AFN 221 Personal Finance - Mortgage PDF

AFN 221 Personal Finance Lecture Topic: Mortgage Andreas Milidonis Department of Accounting & Finance University of Cyprus Ema...

AFN 221 Personal Finance Lecture Topic: Mortgage Andreas Milidonis Department of Accounting & Finance University of Cyprus Email: [email protected] 1 1 “Concept Map” for the Course Introduction Interest Rates Inflation & Time Money Management Savings Consumer Borrowing (Credit) Review & Midterm Exam Mortgage Insurance & Risk Investing Management Retirement Risk & Return Biases Review & Final Exam 2 2  Housing costs and benefits depending on lifecycle stage 3 3 Housing alternatives: Renting vs buying Renting: advantages Flexibility Less responsibilities (e.g. maintenance) Less initial expenses ( loan down payment) Renting: disadvantages Less Financial benefits Living restrictions (pets and remodeling) Buying: Advantages Financial benefits (increase in house prices; an investment) More Living freedom (pets and remodeling) Feelings of pride of owning property Buying: Disadvantages Less financial flexibility More expenses Financial uncertainty as market conditions affect housing prices 4 4  Rent or Buy Housing (1/5) Renting an apartment: Advantages include: easy to move; fewer responsibilities for maintenance; and minimal financial commitment. Disadvantages include: no tax benefits; limitations regarding remodeling; may have restrictions regarding pets, and other activities. 5 5 Rent or Buy Housing (2/5) Renting a house: not for the exam,adv,dis... Advantages include easy to move; less maintenance; more room than apartment; and minimal financial commitment. Disadvantages include higher utility expenses than apartment and limitations regarding remodeling. 6 6  Rent or Buy Housing (3/5) Owning a new house Advantages include no previous owner; pride of ownership, and tax benefits. Disadvantages include financial commitment; higher living expenses than renting; and limited mobility. 7 7 Rent or Buy Housing (4/5) Owning a previously owned house Advantages include pride of ownership; established neighborhood; and tax benefits. Disadvantages include: financial commitment; possibility of repairs or replacements; and limited mobility. 8 8  Rent or Buy Housing (5/5) Owning condominium (we call it an apartment in Cyprus): Advantages include tax benefits; fewer maintenance responsibilities than house; and usually good accessibility to recreation and business districts. Disadvantages include less privacy than house; financial commitment; uncertain demand affecting property value; potential disagreements with other condominium owners; and assessment fees. 9 9 Housing Rental Activities (1/2) The Search: Select an area and rental amount; compare costs and facilities of comparable units; and talk to current and past residents. Before Signing a Lease: Verify lease starting date, costs, and facilities; talk to a lawyer about unclear aspects of the lease; note in writing, signed by the owner, the condition of the rental unit; and remember, if two names are on the lease, one person can be held responsible for the full rent. 10 10  Housing Rental Activities (2/2) Living in Rental Property: Keep all facilities in good condition; contact the owners regarding needed repairs; respect the rights of others regarding noise; and obtain renter’s insurance for personal belongings and liability situations (see Chapter 10). At the End of the Lease: Clean the apartment; leave it in the same condition as when you moved in; tell landlord where to send your security deposit; and require that any deductions from your security deposit be documented. 11 11 The Home-Buying Process the more down payment is ,the less the interest rate bcs bank trust you(25%) 12 12  The Home-Buying Process (1/3) Step 1. Determine Home Ownership Needs. Evaluate owning your place of residence. Assess types of housing units. Calculate the amount you can afford; Get preapproved by lender. Step 2. Find and Evaluate a Property to Purchase. Select a location. Consider using a real estate agent. Conduct home, pest inspection. 13 13 The Home-Buying Process (2/3) Step 3. Price the Property. Determine an appropriate market price. Negotiate an agreement price. Step 4. Obtain Financing. Determine amount of down payment. Investigate the rates and conditions of mortgages. Apply for mortgage and evaluate types of mortgages. 14 14  The Home-Buying Process (3/3) Step 5. Close the Purchase Transaction. Arrange for a closing date. Obtain closing funds and documents. Request clarification of unclear aspects of the transaction. Do walk-through for final approval. 15 15 Conducting a Home Inspection (1/5) 16 16  Conducting a Home Inspection (2/5) The interior construction criteria include the condition of electrical fixtures and wiring; condition of plumbing fixtures; adequate water pressure; water heater condition; type and condition of heating unit; quality/condition of walls, floors, and doors; cracks or potential ceiling problems; ease of operation of windows; type and condition of floor covering; and condition of stairways. 17 17 Conducting a Home Inspection (3/5) The interior design criteria include size and arrangement of rooms; amount of closet and storage space; door sizes for moving furniture; counter space and layout of kitchen; condition of kitchen appliances; ventilation for cooking; adequate laundry area; location of bedrooms relative to other areas; accessibility to attic and basement; and adequate electrical outlets. 18 18  Conducting a Home Inspection (4/5) Exterior construction criteria include material quality and condition of building; construction and condition of foundation; condition of bricks, wood, or other siding; condition and quality of windows; condition and quality of roof and gutters; and type and condition of chimney. 19 19 not in the exam Conducting a Home Inspection (5/5) Exterior facilities criteria include appearance of neighborhood; condition of streets and sidewalks; location of street lights, fire hydrants; quality of landscaping, trees, shrubs; condition of driveway and garage; outdoor lighting; condition of patio or porch; and appropriate drainage system. 20 20  The Main Elements of Buying a Home (1/2) Location. Consider the community and geographic region. In one area, €250,000 may be an average home, while elsewhere that may be expensive. Housing demand is affected by economic conditions and availability of jobs. Down payment. A large down payment reduces mortgage payments. However, funds are also needed for closing costs, moving expenses, repairs, or furniture. Mortgage application. You will likely be asked for recent tax returns, pay stubs, tax forms, a residence and employment history, bank account and investment balances, debt amounts, and evidence of auto and any real estate ownership. 21 21 The Main Elements of Buying a Home (1/2) Points. Compare between a higher interest rate with no discount points and a lower rate requiring points paid at closing. Closing costs. Settlement costs can range from 2 to 6 percent of the loan amount. For a € 100,000 mortgage, this could be € 6,000; this amount is in addition to your down payment. PITI. Your monthly payment for principal, interest, taxes, and insurance is a vital budget item. Beware of buying “too much house” and not having enough for other living expenses. Maintenance costs. Owning a home can be expensive. Set aside funds for repair and remodeling. 22 22  Price the Property Determining the Home Price. Consider recent selling prices in the area, current demand for housing, the length of time the home has been on the market, the owner’s need to sell, financing options, and features of the home. You will make an offer in the form of a purchase agreement. Negotiating the Purchase Price. Counteroffer. Contingency clauses, such as... Buyer must be able to obtain financing. Sale contingent on the sale of the buyer’s current home. 23 23 Qualifying for a Mortgage Qualifying for a Mortgage. A mortgage is a long-term loan on a specific piece of property such as a home or other real estate. Consider various terms. Sources include banks, savings and loan associations, credit unions, mortgage companies. Home is collateral for mortgage. Factors considered include your income, debts, credit history, down payment amount, length of the loan, job stability, assets, and current mortgage rates. Lenders use 33 and 38% of gross income as guidelines for affordability of housing costs. 24 24  Should You Pay off Your Mortgage Early? Considerations. Make sure mortgage does not have a prepayment penalty. You may lose tax deductions. You may lose earnings on the money you use to retire this debt. Before paying additional amounts on your mortgage, be sure to pay off your credit card balances and other high-interest debt. Be aware of organizations that promise to set up additional payments on your mortgage, which is something you can do. 25 25 Mortgage Payments 26 26  Mortgages A home mortgage is a type of loan specifically designed to finance home purchases. Mortgages have the following characteristics:  The house purchased acts as collateral.  The interest rate is expressed as an APR, and payments are monthly.  Fixed-rate mortgages have a fixed rate over the term of the mortgage, while adjustable-rate mortgages (ARMs) have interest rates that change with the rate in the economy.  Lenders often require a down payment to help protect themselves against depreciation in the house’s value in the event of foreclosure.  Mortgage interest payments are typically tax deductible. 27 27 Calculate a mortgage payment A fixed-rate mortgage loan is a good example of an installment loan with a fixed monthly payment. Being able to calculate a mortgage payment can give a consumer an idea of whether a mortgage is affordable given their budget. The following example demonstrates how to calculate a mortgage payment. A prospective home-buyer is considering purchasing a $240,000 home. She has sufficient savings to make a 20% down payment and intends to do so. She plans to finance the remaining amount with a fixed-rate mortgage. After consulting the web sites for a few banks in her area, she estimates that she could secure a 30-year mortgage at an APR of 4.5%. 28 28  Calculate a mortgage payment Because the bank requires a 20% down payment, the buyer must pay $48,000 of the house price up front (0.20 ∗ $240,000 = $48,000). She may borrow the remaining $192,000 from the bank. This is a simple financial calculator problem. Alternatively you can use online mortgage calculators or mobile apps. Here is one example of a mortgage loan calculator: https://www.mortgagecalculator.org/ Feel free to look for more. 29 29 Calculate a future mortgage balance A financial calculator can also be used to calculate a future mortgage balance. This can be helpful for future planning. In the example above, we found that a borrowing $192,000 with a 30-year mortgage at an APR of 4.5% requires monthly payments of $972.84. 30 30  Mortgage amortization New homeowners are often shocked at how much of their first payment goes toward interest.  In the example above, we found that a borrowing $192,000 with a 30-year mortgage at an APR of 4.5% requires monthly payments of $972.84.  In the first $973 payment on the 30-year mortgage above, $720 of this is interest. The balance is only reduced by $253 in the first month. Loan Amortization on a 30-year Mortgage better to take loans for less Interest Paid Principal Paid years(not 30 years) $1,000 $800 $600 $400 $200 $0 31 Month 1 Month 2 Month 3 … Month 180 … Month 359 Month 360 31 Interest cost of a mortgage The interest expense of a mortgage is Interest on a 30-year very large. In the last example, interest Mortgage payments cost $158K over the life of the mortgage. This implies a total cost of $350K to repay a $192K loan! 158,222 This is the cost of borrowing over a long time horizon; the interest expense is substantial. That does not mean it is necessarily a bad deal financially: Total Interest Total Principal  If a homebuyer does not have sufficient savings, a mortgage allows the buyer to enjoy the benefits of homeownership without having to wait several years to accumulate savings.  These benefits may justify the large interest expense.  The important thing is that you, as a buyer, understand these 32 costs! 32  Calculating your affordable home price Given the monthly payment you can afford, you can also calculate the most expensive home you can buy.  For example, if you could afford a $1,000 monthly payment, you can buy a $208,490 house with a 6% APR 30-year mortgage with a 20% down payment.  As a quick rule of thumb, your mortgage payment should not be greater than 20-30% of your monthly income.  The chart below shows the house prices different monthly payments can buy. Affordable House Price $1,200,000 $1,042,448 $1,000,000 $800,000 $600,000 $521,224 $400,000 $312,734 $156,367 $208,490 $200,000 $0 $750 $1,000 $1,500 $2,500 $5,000 Monthly Payment 33 33 Affordability ratios Besides the monthly mortgage payment, there are other costs of owning a home. Banks may take these additional costs into consideration and may apply affordability ratios before making a mortgage loan.  Banks apply affordability ratios to determine whether a borrower qualifies for a mortgage of a particular size.  The “housing expense ratio” stipulates that the sum of a borrower’s monthly mortgage payments, property tax, and homeowner’s insurance be no larger than 25-30% of the borrower’s monthly income.  The “total expense ratio” adds in all other monthly debt payments, and lenders generally require that this total be no more than 33-38% of a borrower’s monthly income. 34 34  Affordability ratios Ex. Johnny just graduated from his local community college and got a job nearby as a mechanic with Wardwell Construction paying an annual salary of $60,000. He has a $175 in monthly student loan payment and a $250 in monthly auto loan payment. He’s looking to buy a home and his bank offers to lend to him under the following terms: 6% APR on a 30-year mortgage with 20% down Maximum housing expense ratio of 28% Maximum total expense ratio of 35% Johnny finds a $215,000 house he’d like to buy. Property tax and homeowners insurance are 1.5% and 0.4%, respectively, of the home value per year, but payments must be made to the bank monthly. Will Johnny’s bank lend him the money to buy this house? 35 35 Affordability ratios Ans. After making the 20% down payment of 0.20 ∗ $215,000 = $43,000, Johnny will need to borrow the remaining $172,000. His monthly payment will be $1,031.23: Time Value of Money Use a financial P/Y 12 PV $172,000 calculator for this or N 360 an online mortgage FV $0 I/Y 6.0% loan calculator. PMT= -$1,031.23 This is only about 20% of Johnny’s $5,000 monthly income ($60,000 divided by 12). However, the bank will also consider property tax, homeowner’s insurance, and Johnny’s other debts… 36 36  Affordability ratios Ans. (continued) Johnny has total debt payments of $175 + $250 = $425 per month. Annual property tax and insurance payments are 1.5% and 0.4% of the home price, so the monthly payments are:. 𝑇𝑎𝑥𝑒𝑠 = ∗ 𝐻𝑜𝑢𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 = 0.00125 ∗ $215,000 = $268.75. 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ∗ 𝐻𝑜𝑢𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 = 0.00033 ∗ 𝐻𝑜𝑢𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 = $71.67 37 37 Affordability ratios Ans. (continued) Based on the housing expense ratio of 28%, the following must hold: 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑇𝑎𝑥𝑒𝑠 + 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 ≤ 0.28 ∗ 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐼𝑛𝑐𝑜𝑚𝑒 Inserting the values found above, the left hand side reduces to: $1031.23 + $268.75 + $71.67 = $1,371.65 And the right hand side reduces to: 0.28 ∗ $5,000 = $1,400 Therefore, Johnny satisfies the housing expense ratio. 38 38  Affordability ratios Ans. (continued) For the total expense ratio of 35%, the following must hold: 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑇𝑎𝑥𝑒𝑠 + 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 + 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 ≤ 0.35 ∗ 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐼𝑛𝑐𝑜𝑚𝑒 Inserting the values found above, the left hand side reduces to: $1031.23 + $268.75 + $71.67 + $425 = $1,796.65 And the right hand side reduces to: 0.35 ∗ $5,000 = $1,750 Johnny does not meet the total expense ratio. Therefore, unless it loosens its standards, the bank will not provide a mortgage to Johnny for purchasing the $215,000 house. 39 39 Summary What home to buy/rent? Rent or buy? Rental things to (not) do. The home buying process. Mortgage payments Calculate Amortize mortgage payments Affordability ratios Maximum housing expense ratio of 28% Maximum total expense ratio of 35% 40 40