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

Basic Dimensions of a Mortgage Loan amount (purchase price minus down payment) = PV Interest rate per period = r Time period for the loan = n Pre-payment option

Self-amortizing, Fixed Rate mortgage Interest rate and monthly payment are fixed. Standard, conventional Example (with monthly compounding): loan amount = $200,000 interest rate = 7.0% time period = 30 years

PV=200,000 r = (.07/12) = n = 30(12) = 360

FVP = $1, per month Please note: this is the PI part of the PITI payment TI will be more every month

Interest Payments on Fixed Rate Mortgage Month 1: interest owed: $200,000(.07/12) = $ principal: $ $ = $ new loan balance: = $200,000 - $ = $199, Month 2: interest owed: = $199,836.07(.07/12) = $ principal: $ – $ = $ new loan balance: $199, $ = $199,671.18

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

Types of Mortgages 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, % 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

What sparked the creation of alternative mortgage instruments in the late 1970s? High rates of inflation made lenders uneasy about locking into a 30-year loan at any fixed interest rate As housing prices rose, first-time home buyers were having difficulty qualifying for the purchase of a home.

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: $

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)

More about the ARM interest rate When the associated index moves and an adjustment period occurs, the lender changes the interest rate by the amount allowed (up or down) recalculates the monthly payments based on the new interest rate and the remaining loan balance.

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 $ ) After 2 years, payment goes to $1000 After another 2 years, payment goes to $1200 Then payment is $ for the rest of the loan (24 years)

Interest Payments on a Graduated Payment Mortgage Month 1: payment = $ interest owed: $200,000(.07/12) = $ loan increased by: $ $800 = $ Month 2: payment = $ interest owed: $200,366.67(.07/12) = $ loan increased by: $ $800 = $ 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

How do those mortgages stack up? Loan TypeInterest 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 fixed6.32%$2,583.73$643.91$84,415$70, yr fixed6.72%$1,939.82$0$97,922$18, yr fixed6.97%$1,857.76($82.06)$103,220$8, yr fixed6.97%$1,798.18($141.64)$103,908 $3,983

Summary: Economic Costs and Economic Benefits of Various Mortgage Instruments Depend Upon... Life cycle stage Business cycle stage Risk tolerance Liquidity needs

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