Chapter 5 Making Automobile and Housing Decisions Chapter Outline Learning Goals I. Buying an Automobile A. Choosing a Car B. Affordability C. Operating Costs D. Gas, Diesel, or Hybrid? E. New, Used, or "Nearly New"? F. Size, Body Style, and Features G. Reliability and Warranties H. Other Considerations I. The Purchase Transaction J. Negotiating Price K. Closing the Deal L. Refinancing Your Auto Loan *Concept Check* II. Leasing Your Car A. The Leasing Process B. Lease versus Purchase Analysis C. When the Lease Ends *Concept Check* III. Meeting Housing Needs: Buy or Rent? A. Housing Prices and the Recent Financial Crisis B. What Type of Housing Meets Your Needs? C. The Rental Option D. The Rental Contract (Lease Agreement) E. Gauging the General Attractiveness of Renting Versus Buying a Home F. Analyzing the Rent-or-Buy Decision *Concept Check* IV. How Much Housing Can You Afford? A. Benefits of Owning a Home B. The Cost of Homeownership C. The Down Payment D. Points and Closing Costs E. Mortgage Payments a. Affordability Ratios F. Property Taxes and Insurance G. Maintenance and Operating Expenses H. Performing a Home Affordability Analysis *Concept Check* V. The Home-Buying Process A. Shop the Market First B. Real Estate Short Sales C. Using an Agent D. Prequalifying and Applying for a Mortgage E. The Real Estate Sales Contract F. Closing the Deal G. Title Check H. Closing Statement *Concept Check* VI. Financing the Transaction A. Sources of Mortgage Loans B. Online Mortgage Resources C. Types of Mortgage Loans D. Fixed-Rate Mortgages E. Adjustable-Rate Mortgages (ARMs) a. Features of ARMs b. Beware of Negative Amortization c. Implications of the ARM Index d. Monitoring Your Mortgage Payments F. Fixed Rate or Adjustable Rate? G. Other Mortgage Payment Options H. Conventional, Insured, and Guaranteed Loans I. Refinancing Your Mortgage *Concept Check* Summary Financial Planning Exercises Applying Personal Finance How's Your Local Housing Market? Critical Thinking Cases 5.1 The Harrisons’ New Car Decision: Lease versus Purchase 5.2 Evaluating a Mortgage Loan for the Meyers 5.3 Sophia’s Rent-or-Buy Decision Money Online! Major Topics Buying a car is probably the first major purchase most people make. And because people tend to purchase another car every two to five years, it is quite possible that during the course of a lifetime, they will spend more money on cars than on homes. Both car ownership and home ownership are important financial goals for most American families, with the home usually representing the largest single purchase a person or family will make at one time. Housing is a necessity for everyone, and ownership can provide peace and security to a family. The best home is one that fits the needs of the family and is affordable (falls within their budget). Whether buying a car, a home or other major purchase, care should be taken to first research the purchase thoroughly, select the item that best suits one's needs, buy the item after negotiating the best price and arranging favorable financing, and then maintaining and repairing the item as needed. The major topics covered in this chapter include: 1. Purchase considerations and procedures involved in buying an automobile. 2. Evaluating the lease versus purchase decision for automobiles. 3. Description of the alternative forms of housing ranging from single-family home ownership to rental apartments and houses. 4. Procedures for renting a home, including contractual considerations and procedures for making the rent-or-buy decision. 5. Motives for home ownership, including its role as a tax shelter and potential hedge against inflation. 6. The costs of owning a home, including the initial purchase price, closing costs, financing costs, and maintenance. 7. The role of real estate agents in the home search, negotiation, and purchase process. 8. Mortgage loans and other documents and procedures, including disclosure statements, title checks, and closing statements involved in closing a home purchase transaction. 9. Financing the home purchase under the best and most appropriate terms. 10. Deciding when to refinance your mortgage. Key Concepts Purchasing big ticket items, such as an automobile or a home, requires much care and planning. Numerous nonfinancial and financial considerations are involved in the decision whether to buy or lease appropriate and affordable transportation and housing, consistent with your personal financial goals. Additionally, home ownership can represent an appreciating asset that may also provide tax benefits while meeting a family's needs for shelter and security. The following phrases represent the key concepts stressed in this chapter. 1. Automobile purchase or lease transactions 2. Alternative forms of housing 3. Home ownership motives 4. The costs of owning a home 5. Mortgage costs 6. Rental housing procedures and justification 7. Shopping for and negotiating a home purchase 8. Sources and types of mortgage loans 9. Adjustable-rate mortgages 10. Types of loan programs 11. Mortgage refinancing 12. Closing the home purchase deal Answers to Concept Check Questions 5-1. a. Affordability is the starting point for a car purchase. Once you know how much you can afford to buy, operate, and maintain, you can look for models suitable for your needs and budget. b. Operating costs include loan payments, insurance, license fees, repairs, gas, oil, tires, and other maintenance. Some cars are more expensive to operate than others. It is important to consider operating expenses as well as the cost of the car when evaluating affordability. c. Gas, Diesel, or Hybrid? It is important to consider the differences between the costs and performance of differently fueled vehicles and decide which type you want before shopping for a specific new or used car. Generally, diesels are a bit noisier, have less acceleration and more power, and have longer engine lives than traditional gas-powered cars. Hybrids are very economical and less polluting than gas- and diesel-powered vehicles. They do have some disadvantages: high cost of battery replacement, more sluggish acceleration, generally higher repair costs, and typically higher initial purchase price. d. New, Used, or “Nearly New”? Of these three choices, the new car is the most expensive but typically has the best warranty. Used cars cost less, but it can be difficult to accurately assess the mechanical condition of the car. Warranty coverage, if available, covers a shorter time period and may be limited. However, you may be able to afford a better used car than if you bought a new car. The “nearly-new” car is a low-mileage used car, such as a car which has come off rental or a dealer "executive" car, which can offer good value. These cars usually have warranties similar to new cars and cost 25 to 40% less than comparable new cars. e. The choice of size, body style, and features affects the purchase price and operating costs. By selecting the desired options before shopping, you can avoid pressure from the salesperson to buy a car loaded with options you don't want. f. By comparing the reliability records of the cars that interest you, using such publications as Consumer Reports, you can select the car with the lowest need for repairs and hopefully reduce your maintenance costs. Manufacturers who offer longer warranty coverage can also save you money. 5-2. The first step in purchasing a new car is to do research on the types of cars available, their features, price, reliability, and other key factors. Educating yourself in these areas will help to determine which car is best suited for your needs and budget. After narrowing the field, you can visit the dealers who sell the cars of interest to you. Test drive them and then select two or three that best meet your needs. Complete the comparison shopping process before making any offers. Next, negotiate price. To do so wisely, find out the dealer's cost for the car and the options you want; the sticker price is not very meaningful. Sources of dealer's cost figures include Consumer Reports magazine and individual cost reports ordered from Consumer Reports and Kelley Blue Book . Edmund’s is now available on-line at www.edmunds.com. Knowing the dealer's cost enables you to negotiate the lowest possible markup. Also take into consideration any rebates that are offered, deducting the amount from the dealer's cost. Doing your homework before starting price negotiations helps to avoid high-pressure sales tactics that may encourage you to take a deal too soon and should also result in a lower price. Until you negotiate a firm price, be sure not to discuss how you plan to finance the purchase or whether you are trading in your old car. These issues can affect price negotiations. The closing process involves signing a sales contract specifying the offering price and other terms of the sale. Once you and the dealer have accepted and signed the contract, it becomes binding. Some dealers require a deposit at this time. The final step is to arrange financing, pay for the car, and accept delivery. 5-3. Advantages to leasing include the ability to afford a better car for the same payment, no or low down payment, and the ability to turn the car in at the end of the lease period. On the other hand, because you only pay for the use of the car during the lease period, you have no ownership. Terminating the lease early may be difficult and costly. Also, finding out the actual cost factors used to calculate the lease payments can be hard, and there will likely be a penalty if you drive the car more miles than the lease allows. 5-4. Student answers as to leasing or purchasing a car will, of course, vary. 5-5. In addition to single-family homes, other types of housing available in this country include condominiums, cooperative apartments, and rental apartments and houses. Single-family homes, condominiums, and cooperatives offer pride of ownership and the opportunity to benefit from price appreciation. The owner of a condominium receives title to an individual unit and a joint ownership of any common areas and facilities, such as lobbies, swimming pools, lakes, and tennis courts. Since buyers own their units, they arrange their own mortgages, pay their own taxes, and pay for maintenance and building services. They are usually assessed, on a monthly basis, an amount deemed sufficient to cover their proportionate share of the cost of maintaining common facilities. The owners also elect a board of directors to supervise their building and grounds. A cooperative apartment, or co-op, is an apartment in a building in which each tenant owns a share of the corporation that owns the building. Residents lease their units from the corporation and are assessed monthly fees in proportion to their ownership shares, which are based on the amount of space they occupy. These assessments cover the cost of service, maintenance, taxes, and the mortgage on the entire building. The assessment can change depending on the actual costs of operating the building and the actions of the board of directors, which determine the corporation's policies. Rental units may be houses or apartments that are owned by someone else and leased for a set time period. The landlord is responsible for the upkeep, and the renter does not build up equity in the property. 5-6. Student answers will vary. There are advantages and disadvantages to both renting and buying. Commonly cited advantages of renting include: (1) a down payment and closing costs are not required, (2) greater mobility because moving in and out of rental units is less complicated and less costly than selling and purchasing homes, (3) some units or complexes have security systems provided, (4) the appeal of community living, and (5) access to certain amenities such as swimming pools and tennis courts may be provided. The disadvantages of renting are primarily financial. Renters neither receive any equity (ownership) interest in the property nor do they receive any tax-deductible benefits from rent payments. In addition, rental units may not be quiet, neighbors may be unfriendly, repairs may not be made promptly, and landlords can be uncooperative. A homeowner has an advantage over a renter with respect to taxes because the homeowner who itemizes deductions for federal income tax purposes can include mortgage interest and property taxes as itemized deductions. Renters do not receive these deductions; generally, no portion of rent is deductible for federal tax purposes. 5-7. A written lease agreement provides better protection than an oral agreement for both the lessor and lessee. It spells out the conditions applicable to both parties and thereby avoids misunderstanding. Lease agreements typically include the monthly payment amount, date due, penalties for late payment, lease term, deposit requirements, distribution of expenses, and restrictions on occupancy. 5-8. People own a home for various reasons, including using it as a tax shelter because both the interest paid on the mortgage and property taxes paid are tax deductible for taxpayers who itemize deductions. In addition, a home can be viewed as an inflation hedge because its value will likely increase with inflation, which typically causes the prices of real assets to increase. The most important reason for preferring to own rather than rent a home is probably the basic security and peace of mind derived from living in one's own home—pride of ownership, a feeling of permanence, and a sense of stability. The least important motive for owning a home is its ability to act as a hedge against inflation; because inflation cycles are unpredictable as are local real estate values, so too are the inflation-hedging benefits of home ownership. 5-9. The loan-to-value ratio specifies the maximum percentage of the value of a property that the lender is willing to loan. The loan-to-value ratio determines the amount of down payment that will be required. For example, if the loan-to-value ratio is 80%, the down payment must be at least 20% of the purchase price. 5-10. Mortgage points are a one-time, up-front fee charged by lenders at the time they grant a mortgage loan. In appearance, they are like interest in that they are a charge for borrowing money. One point is 1% of the loan amount, so if a lender wanted to charge 2.5 points on an $250,000 mortgage, the buyer would have to pay $6,250 ($250,000 x .025) in points. The points are charged in addition to the down payment and other closing costs and are paid at the time of closing the mortgage loan transaction. Paying points is sometimes referred to as “buying down the interest rate.” Lenders are willing to lower the interest rate if borrowers are willing to pay the up-front points necessary to compensate the lender for what he’s giving up in the future stream of mortgage payments. 5-11. Closing costs are all other expenses besides the down payment that borrowers ordinarily pay at the time a mortgage loan is closed and title to the purchased property is conveyed to them. The buyer typically pays the majority of the closing costs, although the seller may, by custom or contract, pay some of the costs. Closing costs are made up of such items as: (1) loan application fees, (2) loan origination fees, (3) points (if any), (4) title search and insurance, (5) attorneys' fees, (6) appraisal fees, and (7) other miscellaneous fees for things like mortgage taxes, filing fees, inspections, credit reports, and so on. Closing costs, including points, can total an amount equal to 50% or more of the down payment. When the down payment is only 10%, closing costs can run as high as 70% or more of the down payment. 5-12. The most common guidelines used to determine the amount of monthly mortgage payments one can afford are the affordability ratios that stipulate: • Monthly mortgage payments should not exceed 25 to 30% of the borrower's monthly gross (before tax) income; and • The borrower's total monthly installment loan payments (mortgage and other consumer loan payments) should not exceed 33 to 38% of monthly gross income. 5-13. The prospective home buyer should carefully investigate property taxes, insurance, maintenance, and operating costs when shopping for a home because these expenses are unavoidable and significantly impact the overall cost of the home. If a person cannot afford these substantial costs in addition to meeting the monthly mortgage payments, then the home would be unaffordable even if the prospective buyer could make the required down payment and closing costs. 5-14. There are many possible answers to this question, some of which follow: • Shop carefully and take time to familiarize yourself with the various residential areas you are considering. • Know why you want a home and what your needs are in terms of lifestyle, physical space, type of neighborhood, features and style of house, etc. • Know in advance what you can afford, and prequalify for a mortgage. • Set priorities, but also be prepared to make compromises; it is unlikely that you will be able to get everything you want. • Negotiate the price, but don't get into a bidding war that could drive the price up. • Read all documents carefully to make sure you understand them. • Have the property inspected before finalizing the sale. 5-15. With their knowledge of the real estate market, real estate agents can expedite the search for housing by matching the individual with appropriate properties. An agent can also help in negotiations with the seller, assist in obtaining satisfactory financing, and help in preparing a real estate sales contract. MLS refers to the Multiple Listing Service, a compilation of properties for sale by members of the MLS in a particular area. Such shared listings provide greater market access for both buyers and sellers. Real estate agents earn a commission on completed sale transactions. The seller typically pays the commission from the sale proceeds. 5-16. A real estate short sale is the sale of property in which the proceeds are less than the balance owed on a loan secured by the property sold. This procedure is an effort by the mortgage lender to come to terms with a homeowner who is about to default or is defaulting on their loan. The benefit of a short sale for the borrower is to prevent a home going into foreclosure and this will appear on the borrower’s credit history. However, a short sale may also have a negative effect on a borrower’s credit score. In the case of a foreclosure, the lender then repossesses the home in order to recover the loan on the property. Mortgage holders only agree to short sales if they believe the proceeds generated will benefit them by bringing smaller losses than foreclosing on the property. For both the lender and the borrower, the benefit of the short sale is that it is usually faster and cheaper than foreclosure. Most short sales satisfy the debt owed by the borrower, but this is not always the case. 5-17. Starting your search for mortgage financing early in the home-buying process helps in many ways. By identifying potential lenders and prequalifying for a mortgage, you know before you start to look at houses how much you can afford, all the costs involved, and whether you can, in fact, obtain financing. You'll have time to correct any problems that may prevent you from getting a mortgage. Also, by focusing on homes that fall within your price range, you can streamline your search and eliminate frustration. Having your financing pre-arranged also saves time once you find a house to buy. 5-18. State laws generally specify that in order to be enforceable in court, real estate buy-sell agreements must be in writing and contain certain information, including (1) names of buyer(s) and seller(s), (2) a description of the property sufficient to provide positive identification, (3) specific price and other terms, and (4) usually the signatures of the buyer(s) and seller(s). An earnest money deposit is money the buyer is asked to pledge at the time she or he makes an offer in order to show good faith. This money is later applied to the closing costs. If, after the sales contract is signed, the buyer withdraws from the transaction without a valid reason, he or she stands to forfeit the earnest money deposit. Contingency clauses make a real estate sales contract conditional upon satisfaction of specified factors, such as obtaining financing or a satisfactory inspection. They protect the buyer. 5-19. The closing process begins once a suitable property is found, a written offer for the property is presented and the price is negotiated and accepted, terms are agreed upon, and both buyer and seller have signed the sales contract. Once the buyer makes the required earnest money deposit, certain legal procedures are followed to close the transaction and ensure the rights of both the buyer and the seller in the transaction. These include review of the RESPA statement of closing costs; hiring a title company to verify that the title to the property is free of all liens and encumbrances except those specified in the sales contract, and paying all required fees, taxes, points, etc. In some states this will be handled by lawyers acting for each party or it may be handled by an escrow company that is a third party working for both the buyer and seller to ensure that all the terms of the contract are correct. This process can take anywhere from a few weeks to several months to complete, depending on the nature of the property, the contract terms, and applicable state laws. 5-20. The sources of home mortgages today include commercial banks, thrift institutions, mortgage brokers and online lenders. Mortgage brokers take loan applications and then find lenders willing to grant the mortgage loans under the desired terms. Credit unions also make some mortgage loans. So do mortgage bankers, who frequently use their own money to initially fund mortgages that they later resell. 5-21. The fixed-rate mortgage is the traditional form of a mortgage and is characterized by the fact that both the rate of interest and the monthly payment are fixed over the full term of the loan. Adjustable-rate mortgages (ARMs) provide that the rate of interest, and therefore the monthly payment, is adjusted up and down in line with movements in interest rates. The rate of interest on the mortgage is linked to a specific interest rate index and adjusted at specific intervals (usually once a year) in accordance with changes in the index. The adjustable-rate mortgage usually has the lowest initial rate of interest. The fixed-rate mortgage has a higher rate of interest because the lender assumes all of the interest rate risk; under ARMs this risk is instead borne by the borrower. Negative amortization of a mortgage loan results in an increasing principal balance because monthly loan payments are lower than the amount of monthly interest being charged. The difference between the loan payment and interest incurred is then added back to the principal, thereby increasing the size of the loan. This occurs either when the initial mortgage payment is intentionally set below the interest charge or when the ARM has interest rates that adjust monthly but the actual monthly payment can only be adjusted annually. Fixed-rate mortgages are usually desirable because the payment amount is known in advance. Their major disadvantage can be their higher cost, although if a fixed rate is obtained during a period of low rates, the homeowner will benefit if rates rise considerably in later years. They are best for those who plan to stay in their homes for five or more years. ARMs generally cost less over the life of the mortgage than fixed-rate loans, although this is hard to predict given the variable nature of the rate. The lower rate makes it possible to afford a larger mortgage. It is important to have an ARM with a cap to protect against rising rates. However, rates can still rise several points in a year, and homeowners should be careful not to overextend themselves and then not be able to make the higher payments on the mortgage when rates rise. Also, as described above, some ARMs can have negative amortization. ARMs are best for those who can live with some uncertainty, are willing to monitor rates so that they can refinance at a fixed rate if necessary, and who plan to stay in their home a short time. 5-22. A conventional mortgage is a mortgage offered by a lender who assumes all the risk of loss. To protect themselves on this type of mortgage, lenders usually require either a 20% down payment or stipulate that the borrower must obtain private mortgage insurance. Insured mortgages, such as those backed by the FHA mortgage insurance program, usually feature lower required down payments, below-market interest rates, few if any points, and relaxed income/debt ratio qualifications. In exchange for a mortgage insurance premium of 2.25% of the loan amount—which is paid by the borrower at closing or included in the mortgage—plus another .5% annual renewal fee, the FHA agrees to reimburse the lender in the event the buyer defaults. Guaranteed loans, such as VA loans provided by the U.S. Veterans Administration, are insured loans but do not require the lender or the borrower to pay a premium for the guaranteed payment. Veterans are eligible for this type loan only one time, and essentially are able to make the purchase without a down payment. Closing costs and a 2.15% funding fee are usually required, however, but the rates on VA loans are usually about .5% below the rate of conventional fixed-rate loans. Financial Planning Exercises 1. Debbie should follow the following steps before making a major purchase, such as a car: a. Research the purchase thoroughly. Car manufacturers and dealers provide information in printed literature obtained from dealers' showrooms or from the manufacturers' or dealers' Web sites. Consumer sources of information include magazines and guides such as Car and Driver, Kiplinger's, and Motor Trend. Internet sources, such as Edmunds.com, provide pricing and model information on new and used vehicles, as well as links to other useful sites. If Debbie currently owns a vehicle, she also needs to research its value so she can decide whether to sell it on her own or trade it in. b. Select the car best suited to your needs. Debbie needs a car primarily to commute to work, so she should focus on vehicles which are fairly economical to operate and maintain, which can be handled well in traffic and that are suited for her driving conditions. She also should select a vehicle which will hold its value fairly well and which will be reliable. c. Arrange favorable financing. Debbie should pull up Web sites such as bankrate.com to find institutions offering the best auto loan rates. She should also research the loan rates and terms available from local lenders as well as the leasing options available from car dealers and manufacturers. Using the various rates and terms, she should then calculate how much she can afford, given her $450 per month budget allotment and $2,000 savings. She also should complete a lease vs. buy analysis to determine the best option for her. If she feels she should buy a car, then she should approach the most favorable lenders and get preapproval for a loan. If she feels she should lease a car, she should seek the most favorable terms. d. Negotiate the best price. Armed with her knowledge of the market and her needs, Debbie should then visit various dealers, test drive the vehicles which interest her, and negotiate prices. If she is considering buying a used car, whether from a dealer or an individual, she should arrange for a mechanic to inspect the car for problems. If she is considering trading in a car on the purchase, she should first negotiate the best deal on the new vehicle before mentioning that she has a possible trade in. e. Understand the terms of the sale. Before she signs any contracts, Debbie should thoroughly understand the terms of the sale. She should compare the written contract with the quoted terms to make sure she is getting exactly what was promised. She should also not allow the seller to hurry her or pressure her in completing the sale. At all times, she needs to remember that she is the one in charge of the sale and there are thousands of other suitable cars available if this deal isn't to her liking. 2. The Automobile Lease vs. Purchase Analysis form for Damien Smart follows. The total cost of the lease (Item 9) is $15,372, while the total cost of the purchase (Item 18) is $15,808. Therefore, Damien should lease the car because it is the least expensive alternative. 3. Rent ratio is the ratio of the average house prices to the average annual rent in the area you are considering to live. Rent ratios between 31 to 35 indicate that it is more attractive to rent than to buy a house. Rent ratios between 6 and 10 indicate that it is more attractive to buy than to rent. And a moderate rent ratio between 16 to 20 suggests that renting is expensive and that it may still be better to buy. Therefore, if the jobs that Cliff is offered are equally attractive, it will likely be more attractive to move to Miami with respect to this ratio. He will likely get better value for his housing dollar in buying a home in Florida. However, the ratio of 20 in L.A. indicates that it would still be better to buy, if Cliff instead decides to move to California. 4. Appraised value of the house = $105,000 80% of the value = 0.80 x $105,000= $84,000 Required down payment at $100,000 selling price = ($100,000 – $84,000) = $16,000 5. If the Taylor family income is $4,000 per month: Maximum monthly payment they could afford: $1,200 ($4,000 x .30). Maximum total monthly installment loan payments: $1,520 ($4,000 x .38). If they are already paying $750 monthly on installment loans, the maximum mortgage payment they could make would be $770 ($1,520 – $750). 6. Using the generalization that with a 10% down payment, one could expect to spend an amount equal to 70% of the down payment for other closing costs, we can estimate that total closing costs would be around $59,400. Down payment = .10 x $220,000 = $22,000 Other closing costs = .70 x 22,000 = $15,400 Estimate of total closing costs = $59,400 This estimate would more than likely already include some amount of points paid on the home mortgage. Exhibit 5.7 shows an example of a typical breakdown of closing costs and includes an allowance for 3 points paid on a $198,000 mortgage ($220,000 purchase price less 10% down payment). To illustrate how points are calculated, one point equals one percent of the loan amount. Three points on a $220,000 home with 10% down would equal $22,000 Loan amount = Purchase price – Down payment = $220,000 – $22,000 =$198,000 Total points = 0.03 x $198,000 = $5,940 Total closing costs would include the down payment, any points paid on the mortgage, and other closing costs. Homebuyers should carefully shop for a loan, because even among lenders offering the same rate on the mortgage, it is possible to save several thousand dollars in closing costs. 7. Over the life of the mortgage the principal portion increases and the interest portion decreases as a percentage of the overall mortgage payment. This is because interest is calculated relative to the remaining outstanding principal, which declines with each payment. This implies that the tax benefit of a mortgage is higher in the earlier than in the later stages of a mortgage. 8. Answers using text Exhibit 5.9 are listed first followed by answers obtained using the financial calculator set on End Mode and 12 payments/year: 9. Aurelia’s rent versus buy analysis is shown on Worksheet 5.2 on the following page and assumes a security deposit equal to one month's rent, a 4% after-tax return on investment and a 3% appreciation factor. Student assumptions may vary. The mortgage payment using Exhibit 5.9 is $1,049 ($175,000/10,000 = 17.5; 17.5 x 59.96 = $1,049.30 which rounds to $1,049). Using the financial calculator, the mortgage payment would be $1049.21 (calculator on 12 P/YR and End Mode: 175,000 PV, 6.0 I, 360 N). Based on the costs of each option, buying the home is $430.25 less per year than renting ($9,004 – $8,573.75). (If students assume no appreciation, renting will be slightly cheaper.) Problem 9—Worksheet 5.2 Note: Assume Aurelia’s security deposit is equal to one month's rent of $725. Also assume a 4% rate on her savings and a 3% annual appreciation in home price. Note: Find monthly mortgage payments from Exhibit 5.9. An easy way to approximate the portion of the annual loan payment that goes to interest (line B.8) is to multiply the interest rate by the size of the loan. To find the principal reduction in the loan balance (line B.7), simply subtract the amount that goes to interest from total annual mortgage payments. *Tax-shelter items, provided Aurelia itemizes deductions. 10. The Home Affordability Analysis (Worksheet 5.3) for Jennie and Caleb McDonald follows. The maximum priced home they can afford is $120,600. Problem 10—Worksheet 5.3 11. From the text’s Exhibit 5.9, using a principal-amount factor of 15 ($150,000/$10,000): a. For a 15-year, 6% fixed rate loan 15 x $84.39 = $1,265.85 monthly payment Using the financial calculator set on End Mode and 12 payments/year: b. For a 30-year adjustable-rate mortgage at 2.5 points above the index rate of 4.5%, the first-year monthly payment would be based on 30 years at 7% (i.e., 2.5% + 4.5%) 15 x $66.53 = $997.95 monthly payment Using the financial calculator set on End Mode and 12 payments/year: 12. Pros: The higher your extra payment, the sooner you pay off your mortgage. This would provide extra future flexibility to meet needs like funding a child’s college education or retirement. Extra payments can also dramatically reduce the total interest paid on a mortgage. Cons: You will have less short-term flexibility because the extra payments obviously absorb resources. And the lower amount of interest will reduce the tax shelter benefit associated with the mortgage. 13. The Mortgage Refinancing Analysis for Miao Tian using Worksheet 5.4 appears below: Given that Miao plans to remain in the condo for another 48 months and she will break even on the refinancing in about 10 months, she should go ahead and refinance the mortgage under the specified terms. Solutions to Critical Thinking Cases 5.1 The Harrisons’ New Car Decision: Lease versus Purchase 1. The Harrisons appear to have made a common mistake by focusing on the advertised payment figure for the lease. They should first do market research using consumer and automobile magazines, dealer information, and information off the Internet to decide what type of car best suits their needs in terms of style, price range, options, reliability, and operating costs. Rather than jumping to a conclusion based on the monthly lease payment, they should comparison shop and choose from several possibilities. 2. The Harrisons need to consider many factors before visiting the dealer. As mentioned in question 1, they should visit several dealers and find out the cost of the cars they have chosen, without discussing whether they wish to lease or finance the purchase. Then they can accurately calculate the total cost of each option. They should also talk to an independent leasing dealer to determine the cost of leasing any of the models they like. Other important considerations are discussed in question 3 (b). The advantages of leasing include no down payment (or a small one) and a lower monthly payment than required to finance the car. This may make it possible to lease a nicer car than you could buy. On the other hand, the lease payments only cover a portion of the car's cost, so you don't own the car at the end of the lease period. Leases are costly to break if your needs change, and extra costs for wear and tear, excess mileage, or an unguaranteed residual may increase the costs at the end of the lease term. 3. a. The Harrisons’ lease versus purchase analysis is on the following page. Leasing the car results in cost savings of $927. b. Other considerations include how long the Harrisons plan to keep the car, the mileage allowance, definition of wear and tear, and end-of-lease fees. c. The Harrisons should lease the car based on the cost analysis. However, if they feel they would like to keep the car longer than 4 years, they might consider buying. If they are uncertain about any of the lease terms, such as keeping the car for the full term, they should buy. They should shop around to find a loan with a lower interest rate, which would make purchasing more attractive and see whether they can earn more than 3% after tax on the down payment. Case 5.1, Problem 3a—Worksheet 5.1 5.2 Evaluating a Mortgage Loan for the Meyers 1. If the Meyers purchase the $215,000 home: The Meyers have saved $44,000—enough for the down payment and $1,000 of the closing costs, but they would be short $13,190 of the total closing cost requirement. In addition, they would be unable to meet many other costs associated with buying and moving into a new home. This financing strategy is clearly unaffordable for the Meyers. 2. With a $25,000 down payment and $190,000 mortgage, closing costs would be: The total cash needed to close the transaction is less than the $44,000 the Meyers have available, making this option feasible for them. Using text Exhibit 5.9, their monthly mortgage payment at 6%, 30 years is: $59.96 x $190,000/$10,000 = $1,139.24 Using the financial calculator (set on End Mode and 12 payments/year): No information has been provided about any other installment debt, so the affordability ratio would consider only their monthly mortgage payment relative to their $5,167 monthly income ($62,000/12). This is well within the required 28% guideline, so the lender should be willing to make the loan. 3. 4. It appears that given the Meyers’ available savings and level of income, they can afford this home. They should go ahead with the purchase. However, they should budget carefully to allow for the additional expenses associated with moving and with repairing and maintaining a home. 5.3 Sophia’s Rent-or-Buy Decision 1. The solution to the rent-or-buy analysis using Worksheet 5.2 follows. Excluding the effect of appreciation in the value of the condo, Sophia should buy because her annual ownership cost would be $10,075 (see line B.11), while the annual rental cost would be $14,998. 2. Including the expected rate of appreciation for the condo further lowers its annual cost. With 3.5% appreciation, the annual cost of the condo declines by $6,125 (.035 x $175,000) in the first year. This lowers the annual ownership cost to $3,950 (see final line). Sophia should definitely buy the condo, since its annual cost with appreciation is far below that of renting. 3. The qualitative factors Sophia should consider include the pride of home ownership and security—benefits that renting does not offer. Purchasing also builds value and savings, while renting does not. On the other hand, home ownership is costly in several non-monetary ways: the owner is totally responsible for its upkeep and repairs. A renter can merely dispatch the landlord to make and pay for work that needs to be done. But, is the landlord good about fixing things? That is another problem. How long does she plan to live there? What is the resale market for condos? What are her future plans and will the condo be suitable for her on down the road? 4. In light of the above analysis, Sophia should definitely buy the condo, assuming she qualifies for the loan. The annual after-tax cost of $3,950 including an adjustment for appreciation is about a fourth of the $14,998 annual cost of renting. The condo offers her appreciation potential, and her mortgage payments will be fixed (except for insurance and taxes). While certain operating costs may be greater in the condo than in the apartment, other benefits of ownership far outweigh this factor. Case 5.3—Worksheet 5.2 Note: Assume Sophia’s security deposit is equal to one month's rent of $1,200. Note: Find monthly mortgage payments from Exhibit 5.9. An easy way to approximate the portion of the annual loan payment that goes to interest (line B.8) is to multiply the interest rate by the size of the loan. To find the principal reduction in the loan balance (line B.7), simply subtract the amount that goes to interest from total annual mortgage payments. *Tax-shelter items, provided Sophia itemizes deductions. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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