978-1305636613 Chapter 5 Solution Manual Part 4

Unlock access to all the studying documents.

View Full Document

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!