1 / 28

Mortgage Decisions

Mortgage Decisions. When TANC is Not Enough. How Can We Choose the Right Mortgage from the Many Options?. So far in the course, we compared fixed rate loan A with fixed rate loan B. The loans only varied in terms of coupon rate and points TANC worked well for guiding us to the best loan.

kadeem-weaver
Download Presentation

Mortgage Decisions

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Mortgage Decisions When TANC is Not Enough

  2. How Can We Choose the Right Mortgage from the Many Options? • So far in the course, we compared fixed rate loan A with fixed rate loan B. • The loans only varied in terms of coupon rate and points • TANC worked well for guiding us to the best loan. • TANC worked because we were comparing loans with very similar patterns of cash flows over time • Loan amounts were fixed • Loan maturities were fixed • Very similar time patterns of cash flows • Now we will consider more complex decisions

  3. GPM v FRM • Basic loan terms • Fixed rate of interest: 6% • Loan Amount: $200,000 • Maturity: 30 years • GPM loan provides for five years of increasing payments with each increase equal to 5% • TANC of both loans (no points/no fees) are identical at 6% no matter when the borrower prepays.

  4. Same Basic Three Steps • Layout the Cash Flows • Determine the Appropriate Discount Rate • Calculate the Present Value • In our case, since we will be calculating the present values of costs, we want to choose the lower PV.

  5. Step 1:Layout the Cash Flows (monthly payments)

  6. What Does the Difference Column Mean? • Think of the difference column as a proposed investment program • You “invest” $217.20 per month for 12 months • Then you invest $168.11/month for 12 months • Invest $116.56 for 12 months • Invest $5.60 for 12 months • Return on your investment comes in months 61-360 • Receive $54.08 per month return (inflow) • Is this a reasonable investment to make? • How would you evaluate this investment opportunity?

  7. Remember the Three Step Rule! • Layout the Cash flows • Determine the right discount rate • Calculate the Present Value • For an investment, we want the present value to be positive • What discount rate should an investor use? • Opportunity cost of capital • What is our alternative best use of capital? • If we accept this investment proposal, what must we give up? Where will we get the money to invest? • Need to adjust for risk—but we will gloss over that here • Opportunity cost of capital varies from individual to individual

  8. Summary of PV Analysis for Different Discount Rates For Opportunity Cost of Capital of 6% of Less the FRM Costs Less For Opportunity Cost of capital > 6%, the GPM Costs Less Figures in Columns Labeled GPM & FRM are present values of future costs. We want the lowest cost possible. Difference column is GPM-FRM

  9. Tools • See EXCEL Spreadsheet for GPM/FRM Comparisons • Allows you to describe a GPM and a FRM Loan • Could input different rates and maturities • Spreadsheet does the manual work for you associated with laying out the cash flows • Plots Cash Flows over time • Calculates differences in cash flows • Calculates present values for different discount rates • Allows specification of different prepayment assumptions • With same rate/same maturity, different prepayment assumptions don’t matter much • With different rates or different maturities, prepayment matters • Experiment yourself: Try GPM rate of 6.125% (compensation for extra risk of GPM)

  10. Loans That Differ in Amount (LTV) • Consider two loans that differ in amount (LTV) and rate • Loan 1: 80% LTV @ 6% • Loan 2: 90% LTV @ 6.5% • Loan rates differ because higher LTV loans have higher default risk • Could be result of higher cost of PMI • Assume House Value is $200,000

  11. Step 1: Layout Cash Flows • Need to know what the payments on the two loans are:

  12. First Look • Cash Flows associated with Loan 2 are always higher: • If there are no points or fees, TANC of Loan 2 is significantly higher than for Loan 1 • But, Loan 2 pays the borrower $20,000 more at time zero.

  13. Tools: Use Compare 2 Loans Spreadsheet(assume no prepayment)Difference calculated as cost of Loan 2 minus cost of Loan 1 minus $20,000 difference in loan amounts

  14. Compare Loans with Different LTV • Assuming No Prepayment: • Table shows that for opportunity cost of capital of 10% or less, Loan 1 is less expensive • For higher opportunity cost of capital, Loan 2 is less expensive • Breakeven is at 10.20% • If you have really profitable investment opportunities that you are confident will earn you more than 10.20%, you should borrow the extra $20,000 and use the extra money in your investment opportunity • If you only plan to sock your savings away in a nice safe CD at 5%, you are better off to use those savings to reduce your loan amount and take loan 1 • Incremental cost of borrowing the extra $20,000 is 10.20% • Determine this by looking at the difference in cash flows.

  15. Prepayment Matters • Because you are paying different rates, it is intuitive that the choice should depend on how long you will be paying the extra rate. The table below shows how the breakeven rate varies with time to prepayment

  16. Prepayment Matters • Previous Slide Shows that Time to Prepayment Matters • But not too much in this case • Shorter time to prepay raises the OCC required to justify using loan 2 • Intuition: The higher LTV loan has a higher interest rate and slower amortization. • Both aspects contribute to the higher payments associated with Loan 2 • The earlier you pay the loan off, the sooner you pay the part of the extra cost associated with the slower amortization.

  17. Refinance Decisions • Refinance Decisions frequently generate the most complicated changes in cash flows. • The same approach still works: • Layout the cash flows from current loan and possible new loan • Choose the right discount rate (OCC) • Calculate the present value of the future costs associated with each alternative • Choose the lowest cost as measured by PV

  18. Refinance Example • Current Loan: • Rate 7% • UPB $185,000 • Remaining Term: 26 years • Monthly PMT $1289.15 • Refinance Loan • Rate 5.75% • Term 15 years • Costs of Obtaining New Loan $5000 • Extra Borrowing $10,000

  19. Step 1: Layout Cash FlowsCurrent Loan • Existing Loan • Borrower is obligated to make payment (1289.15) until the earlier of maturity or prepayment • If prepaid before maturity, borrower must repay remaining loan balance at that time • Initially, assume that the borrower does not intend to prepay.

  20. Step 1: Layout Cash FlowsRefinance Loan • Loan Balance • Depends on whether we “finance” the additional costs ($5,000) and whether we want to “take cash out” • Here assume we finance the costs and take out $10,000 extra cash. • New loan balance= $185,000 (to repay old loan) • +$ 5,000 (for costs) • +$ 10,000 (for cash out) • =$200,000 New loan balance • Regular monthly payment on 15 year, 5.75%, $200,000 loan • $1660.82

  21. Cash Flows for next 12 months

  22. Cash Flows After 15 Years Existing REFI Difference

  23. Complex Cash Flows • If you Refinance, cash flows change sign two different times • You initially collect $10,000 at time zero • You pay $371.67 every month for $180 Months • You save $1289.16 for 132 months • Warning! With these kinds of cash flows, IRR can give you misleading answers • You have to use Present Value not IRR for these kinds of problems

  24. Steps 2 & 3: Calculate Present Value

  25. To REFI or Not To REFI? • If you have a very low OCC (< 10%), the REFI has a lower cost and you should do it. • If you have an OCC >10%, you should stick with your old loan> Why? • Despite the fact that you took out $10,000 at time zero, the higher cost refi loan requires you to make higher payments for 180 Months. With your high opportunity cost of capital, those higher payments simply cost you too much in foregone investment profits. • But, if your OCC is too high (say > 45% --lucky you), then the REFI loan again looks good • In this case, with such a high investment potential, the profits from investing the $10,000 “cash out” dominate the lost profits from the higher payments.

  26. Complex Cash Flows

  27. Prepayment Matters– A Lot!

  28. You Can Solve Any Problem Like These by Following the Three Simple Steps • Layout the cash flows for each alternative being considered • Determine the right discount rate • Calculate the present value of the costs associated with each alternative

More Related