Chapter 9:
The Housing Expenditure
Objectives

Discuss the options available for rented
and owned housing and whether renters
or owners pay more for housing.

Determine how much buyers can afford
for housing.

Discuss the various mechanisms for
financing a home.
Objectives

Identify the numerous costs of buying a
home, including principle, interest, and
closing costs.

List and describe the steps in the homebuying process.

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

Advantages
 Mobility
 Fewer responsibilities
 Lower costs initially
 More amenities

Disadvantages
 Few financial benefits
 Restricted lifestyle
 Cost of renting - deposits
 Legal concerns of a lease
Largest Physical Capital Investment Made by a
Family is a HOUSE.

Home Ownership rates 2012:
 US = 65.4% (lowest since 1997)
 Utah = 71.5%

Since 1900, home ownership has been in
excess of 40% in the U.S.
The Percentage of Families Owning Homes Over
Time
%
70
64.4 64.2
61.9 62.9
60
67.4 68.8
66.9
55
50 46.7 45.7 45.6 47.8
43.6
40
30
20
10
0
1900
1920
1940
1960
1980
2000
2010
Housing Prices are determined by Supply &
Demand

Demand




Average household size down
Average income up
Availability of substitutes down
Life cycle stage of housing
 Childhood home, apartment, starter home,
family home, empty nest home, retirement
home, institutionalization or back to family,
burial vault

Supply
 Business cycle
Advantages of Owning


Pride of ownership
 American dream/norm
Reduced income taxes
 deduct property taxes
 deduct mortgage interest
Advantages of Owning





(continued)
Build an equity
 pay down the loan
 price appreciation
Builds your credit rating
Forced savings-portion of mortgage payment
goes toward building up equity.
Hedge against inflation
Lifestyle flexibility
 can express your individuality
Disadvantages of Owning



Financial risk
 need down payment
 home prices could drop
 Opportunity cost of money tied up in
purchase.
Limited mobility
 can take time to sell
Higher living costs
 maintenance
 repairs & improvements
 utilities & insurance
 real estate taxes
Renting vs. Owning Your Home

WHO PAYS MORE:
 Based on cash flow, renters appear to win
 After taxes and appreciation, owners usually
win
A Cost-Benefit Approach (CBA)
to the home ownership decision

1. What is the time period over which the household plans to
own/rent?

2. What are the one-time fixed costs associated with
purchasing the home?
 down payment
 closing costs (e.g., points, fees)
 Do you pay these costs if you are renting?
A Cost-Benefit Approach (CBA)
to the home ownership decision

3. What are the recurring (i.e., monthly) NET costs associated with
owning compared to renting?
 How much more does it cost you to own than to rent every single month? You
want to get that money back at the end…
 Sum of owning costs (mortgage payment, property taxes, hazard

insurance, operating and maintenance expenses) minus tax savings
 Sum of renting costs (rent, operating expenses)
4. What will the outstanding loan balance be at the end of the time
period?
 You have to pay off your loan when you sell

5. What will the estimated selling costs be at the end of the time period?
 You need to pay a realtor, and you want to get those dollars back
A Cost-Benefit Approach (CBA)
to the home ownership decision

6. Place all of these costs into future value dollars using 3% real interest rate
 Remember, all of our dollars have to be at one point in time – we are putting all of our
dollars in to the future
 One-time costs (because these costs are one-time costs):
FV=PV(1+r)n
 Recurring costs (because these costs happen every single month):
 Loan balance (already in future dollars; do not need to use a formula):
 1  r n  1

Selling
costs:
FVA  PV



r


Add up the one-time costs, recurring costs, loan balance, and selling costs, for the total
costs expressed in future value terms


This equals the minimum required future value of the home, or the break even price
This is how much you have to sell your home for in the future in order to get back all of the
dollars that you have spent
A Cost-Benefit Approach (CBA)
to the home ownership decision

7. Compute the interest rate
 This interest rate is the annual rate of
appreciation that will have to occur if you are to
break even on purchasing a house rather than
renting for n years.
 This converts the dollar amount into an interest
rate, so that you can compare your housing
investment with other types of investments
1
n
 FV 
r 
 1
 PV 
DECISION RULE -

If the forecasted rate of housing appreciation is greater than
the calculated interest rate, then economic benefits of home
ownership outweigh the economic costs.
 So, buy the house

If the forecasted housing appreciation rate is less than the
calculated interest rate, then the economic costs of home
ownership outweigh the economic benefits.
 So, rent
Example



Original Purchase Price = $100,000
1. Time period = 8 years
2. One-time fixed costs:
 Down Payment = $10,000
 Closing Costs = $3,000
 Total = __________

3. Recurring Net costs
 Sum of owning costs – tax savings = $1200
 Sum of renting costs = $900
 Net Costs = $1200 - $900 = _______


4. Loan balance: $81,900 (get from amortization table)
5. Selling Costs: $6,000
Example



6. FV of one-time
costs =
FV=13000(1+.03)8

=$16,468
FVA of recurring costs
(with monthly
compounding) =

= $32,504
 1  .002596  1
FVA  300 

.
0025


Example

6. Now, add up all of the future costs:
 FV
 FVA
 Loan Balance
 Selling Costs

= $136,872 ($16,468 + $32,504 + $81,900 +
$6,000)
Example


7.
 136,872 
r 

 100,000 
= 0.04 or 4%
1
8
1
Example


Decision =
if forecasted housing appreciation rates
are higher than 4%, you should buy this
house
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

Single-family dwelling
 tract housing
 built on speculation by builder
 built to your specifications
 previously lived in home
 manufactured home
 mobile home
Home Buying Process Step 1:
Determine Ownership Needs

How much you can afford
 down payment
 loan amount
 size and quality
 handyman’s special
 sweat equity
Home Buying Process Step 2:
Finding and Evaluating a Property to Purchase

Select a location
 Zoning laws
 Covenants, codes and restrictions
 Using a real estate agent
 Property appraisal
 Conducting a home inspection
9-15
Home Buying Process Step 3:
Pricing the Property



Determining the price to offer
Negotiating the purchase price
 seller’s or buyer’s market
 earnest money
Contingency clauses
 home passes
structural inspection
 able to get a loan
Estimating Mortgage Loan Payments
for Principal and Interest
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
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.
Effect of Down Payment
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
Amount
Of Loan
$145,000
140,000
135,000
Monthly
Payment
$964.69
931.42
898.16
20,000
130,000
864.89
25,000
125,000
831.63
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
Type of Mortgages



Conventional
 fixed rate, amortized
 5, 10 or 20 percent down
 15, 20 or 30 years of fixed payments
Government guaranteed
 Veterans Administration
 Federal Housing Administration
Adjustable rate mortgages
 varies with the prime rate but has a rate cap
Type of Mortgages



(continued)
Graduated payment
 payments start lower and go up
 for persons whose income will increase
Balloon
 fixed monthly payments plus one large
payment, usually after 3, 5 or 7 years
Growing equity
 payment increases to allow loan to be
paid off more quickly
Type of Mortgages

(continued)
Shared appreciation
 borrower agrees to share appreciated
value of the home with the lender
 Home equity loans
 a second mortgage
 home is collateral and interest may be tax
deductible
 Reverse
 a loan based on the home equity
 Refinancing
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, 40year, 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
Fixed rate FHA or VA mortgage

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, + 0.50% 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
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: $1199.10
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)
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
$1330.60)
 After 2 years, payment goes to $1000
 After another 2 years, payment goes to $1200
 Then payment is $1553.60 for the rest of the loan (24 years)
Interest Payments on a Graduated Payment
Mortgage

Month 1:
 payment = $800.00
 interest owed: $200,000(.07/12) = $1166.67
 loan increased by: $1166.67 - $800 = $366.67

Month 2:
 payment = $800.00
 interest owed: $200,366.67(.07/12) = $1168.81
 loan increased by: $1168.81 - $800 = $368.81

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
Summary: Economic Costs and Economic Benefits of Various Mortgage
Instruments Depend Upon...

Life cycle stage
 Business cycle stage
 Risk tolerance
 Liquidity needs
How do those mortgages stack
up?
Loan Type Interest
Rate
Monthly
Pmt
5/1
Interest
Only
$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
6.29%
Compared r pd in 5
to a 30-yr yrs
Equity
created in
5 yrs
$3,983
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
Home Buying Process Step 4:
Obtaining Financing



Determine the amount of down payment
 mortgage insurance
Qualifying for a mortgage
 can be pre-qualified based on income, assets,
debts, credit history and length of loan
 purpose of “points” (prepaid interest)
The home loan application process
 fixed or adjustable rate mortgage
 locking in an interest rate - search Web
Qualifying for a Mortgage

Amount available for down payment
 Amount of income
 Amount of other debts
 Credit rating
 Current mortgage rates
 Length of loan desired
Home Buying Process Step 5:
Closing the Purchase Transaction

Closing Costs









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
 Down payment
 Mortgage application
 Points
 Closing costs
 TIPI (taxes, insurance, principal, interest)
 Maintenance costs
Selling Your Home




Preparing your home
Determining the asking price
 Appraiser
 Realtor
For sale by owner or use a broker
Listing with a real estate agent
Make Sure Security
Deposit Is Returned






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

Listing agent

Selling agent

Buyer’s agent

Dual agent