Residential Borrowing and Lending Decisions

1
Chapter 11

• Residential Borrowing and Lending Decisions

2
The Home Owners Financial Calculus Rational
Financial Decision Making

• Home Ownership Consumption or Investment
  Decisions?
• Consumption
• Rent-buy decisions is analyzed as a net-cash-flow
  cost issue lowest is best choice
• Interest and property taxes lower homeowners
  income taxes if itemized deductions exceed
  standard deduction and adjusted gross income does
  not exceed threshold
• Tenants costs not tax deductible
• Other homeowner costs include closing costs, down
  payment, property maintenance and repairs

3
The Home Owners Financial Calculus Rational
Financial Decision Making

• Home Ownership Consumption or Investment
  Decisions?
• Investment
• Is the PV of appreciation more than the PV of all
  costs for the homeowner?
• Up to 500,000 appreciation tax-free for
  homeowners

4
How Much Can a Buyer Finance?

• Amount of mortgage depends on debtors financial
  circumstances and requirements of lender
• Lender requirements
• LTV
• Availability of loan insurance or guarantee
• Housing expense-to-income ratio
• Total-debt-service-to-income ratio
• Debtor capacity

5
How Much Can a Buyer Finance?

• How much should a buyer finance?
• Financial risk
• Incremental interest rates
• Cost of borrowing (effective rate of return)

6
Should a Homeowner Pay Points?

• Point 1 percent of face amount of loan
• Benefit to lender
• Increased yield effective interest rate

7
Should a Homeowner Pay Points? (continued)

• Example without point _at_ 6.5
• PV 150,000
• N 360
• PMT 948.10
• Solve for i
• i 6.5 (.5417 x 12)

8
Should a Homeowner Pay Points? (continued)

• Example with point _at_ 6.25
• PV 148,500
• N 360
• PMT 923.58
• Solve for i
• i 6.35 (.5288 x 12)

9
Should a Homeowner Pay Points? (continued)

• Example with prepayment in 6 years, without point
• PV 150,000
• N 72
• PMT 948.10
• FV 138,098 (balance in 6 yrs)
• Solve for i
• i 6.5 (.5417 x 12)

10
Should a Homeowner Pay Points? (continued)

• Example with prepayment in 6 years, with point
• PV 148,000
• N 72
• PMT 923.58
• FV 137,606 (balance in 6 yrs)
• Solve for i
• i 6.46 (.53825 x 12)

11
Should a Homeowner Pay Points?

• Benefit to Borrower Lower Contract Interest
  Rate/Payments
• Income Tax Consequences
• Points tax deductible
• If sufficient itemized deductions
• Deductions not reduced because of high income
• Smaller interest payments result in reduced
  interest deductions
• Assumptions
• Deductibility wont change drastically
• Not different marginal tax bracket or percentage
  of itemized deductions to reduce income

12
Should a Homeowner Pay Points?

• Example of after-tax cost of points (home
  purchase)
• Point paid
• (.01 x 150,000) 1,500
• Less
• Tax deduction (.40 x 1500) 600
• ________
• After-tax cost of paying the point 900

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Table 11.1
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Table 11.2
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Table 11.3
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Table 11.4
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Table 11.5
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The Refinancing Decisions

• Oversimplification
• 200 basis points (2) drop in rate
• 2 2 rule 2 and 2 years
• Longer the duration of mortgage more likely
  borrower will benefit from refinance

19
The Refinancing Decisions

• Present value of expected benefits compared to
  costs of refinancing
• Costs include prepayment penalties, charge for
  appraisal and credit reports, origination and
  underwriting fees, and closing costs
• Benefits include all changes in future cash
  flows, same as with payment of points
• Lower monthly payments
• Changed equity at payoff
• Increased taxes from lower interest payments

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Table 11.6
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Table 11.7
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Table 11.8
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Table 11.9
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The Mortgage Lending Decisions Risk and Return
Trade-Offs

• Subprime and Low-Doc lending
• Subprime higher risk and higher contract
  interest rate and/or fees
• Low-Doc streamline approval and closing
• Mortgage loans as portfolio assets
• Mismatch of long-term assts (mortgages) and
  short-term liabilities (depositor accounts)
• Sell loans to secondary mortgage market