Questions and Answers
In a fixed rate mortgage, the lender assumes the risk of an increase in interest rates.
True
Borrowers of adjustable rate mortgages (ARMs) are guaranteed to have lower interest payments over time.
False
Credit card debt is typically considered secured debt.
False
Prepayment penalties are commonly associated with fixed rate mortgages.
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A borrower can often refinance a fixed rate mortgage when interest rates decline significantly.
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The after-tax interest cost on the debt retired should be compared with the after-tax return on investment alternatives when considering mortgage prepayment.
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Marketability risk is not a consideration when deciding to prepay one's mortgage.
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Fixed rate mortgages allow borrowers to benefit from interest rate fluctuations downwards.
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All fixed rate mortgages guarantee a lower interest rate compared to adjustable rate mortgages.
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Homeowners find it easier to qualify for a larger house with an adjustable rate mortgage as lenders consider total interest costs in relation to household income.
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A hybrid ARM is a mortgage that offers a fixed rate for a duration before switching to an adjustable rate.
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Refinancing opportunities are a benefit associated with fixed rate mortgages.
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Liquidity risk is not relevant when considering a fixed rate mortgage.
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Rational borrowers are constantly seeking more funds and may have to take any payment terms offered.
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All of the mentioned factors are used to assess whether credit should be extended to a household.
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Fannie Mae is the Federal National Home Loan Association.
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Government supported organizations like Fannie Mae tend to narrow credit but offer it at a cheaper rate.
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In an amortizing loan, the largest part of the payment at the beginning is interest.
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Paydown of principal occurs at the end of the loan in amortizing loans.
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Prepayment considerations are important for borrowers of fixed-rate mortgages.
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Rising interest rates negatively affect the popularity of adjustable-rate mortgages.
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Borrowing only allows one to raise their standard of living today.
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Debt allows individuals to balance the peaks and valleys in their spending pattern.
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Financial leverage is greater when there is a lower amount of interest expense and debt repayment commitments.
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Operating leverage is greater when there is a lower percentage of discretionary costs.
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In a variable rate mortgage, the borrower assumes the risk of increase in interest rates.
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Home equity loans offer higher relative interest costs than fixed rate mortgages.
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Undertaking additional debt leads to decreased risk and increased potential returns.
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Secured debt includes credit card debt.
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It is easier to qualify for an adjustable rate mortgage than for a fixed rate mortgage.
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Borrowers can typically refinance a fixed rate mortgage when interest rates decline significantly.
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In a variable rate mortgage, the borrower assumes the risk of an increase in interest rates.
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Home equity loans offer lower relative interest costs than fixed rate mortgages.
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Qualification for a loan is easier with an adjustable rate mortgage compared to a fixed rate mortgage.
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Borrowers of fixed rate mortgages can benefit from interest rate fluctuations downwards.
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The lender assumes risk of increase in rates in a fixed rate mortgage.
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Study Notes
Mortgage Considerations
- Assess after-tax interest costs against potential after-tax returns from investment alternatives prior to mortgage prepayment.
- Evaluate risk levels associated with prepayment and investment options.
- Marketability risk pertains to the ease of selling a property which may not be a prepayment concern.
- Liquidity risk refers to having sufficient cash flow to manage payments and other expenses.
Fixed Rate Mortgage Benefits
- Locks in interest rates, protecting borrowers from market rate increases.
- Borrowers may receive lower rates on the mortgage for taking on interest rate fluctuation risks.
- Provides refinancing opportunities if market rates fall.
- All mentioned points are valid benefits of fixed rate mortgages.
Adjustable Rate Mortgage Qualification
- Homeowners may qualify for larger houses due to lower initial interest costs compared to fixed rates.
- Lenders consider total interest costs in relation to household income or expenses primarily in the initial years.
Hybrid Adjustable Rate Mortgage (ARM)
- A hybrid ARM features a fixed interest rate for an initial set period before transitioning to an adjustable rate.
- The fixed initial period offers borrowers stability before potential rate adjustments begin.
Debt Types Classification
- First Mortgage: Typically tax-deductible and secured.
- Home Equity: Secured and tax-deductible.
- Credit Card Debt: Not tax-deductible and unsecured.
- Credit Association Loan: May vary in tax-deductibility and often secured.
- Bank Loan: Tax-deductibility and security depend on the type of loan.
- Pension Loan: Generally not tax-deductible and secured by the pension.
- Insurance Loan: Typically not tax-deductible; may or may not be secured.
- Educational Loan: May be tax-deductible and usually unsecured.
- Loans from Friends and Relatives: Not tax-deductible and generally unsecured.
- Finance Company Loans: Generally not tax-deductible and may be unsecured or secured.
Borrower Types
- Unrational borrowers typically seek more funds and may accept any payment terms.
- Other borrower types such as rational, discrete, or surplus may not exhibit the same constant need for additional funds.
Credit Assessment Factors
- Key elements evaluated when extending credit include income, total outstanding debt, repayment history, and whether the loan is secured.
- All these factors collectively contribute to credit assessment decisions.
Fannie Mae Identification
- Fannie Mae is identified as the Federal National Mortgage Association.
Government Supported Organizations
- Organizations like Fannie Mae, Ginnie Mae, and Freddie Mac aim to broaden credit access and reduce costs compared to traditional lending scenarios.
Amortizing Loan Characteristics
- During an amortizing loan's early term, the majority of payments goes toward interest.
- Over time, a greater portion of payments is allocated toward principal paydown.
- Interest payments decrease while principal payments increase as the loan matures.
Borrowing and Debt
- Borrowing provides funds for enhancing living standards, making investments (e.g., buying a home), and financing businesses.
- Debt characteristics include balancing spending patterns and enabling significant capital expenditures, but it does not alleviate life cycle style needs.
Risk and Leverage
- Debt outstanding relative to assets represents financial risk.
- Operating leverage increases with a higher percentage of fixed costs; if fixed costs are low, operating leverage is lower.
- Financial leverage increases with both high interest expense and debt repayment commitments.
Additional Debt Effects
- Undertaking additional debt leads to increased risk along with increased potential returns.
Fixed vs. Variable Rates
- Fixed Rate Mortgage: Lender assumes interest rate risk; borrower can refinance for savings. Tax-deductible and generally secured.
- Variable Rate Mortgage: Borrower assumes interest rate risk; interest rate adjusts based on benchmark rates. Generally not tax-deductible.
Types of Debt and Tax Deductibility
- Tax-Deductible and Secured Loans:
- First Mortgage: Yes, Yes
- Home Equity: Yes, Yes
- Non-Deductible Loans:
- Credit Card Debt: No, No
- Bank Loan: No, Varies
- Educational Loan: Yes, up to $2,500/year, No
Mortgage Prepayment Considerations
- Factors include comparing after-tax interest costs to investment returns and assessing liquidity and marketability risks.
Advantages of Fixed Rate Mortgages
- Protects against rising market rates and provides refinancing opportunities when market rates decline.
Homeownership with Adjustable Rate Mortgages (ARMs)
- Easier qualification for larger homes due to lower initial interest costs relative to household income or expenses.
Hybrid ARMs
- Combines fixed-rate periods with adjustable rates after a set duration.
Credit Bureaus and Improving Ratings
- Major credit bureaus: Equifax, Experian, TransUnion (not Standard and Poor's).
- Improving credit rating involves timely bill payment, reviewing credit reports, and careful management of credit cards.
Personal Bankruptcy
- Chapter 7 bankruptcy eliminates all existing debts.
- The Bankruptcy Abuse Prevention and Consumer Act of 2005 makes bankruptcy filings more difficult.
Debt Coverage Ratio
- The benchmark is derived by assessing the amount available after deducting normal household overhead expenses from take-home pay.
Comparative Analysis of Mortgages
- An assessment of advantages and disadvantages of fixed-rate versus variable-rate mortgages is important for decision-making.
Fixed vs. Variable Rates
- Fixed rates assign interest rate risk to the lender, while variable rates assign this risk to the borrower.
- Borrowers with fixed rates can refinance if savings surpass the costs; variable rates adjust automatically based on benchmarks.
- Fixed rates typically have a higher interest cost due to guaranteed rates and refinancing options; variable rates are generally lower due to borrower assumption of risk.
- Projected holding periods yield no significant advantage in fixed rates; variable rates may benefit short-term holders with teaser rates.
- Qualification for fixed-rate loans is more challenging compared to adjustable-rate mortgages (ARMs) that often have lower initial rates.
Tax Deductibility and Security of Debt Types
- First mortgages and home equity (second mortgages) are often tax-deductible and secured.
- Credit card debt, personal loans, pension loans, and loans from friends and relatives are generally non-deductible and unsecured.
- Loans from financial institutions, like banks, may vary in terms of deductibility and security.
Interest Rate Calculation
- For a $40,000 loan with $3,000 interest, the interest rate is approximately 7.5%.
- If interest paid is $20,000 with the beginning cash at $230,000 and ending cash at $10,000, the interest rate is around 18.18%.
Annual Percentage Rate (APR) Components
- APR encompasses closing fees, points, and appraisal fees, excluding undefined costs.
Types of Credit
- Open-end credit allows borrowers to use a loan limit for multiple purchases over time; exemplified by credit cards.
- Accurate understanding of loan assessment includes evaluating income, outstanding debt, and repayment history.
Fannie Mae and Government Support
- Fannie Mae is identified as the Federal National Mortgage Association.
- Government entities like Fannie Mae and Freddie Mac enhance credit availability at lower rates.
Mortgage Loan Structure
- In amortizing loans, initial payments consist largely of interest, transitioning towards more principal reduction over time.
Credit Card Popularity
- Credit cards are favored for convenience, expense management, and lower transaction costs than small loans.
Margin Debt Regulations
- The Federal Reserve permits a maximum margin debt of 50% of a security's fair market value upon purchase, and 25% for ongoing collateral value.
Pension Loan Limits
- Pension loans cap at 50% of the vested account balance or $50,000, whichever is less.
Credit Scores
- Negative factors for credit scores include inadequate income or debt levels, while favorable credit history enhances scores.
Major Credit Bureaus
- Equifax, Experian, and TransUnion are notable credit bureaus, while Standard and Poor’s is not.
Improving Credit Ratings
- Strategies to enhance credit ratings include timely bill payments, monitoring credit reports, and not overextending credit cards.
Bankruptcy Types
- Chapter 7 bankruptcy results in total debt discharge, while Chapter 13 involves debt restructuring.
Bankruptcy Reform Impact
- The Bankruptcy Abuse Prevention and Consumer Act of 2005 complicates the bankruptcy filing process for borrowers.
Debt Coverage Ratio Benchmark
- The debt coverage ratio is defined by the amount left after deducting usual household expenses from take-home pay.
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Test your knowledge on the considerations and benefits associated with mortgages, including fixed-rate mortgages and the factors impacting prepayment decisions. Evaluate your understanding of marketability and liquidity risks in this insightful quiz.
