MT431 Unit 10 Mortgage Financing Recommendation Example

A 7/6 ARM With Conditions: An MT431 Unit 10 Financing Recommendation for a $420,000 Purchase

[Student Name]

Purdue University Global

MT431: Real Estate Finance and Ethics

Unit 10 Financing Recommendation

[Instructor Name]

[Date]

The couple, the four loan structures and the compensation estimates are composite; loan figures come from the script described, bracketed amounts are estimates, and the sources cited are real.

The Borrowers

Sam and Priya Delgado, a composite couple, are buying a $420,000 home. Sam's employer has told him his role will likely move to the company's Denver office within five to seven years. They have $90,000 available for a down payment and closing costs and want to keep at least $20,000 in reserve.

Four Structures on a Common Basis

All four options are priced over sixty months, with interest, mortgage insurance, the balance at month 60 and principal repaid, so they can be compared directly.

Option 1 is a 30-year fixed loan at 6.75 percent with 20 percent down, a loan of $336,000. The payment is $2,179.29. Over five years the couple would pay $110,180 in interest, repay $20,578 of principal and owe $315,422 at month 60.

Option 2 is the same fixed loan with 10 percent down, a loan of $378,000, which requires mortgage insurance at about $142 a month. The payment is $2,451.70 before insurance. Five years of interest come to $123,952 and mortgage insurance to about $8,505. The balance at month 60 is $354,850.

Option 3 is a 7/6 adjustable-rate loan indexed to SOFR, starting at 5.99 percent for seven years, with 20 percent down. The payment is $2,012.33. Five years of interest come to $97,364, principal repaid to $23,376 and the balance at month 60 to $312,624.

Option 4 is a 15-year fixed loan at 5.875 percent with 20 percent down. The payment is $2,812.72. Five years of interest come to $87,553, principal repaid to $81,211, and the balance at month 60 to $254,789.

Pricing the Cash Difference

Option 2 keeps $42,000 more in the couple's pocket at closing, so its cost must be measured against that cash. Over five years it costs $13,772 more in interest than Option 1 and adds $8,505 in mortgage insurance, about $22,277 for the use of $42,000, roughly 10.6 percent a year. Unless the couple has a use for the $42,000 that earns more than that, or needs it as a reserve, the smaller down payment is expensive money.

The ARM's Risk

The ARM's rate is fixed for the first 84 months, then adjusts every six months to SOFR plus a margin, within caps of 5, 1 and 5: up to 5 points at the first adjustment, 1 point at each adjustment after, and 5 points over the life of the loan. In the worst case the rate would rise from 5.99 percent to 10.99 percent at month 85. With a balance then of about $301,135 and 276 months remaining, the payment would rise from $2,012.33 to $3,000.21, about $988 more a month. The handbook regulators publish for borrowers stresses exactly this calculation, the payment at the cap, as the figure to plan around (Consumer Financial Protection Bureau, 2014).

The ARM is cheaper for every month the Delgados expect to own the house and dangerous only in months they do not plan to be there.

Comparing the Options Over Five Years

The 15-year loan pays the least interest and builds the most equity, but its payment of $2,812.72 is about $800 more than the ARM's, and much of the equity it builds is simply cash moved from the couple's budget into the house. Over a five-year stay, its advantage is forced saving, not a lower cost of borrowing.

Between the two 20 percent down loans that keep payments low, the ARM saves about $12,816 in interest over five years and leaves a balance about $2,800 lower at sale. Koijen et al. (2009) showed that the choice between fixed and adjustable loans turns largely on the premium a fixed rate charges for protection against future rate changes; for a borrower likely to sell before the first reset, much of that protection goes unused.

Who Earns From Each Structure

A profit map traces each structure to the parties paid by it. The loan officer is usually paid a share of the loan amount, about [1 percent], so a larger loan pays more: about [$3,780] on Option 2 against [$3,360] on the others. The lender earns a gain when it sells a fixed-rate loan into the securities market, and adjustable loans are more often held in its own portfolio, earning the rate spread over time. The mortgage insurer earns only on Option 2, about $8,505 over five years. Investors in mortgage securities earn the interest on the fixed loans. The servicer earns a fee of about [0.25 percent] of the balance each year, roughly [$4,000] over five years on any of the 20 percent down loans. Knowing who earns from each choice explains why some structures are suggested more often than others, and Campbell (2006) notes how often households take the option presented to them rather than the one that suits them.

What the Delgados Should Ask Before Signing

Three questions would protect the couple whatever they choose. They should ask the lender to state the ARM's margin in writing, since the margin, added to SOFR at each reset, decides the rate after year seven and is not limited by the caps. They should ask whether the loan carries a prepayment penalty, since the plan depends on selling or refinancing without one. And they should ask for a second quote on the fixed loan from another lender, since the pricing gap between the fixed loan and the ARM is part of the reason the ARM wins, and that gap can differ from one lender to the next.

They should also compute their own payment at the worst case before signing, not rely on the disclosure alone, and put that figure beside their budget. A household that can carry about $3,000 a month, even if it would be uncomfortable, can take the ARM with a clear view of its risk.

Recommendation and Conditions

The Delgados should take Option 3, the 7/6 ARM with 20 percent down. It has the lowest payment, the lowest five-year interest cost of the low-payment options and a rate fixed through the seven years they expect to own the home.

Three conditions would change the recommendation. If the move to Denver becomes unlikely, and they expect to stay beyond seven years, Option 1 is the better choice, since its rate never changes. If their budget could not carry a payment of about $3,000, they should not take the ARM even for a short expected stay. If they need to keep more than $20,000 in reserve, Option 2 becomes reasonable despite its cost, because cash may matter more than rate.

References

Campbell, J. Y. (2006). Household finance. Journal of Finance, 61(4), 1553-1604. https://doi.org/10.1111/j.1540-6261.2006.00883.x

Consumer Financial Protection Bureau. (2014). Consumer handbook on adjustable-rate mortgages.

Koijen, R. S. J., Van Hemert, O., & Van Nieuwerburgh, S. (2009). Mortgage timing. Journal of Financial Economics, 93(2), 292-324. https://doi.org/10.1016/j.jfineco.2008.09.005