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5-5 In addition to single-family homes, what other forms of housing are available in the
United States? Briefly describe each of them.
Single-family homes: They can be stand-alone homes on their own legally defined lots or row
5-6 What type of housing would you choose for yourself now, and why? Why might you
choose to rent instead of buy?
5-7 Why is it important to have a written lease? What should a rental contract include?
5-8 Briefly describe the various benefits of owning a home. Which one is most important to
you? Which is least important?
5-9 What does the loan-to-value ratio on a home represent? Is the down payment on a home
related to its loan-to-value ratio? Explain.
5-10 What are mortgage points? How much would a home buyer have to pay if the lender
wanted to charge 2.5 points on a $250,000 mortgage? When would this amount have to be
paid? What effect do points have on the mortgage’s rate of interest?
5-11 What are closing costs, and what items do they include? Who pays these costs, and
when?
Closing costs are all other expenses besides the down payment that borrowers ordinarily pay at
5-12 What are the most common guidelines used to determine the monthly mortgage
payment one can afford?
5-13 Why is it advisable for the prospective home buyer to investigate property taxes?
5-14 Describe some of the steps home buyers can take to improve the home-buying process
and increase their overall satisfaction with their purchases.
5-15 What role does a real estate agent play in the purchase of a house? What is the benefit
of the MLS? How is the real estate agent compensated, and by whom?
Most home buyers rely on real estate agents because they’re professionals who are in daily
contact with the housing market. Once you describe your needs to an agent, he or she can begin
5-16 Describe a real estate short sales transaction. What are the potential benefits and costs
from the perspective of the homeowner?
5-17 Why should you investigate mortgage loans and prequalify for a mortgage early in the
home-buying process?
5-18 What information is normally included in a real estate sales contract? What is an
earnest money deposit? What is a contingency clause?
State laws generally specify that, to be enforceable in court, real estate buy–sell agreements must
5-19 Describe the steps involved in closing the purchase of a home.
5-20 Describe the various sources of mortgage loans. What role might a mortgage broker
play in obtaining mortgage financing?
5-21 Briefly describe the two basic types of mortgage loans. Which has the lowest initial
rate of interest? What is negative amortization, and which type of mortgage can experience
it? Discuss the advantages and disadvantages of each mortgage type.
The fixed-rate mortgage still accounts for a large portion of all home mortgages. Both the rate
5-22 Differentiate among conventional, insured, and guaranteed mortgage loans.
Critical Thinking Problems
5.1 The Newtons New Car Decision: Lease versus Purchase
Farrah and Same Newton, a dual-income couple in their late 20s, want to replace their
seven-year-old car, which has 90,000 miles on it and needs some expensive repairs. After
reviewing their budget, the Newtons conclude that they can afford auto payments of not
more than $350 per month and a down payment of $2,000. They enthusiastically decide to
visit a local dealer after reading its newspaper ad offering a closed-end lease on a new car
for a monthly payment of $245. After visiting with the dealer, test-driving the car, and
discussing the lease terms with the salesperson, they remain excited about leasing the car
but decide to wait until the following day to finalize the deal. Later that day, the Newtons
begin to question their approach to the new car acquisition process and decide to
reevaluate their decision carefully.
Critical Thinking Questions
1. What are some basic purchasing guidelines that the Newtons should consider when
choosing which new car to buy or lease? How can they find the information they need?
2. How would you advise the Newtons to research the lease-versus-purchase decision before
visiting the dealer? What are the advantages and disadvantages of each alternative?
3. Assume that the Newtons can get the following terms on a lease or a bank loan for the
car, which they could buy for $17,000. This amount includes tax, title, and license fees.
• Lease: 48 months, $245 monthly payment, 1 month’s payment required as a security
deposit,
$350 end-of-lease charges; a residual value of $6,775 is the purchase option price at the end
of the lease.
• Loan: $2,000 down payment, $15,000, 48-month loan at 5 percent interest requiring a
monthly payment of $345.44; assume that the car’s value at the end of 48 months will be
the same as the residual value and that sales tax is 6 percent.
The Newtons can currently earn interest of 3 percent annually on their savings. They
expect to drive about the same number of miles per year as they do now.
a. Use the format given in Worksheet 5.1 to determine which deal is best for the Newtons.
b. What other costs and terms of the lease option might affect their decision?
c. Based on the available information, should the Newtons lease or purchase the car? Why?
Name Farrah and Same Newton Date 4-May-16
Item Description Amount
Lease
1 Initial payment:
a. Down payment (capital
cost reduction)
b. Security deposit: 245
2 Term of lease and loan (years) 4
3 Term of lease and loan (months) (item 2 * 12) 48
4 Monthly lease payment 245
5 Total payment over term of lease (item 3 * 4) 11,760
6 Interest rate earned on savings (in decimal form) 0.03
7 Opportunity cost of initial payemnt (item 1*2*6) 29
8 Payment/refund from market value adjustment
at end of lease ($0 for closed-end leases) and/or 350
estimated end-of-term charges
16 Opportunity cost of down payment (item 2 * 6 * 11) 240
17 Estimated value of car at end of loan 6,775
18 Total cost pf purchasing (item 11 + 13 + 15 + 16 - 17) 13,066$
Decsion: If the value of item 9 is less than the value of item 18, leasing
is preferred; otherwise the purchase alternative is preferred.
Automobile Lease Versus Purchase Analysis
5.2 Evaluating a Mortgage Loan for the Gerrards
Ben and Marie Gerrard, both in their mid-20s, have been married for four years and have
two preschool-age children. Ben has an accounting degree and is employed as a cost
accountant at an annual salary of $62,000. They’re now renting a duplex but wish to buy a
home in the suburbs of their rapidly developing city. They’ve decided they can afford a
$215,000 house and hope to find one with the features they desire in a good neighborhood.
The insurance costs on such a home are expected to be $800 per year, taxes are expected to
be $2,500 per year, and annual utility bills are estimated at $1,440—an increase of $500
over those they pay in the duplex. The Gerrards are considering financing their home with
a fixed-rate, 30-year, 6 percent mortgage. The lender charges 2 points on mortgages with
20 percent down and 3 points if less than 20 percent is put down (the commercial bank that
the Gerrards will deal with requires a minimum of 10 percent down). Other closing costs
are estimated at 5 percent of the home’s purchase price. Because of their excellent credit
record, the bank will probably be willing to let the Gerrards’ monthly mortgage payments
(principal and interest portions) equal as much as 28 percent of their monthly gross
income. Since getting married, the Gerrards have been saving for the purchase of a home
and now have $44,000 in their savings account.
Critical Thinking Questions
1. How much would the Gerrards have to put down if the lender required a minimum 20
percent down payment? Could they afford it?
2. Given that the Gerrards want to put only $25,000 down, how much would their closing
costs be?
Considering only principal and interest, how much would their monthly mortgage
payments be?
Would they qualify for a loan using a 28 percent affordability ratio?
3. Using a $25,000 down payment on a $215,000 home, what would the Gerrards’ loan-to-
value ratio be? Calculate the monthly mortgage payments on a PITI basis.
4. What recommendations would you make to the Gerrards? Explain.
5.3 Julie’s Rent-or-Buy Decision
Julie Brown is a single woman in her late 20s. She is renting an apartment in the
fashionable part of town for $1,200 a month. After much thought, she’s seriously
considering buying a condominium for $175,000. She intends to put 20 percent down and
expects that closing costs will amount to another $5,000; a commercial bank has agreed to
lend her money at the fixed rate of 6 percent on a 15-year mortgage. Julie would have to
pay an annual condominium owner’s insurance premium of $600 and property taxes of
$1,200 a year (she’s now paying renter’s insurance of $550 per year). In addition, she
estimates that annual maintenance expenses will be about 0.5 percent of the price of the
condo (which includes a $30 monthly fee to the property owners’ association). Julie’s
income puts her in the 25 percent tax bracket (she itemizes her deductions on her tax
returns), and she earns an after-tax rate of return on her investments of around 4 percent.
Critical Thinking Questions
1. Given the information provided, use Worksheet 5.2 to evaluate and compare Julie’s
alternatives of remaining in the apartment or purchasing the condo.
A. Cost of Renting
1 Annual rental costs 14400
(12 * monthly rental rate of 1200
2Renter’s insurance 550
3 Opportunity cost of security deposit:
times after-tax saving rate 4.0% 0
Total cost of renting (line A.1 + line A.2 + line A.3) 14,950$
B. Cost of Buying
Purchase price of home 175,000
1
Annual mortgage payments:
Terms 140,000 6.0% 15
(12 * monthly mortgage payment of $1,181.40 14,177
Mortgage pay't from Exhibit 5.9
Less:
7 Principal reduction in loan balance (see note below) 5,777
Tax Rate 0.25
8 Tax savings due to interest deductions* 2,100
of price of home) 0
Total cost of buying (line B.11 - line B.12) 10,275$
RENT-OR-BUY ANALYSIS -- Julie Brown
Note: Find monthly mortgage payments using a calculator or from Exhibit 5.9. An
easy way to approximate the portion of the annual loan payment that goes to
2. Working with a friend who is a realtor, Julie has learned that condos like the one that
she’s thinking of buying are appreciating in value at the rate of 3.5 percent a year and are
expected to continue doing so. Would such information affect the rent-or-buy decision
made in Question 1?
Explain.
3. Discuss any other factors that should be considered when making a rent-or-buy decision.
Location is important and must be considered. For example, the rental unit may be on a public
4. Which alternative would you recommend for Julie in light of your analysis?
Terms Found in the Chapter
adjustable-rate
mortgage (ARM)
A mortgage on which the rate of interest, and therefore the size of the
monthly payment, is adjusted based on market interest rate
movements.
adjustment period
On an adjustable-rate mortgage, the period of time between rate or
payment changes.
anchoring
A behavioral bias in which an individual tends to allow an initial
estimate (of value or price) to dominate one’s subsequent assessment
(of value or price) regardless of new information to the contrary.
balloon-payment
mortgage
A mortgage with a single large principal payment due at a specified
future date
biweekly mortgage
A loan on which payments equal to half the regular monthly payment
are made every two weeks.
buydown
Financing made available by a builder or seller to a potential new-
home buyer at well below market interest rates, often only for a short
period.
capitalized cost
The price of a car that is being leased.
closed-end lease
The most popular form of automobile lease; often called a walk-away
lease, because at the end of its term, the lessee simply turns in the car
(assuming the preset mileage limit has not been exceeded and the car
hasn’t been abused).
closing costs
All expenses (including mortgage points) that borrowers ordinarily
pay when a mortgage loan is closed and they receive title to the
purchased property.
condominium
(condo)
A form of direct ownership of an individual unit in a multiunit project
in which lobbies, swimming pools, and other common areas and
facilities are jointly owned by all property owners in the project.
contingency clause
A clause in a real estate sales contract that makes the agreement
conditional on such factors as the availability of financing, property
inspections, or obtaining expert advice.
conventional
mortgage
A mortgage offered by a lender who assumes all the risk of loss;
typically requires a down payment of at least 20 percent of the value
of the mortgaged property.
convertible ARM
An adjustable-rate mortgage loan that allows borrowers to convert
from an adjustable-rate to a fixed rate loan, usually at any time
between the 13th and the 60th month.
cooperative
apartment (co-op)
An apartment in a building in which each tenant owns a share of the
nonprofit corporation that owns the building.
depreciation
The loss in the value of an asset, such as an automobile, that occurs
over its period of ownership; calculated as the difference between the
price initially paid and the subsequent sale price.
down payment
A portion of the full purchase price provided by the purchaser when a
house or other major asset is purchased; often called equity.
earnest money
deposit
Money pledged by a buyer to show good faith when making an offer
to buy a home.
FHA mortgage
insurance
A program under which the Federal Housing Administration (FHA)
offers lenders mortgage insurance on loans having a high loan-to-
value ratio; its intent is to encourage loans to home buyers who have
very little money available for a down payment and closing costs.
fixed-rate mortgage
The traditional type of mortgage, in which both the rate of interest and
the monthly mortgage payment are fixed over the full term of the loan.
foreclosure
The process whereby lenders attempt to recover loan balances from
borrowers who have quit making payments by forcing the sale of the
home pledged as collateral. A borrower typically cannot make
scheduled mortgage payments and the lender repossesses the property
in an effort to recover the loan balance owed.
graduated-payment
mortgage
A mortgage that starts with unusually low payments that rise over
several years to a fixed payment.
growing-equity
mortgage
Fixed-rate mortgage with payments that increase over a specific
period. Extra funds are applied
to the principal so that the loan is paid off more quickly.
homeowner’s
insurance
Insurance that is required by mortgage lenders and covers the
replacement value of a home and its contents.
interest-only
mortgage
.
A mortgage that requires the borrower to pay only interest; typically
used to finance the purchase of more expensive properties
index rate
On an adjustable-rate mortgage, the baseline index rate that captures
interest rate movements.
interest rate cap
On an adjustable-rate mortgage, the limit on the amount that the
interest rate can increase each adjustment period and over the life of
the loan.
lease
An arrangement in which the lessee receives the use of a car (or other
asset) in exchange for making monthly lease payments over a
specified period.
loan-to-value ratio
The maximum percentage of the value of a property that the lender is
willing to loan.
margin
On an adjustable-rate mortgage, the percentage points a lender adds to
the index rate to determine the rate of interest.
money factor
The financing rate on a lease; similar to the interest rate on a loan.
mortgage banker
A firm that solicits borrowers, originates primarily government-
insured and government- guaranteed loans, and places them with
mortgage lenders; often uses its own money to initially fund
mortgages that it later resells.
mortgage broker
A firm that solicits borrowers, originates primarily conventional loans,
and places them with mortgage lenders; the broker merely takes loan
applications and then finds lenders willing to grant the mortgage loans
under the desired terms.
mortgage loan
A loan secured by the property: If the borrower defaults, the lender
has the legal right to liquidate the property to recover the funds it is
owed.
mortgage points
Fees (one point equals 1 percent of the amount borrowed) charged by
lenders at the time they grant a mortgage loan; they are related to the
lender’s supply of loanable funds and the demand for mortgages.
Multiple Listing
Service (MLS)
A comprehensive listing, updated daily, of properties for sale in a
given community or metropolitan area; includes a brief description of
each property with a photo and its asking price but can be accessed
only by realtors who work for an MLS member.
negative
amortization
When the principal balance on a mortgage loan increases because the
monthly loan payment is lower than the amount of monthly interest
being charged; some ARMs are subject to this undesirable condition.
open-end (finance)
lease
An automobile lease under which the estimated residual value of the
car is used to determine lease payments; if the car is actually worth
less than this value at the end of the lease, the lessee must pay the
difference.
payment cap
On an adjustable-rate mortgage, the limit on the monthly payment
increase that may result from a rate adjustment.
PITI
Acronym that refers to a mortgage payment including stipulated
portions of principal, interest, property taxes, and homeowner’s
insurance.
prequalification
The process of arranging with a mortgage lender, in advance of
buying a home, to obtain the amount of mortgage financing the
lender deems affordable to the home buyer.
private mortgage
insurance (PMI)
An insurance policy that protects the mortgage lender from loss in the
event the borrower defaults on the loan; typically required by lenders
when the down payment is less than 20 percent.
property taxes
Taxes levied by local governments on the assessed value of real estate
for the purpose of funding schools, law enforcement, and other local
services.
purchase option
A price specified in a lease at which the lessee can buy the car at the
end of the lease term.
Real Estate
Settlement
Procedures Act
(RESPA)
A federal law requiring mortgage lenders to give potential borrowers a
government publication describing the closing process and providing
clear, advance disclosure of all closing costs to home buyers.
real estate short
sale
Sale of real estate property in which the proceeds are less than the
balance owed on a loan secured by the property sold.
rent ratio
The ratio of the average house price to the average annual rent, which
provides insight into the relative attractiveness of buying a house
versus renting in a given area of potential interest.
rental contract
(lease agreement)
A legal instrument that protects both the lessor and the lessee from an
adverse action by the other party; it specifies the amount of the
monthly payment, the payment due date, penalties for late payment,
the length of the lease agreement, deposit requirements, fair wear and
tear, definitions and provisions, the distribution of expenses, renewal
options and early termination penalties, and any restrictions on
children, pets, subleasing or using the facilities.
residual value
The remaining value of a leased car at the end of the lease term.
sales contract
An agreement to purchase an automobile that states the offering price
and all conditions of the offer; when signed by the buyer and seller,
the contract legally binds them to its terms.
shared-appreciation
mortgage
A loan that allows a lender or other party to share in the appreciated
value when the home is sold.
title check
The research of legal documents and courthouse records to verify that
the seller conveying title actually has the legal interest he or she
claims and that the title is free of all liens and encumbrances.
two-step ARM
.
An adjustable-rate mortgage with just two interest rates: one for the
first five to seven years of the loan, and a higher one for the
remaining term of the loan
VA loan guarantee
A guarantee offered by the U.S. Veterans Administration to lenders
who make qualified mortgage loans to eligible veterans of the U.S.
Armed Forces and their unmarried surviving spouses.
Chapter 5
Making Automobile
and Housing Decisions
Learning Goals
How Will This Affect Me?
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
II. The Purchase Transaction
A. Negotiating Price
B. Closing the Deal
III. Leasing Your Car
A. The Leasing Process
B. Lease versus Purchase Analysis
C. When the Lease Ends
IV. Meeting Housing Needs: Buy or Rent?
A. Housing Prices and the Financial Crisis 2008-2009
B. What Type of Housing Meets Your Needs?
C. Analyzing the Rent-or-Buy Decision
V. 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
F. Affordability Ratios
G. Property Taxes and Insurance
H. Maintenance and Operating Expenses
I. Performing a Home Affordability Analysis
VI. 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
VI. Financing the Transaction
A. Sources of Mortgage Loans
B. Types of Mortgage Loans
C. Fixed-Rate Mortgages
D. Adjustable-Rate Mortgages (ARMs)
a. Features of ARMs
b. Beware of Negative Amortization
E. Fixed Rate or Adjustable Rate?
