Chapter 9 The Housing Expenditure Objectives n

Chapter 9: The Housing Expenditure

Objectives n Discuss the options available for rented and owned housing and whether renters or owners pay more for housing. n Determine how much buyers can afford for housing. n Discuss the various mechanisms for financing a home.

Objectives n Identify the numerous costs of buying a home, including principle, interest, and closing costs. n List and describe the steps in the homebuying process. n 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. 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. 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, 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 n Advantages w Mobility w Fewer responsibilities w Lower costs initially w More amenities n Disadvantages w Few financial benefits w Restricted lifestyle w Cost of renting - deposits w Legal concerns of a lease

Largest Physical Capital Investment Made by a Family is a HOUSE. n Home Ownership rates 2012: w US = 65. 4% (lowest since 1997) w Utah = 71. 5% n 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 n Demand w w Average household size down Average income up Availability of substitutes down Life cycle stage of housing Ÿ Childhood home, apartment, starter home, family home, empty nest home, retirement home, institutionalization or back to family, burial vault n Supply w Business cycle

What Are the Costs of Owning a Home? • One-time Costs • Closing costs (range of 3 -4% of the mortgage loan amount). • Downpayment • Selling Costs • Real Estate Fees • Periodic Costs • Lost Investment Return One-time Costs • Principal and Interest Payment • Property Taxes • Hazard Insurance • Operating and Maintenance Costs

Factors Reducing the Cost of Homeownership • Tax Benefits • Homeowners MTR x (annual mortgage interest + annual property tax – standard deduction) • Example: • . 28 x ($8, 000 + $2, 000 - $7, 350) = $742 • Appreciation

Advantages of Owning Pride of ownership w American dream/norm n Reduced income taxes w deduct property taxes w deduct mortgage interest n

Advantages of Owning (continued) Build an equity w pay down the loan w price appreciation n Builds your credit rating n Forced savings-portion of mortgage payment goes toward building up equity. n Hedge against inflation n Lifestyle flexibility w can express your individuality n

Disadvantages of Owning Financial risk w need down payment w home prices could drop w Opportunity cost of money tied up in purchase. n Limited mobility w can take time to sell n Higher living costs w maintenance w repairs & improvements w utilities & insurance w real estate taxes n

Renting vs. Owning Your Home n WHO PAYS MORE: w Based on cash flow, renters appear to win w After taxes and appreciation, owners usually win

Renting versus Buying Place of Residence RENTAL COSTS Annual Rent Payments Renter’s Insurance Interest Lost on Security Deposit (amount of security deposit times after-tax savings account rate) Total annual cost of renting Annual mortgage payments Property taxes (annual) Homeowner’s insurance (annual) Estimated maintenance and repairs (1%) After-tax interest lost on down payment and closing costs EXAMPLE $15, 000 210 36 $15, 246 $15, 168 4, 800 600 2, 000 750 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%) Total annual cost of buying (3, 000) $14, 806 YOUR FIGURES 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 n Single-family dwelling w tract housing w built on speculation by builder w built to your specifications w previously lived in home w manufactured home w mobile home

Home Buying Process Step 1: Determine Ownership Needs n How much you can afford w down payment w loan amount w size and quality w handyman’s special w sweat equity

Home Buying Process Step 2: Finding and Evaluating a Property to Purchase Select a location n Zoning laws n Covenants, codes and restrictions n Using a real estate agent n Property appraisal n Conducting a home inspection n 9 -15

Home Buying Process Step 3: Pricing the Property Determining the price to offer n Negotiating the purchase price w seller’s or buyer’s market w earnest money n Contingency clauses w home passes structural inspection w able to get a loan n

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 Interest 15 yr 4. 5 7. 6499 5. 0 7. 9079 5. 5 8. 1708 6. 0 8. 4386 6. 5 8. 7111 7. 0 8. 9883 7. 5 9. 2701 8. 0 9. 5565 8. 5 9. 8474 9. 0 10. 1427 9. 5 10. 4422 10. 0 10. 7461 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. 30 yr Diff in % 5. 0669 50. 98% 5. 3682 47. 31% 5. 6779 43. 91% 5. 9955 40. 75% 6. 3207 37. 82% 6. 653 35. 10% 6. 9921 32. 58% 7. 3376 30. 24% 7. 6891 28. 07% 8. 0462 26. 06% 8. 4085 24. 19% 8. 7757 22. 45%

Effect of Down Payment Size on Monthly Payment for a $150, 000 Home (7 Percent Mortgage Loan for 30 Years) Down Payment $5, 000 10, 000 15, 000 20, 000 25, 000 Amount Of Loan $145, 000 140, 000 135, 000 130, 000 125, 000 Monthly Payment $964. 69 931. 42 898. 16 864. 89 831. 63

How do households finance the purchase of a house? n Down payment w typically 10% of selling price, but 20% is the magic number n Mortgage w loan to pay the seller the difference between the purchase price and the down payment n Mortgage choices impact the economic cost of a home

Type of Mortgages Conventional w fixed rate, amortized w 5, 10 or 20 percent down w 15, 20 or 30 years of fixed payments n Government guaranteed w Veterans Administration w Federal Housing Administration n Adjustable rate mortgages w varies with the prime rate but has a rate cap n

Type of Mortgages (continued) Graduated payment w payments start lower and go up w for persons whose income will increase n Balloon w fixed monthly payments plus one large payment, usually after 3, 5 or 7 years n Growing equity w payment increases to allow loan to be paid off more quickly n

Type of Mortgages (continued) Shared appreciation w borrower agrees to share appreciated value of the home with the lender n Home equity loans w a second mortgage w home is collateral and interest may be tax deductible n Reverse w a loan based on the home equity n Refinancing n

Economic Advantages and Disadvantages of Fixed Rate Mortgage? n Advantages: w future housing costs are known with relative certainty (only possible changes are property taxes, insurance, and utilities) w can choose 15 -year, 20 -year, 25 -year, 30 -year, 40 year, or 50 -year loan time w interest deductions from income taxes are high during the early years of the loan

Economic Advantages and Disadvantages of Fixed Rate Mortgage? n Disadvantages: w more difficult for young households (with lower incomes) to qualify w Locked in to the fixed rate. w 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 n Federally insured mortgages w If the borrower defaults, the lender still gets the mone n Advantages: w interest rates frequently lower on FHA or VA mortgages than on conventional mortgages w qualifying is typically easier w FHA/VA loans are assumable w down payment requirements are typically lower

Fixed rate FHA or VA mortgage n Disadvantages: w loan limits (2008 = $729, 750 in SLC, Summit, and Tooele Counties; $323, 750 in Utah County; $271, 050 most everywhere else) w insurance fees (1. 5% upfront, + 0. 50% per year of the loan amount – can be financed) w typically pay additional points (one-time, fixed costs) Ÿ Rates on 10/30/08 Ÿ 30 year fixed is 6. 46%, with 0. 7 points Ÿ 15 year fixed is 6. 19%, with 0. 7 points w May take longer to process

Self-amortizing, Adjustable Rate Mortgage (ARM) Interest rate and monthly payment are both variable (e. g. , adjustable). n Example: n w loan amount = $200, 000 w interest rate = 6. 0% initially w time period = 30 years w initial monthly payment: $1199. 10

More about the ARM interest rate n 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 n Spread - the amount that is added to the index to arrive at the ARM interest rate.

More about the ARM interest rate n Frequency of rate change - how often the lending institution can change the ARM interest rate. n Rate cap - limitations on either the increase or the decrease in the ARM interest rate that can occur at a point in time. n 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? n Advantages: w Initial interest rates are typically lower w If you are buying when mortgage rates are high, but expected to fall in the future n Disadvantages: w 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. n Example: n Ÿ loan amount = $200, 000 Ÿ interest rate = 7. 0% Ÿ time period = 30 years w monthly payment at first is $800 (rather than $1330. 60) Ÿ After 2 years, payment goes to $1000 Ÿ After another 2 years, payment goes to $1200 Ÿ Then payment is $1553. 60 for the rest of the loan (24 years)

Interest Payments on a Graduated Payment Mortgage n Month 1: w payment = $800. 00 w interest owed: $200, 000(. 07/12) = $1166. 67 w loan increased by: $1166. 67 - $800 = $366. 67 n Month 2: w payment = $800. 00 w interest owed: $200, 366. 67(. 07/12) = $1168. 81 w loan increased by: $1168. 81 - $800 = $368. 81 n This is an example of negative amortization

Economic Advantages and Disadvantages of a Graduated Payment Mortgage? n Advantages: w Easier to qualify for lower income households w lower monthly payments early in the mortgage n Disadvantages: w Loan amount is larger than with a conventional, fixed rate mortgage w 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) n A reverse mortgage is a loan against your home that you do not have to pay back for as long as you live there. w It can be paid to you all at once, as a regular monthly advance, or at times and in amounts that you choose. w 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. n Your house must be paid off (or close to it) n You must be over 62 n

REMs n Advantages: w Way to access your home equity without having the burden of repayment w Creates income n Disadvantages: w Reduces the value of your estate w 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 n Your payment only covers the interest owed on the loan w Then you have a balloon payment after a specified # of years (e. g. 7 or 12) with the principal balance due w Or your loan will amortize over a shorter amount of time Ÿ E. g. 40 yr IO – pay IO for 10 years, and then amortized over 30 yrs Advantages: w Lower monthly payments w Maybe good for rental properties and/or high-equity growth areas n Disadvantages: w Negative amortization may occur w No gain in equity from principal reduction w Very risky n

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

How do those mortgages stack up? Loan Type Interest Rate Compared Int. pd in 5 Equity to a 30 -yr yrs created in 5 yrs $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 5/1 Interest Only 6. 29% Monthly Pmt $3, 983 5/1 adjustable-rate mortgage refinance A 5/1 ARM refinance has a fixed interest rate for the first 5 years. After 5 years, the rate can change once every year for the remaining term of the loan. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.

How to reduce the amount of interest paid on your mortgage Pay extra principal every month n Pay next month’s principal this month n w Pays off a 30 -year mortgage in about 15 years and 8 months n Pay bi-weekly w Pay 26 half payments a year, or 13 monthly payments w Cuts about 7 years off of 30 year mortgage n Pay semi-monthly w Pay 24 half payments a year w 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 n Refinance to a 15 year mortgage at 5. 25% with a payment of $450 n Answer = NO Under current payment plan, will pay 642(8)(12) = $61, 632 over next 8 years n Under refinance, will pay 450(15)(12) = $81, 000 over next 15 years n More out of pocket, and more opportunity costs n n

Home Buying Process Step 4: Obtaining Financing Determine the amount of down payment w mortgage insurance n Qualifying for a mortgage w can be pre-qualified based on income, assets, debts, credit history and length of loan w purpose of “points” (prepaid interest) n The home loan application process w fixed or adjustable rate mortgage w locking in an interest rate - search Web n

Qualifying for a Mortgage Amount available for down payment n Amount of income n Amount of other debts n Credit rating n Current mortgage rates n Length of loan desired n

Home Buying Process Step 5: Closing the Purchase Transaction n Closing Costs n n n n n 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

The Main Elements of Buying a Home Location n Down payment n Mortgage application n Points n Closing costs n TIPI (taxes, insurance, principal, interest) n Maintenance costs n

When Should You Refinance Your Mortgage? Expected length of stay in house from time of refinancing. For refinancing to be financially beneficial, new mortgage interest rate must be at least: 2 years 4% lower than existing rate 5 years 2% lower than existing rate 10 years 1% lower than existing rate 15 years ¾% lower than existing rate 25 years ¾% lower than existing rate Assumes closing costs equal to 4% of loan, 1% mortgage discount rate, 28% federal tax bracket, new mortgage term equal to remaining term of original mortgage, and an alternative before-tax investment rate of 8%.

Selling Your Home Preparing your home n Determining the asking price w Appraiser w Realtor n For sale by owner or use a broker n Listing with a real estate agent n

Make Sure Security Deposit Is Returned n n n 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 n Listing agent n Selling agent n Buyer’s agent n Dual agent