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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.
From the worksheet below, there is an advantage to purchasing of over $8.000. Assuming that
the location and quality of the condo space is equal to the rental space, Julie should purchase the
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
Also the case is mute about how long she plans to remain in this location. If she plans to move
4. Which alternative would you recommend for Julie in light of your analysis?
I suggest she purchase the condo.
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.
foreclosure 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 A mortgage that requires the borrower to pay only interest; typically
mortgage
.
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
G. Reliability and Warranties
H. Other Considerations
I. The Purchase Transaction
J. Negotiating Price
K. Closing the Deal
L. Refinancing Your Auto Loan
*Testing Yourself*
II. Leasing Your Car
A. The Leasing Process
B. Lease versus Purchase Analysis
C. When the Lease Ends
*Testing Yourself*
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
*Testing Yourself*
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
F. Affordability Ratios
G. Property Taxes and Insurance
H. Maintenance and Operating Expenses
I. Performing a Home Affordability Analysis
*Testing Yourself*
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
*Testing Yourself*
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
*Testing Yourself*
Planning over a Lifetime
Summary
Financial Planning Exercises
Applying Personal Finance
How's Your Local Housing Market?
Critical Thinking Cases
5.1 The Newtons’ New Car Decision: Lease versus Purchase
5.2 Evaluating a Mortgage Loan for the Gerrards
5.3 Julie’s Rent-or-Buy Decision
Money Online!
