9.3: Identify the Financing
- Page ID
- 112082
\( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)
\( \newcommand{\dsum}{\displaystyle\sum\limits} \)
\( \newcommand{\dint}{\displaystyle\int\limits} \)
\( \newcommand{\dlim}{\displaystyle\lim\limits} \)
\( \newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\)
( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\)
\( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\)
\( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\)
\( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\)
\( \newcommand{\Span}{\mathrm{span}}\)
\( \newcommand{\id}{\mathrm{id}}\)
\( \newcommand{\Span}{\mathrm{span}}\)
\( \newcommand{\kernel}{\mathrm{null}\,}\)
\( \newcommand{\range}{\mathrm{range}\,}\)
\( \newcommand{\RealPart}{\mathrm{Re}}\)
\( \newcommand{\ImaginaryPart}{\mathrm{Im}}\)
\( \newcommand{\Argument}{\mathrm{Arg}}\)
\( \newcommand{\norm}[1]{\| #1 \|}\)
\( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\)
\( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\AA}{\unicode[.8,0]{x212B}}\)
\( \newcommand{\vectorA}[1]{\vec{#1}} % arrow\)
\( \newcommand{\vectorAt}[1]{\vec{\text{#1}}} % arrow\)
\( \newcommand{\vectorB}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\( \newcommand{\vectorC}[1]{\textbf{#1}} \)
\( \newcommand{\vectorD}[1]{\overrightarrow{#1}} \)
\( \newcommand{\vectorDt}[1]{\overrightarrow{\text{#1}}} \)
\( \newcommand{\vectE}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash{\mathbf {#1}}}} \)
\( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)
\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Define the effects of the down payment on other housing costs.
- Calculate the monthly mortgage payment, given its interest rate, maturity, and principal balance.
- Distinguish between a fixed-rate and an adjustable-rate mortgage, and explain their effects on the monthly payment and interest rate.
- Distinguish between a rate cap and a payment cap, and explain their uses and risks.
- Determine the effect of points on the monthly mortgage payment.
- Identify potential closing costs.
Just as your house may be your most significant purchase, your mortgage may be your most significant debt. The principal is likely far more than your short-term disposable income. It may need to be paid over a period of fifteen to thirty years. The house secures the loan, so if you default or miss payments, the lender may foreclose on your house or claim ownership of the property, evict you, and resell the house to recover what you owe. You may lose not only your house but also your home.
Banks, credit unions, finance companies, and mortgage finance companies sell mortgages. They profit by lending and competing for borrowers. It makes sense to shop around for a mortgage, as rates and terms (i.e., the borrower's costs and conditions) may vary widely. The Internet has made it easy to compare; a quick search for "mortgage rates" yields many websites that provide national and state averages, lenders in your area, comparable rates and terms, and free mortgage calculators.
You may feel more comfortable obtaining your mortgage through your local bank, which may process the loan and then sell it to a larger financial institution. The local bank typically continues to service the loan and collect payments. Still, these cash flows are then passed through to the financial institution (usually a much larger bank) that has purchased the mortgage. This secondary mortgage market enables your local bank to have more liquidity and reduced risk, as it is repaid promptly, allowing it to make more loans. As long as you continue to make your payments, your only interaction is with the bank that services the loan. Alternatively, local banks may earmark a percentage of mortgages to keep "in-house" rather than sell.
The U.S. government assists some groups, such as Native Americans, Americans with disabilities, and veterans, in obtaining home loans. Veterans can find resources at the U.S. Department of Veterans Affairs (VA) Home Loans (www.benefits.va.gov/homeloans/).
Please note that the costs discussed in this chapter, which are associated with various types of mortgages, are subject to change. The real estate market, government housing policies, and government regulation of the mortgage financing market may change. When shopping for a mortgage, it is essential to stay informed about the latest developments.
Down Payment
Mortgages typically require a down payment, which is a percentage of the purchase price paid in cash at the time of purchase. Most buyers fund the down payment with money from savings, another home sale, an inheritance, a windfall like lottery winnings, or a family gift.
The size of the down payment does not directly affect the price of the house, but it can impact the cost of financing. For a certain house price, the larger the down payment, the smaller the mortgage and, all things being equal, the lower the monthly payments. An example of a thirty-year mortgage is shown in Table 9.3.1 .
| Purchase Price | % Down | Mortgage | Mortgage Rate | Mortgage Payment |
|---|---|---|---|---|
| $ 250,000 | 5.00% | $ 237,500 | 5.00% | $ 1,274.95 |
| $ 250,000 | 10.00% | $ 225,000 | 5.00% | $ 1,207.85 |
| $ 250,000 | 20.00% | $ 200,000 | 5.00% | $ 1,073.64 |
| $ 250,000 | 30.00% | $ 175,000 | 5.00% | $ 939.44 |
| $ 250,000 | 40.00% | $ 150,000 | 5.00% | $ 805.23 |
| $ 250,000 | 50.00% | $ 125,000 | 5.00% | $ 671.03 |
Typically, if the down payment is less than 20 percent of the property's sale price, the borrower is required to pay for private mortgage insurance (PMI). If a borrower defaults on a mortgage that includes PMI, the lender is insured against loss. A larger down payment generally eliminates the need for PMI, saving the borrower that expense.
A larger down payment can offset the annual cost of the financing, but it may create opportunity costs and decrease liquidity. Cash will also be required for the closing costs (transaction costs) of this purchase, as well as for any immediate renovations or repairs. Those needs will have to be weighed against your available cash to determine the amount of your down payment.
Monthly Payment
The monthly payment is the ongoing cash flow obligation to the loan. If you fail to make this payment, you will default on the loan and may eventually lose the house, with no compensation for the money you have already invested in it. Your ability to make the monthly payment determines your ability to keep the house.
The interest rate and the maturity (lifetime of the mortgage) determine the monthly payment amount. With a fixed-rate mortgage, the interest rate remains constant throughout the entire mortgage term, and so does the monthly payment. Conventional mortgages are fixed-rate mortgages for thirty, twenty, or fifteen years.
The longer the term, the greater the interest rate, because the lender faces more risk the longer it takes for the loan to be repaid.
A fixed-rate mortgage is structured as an annuity: regular periodic payments of equal amounts. Some of the payment is repayment of the principal, and some is for interest expense. As you make a payment, your balance gets smaller, so the interest portion of your next payment is smaller, and the principal payment is larger. In other words, as you continue making payments, you are paying off the loan balance faster and paying less interest.
An example of a mortgage amortization, or a schedule of interest and principal payments over the life of the loan, is shown in Table 9.3.2 . The mortgage is a thirty-year, fixed-rate mortgage. Only year one is shown, but the spreadsheet extends to show the amortization over the term of the mortgage.
| End of Month | Payment | Interest Expense | Principle Paid | Balance |
|---|---|---|---|---|
| $ 200,000.00 | ||||
| 1 | $ 1,264.14 | $ 1,083.33 | $ 180.80 | $ 199,819.20 |
| 2 | $ 1,264.14 | $ 1,082.35 | $ 181.78 | $ 199,637.42 |
| 3 | $ 1,264.14 | $ 1,081.37 | $ 182.77 | $ 199,454.65 |
| 4 | $ 1,264.14 | $ 1,080.38 | $ 183.76 | $ 199,270.89 |
| 5 | $ 1,264.14 | $ 1,079.38 | $ 184.75 | $ 199,086.14 |
| 6 | $ 1,264.14 | $ 1,078.38 | $ 185.75 | $ 198,900.39 |
| 7 | $ 1,264.14 | $ 1,077.38 | $ 186.76 | $ 198,713.63 |
| 8 | $ 1,264.14 | $ 1,076.37 | $ 187.77 | $ 198,525.86 |
| 9 | $ 1,264.14 | $ 1,075.35 | $ 188.79 | $ 198,377.07 |
| 10 | $ 1,264.14 | $ 1,074.33 | $ 189.81 | $ 198,147.26 |
| 11 | $ 1,264.14 | $ 1,073.30 | $ 190.84 | $ 197,956.42 |
| 12 | $ 1,264.14 | $ 1,072.26 | $ 191.87 | $ 197,764.55 |
In the early years of the mortgage, your payments are mostly interest, while in the final years, they are mostly principal. It is essential to distinguish between them because the mortgage interest is generally tax-deductible. That tax benefit is greater in the earlier years of the mortgage, when the interest expense is larger.
Monthly mortgage payments can be estimated using the mortgage factor. The mortgage factor is a calculation of the payment per $1,000 of the mortgage loan, given the interest rate and the mortgage maturity. Mortgage factors for 30-, 20-, and 15-year mortgages are shown in Table 9.3.3 .
| Mortgage Amount | Mortgage Rate | 30-Year Mortgage Factor |
20-Year Mortgage Factor |
15-Year Mortgage Factor |
|---|---|---|---|---|
| $ 1,000 | 4.00% | 4.77 | 6.06 | 7.40 |
| $ 1,000 | 4.50% | 5.07 | 6.33 | 7.65 |
| $ 1,000 | 5.00% | 5.37 | 6.60 | 7.91 |
| $ 1,000 | 5.50% | 5.68 | 6.88 | 8.17 |
| $ 1,000 | 6.00% | 6.00 | 7.16 | 8.44 |
| $ 1,000 | 6.50% | 6.32 | 7.46 | 8.71 |
| $ 1,000 | 7.00% | 6.65 | 7.75 | 8.99 |
| $ 1,000 | 7.50% | 6.99 | 8.06 | 9.27 |
| $ 1,000 | 8.00% | 7.34 | 8.36 | 9.56 |
| $ 1,000 | 8.50% | 7.69 | 8.68 | 9.85 |
| $ 1,000 | 9.00% | 8.05 | 9.00 | 10.14 |
The monthly payment can be calculated as
\(\displaystyle{\mathrm{mortgage \enspace factor} \times ( \mathrm{principal} \div 1,000 )}\)
If you purchase a house for $250,000 with a $50,000 down payment and finance the remaining $200,000 with a 30-year, 6.5 percent mortgage, your monthly mortgage payment would be 6.32 × ($200,000 ÷ 1,000) = $1,264. If you choose a 15-year mortgage, your monthly payment would be 8.71 × ($200,000 ÷ 1,000) = $1,742. If you opt for a 30-year mortgage at a 6 percent rate, your monthly payment would be $1,200.
Potential lenders and many websites provide mortgage calculators to do these calculations. You can estimate your monthly payments for a fixed-rate mortgage if you know the mortgage rate, the term to maturity, and the principal borrowed.
Mortgage Designs
So far, the discussion has focused on fixed-rate mortgages, which are mortgages with fixed or constant interest rates and payments that remain unchanged until maturity. With an adjustable-rate mortgage (ARM), the interest rate and the monthly payment can change. If interest rates rise, the monthly payment will increase; if rates fall, the monthly payment will decrease. By federal law, adjustable interest rates cannot increase by more than 2 percent at a time; however, even with this rate cap, homeowners with adjustable rates risk unexpected payment increases. Borrowers can mitigate this interest rate risk by implementing a payment cap; however, this introduces another risk.
A payment cap limits the amount that payments can increase or decrease. That sounds like it would protect the borrower, but if the payment is capped and the interest rate rises, more of the payment goes toward the interest expense and less toward the principal payment, so the balance is paid down more slowly. If interest rates are high enough, the payment may be too small to cover all the interest expense, and any unpaid interest will be added to the mortgage principal balance.
In other words, instead of paying off the mortgage, your payments may increase your debt, and you could end up owing more money than you borrowed, even if you make all your required payments on time. This is called negative amortization. If you have this type of loan, you can voluntarily increase your monthly payment amount to avoid the negative effects of a payment cap.
Adjustable-rate mortgages are risky for borrowers. However, these mortgages are usually offered at lower rates than fixed-rate mortgages and may be more affordable. Borrowers who expect an increase in their disposable income (which would offset the risk of a higher payment) or who expect a decrease in interest rates may prefer an adjustable-rate mortgage, which can have a maturity of up to forty years. Otherwise, a fixed-rate mortgage is generally the better option.
Some mortgages combine fixed and variable rates; these mortgages offer a fixed rate for a specified period, followed by an adjustable rate. Another type of mortgage is a balloon mortgage; these offer fixed monthly payments for a specified period - usually three, five, or seven years - and then a final repayment of the outstanding principal (the balloon payment). An Option Adjustable Rate Mortgage allows the borrower to pay either interest-only or principal and interest for the first few years of the loan. This helps make homeownership more affordable for many buyers. However, although you may save money at first by paying interest only, you are not accumulating stored value, known as equity, in your investment.
As an asset, a house may be used to secure other types of loans. A home equity loan or a second mortgage allows homeowners to borrow against the equity in their home. A home improvement loan is a type of home equity loan. A home equity line of credit (HELOC) enables homeowners to secure a line of credit, or a loan that is borrowed and repaid as needed, with interest paid only on the outstanding balance. A reverse mortgage provides homeowners with long-term equity in their property a monthly income in the form of a loan. A reverse mortgage is a loan against your home that you do not have to repay as long as you live there. To be eligible for most reverse mortgages, you must own your home and be 62 or older. You or your estate repays the loan when you decide to sell the house or if you pass away and the house is sold.
Points
Points are another possible financing cost. One point is equivalent to one percent of the mortgage amount. When the mortgage originates, points can be paid to the lender as prepaid interest. Points are used to decrease the mortgage rate. In other words, paying points is a way of buying a lower mortgage rate.
To decide whether or not it is worth paying points, consider the difference the lower mortgage rate will make to your monthly payment and how long you will be paying this mortgage. When will the points pay for themselves in reduced monthly payments? For example, suppose you have the following choices for a 30-year, fixed-rate, $200,000 mortgage: a mortgage rate of 6.5 percent with no points or a rate of 6 percent with two points.
First, calculate the difference in your monthly payments for each situation. Using the mortgage factor for a 30-year mortgage, the monthly payments in each case would be the mortgage factor × $200,000 ÷ 1,000 or
| Points | Mortgage rate | Mortgage factor | Monthly payment |
|---|---|---|---|
| 0 | 6.50% | 6.32 | 1,264 |
| 2 | 6.00% | 6.00 | 1,200 |
Paying the two points allows you to enjoy a lower monthly payment and saves you $64 per month. The two points cost $4,000 (2% of $200,000). At the rate of $64 per month, it will take 62.5 months ($4,000 ÷ 64) or a little over five years for those points to pay for themselves. If you do not plan on keeping this mortgage for a long time, paying the points is not worth it. Paying points has liquidity and opportunity costs up front that must be weighed against its benefits. Points are part of the closing costs, but borrowers do not have to pay them if they are willing to pay a higher interest rate.
Closing Costs
Another cost of a home purchase is transaction costs, which are the expenses incurred to facilitate the transaction that are not directly related to the home or financing. These are referred to as closing costs, because they are paid at the closing, the meeting between buyer and seller where ownership and loan documents are signed and property is legally transferred. Buyers pay closing costs, which include the appraisal fee, title insurance, and filing fee to record the deed with the county recorder.
The lender will require an independent appraisal of the home's value to guarantee the mortgage amount is reasonable given the value of the house it secures. The lender will also require a title search and contract for title insurance. The title company will research any claims or liens on the deed. The purchase cannot go forward if the deed cannot be freely transferred. Over the mortgage term, title insurance protects against defects not revealed in the original title and any claims that may arise. The buyer also pays a fee to file the property deed with the township, municipality, or county. Some states may also have a property transfer tax that is the buyer's responsibility.
Closings may occur in an escrow office (a neutral third-party office) or a title company office. Closings may also happen in the lender's space, such as a bank or legal office, if the buyer and seller's attorneys are involved in mediation. Real estate attorneys ensure that all legal requirements are met and all filings of legal documents are completed. For example, homebuyers have the right to review a U.S. Department of Housing and Urban Development (HUD) Settlement Statement twenty-four hours before signing at closing. This document, along with a Truth-in-Lending disclosure statement, outlines and explains all the terms of the transaction, including the costs of buying the house and all closing costs. The buyer and seller must both sign the HUD document and are legally bound by it.
- The percentage of the purchase price paid upfront as the down payment will determine the amount borrowed. That principal balance on the mortgage, in turn, determines the monthly mortgage payment
- A larger down payment may make the monthly payment smaller, but it creates the opportunity cost of losing liquidity
- A fixed-rate mortgage is structured as an annuity; the monthly mortgage payment can be calculated from the mortgage rate, the maturity, and the principal balance on the mortgage
- A fixed-rate mortgage has a fixed mortgage rate and fixed monthly payments
- An Adjustable-Rate Mortgage may have an adjustable rate and/or adjustable payments
- A rate cap or a payment cap may be used to offset the effects of an ARM on monthly payments
- Points are borrowing costs paid upfront (rather than over the maturity of the mortgage)
- Closing costs are transaction costs such as an appraisal fee, title search and title insurance, filing fees for legal documents, transfer taxes, and sometimes agent real estate commissions
- You are considering purchasing an existing single-family house for $500,000 with a 20 percent down payment and a 30-year fixed-rate mortgage at 6 percent.
- What would be your monthly mortgage payment?
- If you decided to buy two points for a rate of 5.5 percent, how much would you save in monthly payments? Would it be worth it to buy the points? Why, or why not?
- Review the explanation of adjustable-rate mortgages consumer guide (www.federalreserve.gov/pubs/arms/arms_english.htm) written by the U.S. Federal Reserve (the Fed). According to the Fed, why should you be cautious about adjustable-rate mortgages?
- Do you presently rent or own your home or condo? What are your housing costs? What percent of your income is taken up by housing costs? If housing costs you more than a third of your income, what could you do to reduce that cost? Record your alternatives in your personal finance journal.
- As a prospective homeowner, what would be your estimated PITI? Would a bank consider you qualified for a mortgage loan at this time? Why or why not? What criteria do lenders use to determine your eligibility for a home mortgage?
- Can you afford a mortgage now? How much of a mortgage could you afford? Answer these questions using online mortgage affordability calculators. If you cannot afford a mortgage now, how would your situation and/or your budget need to change to make that possible? Establish home affordability as a goal in your financial planning. When do you expect to reach that goal? Write an estimated date in your journal.
- Read 12 Steps of a Real Estate Closing (www.investopedia.com/articles/mortgages-real-estate/10/closing-home-process.asp). According to Investopedia, who attends the closing? What legal documents are processed at the closing?
- Review affordable local real estate, condo, or apartment listings. Choose a home you'd like to own and do some research for your personal finance journal.
- Record the purchase price
- Determine the down payment you would make
- Calculate the mortgage amount you would seek
- Determine the current interest rates on a mortgage loan for fixed- and adjustable-rate mortgages for various periods or maturities
- Select the type of mortgage you would prefer
- Determine the rate and maturity you would seek
- Determine the points you would buy (if any)
- Calculate the number of monthly mortgage payments you would expect to make
- Select the names of lenders you would consider approaching for a loan