Property Investment and Financing Chapter 6

Chapter06:Mortgages:AdditionalConcepts,Analysis,andApplicationsMcGraw-Hill/IrwinCopyright©2011bytheMcGraw-HillCompanies,Inc.Allrightsreserved.6-2IncrementalBorrowingCostComparefinancingalternatives–Whatistherealcostofborrowingmoremoneyatahigherinterestrate?–Alternatively,whatistherequiredreturntojustifyalowerdownpayment?–Basicprinciplewhencomparingchoices:Whatarethecashflowdifferences?6-3IncrementalBorrowingCostExample6-1:–HomeValue=$150,000–TwoFinancingAlternatives#1:90%LoantoValue,8.5%InterestRate,30Years#2:80%LoantoValue,8%InterestRate,30Years–Itappearsthereisonlya0.5%interestratedifference,but…6-4IncrementalBorrowingCostAlternative#1Alternative#2LTV90%80%i8.5%8%Term30Years30YearsDownpayment$15,000$30,000Loan$135,000$120,000Payment$1,038.03$880.526-5Exhibit6-2EffectofLoan-to-ValueRatioonLoanCost6-6Take-HomeMessageThemoreyouborrow,thehighertheinterestratewillbe.Whilewewilldiscussthisindetaillateron,thereisapointatwhichyoushouldnotborrowmoremoney.Theinterestratewillbejusttoohigh.Itisnoteconomicallyrationaltoborrowasmuchmoneyaspossible.6-7IncrementalBorrowingCostCashFlowDifferences–Borrow$15,000more–Pay$157.51permonthmore=$15,000=$157.51=360=$0=12.28%niCPTFVPMTPV6-8IncrementalBorrowingCost12.28%representstherealcostofborrowingtheextra$15,000.Canyouearnanequivalentriskadjustedreturnonthe$15,000thatisnotinvestedinthehome?Alternatively,canyouborrowtheadditional$15,000elsewhereatalowercost?6-9IncrementalBorrowingCostInExample6-1,whatiftheborrowerexpectstorelocateafter8years?Weneedthefutureexpectedloanbalances:–Alt#1:$123,810.30–Alt#2:$109,221.24–Difference:$14,589.06Thisbecomesafuturevalueinouranalysis.6-10IncrementalBorrowingCostCashFlowDifferences=$15,000=$157.51=96=$14,589.06=12.40%niCPTFVPMTPV6-11IncrementalBorrowingCostUseofdiscountpoints–AnalysiswouldchangeDependingonthepoints,thecashflowdifferenceattimezerowouldchange.InExample6-1,the$15,000differencewouldchange.Differentmaturities–InExample6-1,let’schangethetermofthealternative#2to25years.6-12IncrementalBorrowingCostAlternative#1Alternative#2LTV90%80%i8.5%8%Term30Years25YearsDownpayment$15,000$30,000Loan$135,000$120,000Payment$1,038.03$926.186-13IncrementalBorrowingCostCashFlowDifferences–Attime0:$15,000–Forthefirst300months:$111.85–Forthefinal60months:$1038.036-14IncrementalBorrowingCostUsingtheCashFlowRegister,=$15,000=$111.85=300=$1038.03=60=.8926x12=10.71%C0CPTC1F1C2F2IRR6-15LoanRefinancingBorrowerconsiderations–Termsonthepresentoutstandingloan–Whatarethenewloanterms?–Whatarethefeesassociatedwithpayingofftheoldloanandobtaininganewone?Applicationofbasiccapitalbudgetinginvestmentdecision–Whatisourreturnonaninvestmentinanewloan?6-16LoanRefinancingExample6-2:–Aborrowerhassecureda30year,$120,000loanat7%.Fifteenyearslater,theborrowerhastheopportunitytorefinancewithafifteenyearmortgageat6%.However,theupfrontfees,whichwillbepaidincash,are$2,500.Whatisthereturnoninvestmentiftheborrowerexpectstoremaininthehomeforthenextfifteenyears?6-17LoanRefinancingInitialLoan:–$120,000–30Years–7%Interest–Payment=$789.3615YearsLater–LoanBalance=$88,822.64–NewPaymentat6%=$749.546-18LoanRefinancingCost=$2,500Benefit=$48.82permonthfor15years=($2500)=$0=$48.82=180=22.62%niCPTFVPMTPV6-19LoanRefinancingInExample6-2,whatisthereturnoninvestmentiftheborrowerexpectstorelocateaftersevenyearsandnotremaininthehomeforthefullfifteenyears?–Nowweneedtheexpectedfutureloanbalancesfortheoriginalloanandthepossiblenewloan.6-20LoanRefinancingOriginalLoanBalance=$58,557.76RefinancedLoanBalance=$57,036.41Difference=$1521.35=($2500)=$1521.35=$48.82=84=20.93%niCPTFVPMTPV6-21LoanRefinancingInExample6-2,refinancingappearstobeagoodinvestment.Effectivecostofrefinancing:Prepaymentfeesonoldloancanbethoughtofasbeingofnewfeesfornewloan.BorrowingtherefinancingcostBiweeklypayments–Lowertheamountofinterestoverthelifeoftheloan–Repaytheloansooner6-22MarketValueofaLoanHowmuchwouldaninvestorpayfortheloan?–Theinvestorisbuyingthecashflowstreamoftheloan.–Discountloancashflowatthemarketrateofinterestthattheinvestorcanearnoninvestmentsofequivalentrisk.6-23MarketValueofaLoanExample6-3:–$100,000Loan–30Years–6%interest–Payment=$599.55–Oneyearlater,bookvalue=$98,771.99–Assumeinterestrateshaverisento7%.6-24MarketValueofaLoanTheinvestorwillnotpaybookvalue.Tocomputethemarketvalue:=$599.55=348=$0=7=$89,201.49Comparethistobookvalue.niCPTFVPMTPV6-25EffectiveCostofTwoorMoreLoansBasicTechnique–Computethepaymentsfortheloans–Combineintoacashflowstream–Computetheeffectivecostoftheamountborrowed,giventhecashflowstream.–Comparethecosttoalternativefinancingoptions.6-26EffectiveCostofTwoorMoreLoansExample6-4:–Youneeda$500,000financingpackage.–$100,000at7%,30YearsPayment=$665.30–$200,000at7.5%,20YearsPayment=$1611.19–$200,000at8%10YearsPayment=$2426.556-27EffectiveCostofTwoorMoreLoansUsingtheCashFlowRegister,=$500,000=$4703.04=120=$2276.49=120=$665.30=120=.6239x12=7.49%CF0CPTIRRC1F1F2C3F3C26-28BelowMarketFinancingAsellerwithabelowmarketrateassumableloaninplacemaybeabletosellthepropertyformorethan