Section 11.5
Buying a
House with a
Mortgage
INB Table of Contents
Date Topic Page #
February 19, 2014 Section 11.5 Examples 36 February 19, 2014 Section 11.5 Notes 37
What You Will Learn
Homeowner’s Mortgage
Conventional Loans
Adjustable-Rate Mortgages
Homeowner’s Mortgage
A
homeowner’s mortgage
is a
long-term loan in which the property is
pledged as a security payment of the
difference between the down payment
and the sale price.
Homeowner’s Mortgage
The two types are the
conventional
loan
and the
adjustable-rate loan
(or
the
variable-rate loan
).
The major difference between the two is
that the interest rate for a conventional
loan is fixed for the duration of the loan,
where as the interest rate for the
variable-rate loan may change every
period, as specified in the loan
.
Homeowner’s Mortgage
Lending institutions may require the buyer to
pay one or more
points
for a loan at the time
of the closing (the final step in the sale
process).
According to the Internal Revenue Service,
points are interest prepaid by the buyer and
may be used to reduce the stated interest rate
the lender charges.
One point is equal to 1% of the loan amount.
Example 1: Down Payment and
Points
Patricia and Marshall Martin wish to purchase a house selling for $249,000. They plan to obtain a loan from their bank. The bank
requires a 15% down payment, payable to the seller, and a payment of 2 points, payable to the bank, at the time of closing.
a) Determine the Martin’s down payment.
b) Determine the amount of the Martin’s mortgage.
c) Determine the cost of the 2 points paid by the Martins on their
mortgage.
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Qualifying for a Mortgage
Banks use a formula to determine the maximum
monthly payment that they believe is within the purchaser’s ability to pay.
They calculate the adjusted monthly income which
equals the gross monthly income minus any fixed monthly payments (with more than 10 payments remaining).
They multiply that result by 28%.
This is the maximum monthly payment the lending
institution believes the purchaser can afford.
This includes: principal, interest, tax, insurance.
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Principal and Interest Payment
Formula
m is principal and interest payment
p is the amount of the mortgage
r is the interest rate as a decimal
n is the number of payments per year
t is the time in years
m
p
r
n
1
1
r
n
nt
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Example 3: Using the Principal
and Interest Payment Formula
Use the principal and interest payment formula to calculate the Martin’s monthly principal and interest
payment. Recall that the Martins are seeking a 30-year, $211,650 mortgage with an interest rate of 7%.
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Amortization Schedule
By repeatedly using the simple interest formula month
to month on the unpaid balance, you could calculate the principal and the interest for all the payments, which is a tedious task.
However, a list containing the payment number,
payment on the interest, payment on the principal, and balance of the loan can be prepared using a computer. Such a list is called a loan amortization schedule.
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Am
or
tizati
on
Sch
edule
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Adjustable Rate Mortgages
Also, called ARMs or
variable-rate
mortgages
.
The monthly mortgage payment rate
remains the same for a 1, 2, or 5-year
period, even though the interest rate of a
mortgage may change every 3 or 6
months or some other predetermined
period.
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Adjustable Rate Mortgages
The monthly payment is readjusted
after the time period so the loan will be
paid off in the set amount of time or
the bank may extend the time period
of the loan beyond the predetermined
years to make the payment affordable.
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Example 5: An Adjustable-Rate
Mortgage
Tony and Keisha Torrence purchased a house for $115,000 with a down
payment of $23,100. They obtained a 30-year adjustable-rate mortgage with the following terms. The interest rate is based on a 6-month Treasury bill. The interest rate charged is 3% above the interest rate of the 6-month Treasury bill (3% is the add on rate). The interest rate is adjusted every 6 months on the date of adjustment. The interest rate will not change more than 1% (up or down) when it is adjusted. The maximum interest rate for the duration of the loan is 12%. There is no lower limit on the interest rate. The initial mortgage interest rate is 5.5%, and the monthly payments (including principal and
interest) are adjusted every 5 years.
a) Determine the initial monthly payment.
b) Determine the adjusted interest rate in 6 months if the interest rate on the
Treasury bill at that time is 2%.
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Table
11.4
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Rate Caps
To prevent rapid increases in interest rates,
some banks have a rate cap. A rate cap limits
the maximum amount the interest rate may
change.
A periodic rate cap limits the amount the
interest rate may increase in any one period.
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Rate Caps
An aggregate rate cap limits the interest rate
increase and decrease over the entire life of
the loan.
A payment cap limits the amount the monthly
payment may change but does not limit
changes in interest rates.
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