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Mortgage Decision Mini-Case #4 Travis May and Adam September 5, 2002 Introduction Taking out a mortgage of this size is a big decision and gives room to spend thousands of dollars that did not necessarily have to be spent. Decisions on how to pay a 30-year mortgage off can literally mean tens of thousands of dollars in finance charges. In light of the importance about the decision, we had to make a few assumptions before digging in. Assumptions First, we assumed that the loan would be sold to a corporation like Fannie Mae or Freddie Mac to be able to get a rate of 5.75% (fanniemae.com, freddimac.com). This, therefore would be a fixed rate note and all payments must be paid at the back-end of the note (Wilson). Second, we assumed that they purchased term insurance for at least the amount of the house to cover their assets if there was a death (Wilson). Third, we assumed that up to 3 payments a year could be made over and above the normal schedule of payments without hindering their current budget. Definitions There are some terms that may be confusing to the person without a financial background. This section gives clarification to terms that may be difficult to understand. Back End of Note: Payment made that does not roll a due date, the next payment must be made at originally scheduled time. Finance Charges: Cost of interest from taking out a loan, where the bank makes a profit CD: Initials for “Certificate of Deposit”; money deposited that will lock in a return from interest if kept deposited for a specific amount of time. Mortgage Loan: Money borrowed that will be paid off in a specific amount of time in installments at specified times, usually charges an interest rate on money borrowed. Home Equity Loan: Money that can be borrowed against the money that has already been paid into an original Mortgage loan for a house. Up to 80% of the appraised amount of property may be borrowed (Wilson). Sources Used In the pursuit of solving this case, bankrate.com, fanniemae.com, and freddiemac.com were used in figuring rates for loans, savings deposits and CD’s. Another source that was used was David Wilson, Senior Vice President and Commercial Loan Officer of Longview Bank & Trust Co. Through Mr. Wilson’s practical knowledge about this subject, and the facts from the three web sites, a very informed, and hopefully wise, decision was made. Questions to Be Answered To solve this problem, the following questions must be answered: 1. How many years can I cut off my note by paying one, two, and three payments extra each year? 2. What if the customer does not know if they can afford to make extra payments? 3. What are some alternatives and would they be beneficial? Solutions to Case Below is a chart that depicts how many years it will take to payoff this loan with one, two, and three payments being made above the normal payments during a year. It also gives an approximate value of money saved in finance charges by doing this. Approximate Figures for Early Payoff No Extra 1 Extra 2 Extra 3 Extra Payments Payment Payments Payments Time to Payoff 30 Years 25 Years * 21 1/2 Years 19 Years Interest Saved $ - $ 11,666.70 $ 23,333.40 $ 35,000.10 * Rounded Obviously, paying the most extra payments would payoff the loan the quickest. If the customer does not know if they can fit the extra payments into their budget, it would probably be a safe bet to not put that money in. However, a home equity loan may be taken out on the house. With a down payment of $80,000 given up front, this gives you the equity and allows some breathing room. With this cushion, the risk in paying extra is cut down considerably. There is at least one alternative. One could take out a CD and put money into it hoping to gain the interest money for paying off the note early. However, as shown on the last page, CD rates are lower than the interest rate on the loan (bankrate.com). With the home equity loans that are now in place, paying into your loan would be a better investment because of the higher interest rate and the fact that you can get that money back almost as easy as you can get the money back from a CD. Another alternative would be to invest that money into the stock market or into bonds. However, with age being somewhat of a factor, and with the market in the volatile stage that it is in, this could prove to be disastrous in the future. The risk is great but the return is high. Decision We have decided that that the best way for this customer to pay of f the note would be to add three or more payments per year. This will allow them to save $35,000 in finance charges, cut seven and one half years off their mortgage payout, and the money paid in is still accessible through a home equity loan if they ever got into a bind. This, however, must be reevaluated from time to time. With interest rates constantly changing, the return on investment in the different areas discussed above may be higher down the road. This customer is at an advantage if the rate is fixed at this relatively low interest rate. If they continue to be diligent in paying down the note, they will have many options in the future.
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