 - $0.

94. Getting Ready for NPV Since none of these cash flows is an annuity, I have 70 cash flow elements to sweep back one at a time with a P/F. - You can bet I’m planning to use my spreadsheet for that one. Herby pays a $200 loan application fee $0 - $200 Bank loan payments stay the same while the credit card payments go down with time. They start at -$1.39 and end at -$36.87 After the bank loan is paid off Herby would still have credit card bills so now Herby is saving money by having the bank loan instead of the credit card. Savings start at $64.05 and decline to $60.35 when the house sells We’ll assume Herby would pay off the credit card when the house sold. By having the bank loan instead of the credit card, Herby keeps money he would otherwise have to use to pay off the credit card $3,017.62 - $0.

95. Big Cash Flows with a Spread Sheet I just stuck my cash flow right along side my credit card payoff schedule

96. What Interest Rate to Use We’ve looked at what peoples marginal rate of interest may be We’ve looked at feeling around with NPVs using different interest rates to see what happens Another tool is the IRR –Internal Rate of Return –It is the interest rate that makes NPV zero

97. The IRR The IRR is popular because it tells you what interest rate the investment makes –Can make complicated cash flow into an interest rate like is posted at a bank Very simple flows have a formula for IRR but most cash flow IRRs are computed iteritivly until the NPV is zero –The way financial calculators do it –Excel has an IRR function that works same way. –Where going to do manual iteration this time

98. Lets Try 2% NPV is still Positive - the interest rate is higher.

99. Lets Try 6% Still Positive - We’re making over 6%

100. Lets Try 12% Interest Rate is Still higher.

101. Lets Try 30% So its gone negative. The interest rate is less than 30%, but probably not much.

102. Lets Try 28% We’re Close. It’s a little above 28%.

103. I’ll Call this Close Enough

104. Conclusion Picking the bank loan instead of a credit card to pay for his home repairs is like Herby investing at around 28.1% interest –I doubt Herby has many opportunities for that kind of return You can see how wise choices about needed expenses can help you to accumulate wealth Do not confuse this to mean that spending money for anything makes you wealthy.

105. Interpreting IRR The IRR represents the rate of interest paid by the project (or the selection of the preferred cost scenario over its alternative) The IRR is compared to the Rate of Return that the investor requires (or the interest rate for the investor’s other opportunities) –If the rate is greater or equal to the target rate then GO FOR IT –If not spit in the pot and walk away

106. Herby’s Home Buy Cash Flow $2,800 Down Payment $1,260 Loan Initiation Fees $600 Homeowners Insurance Bank also charged $378 in “Points that rolled into loan $230.31 $227.52 $224.55 $221.39 $218.03 $161.18 $132$139 $146$153$161$169$372.06/mo. $385.56/mo. $310.56 $316.56$323.05$329.84 $200 Home improvement loan initiation. $75/month for Home Repairs $101.39/month Bank Loan for Repairs $79.22/month Sinking Fund for Roof

107. One More Issue Herby will sell the house when he graduates Herby hopes to have built some equity –Herby’s has $22,792.47 left on his home loan –Herby’s house should have grown in value according to tax assessment records the home value has increased 27.63% since he bought it $28,000 + 1.2763 = $35,736 Herby has also made some home improvements since he got the house

108. Home Improvements and Equity Many home maintenance items are needed to keep a salable house but add little to the selling value –There are guides on what kinds of things add value example new Kitchen usually returns value finishing a basement often does not –Many items add part, but not all of their cost to the homes value

109. Herby’s Home Improvements Herby bought $5,000 in goods and put a lot of sweat into installing them. –Lets assume Herby gets his cash out, but not his sweat –Value increases $5,000 Herby has just reroofed –Herby may get 50% out of that –Value increases $2,100 Herby’s new home value –$35,736 + $7,100 = $42,836

110. Herby’s Equity Home Value is $42,836 Buyers will usually try to hack at the price –In a sellers market you can get what you ask (if its reasonable) –In a buyers market you often have to be dickered down (Southern Illinois is a buyers market) –Lets assume Herby will get $40,000 Herby’s Equity –$40,000 - $22,792.47 = $17,207.53

111. Not So Fast It costs money to sell a house –Real Estate Brokers Commission 7% of selling price $2,800 –Title Insurance $400 –Dead Preparation $200 –Mortgage Release Recording $15 –Real Estate Stamps (about 75cent/$100) $40,000/$100 = 400 * 0.75 = $300

112. Taxing Questions Property Taxes are in arears - Buyer will get a credit –Next years taxes will be about 5% higher than last years –$1,123.38 * 1.05 = $1,179.58 –Herby sold part way through the year so he only covers 9 months of the 12 $1,179.58 * 9/12 = $884.66

113. Herby’s Windfall Sellers Costs –$2800 + $400 + $200 + $15 + $300 + $884.66 +$22,792.47 = $27,392.13 Home Sells for $40,000 –$40,000 - $27,392.13 = $12,607.87 Cleared Herby can also cash in that Escrow Account –Account will have $3,657 - $2,051.89 + $177.78*9 = $3205.13 Herby can also cancel his homeowners insurance for last 3 months of year –$730 * 0.25 = $182.50 –

114. Herby’s Homey Cash Flow $2,800 Down Payment $1,260 Loan Initiation Fees $600 Homeowners Insurance Bank also charged $378 in “Points that rolled into loan $230.31 $227.52 $224.55 $221.39 $218.03 $161.18 $132$139 $146$153$161$169$372.06/mo. $385.56/mo. $310.56 $316.56$323.05$329.84 $200 Home improvement loan initiation. $75/month for Home Repairs $101.39/month Bank Loan for Repairs $79.22/month Sinking Fund for Roof $15,995.50 from sale of home

115. Now How Do We Decide Whether to Buy or Rent? That’s Right - The old subtract one alternative from the other trick Our Thought would probably be that Herby Should Buy Rather than Rent. –Lets try to cash flow Hand Out the Cash Flow

116. Look At Flow Note that the cash flow of the Preferred Alternative is just Preferred - Alternate.

117. Look at the Cumulative Cash Position Point at Which the Cumulative Cash Position Goes Positive is Called the Payback Period What are the Chances of Getting Your Rate of Return from a Cash Flow that never pays back? Payback Period can be a quick check for a looser proposition.