Chapter 06 - Mortgages: Additional Concepts, Analysis, and Applications 6-1 Solutions to Questions - Chapter 6 Mortgages: Additional Concepts, Analysis, and Applications Question 6-1 What are the primary considerations that should be made when refinancing? The borrower must determine whether to present value of the savings in monthly payments is greater than the refinancing costs (points, origination fees, costs of (1) appraisal, (2) credit reports, (3) survey, (4) title insurance, (5) closing fees, etc. Question 6-2 What factors must be considered when deciding whether to refinance a loan after interest rates have declined? The payment savings resulting from the lower interest rate must be weighed against the costs associated with refinancing such as points on the new loan or prepayment penalties on the loan being refinanced. Question 6-3 Why might the market value of a loan differ from its outstanding balance? The balance of a loan depends on the original contract rate, whereas the market value of the loan depends on the current market interest rate. Question 6-4 Why might a borrower be willing to pay a higher price for a home with an assumable loan? An assumable loan allows the borrower to save interest costs if the interest rate is lower than the current market interest rate. The investor may be willing to pay a higher price for the home if the additional price paid is less than the present value of the expected interest savings from the assumable loan. Question 6-5 What is a buydown loan? What parties are usually involved in this kind of loan? A buydown loan is a loan that has lower payments than a loan that would be made at the current interest rate. The payments are usually lowered for the first one or two years of the loan term. The payments are “bought down” by giving the lender funds in advance that equal the present value of the amount by which the payments have been reduced. Question 6-6 Why might a wraparound lender provide a wraparound loan at a lower rate than a new first mortgage? Although the wraparound loan is technically a “second mortgage,” the wraparound lender is only required to make payments on the existing mortgage if the borrower makes payments on the wraparound loan. Furthermore, the wraparound lender is typically taking over an existing mortgage that has a below market interest rate. Thus, the wraparound lender is benefiting from the spread between the rate being earned on the wraparound loan and that being paid on the existing loan. This allows the wraparound lender to earn a higher return on the incremental funds being advanced even if the rate on the wraparound loan is less than the rate on a new first mortgage. Question 6-7 Assuming the borrower is in no danger of default, under what conditions might a lender be willing to accept a lesser amount from a borrower than the outstanding balance of a loan and still consider the loan paid in full? If interest rates have risen significantly, the market value of the loan will be less. Thus, the lender may be willing to accept less than the outstanding balance of the loan, especially if the lender still receives more than the market value of the loan. The lender can then make a new loan at the higher market interest rate. Question 6-8 Under what conditions might a home with an assumable loan sell for more than comparable homes with no assumable loans available? The home with an assumable loan might be expected to sell for more than comparable homes with no assumable loans available when the contract interest rate on the assumable loan is significantly less than the current market rate on a loan with similar maturity and similar loan-to-value ratio. Note that if the dollar amount of the assumable loan is significantly less than that which could be obtained with a market rate loan, the benefit of the assumable loan is diminished because the borrower may need to make up the difference with a second mortgage.Chapter 06 - Mortgages: Additional Concepts, Analysis, and Applications 6-2 Question 6-9 What is meant by the incremental cost of borrowing additional funds? The incremental cost of borrowing funds is a measure of what it really costs to obtain additional funds by getting a loan with a higher loan-to-value ratio that has a higher interest rate. This measure is important because the contract rate on the loan with the higher loan-to-value ratio does not take into consideration the fact that this higher rate must be paid on the entire loan - not just the additional funds borrowed. Thus, the borrower should consider the incremental cost of the additional funds to know what it is really costing to borrow the additional funds. Question 6-10 Is the incremental cost of borrowing additional funds affected significantly by early repayment of the loan? The incremental cost of borrowing additional funds can be affected significantly by early repayment of the loan, especially if additional points were paid to obtain the additional funds. Thus, the borrower should consider how long he or she expects to have the loan when calculating the incremental cost of the additional funds. Solutions to Problems - Chapter 6 Mortgages: Additional Concepts, Analysis, and Applications INTRODUCTION The following solutions were obtained using an HP 12C financial calculator. Answers may differ slightly due to rounding or use of the financial tables to approximate the answers. As pointed out in the chapter, there is often more than one way of approaching the solution to the problems in this chapter. Thus “alternative solutions” are shown were appropriate. Problem 6-1 (a) Because the amount of the loan does not matter in this case, it is easiest to assume some arbitrary dollar amount that is easy to work with. Therefore we will assume that the purchase price of the home is $100,000. Thus the choice is between an 80 percent loan for $80,000 or a 90 percent loan for $90,000. The loan information and calculated payments are as follows: Alternative Interest Rate Loan Term Loan Amount Monthly Payments 90% Loan 8.5% 25 yrs. $90,000 $724.70 80% Loan 8.0% 25 yrs. 80,000 617.45 Difference $10,000 $107.25 i(n,PV,PMT,FV) n = 25x12 or 300 PMT = $107.25 PV = -$10,000 FV = 0 Solve for the annual interest rate: i = 12.26% Solving for the interest rate with a financial calculator