Chapter 9: The Housing Expenditure

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.

Young Couple, No Children Couple, Children No Longer At 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 %

Housing Prices are determined by Supply & 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 (continued) 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

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 WHO PAYS MORE: Based on cash flow, renters appear to win After taxes and appreciation, owners usually win

A Cost-Benefit Approach (CBA) to the home ownership decision 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

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

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

Example 6. FV of one-time costs = =$16,468 FV=13000(1+.03)8 FVA of recurring costs (with monthly compounding) = =$16,468 = $32,504

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 7. = 0.04 or 4%

Example Decision = if forecasted housing appreciation rates are higher than 4%, you should buy this house

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 (Monthly Payment per $1,000 Borrowed)   Payment Period (Years) Interest Rate (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 Down Payment Amount Of Loan Monthly $5,000 Effect of Down Payment Size on Monthly Payment for a $150,000 Home (7 Percent Mortgage Loan for 30 Years) Down Payment Amount Of Loan Monthly $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

Type of Mortgages 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 Graduated payment payments start lower and go up (continued) 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

Type of Mortgages Shared appreciation (continued) 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

Economic Advantages and Disadvantages of Fixed Rate Mortgage? 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? 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? 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: 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? 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: Disadvantages: 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

Life cycle stage Business cycle stage Risk tolerance Liquidity needs 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 $97,922 $18,467 40-yr fixed 6.97% $1,857.76 ($82.06) $103,220 $8,245 50-yr fixed $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

Home Buying Process Step 4: Obtaining Financing 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

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

Home Buying Process Step 5: Closing the Purchase Transaction 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 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.

Types of Real Estate Agents Listing agent Selling agent Buyer’s agent Dual agent