The Home Decision

Personal Finance:

Another Perspective

Objectives

• A. Understand how a house fits into your personal financial plan and our leader’s counsel on home buying

• B. Understand the advantages and disadvantages of renting, buying, building, and renovating

• C. Know the process on buying a home• D. Know how to compare different types of loans with

different fees• E. Understand my recommendations in obtaining a

home

Personal Financial Plan

• There are no financial plan assignments for this section• However, since you will likely be buying a

home soon, you should learn this material well

A. Understand how a house fits into your Personal Financial Plan

Is a house important? It’s likely the largest single purchase you

will ever make. What does it provide:

A good location for raising children, teaching them to work, good neighbors, etc.

A convenient location to minimize travel time

A place to reflect your personal tastes

Risks in Home Ownership

You buy a house you can’t afford• Your other financial goals are not attained

You buy a fixer-upper without the necessary skills or time• It stays a fixer upper

You buy the wrong type of house for your lifestyle• You must pay others to keep it up

You buy a house without the necessary inspections• You pay dearly for your mistakes

You are too far in debt and you lose your job• You lose the house and your self-respect

Our Leader’s Counsel on Buying a Home

President James E. Faust stated: Over the years the wise counsel of our leaders has

been to avoid debt except for the purchase of a home or to pay for an education. I have not heard any of the prophets change this counsel. (“Doing the Best Things in the Worst Times,” Ensign, August 1984, 41.)

Our Leaders Counsel (continued)

President Gordon B. Hinckley commented:• We have been counseled again and again concerning self-

reliance, concerning debt, concerning thrift. When I was a young man, my father counseled me to build a modest home, sufficient for the needs of my family, and make it beautiful and attractive and pleasant and secure. He counseled me to pay off the mortgage as quickly as I could so that, come what may, there would be a roof over the heads of my wife and children. I was reared on that kind of doctrine. (“The Times in Which We Live,” Ensign, Nov. 2001, 72.)

Our Leaders Counsel (continued)

He further counseled: • I recognize that it may be necessary to borrow to get a

home, of course. But let us buy a home that we can afford and thus ease the payments which will constantly hang over our heads without mercy or respite for as long as 30 years. … I urge you to be modest in your expenditures; discipline yourselves in your purchases to avoid debt to the extent possible. Pay off debt as quickly as you can. … That’s all I have to say about it, but I wish to say it with all the emphasis of which I am capable.” (Gordon B. Hinckley, “To the Boys and to the Men,” Ensign, Nov. 1998, 51. )

Our Leaders Counsel (continued)

Finally, President J. Reuben Clark said:• Let every head of every household aim to own his own

home, free from mortgage. Let every man who has a garden spot, garden it; every man who owns a farm, farm it. (Conference Report, April 1937, p. 26.)

The challenge then becomes one to determine what is a modest home. • In the Handbook for Families, it recommends:

• Avoid spending more than 25 to 40 percent of your take-home pay for the total house payment, including insurance, taxes, and maintenance costs. (“Preparing for Emergencies,” Ensign, Dec. 1990, 59.)

Questions

Do you understand how a house fits into your financial plan and our leader’s counsel on homes?

B. Understand your options in the housing decision

Renting• Advantages

• High mobility – can move with minimal costs

• No repairs and maintenance• Minimal financial commitment • Lower initial costs• Easier budgeting

Renting (continued)

Disadvantages • Lack of permanence & pride of ownership• Rents may increase unexpectedly• Possible restrictions• No tax benefits • No potential for property appreciation

Buying

Advantages• Permanence & pride of ownership• You get what you see (usually)• Tax benefits• Generally a fixed monthly mortgage payment• Leverage• Can borrow against equity• Minimal time commitment relative to building• Mature landscaping & neighborhood• Few surprises in terms of neighborhood, schools,

shopping, etc• Can negotiate favorable price and terms

Buying (continued)

Disadvantages• Low mobility—Low liquidity so difficult to

sell if needed (must make 6% just to break even)

• Significant upfront costs• Higher living expenses• Large financial commitment

• Possible decrease in value• Possible mortgage default

Building

Advantages• Can build exactly what you want• Sometimes cheaper to build than buy

(depending upon market conditions)• New appliances and housing systems• Can pick the location

Building (continued)

Disadvantages • Interpreting building plans (size of rooms, etc.) can

cause difficulty if you are unused to it• Often over budget and delays• Unanticipated additional expense for yard and

fencing• Combined construction loan interest and rental

expense• High monitoring costs!!!• High Stress!!• High Risk!!

Renovating

• Advantages• May get what you want faster than building• Can see what you want generally• May be cheaper to buy and renovate than

build, particularly if you can do much of the work yourself (sweat equity)

• There may not be available lots in a desired area

Renovating (continued)

• Disadvantages• May be more expensive than to build it new• Often over budget and delays. The rule of thumb is

to double you budget and then double that again • Unanticipated additional expenses for yard and

fencing depending on what was renovated• Combined construction loan interest and rental

expense• May have other major problems not noted before• High monitoring costs!!! It will take you

significant amounts of time to make decisions• High Stress and High Risk!!

Questions

• Any questions on your options in the housing decision?

C. Buying a Home: the Process

There is a process, which, if followed, will help you to make much better decisions in the process of buying a home• 1. Analyze your finances and know your

bounds• 2. Don’t rush to purchase• 3. Establish a sound plan• 4. Do your homework –and footwork• 5. Use a team approach• 6. Enjoy home ownership

Step 1: Analyze your Finances

There are four key areas: a. Budgeting

• Develop and Live on a Budget• President Spencer W. Kimball said:

“Every family should have a budget.”• Know your lifestyle

• Make sure your budget is representative of your lifestyle

• Take into account likely lifestyle changes, i.e., taxes, babies

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b. Credit Awareness

Know your Credit History• Review your credit history every 1-2 years (from

all three agencies)• Remember:

• Almost 50% contain inaccurate information

• You can obtain a free copy of your credit report if denied credit

• You can dispute inaccuracies by requesting an investigation

• To limit authorized inquires (call 1-888-5-OPTOUT) or www.optoutprescreen.com

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c. Mortgage Lending

Know the rules• Get pre-approved—not pre-qualified

• Pre-qualified is an estimate. Pre-approved means your lending institution has done the necessary credit checks and has approved a specific amount.

• Warning:• Don’t get pre-approved for a loan with two

wage earners when you expect to reduce to one earner later!

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Mortgage Lending (continued)

Know your affordability ratios • Front end ratio

• Housing Expenses: Monthly PITI <28% Monthly Gross Income

• PITI = principle, interest, property taxes, and property insurance

• Back end ratio• Debt Obligations: Monthly PITI and other <36%

Monthly Gross Income• See TT11 - Maximum Mortgage Payments for

LDS• Be sure to take into account your savings and

tithing

d. Upfront Costs

Up-front costs of buying:• Down payment (3-20 percent)• Points• Closing and other non-lender costs (2-5 percent):

• Title insurance

• Attorney’s fee

• Property survey

• Recording fees

• Lender’s origination fee

• Appraisal

• Credit report

• Termite/Mold inspection

• Escrow (Prepaids: property insurance & taxes, mortgage interest)

•Home Inspection report

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Impound (or escrow or reserve) Accounts

Impounds are that portion of a borrower’s monthly payments held by the lender or servicer to pay for:• Taxes• Hazard insurance• Mortgage insurance• Lease payments, and• Other items as they become due

This is over and above your monthly mortgage payments• These may or may not be required

Step 2: Don’t Rush to Purchase

Be Patient• Estimate the time you will be in the house

• If it is less than 3-5 years, look into renting

• You must make 6-7% on your house price just to break even when you sell it (realtor fees are 6-7%)

• Often renting a luxury apartment for 6 months will give you time to search thoroughly

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Step 3: Establish a Plan

Establish a Sound Plan• Determine what is important to you

• Location, home, yard, etc.• Remember you will probably move within five

years• Once you know where you want to be, what you

can afford, and what you want (your plan):• Then start driving around and looking in earnest• But keep to your plan

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Step 4: Do your Homework

Do your homework--and footwork• Get a good realtor

• Remember realtors are working for sellers. It may be wise to have a buyer’s broker that works for you (and you pay them)

• Brokers should know the neighborhood• Take matters into your own hands

• Talk with friends, neighbors, and others• Use the internet and other tools

• Stay true to your Plan and have patience• Be liquid and ready to react quickly• Ask lots of questions--be creative if necessary

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Step 5: Use a Team Approach

Use a team approach—get lots of good help • Use others to help

• Buyers broker, appraiser, attorney to review contract

• Have home inspections—multiple if necessary• Don’t buy someone’s problem

• Don’t become emotionally attached to a potential house

• Be willing to walk away• Watch your loan contract and read the fine print!

• Rely on your broker, but ensure there are no prepayment penalties

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Step 6: Enjoy Home Ownership

Enjoy home ownership• Maintain it well

• Take care of your purchase and it will take care of you

• Generally it will take roughly 1% of the home’s value annually for upkeep. Budget accordingly

• A professional cleaning a few times a year can help retain a home’s value

• Now keep the value of your home up!

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The Mortgage Process

9. Lender audits the documents, verifies all conditions are filled, and funds the loan!

1. You’ve found a home that suits your lifestyle and budget, using resources such as a realtor.

2. The realtor refers you to a mortgage broker.

3. The broker pulls credit, determines your needs and tries to find lenders among the competition to meet those needs.

4. Each lender has unique programs. Lender and broker negotiate points, rates, fees, PPP, and other features of the loan.

5. Broker recommends the best loan to the consumer, reviewing the features agreed upon. Consumer makes the final decision.

6. Lender takes the loan package, structures the loan and conditions for any additional information they need to close the deal.

7. Broker, Title, Escrow, and Lender work to fill all conditions

8. Lender sends out the documents to escrow for signing

Questions

Any questions on the six-step process to buy a home?

D. Comparing different types of loans with different fees

Know Yourself• Know your goals, budget and how much you can

afford

• Don’t buy the biggest house in the neighborhood

• Know all your other fees and expenses

• There are a lot of them

• Understand how to calculate a comparable rate on loans with different fee structures and fees

• It will save you lots of money overall

Key Points on Points

What are points?• One percent or one hundred basis points of the loan

Why do lenders charge points?• To recover costs associated with lending (origination

points—these are not tax deductible (line 801))• To increase the effective interest rate (discount

points)• To provide for negotiating flexibility (in a market

where interest rates fluctuate, or to adjust for differences in risk between loans)

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More Points on Points

What is the relationship between borrowing costs and mortgage choice?• Lenders offer many choices on interest rates and

points• Your challenge is to minimize your effective

cost of borrowing and get the least expensive loan

How do you differentiate between different loans?• Remember, the lender retains the amount attributed

to points when distributing the loan proceeds; however, the monthly payment will be based on the entire loan amount

Effective Interest Rate

What is the difference between the APR and the Effective Interest Rate? (Note: this is different from the effective annual interest rate!)• The APR is a rate that is generated from a precise

calculation specified in Regulation Z • The Effective Interest Rate is the precise interest

rate the borrower is paying after all fees and costs are taken into account. We assume all costs come out of the loan or are paid back by the loan

• If no prepayment or other costs, the EIR = APR• It is important as it will allow you to quickly

compare rates from various lenders with various schedules and costs

Effective Interest Rate Calculations

This is the effective rate to the borrower after all costs and fees are taken into account• The lender retains the amount from points while the

payment is based on the entire loan amount. Note that the borrower pays many additional fees and

costs, over and above costs that are included in the loan documents• How do you account for these?

Effective Interest Rate (continued)

The Effective Interest Rate calculation takes into account all costs, both out-of-pocket and loan costs

How is it calculated? • 1. Calculate the payments on the total amount you

will be repaying, i.e. the amount borrowed = PMT• 2. Calculate the amount of money you actually

received, i.e., the total loan less all costs = - PV• 3. Set PMT, PV = - what you actually received, N =

years, and solve for your interest rate. This is the rate you are actually getting.

• It takes into account all your fees, including explicit and out-of-pocket fees

What about Prepayment?

What is prepayment?• Prepayment is when you repay the loan early

How do you calculate your effective interest rate when you plan to prepay the loan before maturity? • The process is similar, except that you must

calculate your balance remaining as of the prepayment date, i.e. the balloon payment

• To get your balance remaining or balloon amount, take your payment as PMT, N as the number of years remaining after your prepayment, and your interest rate as I, and solve for your Present Value. The PV is the present value of all the payments you will eliminate

Prepayment (continued)

With expected prepayment:• 1. Calculate your payment = PMT• 2. Calculate your amount received = -PV• 3. Calculate your balance remaining after you

prepay (the balloon amount). This balance remaining will be your FV

• 4. Set your number of years before prepayment as your = N, your balance remaining as your FV, amount received as your –PV, and solve for I = your effective interest rate

Questions

Any questions on how to compare loans from different lenders with different APRs, points, and fees?

D. Final Recommendations: Buying

Before you begin looking• Spend a significant amount of time trying to

understand your needs and requirements• What is important to you, to your spouse, and to

your children?• How important are schools, shopping, work?• How long are you willing to commute each day?

• Generally, this will require you to rent for a period of time. Use this time wisely.

• Try to rent in your preferred area first• Check into rental houses. They can be a good

intermediary between renting and buying.

Recommendations: Buying (continued)

• When planning to buy:• Calculate how much you can afford to spend on a

home• Don’t spend so much on this goal that you are

crimped in your other personal goals.• Calculate into your spending the fact that you

will be saving 10-20% (minimum) each month for savings.

• Don’t buy a “fixer-upper” unless you have the time and the inclination to do it.

• Remember your first priority is to do well at work.• Having a beautiful house may not advance your

career (although your spouse may love it).

Recommendations: Buying (continued)

• Once you have decided on a home:• Don’t scrimp on home inspections—they are good

investments• Don’t let the current owners discourage you

from doing inspections. • Beware of the hidden costs of home ownership.

• Keep room in your budget for these.• Get pre-approved for your loan

• Don’t spend your maximum amount.• Keep good records of improvements

• These can increase the cost basis of your home and reduce taxes when you sell

Final Recommendations: Building

• If you decide to build:• The key decision is your contractor. He will either

make it extremely easy or difficult for you. • Choose wisely. Interview his past clients, and

check financial condition and license.• Ensure permit required repairs have final

inspections• Know what you want and put it on the plans.

• Have friends review plans to make sure you have not forgotten anything. Changes are four times as expensive after plans are completed.

• Work with the contractor (but a penalty clause for completion may be useful).

• Keep back 5% of the price until all problems have been fixed.

Final Recommendations: Renovating

• If you decide to renovate:• Make sure you have your vision of the house, and

make sure that vision is on paper. • For every change, ensure a change order is drawn.

• Keep a running tally of all past, current, and estimated costs to complete the project. Review this weekly with the contractor.

• You might even put in a clause that if the contractor goes over the planned amount, he makes no new money on the excess over the planned amount.

• Be aware of the large time commitment necessary to renovate.

Review

• A. Do you understand how a house fits into your personal financial plan?

• B. Do you understand the advantages and disadvantages of renting, buying, building, and renovating?

• C. Do you know the process on buying a home?• D. Can you compare different types of loans with

different fees?• E. Do you understand my recommendations on

getting a home?

Case Study #1

Data• Bill and Brenda make $60,000 per year. They

decided that they have outgrown their small house, and found the house they wanted for $225,000. They have agreed to a 30-year loan, and estimate property taxes and insurance costs will be $200 per month, and estimate they can get a fixed rate mortgage loan for 6.5%. They have a car loan of $270 per month and student loan of $50 per month.

Calculations• Calculate Bill and Brenda’s front-end ratio and

back-end ratio (28% and 36%, respectively). Application

• What is the amount that most banks will lend (most banks will lend to the lower of the two ratios)?

Salary $60,000, $225,000 house, 6.5% interest rate, Property taxes and insurance $200/month, car loan of $270/month + student loan of $50 / month.

Calculate the front end (28%) and back-end ratios (36%)

Case Study #1 Answers

Calculations: 1. Front-end Ratio Calculations at 6.5%

PITI / Gross IncomeAnnual Income 5,000

times 0.28% 1,400 Real estate tax (T) and insurance payments (I)

- 200

Maximum Monthly Mortgage Payment of Principle (P) and Interest (I) 1,200

Set 6.5% = I, Pmt = 1200, N=30, PV

Maximum Amount Bank will lend: $189,853

Case Study #1 Answers (continued)

2. Back-end Ratio Calculations at 6.5%

(PITI+ Debt expenses) / Gross Income

Annual Income 5,000

36% 1,800

Real estate tax (T) and insurance payments (I) 200

Monthly debt payments: Car payment 270

Student Loan 50

Maximum Monthly Principle (P) and Interest (I) 1,280 Set 6.5% = I, Pmt = 1280, N=30, PV

Maximum Amount Bank will lend: $202,510

Case Study #1 Answers (continued)

Applications:Since the bank will generally lend the lesser of the two ratios, they would likely be allowed $189,853.

Case Study #2

Data• You have decided on your dream house (well, at

least your first house). In discussions with your mortgage broker, you have the choice between two $200,000 loans, both which are amortized over 30 years. Loan A is for 6.0% with no points or loan origination fees, and loan B is for 5.75% with a $1,500 loan fees and 1 point.

Calculations• Assuming you plan to stay in the house for 30

years, which loan is more advantageous based on the Effective Interest Rate (EIR) and assuming annual payments?

Loan A $200,000 6.0% no points, no fees, 30 years

Loan B $200,000 5.75% 1 points, $1,500 fees , 30 years

Case Study #2 Answers

Note: Loan A has an EIR of 6% as there are no fees 1. Calculate payment for loan B

• N=30, I=5.75%, PV = -$200,000 PMT = ? • PMT = $14,143.25

2. Calculate the amount you received after all fees • $200,000 – 1 point ($2,000 * 1) - 1,500 = ?• $196,500

3. Calculate your effective interest rate• Set your PMT= $14,143.25, N = 30, PV = -

$196,500, Solve for I • I = 5.91% Loan B is the cheaper loan

Case Study #3

Data• Your spouse reminds you that you will likely only

be in the home for 6 years, although the job looks wonderful. You compromise, and estimate that you will be in the home for 12 years. Review your choice between the two $200,000 loans, both which are amortized over 30 years, but which will be paid back in 12 years. Loan A is for the same 6.0% with no points or fees, and loan B is for 5.75% with a $1,500 loan fee and 1 point.

Calculations• Calculate the EIR for both loans, assuming

prepayment after 12 years and annual payments. Application

• Which loan is more advantageous with prepayment using the EIR?

Prepay after 12 years: Loan A $200,000 6.0% no points, no fees, 30 years Loan B $200,000 5.75% 1 point, $1,500 fees

Case Study #3 Answers

1. Calculate payment for loan B• N=30, I=5.75%, PV = -$200,000 PMT =

$14,143.25 2. Set PV = to the amount you receive after all costs

• $200,000 – 1 point ($2,000 * 1) - 1,500 = $196,500 3. Solve for your balloon payment at year 12

• N = 18, PMT = $ 14,143.25, I = 5.75, PV = $156,054.03

4. Solve for your effective rate • PMT = $ 14,143.25, PV is -$196,500, N = 12, FV =

$156,054.03, solve for I• I = 5.98% Loan B is still cheaper (barely)

Case Study #4

Data• Your broker has said that for 1 more “buy down”

point (a total of 2 points with the same $1,500 fees), he can give you loan C with an interest rate of 5.50%.

Calculations• Calculate the EIR for Loan C. How much did that

extra point save you in terms of your effective interest rate over Loan A and Loan B?

Application• Assuming the same 12 year prepayment plan, which

loan should you take?

Prepay after 12 years: Loan C $200,000 5.5%, 2 points, $1,500 fees , 30 years. How much did the 2nd point save?

Case Study #4 Answers

1. Calculate payment for loan C• N=30, I=5.5%, PV = -$200,000 PMT = $13,761.08

2. Calculate amount received after all fees (2 points)• $200,000 –2 points ($2,000 * 2) - 1,500 = $194,500

3. Calculate the balance owed after 12 years (18 years remaining) The PV of 18 years of the PMT is:• N=18, I=5.5%, PMT= -$13,761.08, PV =

$154,758.11 4. Calculate effective interest rate to lender

• Set your FV at year 12 to = $ 154,758.11, PMT= $ 13,761.08, N = 12, PV = -$194,500, Solve for I = ?

• I = 5.85% Loan C saves .15% and .13% over Loans A and B

Case Study #5

Data• You have taken a job that you expect to be

at for 3-5 years until you go back to graduate school. You are debating whether to rent or buy. Your spouse really wants to buy, and you are unsure. She has found a house in a nice neighborhood near your school that she thinks is perfect.

Application• Are there any other tools or sources of

information that may be helpful to you to help in this decision?

Will live there 3-5 years until graduate school. Have found a nice house in a nice neighborhood. Any other tools to help in the

decision making process?

Case Study #5 Answers

There are two additional pieces of information that may be useful as you “study it out in your mind” before you make a final decision as to what to do.

1. Talk with a realtor about the neighborhood. Find the average days on the market (or DOM) for the area. If houses are selling quickly <30-45 DOM, the market is currently strong. If the DOM>90-120, it is difficult to sell homes now and may be difficult in the future.

2. Talk with a realtor and get the data on the average annual appreciation of the houses in that neighborhood. If they have continued to appreciate over the last few years, there may be support for continued appreciation in the future. If not, they may be difficult to sell in the future.

Teaching Tools

Please note that I have prepared two teaching tools which may be helpful as you work on buying a home. They are:• TT19 Home Loan Comparison with Prepayments

(for 3 different loans), and • TT09 Debt Amortization and Prepayments• TT11 Maximum Mortgage Payments for LDS

Please note that while they are helpful, they cannot be used for quizzes or exams.

For another good source of information, see www.mtgprofessor.com