Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
Buy vs. Rent
1. What are the advantages of home ownership? Please include the tax benefit(s).
Owning a home has many advantages. There are personal and financial advantages to home
ownership. Home owners have a more stable monthly housing expense. There are also tax
benefits that go along with owning a home. Home ownership is a tax shelter and tax rates favor
homeowners. As long as your mortgage balance is smaller than the price of your home,
mortgage interest is fully deductible on your tax return. Interest is the largest component of your
mortgage payment. Owning a home can save consumers thousands of dollars in taxes. Under
federal law, homeowners may deduct the interest paid on a mortgage loan. There are also other
advantages to home ownership such as privacy and the ability to remodel
2. What are the disadvantages of home ownership?
There are also disadvantages to homeownership. When you own a home, you are responsible
for all of the maintenance. Maintenance expenses can be unpredictable and vary from month
to month. Down payment and closing costs can also be very expensive. In addition, if the house
is sold in a down market, you might actually lose money on the house. The risks of foreclosure
and bankruptcy come along with homeownership. In today’s economy, this is a serious risk.
3. “Is home ownership a good investment?” is a question that will receive a “yes” from some and
“no” from others. Use the “Real Estate Buy vs. Rent” Excel spreadsheet and the information
below to determine whether home ownership is a good investment considering the facts
provided below:
a. Rent a house for $1,200 per month or buy the same house for $160,000, 20% down
payment, 6% interest rate, monthly payments, 30 year amortization
b. 25% Income Tax Bracket or Rate
c. Annual After-Tax Investment Return: 6%
d. Expected Annual Appreciation of Real Estate: 3%
e. Real Estate Taxes: $2,000 annually
f. Property Insurance: $500 annually
g. Repairs: 1% of value of property
Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
Buy vs. Rent
Federal Marginal Tax Rate
State Marginal Tax Rate
Annual After-Tax Investment Rate
Estimated Appreciation of Property
Gray: Input
Yellow-- formula in the cell, please understand formulas
25.00%
25.00%
6.00%
3.00%
Buy Information
Value
%
downpay
$ 160,000 ment
$
Downpay
20.00% ment
$
Mortgage
32,000 Amount
Rent
1,200.00
Monthly Rent Expense or Mortgage Payment
$
Annual Rent Expense or Mortgage Payment
Real Estate Taxes
Property Insurance
Repairs and Maintenance @ 1% of Value
Cash Outflow before investment
income, income taxes, and
appreciation considerations
$ 14,400.00
$ 14,400.00
$
$
128,000 Years
Rate
Buy
767.42
$
$
$
$
9,209.10
2,000.00
500.00
1,600.00
$
13,309.10
30
6.00%
Should you Buy or Rent? The Facts
a. Rent: $1500 per month or buy the
same house for $200,000, 20%
downpayment, 6% mortgage, monthly
payments, 30 year amortization
b. 15% federal; 5% state tax brackets
c. after-tax return: 7%
d. Expected appreciation of real estate:
4%
Benefits
Income from Investments- investing
the downpayment money
$
e. real estate taxes: $2200
960
Principal Repaid on the Mortgage
$1,572
f. insurance: $600
g. repairs: 1% of value
Tax Benefit from Real Estate Taxes
Tax Benefit from Mortgage Interest
1st Year Interest Expense
$
$
$7,637.24
Estimated Appreciation of Property
Net Cost- 1st Year
1,000
3,819
$ 13,440.00
$
4,800
$
2,118.62
Home ownership is a good investment for these people because they will spend $2,118.62 in
their first year as home owners. If they would have rented, they would have spent $13,440 in
the first year as renters.
4. What is the importance of the tax bracket in determining buy vs. rent?
If you are in a higher tax bracket, and write off loan amounts and possibly home improvement
expenses these write offs can bring you into a lower tax bracket.
5. What is the purpose of using an amortization schedule in determining buy vs. rent?
An amortization schedule shows each mortgage payment over a certain number of years
required to amortize the mortgage loan. If someone buys a home, they will have a mortgage.
By using an amortization schedule, you can determine exact mortgage payments and how much
is left on the mortgage at any given point. For a thirty year mortgage, the amortization schedule
is for 360 months.
6. If you were to select one variable or assumption or fact that drives whether buying a home is a
good investment, what would it be? Explain.
It is important to understand that there is a difference between price and value. As the housing
market goes up and down, so does the price of homes. If the housing market is doing really
Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
well, a home might be on the market for a high price. For example, several years ago, home
prices were very high. Now that the housing market has crashed, home prices are much lower.
This has not necessarily changed the value of the home.
How Much House Can You Afford?
1. What rules of thumb or ratios are used by lenders to determine how much house (i.e. the
maximum mortgage payment) you can afford?
Lenders look at debt ratios such as front-end ratios and back-end ratios. The front-end ratio
tells a lender the payment a buyer can reasonably afford. The back-end ratio reflects a new
mortgage payment, plus all recurring debt. Other variables such as home sales price
affordability, down payments, payment comfort levels, and incomes are used to determine how
much house someone can afford.
2. Are these rule-of-thumb or ratios the methods you should use to determine how much to spend
on a house? Explain.
These ratios can be used to determine how much you can afford but other factors should be
considered as well. Factors such as the actual value of the home, tax bracket, opportunity costs,
and expected rate of appreciation should all be considered when purchasing a new home as
well.
Mortgage
1.
Traditionally, 15 year and 30 year mortgages have been the most common. What are the
advantages of a 15 year mortgage? 30 year mortgage? Check the appropriate box and write
any narrative to justify your answer.
A fifteen year mortgage will allow you to own the home in half the time. In addition, you will
spend much less money on interest. You will also receive a lower interest rate for a fifteen year
mortgage than a thirty year mortgage. Thirty year mortgages can be good for people that do
not have much money to spend monthly. Monthly mortgage payments on thirty year
mortgages are much lower.
15 Year
Lower interest rate
Lower mortgage payment
Loan paid off sooner
Risk added due to high payment
Risk added due to longer # of PMTS
Greater Tax Benefit
Lower risk because you know your investment return*
*Please see your instructor for more details about this.
30 Year
X
X
X
X
X
X
Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
A colleague and friend are debating the following mortgage choices: 15 year mortgage, 6.75% OR 30
year mortgage, 7.00%-- loan amount is $160,000, Income Tax Bracket: 25%, Assumed Annual Rate of
Return on Investments: 6%
2. Your colleague believes a 15 year mortgage is better than a 30 year mortgage. Argue against your
colleague.
If you have less money to spend each month, a thirty year mortgage is the best bet. Thirty year
mortgages have much lower monthly payments than fifteen year mortgages. If you are expecting to
make much more money down the road, a thirty year mortgage is the best bet.
3. Your friend believes a 30 year mortgage is better than a 15 year mortgage. Argue against your friend.
With a fifteen year mortgage, you can own the house in half the time. While the monthly mortgage
payments might be higher, the interest rate will typically be lower. You end up paying less than half the
interest over the life of the loan. If you can afford the higher monthly payment, it is well worth it. You
will pay much less interest and many believe that offsets the downfall of a higher monthly payment.
With a fifteen year mortgage, you build more equity, you own the home in half the time, and most
importantly, you save more than half the amount of interest.
4. Do you believe your friend or colleague? Explain. Note: To answer this question, you really need to
use Excel; however, for this course, this level of detail is not required for this task.
We believe that the colleague is right in saying a fifteen year mortgage is better. Ultimately, you will
spend less money with a fifteen year mortgage. You will have a lower interest rate and have a much
shorter period of time in which you have to pay interest.
5. You pay $1,000 in mortgage interest and are in the 25% tax bracket. Your friend pays $1,000 in
mortgage interest and is in the 15% tax bracket. Who benefits the most from the mortgage interest
deduction? Explain.
Tax benefit=interest expense*tax bracket.
We would have a more benefit than my friend. This is because I am in a higher tax bracket. My tax
benefit would be $250 while my friend’s tax benefit would be $150.
6. What are closing costs? List and define the most common types of closing costs and approximate
costs for each type of closing cost.
Closing costs are fees and expenses that buyers and sellers incur during the transfer of property
ownership. Closing costs can add up to be thousands of dollars. They usually end up costing between
3% and 6% of the price of the home. Examples of closing costs are points or loan origination fees,
escrow fees, homeowner’s insurance, title insurance, property taxes, legal fees, and notary. Points or
loan origination fees is an up-front payment of the interest that you owe your lender. They can cost up
to 3% of the loan. Escrow fees are the fees that are charged to process all of the paperwork and keep
the money in a safe place while you and the seller dicker over things. They can cost up to a couple
thousand dollars. Homeowner’s insurance can cost between five-hundred and two thousand dollars
Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
depending on the value of the home. Title insurance will cost between five-hundred and two thousand
dollars and will cover you discover that the person who sold you the house didn’t really own it. You may
need to reimburse the previous owner for property taxes already paid. You may or may not have to pay
legal fees depending on whether you use a lawyer or not. A notary involves someone assuring that you
are who you say you are. A notary will cost roughly fifty dollars.
7. Define a “point” in relation to obtaining a loan. Under what circumstance(s) is it a good idea to pay a
point.
Points are a form of prepaid interest. One point is equivalent to one percent of a loan amount. It might
be a good idea to pay a point if a borrower wants to reduce the interest rate on a loan. If a borrower
pays a point, they monthly mortgage payment will go down. If interest rates are going up, it might be
smart to pay a point. Points may also be paid to reduce the monthly payment for the purpose of
qualifying for a loan.
8. You have two options: 1) $200,000, 30 year fixed-rate mortgage, monthly payments, 6.5 percent
interest OR 2) $200,000, 15 year fixed-rate mortgage, monthly payments, 7.0 percent interest, 1 point.
Compare the two mortgage payments. How long will it take to recoup the 1 point?
(EXCEL sheet from website) It would take 3.75 months to recoup the one point.
9. ARM—Adjustable Rate Mortgage
a. What is an ARM—adjustable rate mortgage?
An adjustable rate mortgage is a mortgage loan that has occasional interest rate adjustments.
The initial interest rate of an ARM is lower than that of a fixed rate mortgage. An ARM has four
components: an index, a margin, an interest rate cap structure, and an initial interest rate
period.
b. What are the advantages of an ARM?
An adjustable rate mortgage provides you with certain advantages that depend personal
circumstances and the economy. Most adjustable rate mortgages have a fixed rate portion of
the loan. This portion of the loan allows you to enjoy a fixed rate for that period of time that you
choose. This can be really good if the economy is doing well and the rates are low. It is this
feature that could also allow you to get a larger house than you might be able to afford if you
went for a fixed rate mortgage.
c. When should an ARM be considered?
If someone is looking to own a home for a short period of time, an ARM should be considered.
In addition, if someone expects an increase in future earnings, an ARM should be considered.
Lastly, if the economy is doing really well, an ARM might be a good idea.
d. When should an ARM not be considered?
If the economy is really bad, an ARM would probably not be a good idea. If you get locked into
an interest rate and the economy goes down, you would be at a loss.
Group D – FIN 234
Module #16
Regina Antolick, Theo Barbour, Alex Crutchfield,
Chandler Davis, Matt Ingersoll, Stephanie Wallin
10. You are considering a 5/1 ARM. The initial rate is 6%. The cap is limited to 2 percent per year, 5
percent for the life of the loan
a. What will the maximum interest rate equal in three years?
6%
b. What will the maximum interest rate equal in six years?
8%
c. What will the maximum interest rate equal for the life of the loan?
11%
11. You are considering a mortgage with a “60 day lock”. What does this mean?
Locking refers to locking into an interest rate. While a loan application is being considered, many
lenders will offer a lock which is a rate-lock or rate commitment. Lock-ins protect you against interest
rate increases while your application is processed.