FHCE 3300 1st Edition Lecture 8Outline of Last Lecture I. Advantages and Disadvantages A. Owning a HomeB. Renting a HomeII. The Rental ProcessIII. The Home Buying Process A. Self-evaluationA. Credit HistoryB. Pre-qualificationC. Mortgage Pre-approvalD. Real Estate Agent AssistanceE. Purchase OfferF. Mortgage FinancingG. Home InspectionH. ClosingOutline of Current Lecture I. House PaymentsII. Front-end RatioIII. Back-end RatioThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.IV. The Three-Legged Stool of Housing EquityA. Down PaymentB. Principal Drawdown C. House Price Appreciation V. Mortgage LoansA. Mortgage FinancingB. Interest RatesC. Loan TermD. Types of Mortgage LoansA. Fixed-rateB. Adjustable-rateCurrent LectureI. House Payments- House payments = (PITI)- Mortgage principal- Mortgage interest- Property taxes- Insurance (homeowners and mortgage)II. Front-end Ratio- Shows how much of your gross (pre-tax) monthly income would go toward the mortgage payment- No more than 28% of monthly gross income should be used to cover house payments - Maximum housing expense ratio = annual salary x 0.28/12 (months) Front-end ratio limit for someone making o $35,000 a year = 35,000 x 0.28 = 9800/12 = 816.66o $50,000 a year = 50,000 x 0.28 = 14,000/12 = 1166.66o $75,000 a year = 75,000 x 0.28 = 21,000/12 = 1750- Ex:  Annual salary = $80,000 Estimate house costs o Principal and interest = $1,045o Taxes = $200o Insurance = $69 (homeowners) Annual salary = 80,000 x 0.28/12 = $1,866.66 Housing costs = $1,314III. Back-end Ratio- No more than 36% of monthly income should be used to cover total debt payments- Total debt payments = proposed home mortgage payment and credit card obligations, car payments, student loans, other debt- Maximum allowable debt-to-income ratio = annual salary x 0.36/12 (months) Back-end ratio limit for someone makingo $35,000 a year = 35,000 x 0.36 = 12600/12 = 1050o $50,000 a year = 50,000 x 0.36 = 18,000/12 = 1500o $75,000 a year = 75,000 x 0.36 = 27,000/12 = 2250- Ex: Lexus payment = $960/month Student loan payment = $100 Credit card debt payment = $75 Total = $2,449 Back-end ratio = 80,000 x 0.36/12 = $2,400IV. The Three-Legged Stool of EquityA. Down Payment- Doesn’t change once mortgage is originated- Banks usually like a large down payment- Some borrowers like to improve their leverage by lowering their down payment- Mortgage insurance implications at down payment < 20% of house price  Mortgage insurance policy protects your lender in case you default on the payments. As a borrower, you pay the premiums, and the lender is the beneficiary - Ex: A consumer buys a $225,000 house. How much does she need to put down to avoid payment mortgage insurance? 20% = 225,000 x 0.20 = $45,000- Ex: Mike buys a $400,000 house. How much is a 10% down payment? How much is a 20% down payment? $400,000 x 0.10 = $40,000; $400,000x 0.20 = $80,000 B. Principal Drawdown - The amount of principal that you have paid down from your mortgage over time- The best way of computing this part of the equity puzzle is to subtract your current mortgage amount from the original mortgage amountC. House Price Appreciation- While the other 2 legs of the house price appreciation stool are controlledby you, the market appreciation rate is largely outside your control. What market factors affect house price appreciation rates? Location, surroundings, school systems, economy- HPA = [(Initial house price) x (1+Y1 appreciation) x (1+Y2 appreciation) x (1+Y3 appreciation) x (1+Y4 appreciation)] – initial house price - Ex: Mike buys a $400,000 house. Assume that house prices take the following pattern during the first 4 years that he lives in the house. Year 1: 3% increase Year 2: 4% increase Year 3: 1.5% increase Year 4: 2.5% increase HPA = [(400,000) x (1+0.03) x (1+0.04) x (1+.015) x (1+.025)] – 400,000 = $32,604V. Mortgage LoansA. Mortgage Financing- Most real estate purchases are financed with mortgages- Mortgage is a  Long-term loan on real property, which serves as collateral for loan Legal document that allows lender to remain title or place a lien orclaim on the title and gives the lender the right to demand full payment if borrower fails to make payments- Securing a mortgage includes decisions about: down payment amount, mortgage type, loan term, interest rate B. Interest Rates- Interest rates on prime loans are tied to the bond market- Individual credit scores also influence the interest rate for mortgage loans- Prime vs. subprime C. Loan Term- Length of the loan- Typically 15 or 30 yearsD. Types of Mortgage LoansA. Fixed-rate- Interest rate is set at the start of the mortgage and remains unchanged through the life of the mortgage- Principal and interest payment remains the same- Length of the loan terms can vary: 30 years, 15 years - Pros:  No surprises. Rate and payment stays the same Easier to budget Easy to understand- Cons: Can be more expensive initially Requires re-financing to take advantage of drop in interestrates B. Adjustable-rate- Initial interest rate and payment – In effect for a period of time. After this period, rates and payment change drastically even if interest rates are stable- Adjustment period – The period between rate changes. A loan with a one year adjustment period is called a “1 year ARM”- Index – Interest rate is made up of 2 parts: index and margin. Index is the measure of interest rates- Margin is the extra percentage points added by the lender- Interest rate caps: Periodic adjustment cap, lifetime cap- Hybrid ARMS: Have a fixed rate period and an adjustable rate period  3/1 ARM, 5/1 ARM 1st number tells you the fixed rate period, second number is adjustment period- Interest only ARMS – Pay only interest for a set number of years - Pros: Lower interest rates and payments early on Borrowers can sometimes take advantage of low and falling rates without re-financing More money available, can use for other investments- Cons: Interest rate can increase substantially over time, which will increase the payment Difficult to understand loan terms Some ARMS result in negative