Herby Builds a Cash Flow

Some Events in Both Personal and Business Life are Measured by the Cost of Something

Needed, Rather than by Profit• Example - Herby Housing needs a place for his

family to live while he goes to school at SIU. Herby is debating whether to rent an apartment or buy a house (he has military benefits and his wife Hanna will be

working). Herby finds that the cost of renting will be $650/month. Herby does some house shopping and finds he can get a house in DeSoto for $28,000. Herby expects to take 5 years for school and wants to know what his housing is really going to cost?

Herby Builds a Cash Flow

$650Rent

$650Deposit

$650 Rent $730 Rent

$650 DepositRefund0 1 2 3 4 5 6 7 8 54 55 56 57 58 59 60

61

Cash Flow for Renting Scenario

Herby assumes rent will go up $20/year with inflation

The NPV of this cash flow will surely be negative - does that mean no go?

Herby Studies Buying

• The house will cost Herby $28,000. (Herby will finance that)

• Herby needs a 10% down payment $2,800• Herby discovers that there are “Closing Costs” when

you buy a house– Appraisal fee $250

– Flood Determination Letter $150

– Credit Report $25

– Dead Registration $15

– Mortgage Registration $15

– Private Mortgage Insurance $280

Herby’s first time home buyers adventure continues

• Herby will need to get Home Owners Insurance $600/year• Herby discovers that banks also like to charge their little “fees”

for starting up a loan• Herby can get a local loan from Union Shafters Bank

– Union Shafters will simply recover closing costs– Union Shafters will charge 8% annual interest compounded monthly over

15 years

• Herby could also get a loan over the internet from Inter Your Pocket Mortgage Lenders– 5% of face amount loan initiation - covers all closing costs– 1.5 points (rolled into the mortgage)– 6.25% annual interest compounded monthly over 30 years

Herby Compares Loans

• Union Shafters– Closing Costs $735– Down Payment $2,800– Needs $3,535 now

• Mortgage Payments– Loan Amount $28,000 - $2,800 (down payment) =

$25,200– Loan over 15 years at 8% interest - How do I get the

Payments?

Enter Our Super Hero

• I need to convert a present value amount into an annuity– A/P * Present Loan = Annuity of Loan

Payments• cancellation of units checks out

• What is the value of n?

• 15 years * 12 months/year = 180

• What is the value of i?

Oh NO You Don’tWe is smart students. We know that interest rate did not match the compounding period.

• Annual interest is 8%

• But it is compounded monthly

• Get the monthly rate– 8%/12 = 0.00667

• Plug and Crank– { 1.00667180 * 0.00667}/{1.00667180 -1} =

0.009559– $25,200 * 0.009559 = $240.88/month

Now Check Out the Internet Bank

• Loan Amount $25,200– 5% initiation fee $25,200*0.05 = $1,260

• Whats this point business– Lenders discount interest rate on the loan for an up

front payment of a percentage of the loan amount. A point is a catchy way of saying what percent of the loan amount they will charge (they often roll it into the loan)

– $25,200 * 0.015 = $378– Loan amount is $25,578

Get Our Monthly Payments

• What is n (30 year loan) n= 360

• Watch out for i compounding period mismatch trick– 6.25%/12 = 0.0052083

• Plug and Crunch– A/P 0.0052083, 360 = 0.006157

– $25,578 * 0.006157 = $157.49

Some Initial Statistics

• Action Up Front Cost Monthly Cost– Rent $1,300 $650– Buy with US $3,535 $240.88– Buy with IYP $4,060 $157.49

• Buying is looking really good right now except for those scary up front costs.

• Which loan should Herby get if he does buy the house?

Building some cash flows

………………………...

0 1 2 3 4 5 6 7 8 9

Resell theHouse

Interest is tax deductible but the loans have different interestrates

Loans have different terms so one loan will be more paid-offwhen the house sells (they will build “equity” faster)

69 months(assumed takes9 months to sellhouse)

The tax deduction and equity problem

• The handy magic numbers are designed to sweep cash in standard positions into the pot.

• We can always get questions they really weren’t designed to answer– This case - how much is interest and how much

is building equity

• Enter another answer - the spreadsheet

Setting Up Our SpreadsheetMortgage Calculation

Interest Rate/YearMonthly Interest

Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity

A speadsheet is a series of cells into which we type words, numbers or formulas.It will calculate the values for us automatically (it’s a nice little calculator).Because we can copy formula’s around it can help us avoid key punch errors or redoour homework quickly if we find we have made just one little mistake.

I often use convention of coloring cell yellow where I want someone to put in a number.

Putting in a FormulaMortgage Calculation

Interest Rate/Year 8Monthly Interest 0.006666667

Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity

I entered formula =c3/100/12

Each cell in the spreadsheet has a name. I can tell myformula to look in a specific cell for a value. This is howI can build formulas that refer to information I can change.(Remember I have two bank loans to work with).

In Excel I have to start a formula with =

The / sign means divide just like on acalculator.

Copy Formula TrickMortgage Calculation


Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity12

I entered 1 in cell a7

I entered =a7+1 into cell a8

I will click on that cell and copy it to the cells below. When I copy the formula each cell willrefer to the one above it. (ie- cell a12 will say = a11 + 1)

Developing the SpreadsheetMortgage Calculation


Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity1 25200 240.88 168 72.88 25127.1223456789

101112131415

You cansee whathappenedwhen Icopied theformula

I entered = b7*c4I entered =c7-d7

I entered =b7-e7

More Formula CopyingMortgage Calculation


Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity1 25200 240.88 168 72.88 25127.122 240.883 240.884 240.885 240.886 240.887 240.888 240.889 240.88

10 240.8811 240.8812 240.8813 240.8814 240.8815 240.88

I entered =c7 in cell c8 and then copied.Thus each cell simply copies the one above it.

What if I want to refer to the same cell each time and copy a formula?My interest cell multiplies the outstanding principle by c4 the monthlyinterest rate and I want to keep the same interest.

Lets Change formula in cell d7.Right now it says = b7*c4

In Excel, putting a dollar sign in frontof part of a cell name makes it stay thesame when copied. In this case I wantthe 4 part of c4 to stay the same= b7 * c$4

We’ll makenext periodsprincipleequal to whatwas leftfrom the timebefore.

= f7

Copy the FormulasMortgage Calculation


Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity1 25200 240.88 168 72.88 25127.122 25127.12 240.88 167.5141333 73.36586667 25053.754133 25053.75413 240.88 167.0250276 73.85497244 24979.899164 24979.89916 240.88 166.5326611 74.34733893 24905.551825 24905.55182 240.88 166.0370121 74.84298785 24830.708836 24830.70883 240.88 165.5380589 75.34194111 24755.366897 24755.36689 240.88 165.0357793 75.84422071 24679.522678 24679.52267 240.88 164.5301511 76.34984885 24603.172829 24603.17282 240.88 164.0211522 76.85884784 24526.31398

10 24526.31398 240.88 163.5087598 77.37124016 24448.9427411 24448.94274 240.88 162.9929516 77.88704843 24371.0556912 24371.05569 240.88 162.4737046 78.40629542 24292.6493913 24292.64939 240.88 161.9509959 78.92900406 24213.7203914 24213.72039 240.88 161.4248026 79.45519742 24134.2651915 24134.26519 240.88 160.8951013 79.98489873 24054.28029

Notice that with time the amount of moneygoing to Principle increases and interest decreasesas the debt is paid-off.

Equity is thedifference betweenwhat the house isworth and whatthe unpaid load is.Enter formula=b$7-f7and copy theformula

Magic at the EndMortgage Calculation


Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity1 25200 240.88 168 72.88 25127.12 72.882 25127.12 240.88 167.5141333 73.36586667 25053.75413 146.24593 25053.75413 240.88 167.0250276 73.85497244 24979.89916 220.10084 24979.89916 240.88 166.5326611 74.34733893 24905.55182 294.44825 24905.55182 240.88 166.0370121 74.84298785 24830.70883 369.29126 24830.70883 240.88 165.5380589 75.34194111 24755.36689 444.63317 24755.36689 240.88 165.0357793 75.84422071 24679.52267 520.47738 24679.52267 240.88 164.5301511 76.34984885 24603.17282 596.82729 24603.17282 240.88 164.0211522 76.85884784 24526.31398 673.686

10 24526.31398 240.88 163.5087598 77.37124016 24448.94274 751.057311 24448.94274 240.88 162.9929516 77.88704843 24371.05569 828.9443 Year 1 Interest12 24371.05569 240.88 162.4737046 78.40629542 24292.64939 907.3506 1983.20913 24292.64939 240.88 161.9509959 78.92900406 24213.72039 986.279614 24213.72039 240.88 161.4248026 79.45519742 24134.26519 1065.73515 24134.26519 240.88 160.8951013 79.98489873 24054.28029 1145.7216 24054.28029 240.88 160.3618686 80.51813139 23973.76216 1226.23817 23973.76216 240.88 159.8250811 81.05491893 23892.70724 1307.29318 23892.70724 240.88 159.2847149 81.59528506 23811.11196 1388.88819 23811.11196 240.88 158.7407464 82.13925363 23728.9727 1471.02720 23728.9727 240.88 158.1931513 82.68684865 23646.28585 1553.71421 23646.28585 240.88 157.6419057 83.23809431 23563.04776 1636.95222 23563.04776 240.88 157.0869851 83.79301494 23479.25474 1720.74523 23479.25474 240.88 156.528365 84.35163504 23394.90311 1805.097 Year 2 Interest24 23394.90311 240.88 155.9660207 84.91397927 23309.98913 1890.011 1907.925 23309.98913 240.88 155.3999275 85.48007247 23224.50906 1975.49126 23224.50906 240.88 154.8300604 86.04993962 23138.45912 2061.54127 23138.45912 240.88 154.2563941 86.62360588 23051.83551 2148.16428 23051.83551 240.88 153.6789034 87.20109659 22964.63442 2235.36629 22964.63442 240.88 153.0975628 87.78243723 22876.85198 2323.14830 22876.85198 240.88 152.5123465 88.36765348 22788.48432 2411.51631 22788.48432 240.88 151.9232288 88.95677117 22699.52755 2500.47232 22699.52755 240.88 151.3301837 89.54981631 22609.97774 2590.02233 22609.97774 240.88 150.7331849 90.14681508 22519.83092 2680.16934 22519.83092 240.88 150.1322061 90.74779385 22429.08313 2770.91735 22429.08313 240.88 149.5272209 91.35277914 22337.73035 2862.27 Year 3 Interest36 22337.73035 240.88 148.9182023 91.96179767 22245.76855 2954.231 1826.33937 22245.76855 240.88 148.3051237 92.57487632 22153.19368 3046.80638 22153.19368 240.88 147.6879578 93.19204216 22060.00163 3139.99839 22060.00163 240.88 147.0666776 93.81332245 21966.18831 3233.81240 21966.18831 240.88 146.4412554 94.43874459 21871.74957 3328.2541 21871.74957 240.88 145.8116638 95.06833623 21776.68123 3423.31942 21776.68123 240.88 145.1778749 95.70212513 21680.9791 3519.02143 21680.9791 240.88 144.5398607 96.3401393 21584.63897 3615.36144 21584.63897 240.88 143.8975931 96.9824069 21487.65656 3712.34345 21487.65656 240.88 143.2510437 97.62895628 21390.0276 3809.97246 21390.0276 240.88 142.600184 98.27981598 21291.74779 3908.25247 21291.74779 240.88 141.9449852 98.93501476 21192.81277 4007.187 Year 4 Interest48 21192.81277 240.88 141.2854185 99.59458152 21093.21819 4106.782 1738.0149 21093.21819 240.88 140.6214546 100.2585454 20992.95964 4207.0450 20992.95964 240.88 139.9530643 100.9269357 20892.03271 4307.96751 20892.03271 240.88 139.2802181 101.5997819 20790.43293 4409.56752 20790.43293 240.88 138.6028862 102.2771138 20688.15581 4511.84453 20688.15581 240.88 137.9210388 102.9589612 20585.19685 4614.80354 20585.19685 240.88 137.2346457 103.6453543 20481.5515 4718.44955 20481.5515 240.88 136.5436767 104.3363233 20377.21517 4822.78556 20377.21517 240.88 135.8481012 105.0318988 20272.18328 4927.81757 20272.18328 240.88 135.1478885 105.7321115 20166.45116 5033.54958 20166.45116 240.88 134.4430078 106.4369922 20060.01417 5139.98659 20060.01417 240.88 133.7334278 107.1465722 19952.8676 5247.132 Year 5 Interest60 19952.8676 240.88 133.0191173 107.8608827 19845.00672 5354.993 1642.34961 19845.00672 240.88 132.3000448 108.5799552 19736.42676 5463.57362 19736.42676 240.88 131.5761784 109.3038216 19627.12294 5572.87763 19627.12294 240.88 130.8474863 110.0325137 19517.09043 5682.9164 19517.09043 240.88 130.1139362 110.7660638 19406.32436 5793.67665 19406.32436 240.88 129.3754957 111.5045043 19294.81986 5905.1866 19294.81986 240.88 128.6321324 112.2478676 19182.57199 6017.428

In year #1 Herby will pay $1983.21 inpotentially tax deductible interest

In year #2 Herby has $1907.90 in deductions

In year #3 $1826.34In year #4 $1738.01In year #5 $1642.35In year #6 (before the house is resold)$1164.23

When the house resells - Herbywill have $6358.68 in equityThe question of whether Herby gets adeduction depends on whether his itemizeddeductions exceed the standard deduction.

Tax Assumption

• Lets assume Herby can deduct his interest, but that he is only in the 15% tax bracket

• The money Herby saves on his taxes may be a positive flow into his pocket as a refund check– Year #1 $1983 * 0.15 = $297.48

– Year #2 $1907.9 * 0.15 = $286.19

– Year #3 $1826.33 *0.15 = $273.95

– Year #4 $1738.01 * 0.15 = $260.70

– Year #5 $1642.35 * 0.15 = $246.35

Cash Flow for Buying with Local Loan

0 1 - 12 13 - 24 25 - 36 37 - 48 49 - 60 61 - 69 73

$3,535

$240.88 per month

$6,358.68

$297.48 $286.19 $273.95 $260.70 $246.35 $174.63

Can do the Same Thing for the Internet Loan

Mortgage Calculation

Interest Rate/Year 6.25Monthly Interest 0.005208333

Month Outstanding Principle Monthly Payment Interest Amount Principle Payment New Principle Equity1 25578 157.49 133.21875 24.27125 25553.72875 24.271252 25553.72875 157.49 133.0923372 24.39766276 25529.33109 48.668913 25529.33109 157.49 132.9652661 24.52473392 25504.80635 73.193654 25504.80635 157.49 132.8375331 24.65246691 25480.15389 97.846115 25480.15389 157.49 132.7091348 24.78086517 25455.37302 122.6276 25455.37302 157.49 132.5800678 24.90993218 25430.46309 147.53697 25430.46309 157.49 132.4503286 25.03967141 25405.42342 172.57668 25405.42342 157.49 132.3199136 25.17008637 25380.25333 197.74679 25380.25333 157.49 132.1888194 25.30118057 25354.95215 223.0478

10 25354.95215 157.49 132.0570425 25.43295755 25329.51919 248.480811 25329.51919 157.49 131.9245791 25.56542087 25303.95377 274.0462 Year 1 Interest12 25303.95377 157.49 131.7914259 25.6985741 25278.2552 299.7448 1590.13513 25278.2552 157.49 131.6575792 25.83242084 25252.42278 325.5772 238.520314 25252.42278 157.49 131.5230353 25.9669647 25226.45581 351.544215 25226.45581 157.49 131.3877907 26.10220931 25200.3536 377.6464

Note that with the spreadsheet I just retyped the 3 numbersin yellow and it did my whole interest, tax, and equity problemfor me instantly

Cash Flow for Internet Loan

0 1 - 12 13 - 24 25 - 36 37 - 48 49 - 60 61 - 69 73

$4,060

$157.49 per month

$238.52 $235.64 $232.55 $229.27 $225.79 $166.92

$1630.95

Herby Must Now Compare

• Herby is comparing two alternatives that will both cost him money

• One often used technique is to subtract one alternative from the other and look at the incremental value of choosing one alternative over the other– This then becomes a question of how much you

gain (or loose by choosing one alternative over the other)

Application

Need to first decide which alternative we think we want to choose. - Oh yesthe loan with the lower payments.

$3,535-$4,060=-$525

$240.88 - $157.49 =83.39 / month

$238.52 -$297.48 =-$58.96

-$50.56 -$41.40 -$31.43 -$20.56 -$7.71

$1630.95 - $6358.68 =-$4,727.73

Now What Should Herby Do?

• He has a cash flow that represents the value of choosing the loan with the lower payments and interest rate

• Naturally he could discount it back to his decision point (when he goes to bank or signs on the internet)– But What Rate?

Herby’s Interest Rate Dilemma

• Herby hopes to save some money by picking the lower monthly payments and interest rate– What will he do with the money he saves?

• May very well use it for school. Herby may be looking at student loans for what ever he and wifey can’t get together– Herby’s incremental cost of money may be what student

loans would cost

• Herby may be playing the market on the side– What could Herby get on the market if he were to invest

More on Herby’s Dilemma

• Herby might not know what the heck his cost or value of money is

• Lets suppose Herby is clueless

• With spreadsheet Herby can try different interest rates and see what the resulting flow is.

Lets identify our cash flow elements

-$50.56 -$41.40 -$31.43 -$20.56 -$7.71

What an element is depends on where the pot is (remember the annuity problem)

We have aPresent Value thatneeds no magic number

SpreadsheetInterest Rate 2 % per year

0.001667 % per monthCash Flow n Magic # Multiplied

-525 0 1 -52583.39 69 65.12911 5431.117

-58.96 13 0.978584 -57.6973-50.56 25 0.959223 -48.4983-41.4 37 0.940244 -38.9261

-31.43 49 0.921642 -28.9672-20.56 61 0.903407 -18.574-7.71 73 0.885533 -6.82746

-4727.73 69 0.891451 -4214.54290.56

sum 492.0845

Another CaseInterest Rate 8 % per year

0.006667 % per monthCash Flow n Magic # Multiplied

-525 0 1 -52583.39 69 55.16279 4600.025

-58.96 13 0.917246 -54.0809-50.56 25 0.84695 -42.8218-41.4 37 0.782041 -32.3765

-31.43 49 0.722107 -22.6958-20.56 61 0.666765 -13.7087-7.71 73 0.615665 -4.74678

-4727.73 69 0.632248 -2989.1290.56

sum 915.4964

Observations

• Notice that even where something is going to cost you money that subtracting one alternative from another will show an NPV for the value of picking one alternative instead of the other.– If somethings going to cost you you usually have

choices. This technique allows you to measure the value of one choice vs. the other

– If you have only one choice you can still get the NPV of what it will cost you.

More Observations

• In this case one of the reasons for choosing the spreadsheet was we were unsure of what interest rate to use.

• Many activities and needs cost money. Freeing up money from the activity brings other opportunities– They may be to eliminate debt or the need for debt– They may be to invest.

A Personal Life Interest Rate

• Herby may have several things that cost him money (look for where your additional margin of dollars go and what interest rate or forgone interest rate opportunities there are)– School - if you can’t pay as you go you have student loans

– Credit Cards - if you have needs you are going to charge (or a credit card debt from previous needs)

– If you have investment opportunities

– If you could put money into CDs or a money market account

– If you have an interest bearing checking account it may have a rate

– The home loan itself has an interest rate - and most allow extra payment directly against principle.

Notes about NPV

• The NPV of picking the internet loan over the local loan is positive for any positive rate of interest– (just cash flow total was positive)– The higher the interest the more discounted the

home equity at the end is and the greater the savings on monthly payments and interest expenses.

Conclusion

• Herby should pick the internet loan

• Notice that this kind of calculation can be done to decide when to refinance a house or to choose between various borrowing options.

• We’ve now decided which loan is best for the house - but not whether Herby should buy or rent.

The Home Loan Payments Game

• We found that Herby’s mortgage payments will be pretty small compared to rent payments

• The payments consider– Principle (paying off part of the debt each month)

– Interest (paying investors each month for the gratification they are giving up by keeping money in Herby’s House)

• Banks Charge Other Fees as part of the payments.

The Escrow Costs

• There is that homeowners insurance payment $600 per year including a chunk right up front

• There is the private mortgage insurance $280 per year (first year was covered in closing)

• There is property tax• The bank doesn’t trust you to save this money so

they charge it to you each month– They stash it in an escrow account (where they usually

make the interest)

The Insurance Costs

• Insurance $280 + $600 = $880

• 12 payments = $880/12 = $73.33

The Property Tax Game• Illinois (and most states) try to baffle people

with convoluted formulas to keep them too confused to fuss

• In Illinois You first compute “Fair Market Value”– Many communities estimate low

• You think your getting a deal so your less likely to fuss• If the state ever wishes to use eminent domain to buy you out they

have a basis for a lower value• If property taxes are ever frozen, they can keep the tax rate and jack

up the property value

Herby’s Property Tax

• DeSoto values Herby’s house at $27,000

• Next you get the “Assessed Valuation”– By law in Illinois - this is 1/3rd of fair market

value• $9,000

• (People really think they’re getting a deal when the realize they are only paying taxes on this little amount - never mind the tax rate is about 3 times as high as in states that don’t do this step)

Figuring Herby’s Property Tax

• Apply the tax rate to the “Assessed Valuation”– Tax rate about 9.78%

• rates can be high is Southern Illinois because of a weak industrial base

• They can be high in Chicago suburbs because suburban school districts and governments are very very good at spending money

• Apply and let dry– $9,000 * 0.0978 = $880.20 per year

The Escrow Account• Insurance monthly payments were $73.33• Taxes $880.2/ 12 = $73.35• The Total = $146.78• Wrong

– Banks usually charge you 1.5 times the estimated amount to accumulate money in the escrow account

• Official reason - so if rates go up there is money there• Unofficial reason - since they get to collect the interest on the

account it gives them more of your money to make extra money on.

– $220/month

More on Escrow

• Banks adjust escrow payments each year based on actual tax and insurance rates– They don’t charge 1.5 times forever but they do get the

amount up to about twice the actual experience before they back off on overcharging you

• Escrow payments can drastically alter what you thought your mortgage was– 30 year internet mortgage is $157.49 + $220 = $377.49/month

Herby Looks at Later Year Mortgage Payments

• In order to know what escrow payments will be the second year - Herby has to know how much tax and insurance will take out of his escrow account.

• On the insurance - Herby will pay that for the first year (or 6 months) when he gets the loan.– He’ll accumulate escrow for a year and then pay it

again.

Herby’s Insurance• Herby has Private Mortgage Insurance

– Usually stays the same - in fact lenders risk is declining as you get more paid off

– $280

• Herby has homeowners insurance– say goes up about with inflation 4%/year– $600*1.04 = $624

• Herby’s escrow account will pay out $904 for insurance at the end of the first year (note this won’t be a Herby cash flow item because Herby makes monthly escrow and the banker worries about the insurance premiums)

Herby’s Taxes and Escrow

• Taxes are paid “in arrears”– That means that in 2001 you pay property tax for year

2000

• This can be a problem for buying because you will get a tax bill for when you didn’t own the house– Solved by giving you a “credit” at closing (adjusts

your loan amount)• may adjust exact mortgage amount but we already found

which loan was best

Payments Out of Herby’s Escrow

• Taxes at end of year will be the previous years amount $880.20

• Insurance at the end of the year $904

• Money out of account– $1,784.20

• Money into account– $220 * 12 = $2640

• Balance in account $855.20

Billy Banker Reviews Next Years Tax and Insurance Cost

• Insurance was $904.00

• Taxes– $880.20 this year– Each year the State estimates the increase in property

value around the state• When real estate sells have to fill out a report form to the

government– (Also used by appraisers)

– State Issues a multiplier• say (1.05)

The State Multiplier Strikes Again

• Periodically the county also reappraise all the property (usually do a roving system so it won’t be all at once)

• County makes any changes they see, supervisor of assessments reviews, then multiply by state multiplier– Get a new assessed valuation– Last year $9,000*1.05 = $9450

• Next Years Tax $9,450*0.0978 = $924.21

Figuring Year II Escrow

• Taxes will be $924.21

• Insurance will be $904

• Total Payout estimated for end of year II– $1,828.21

• Billy Banker Would Like twice that in account– about $3,657

• Billy Banker has $855.20 in there now

Setting Next Years Escrow

• $3657-855.20 = $2802• $2802/12 months = $233.50 for Escrow• Mortgage Principle and Interest is

– $157.49– Add Escrow– $390.99 next years mortgage payment

• During Year #1 pay $377.49• During Year #2 pay $390.99

Estimating Escrow for Later Years

• Escrow account has now built up the bankers interest free extra money - now they’ll just have Herby pay as he goes

• Assume PMI (Private Mortgage Insurance) stays same - Home owners goes up 4% per year

• Assume taxes up 5% per year

Taxes and Insurance

• Year #3 homeowners insurance– Year #2 was $624– Year #3 $624*(1.04) = $649– Year #4 $649*(1.04) = $675– Year #5 $675*(1.04) = $702– Year #6 (until house sells) $702*1.04 = $730

• PMI stays the same at $280

• Taxes will go up 5% each year

Taxes and Escrow

• Year 2 taxes were $924.21

• Year 3 taxes $924.21*1.05 = $970.42

• Year 4 taxes $970.42*1.05 = $1,018.94

• Year 5 taxes $1,018.94*1.05 = $1,069.89

• Year 6 taxes $1069.89*1.05 = $1123.38

Future Years Escrow

• Year 3 $280 + $649 + $970.42 = $1899.42

• Year 4 $280 + $675 + $1,018.94 = $1973.94

• Year 5 $280 + $702 + $1,069.89 = $2051.89

• Year 6 $280 + $730 + $1,123.38 = $2133.88

Important Inflation Features

• Note that the Taxes and Insurance Payments are just going up by 3.9% over-all each year

• Many Times in Inflation Scenarios you see a cost that grows and compounds with inflation– If the costs grow at a steady rate through each

compounding period you have something like an annuity with inflation

• can’t use P/A or A/P because payment amount changes

The Geometric Gradient

• In some engineering econ problems we see what would be an annuity except that it grows at a steady rate each compounding period.– Some equipment maintenance expenses behave

this way– Most common source is inflation in the cash flow

(ie - its an annuity with inflation)• The tax and insurance expense is behaving this way

Special Features for Special Problems

• We’ve met P/A– They really don’t do anything for us that can’t be done

with a large number of different P/F values

– We got P/A because it let us treat an obnoxious series of numbers as one cash flow element that can be dealt with all at once

• Now we have an annuity almost except its growing– Without help it’s a large number of P/F problems

Another Super Hero

• P/Ag,i,n

– Looks very similar to our old friend P/A only this one has 3 numbers

– The first two numbers look like interest rates

• Actually what you have is a rate of inflation or cost escalation, and an interest rate, and a number of payments or compounding periods

Super Hero Formula

• Look in the front of the book “Geometric Series Present Worth”

• In our case we won’t be able to use the hero because Herby’s escrow payments are made monthly, while the growth is yearly

• Why introduce the Geometric Series Present Worth this way?– Example illustrates how inflation commonly produces these

growing annuities

– Also I don’t like inflation in engineering cash flow analysis and so I’m not putting out a lot of emphasis

Back from the Detour

• Annual Escrow Payments– Year #3 $1,899.42/12 = $158.29

– Year #4 $1973.94/12 = $164.50

– Year #5 $2051.89/12 = $170.99

– Year #6 $2133.88/12 = $177.78

Adjusting the Mortgage Payments

• Basic Loan will be for $25,200

• The Bank also charges points– (an up front premium in exchange for a lower

interest rate - or a good way for bankers to make their loan

look like a better deal and still make the same money)– $378

• But Herby gets credit for last years taxes (since he’ll end up paying them)

– $880.20

Herby’s Loan with Tax Adjustment

• $25,200 + $378 - $880.2 = $24,698• A/P is 0.006157 for 360 payments with 6.25% annual

interest (divided by 12 for monthly compounding)

• $24,698*0.006157 = $152.06• Mortgage Payments

– Year #1 - $152.06 + $220 = $372.06

– Year #2 - $152.06 + $233.50 = $385.56

– Year #3 - $152.06 + $158.29 = $310.35

– Year #4 - $152.06 + $164.50 = $316.56

– Year #5 - $152.06 + $170.99 = $323.05

– Year #6 - $152.06 + $177.78 = $329.84

Building the Home Buy Cash Flow

$2,800Down Payment

$1,260Loan Initiation Fees$600Homeowners Insurance

Bank also charged$378 in “Points thatrolled into loan

$372.06/mo. $385.56/mo. $310.56

$316.56 $323.05 $329.84

$230.31 $227.52 $224.55 $221.39 $218.03 $161.18$132 $139 $146 $153 $161 $169

Maintenance Costs

• Home owners have regular repair costs

• DeSoto house needs some initial repairs– about $5,000 for materials plus some personal

“sweat equity”• Herby could get a personal loan from the bank for 5 years

at 8% interest with a $200 loan application fee• Herby’s could just use his credit card at 15% interest

• There are routine things that break down - Herby figures about $75/month

Herby’s Big Kicker

• Herby is getting the house pretty cheap but

• The roof will probably fail in 4 years– This will likely cost about $4,200– Herby is concerned about whether he will be

able to get additional money on loans at a critical time like that.

How Should Herby Deal With This?

• $75/month maintenance is just an annuity in the cash flow.

• The loan vs. credit card choice is another of those spreadsheet comparison jobs– Figure the cash flow from each– Pick a preferred alternative– Subtract one alternative from the other to define a cash flow

of costs and benefits from choosing your favorite– Discount cash flow back and see if your preferred alternative

saved you enough.

The Roof

• Herby sees a big expense coming and can’t risk ability to get credit when it hits

• Answer is a business device called a sinking fund– Save up money just like Fursee Foresight– Money is saved up as a series of regular savings

at the end of each compounding period - ie. Its an annuity.

The Sinking Fund

• Discounted Cash Flow was developed in Mining– Got its name from the practice of saving money to

sink a new mine shaft

• Trick here is that we are trying to find an annuity that will reach a set amount of money at some time in the future– P/A and A/P deal with present values– F/A converts and annuity to a future value

Enter a New Super Hero

• A/F• Check to make sure she can do the job

– A/F * Future Cost of Re-roofing

• Need to know n– re-roof in 4 years (but we’re on a monthly schedule)

• 4*12 = 48

• Need to know i– What ever Herby can get on his savings

Herby Builds a Sinking Fund for His Roof

• Herby will put money into a money market account at 5% interest (compounded monthly)

• Using the formula– Just F/A flipped

– ( i / {[1 + i ]n -1}) = A/F• for i= 0.05 /12 = 0.004167• and n=48• A/F = 0.018863

Herby’s Monthly Cost for the Roof

• 0.018863 * $4,200 = $79.22

• Herby now has monthly maintenance costs of– $75/month routine maintenance– $79.22/month sinking fund to replace the roof– Herby still needs to deal with the $5,000 in

initial repairs

Herby’s Personal Loan Choice

• $5,000 in initial repairs• The Bank Loan Option

– $200 loan application fee– 8% compounded monthly– 5 year amortization

• Convert a present loan amount into an annuity of payments in the future– A/P * Present Loan Amount check

A Bank Loan for Herby

• A/P– n = 60 = 5 years * 12 months per year– i = 8% per year/ 12 months per year = 0.00667

– A/P0,00667, 60 = 0.020278

• Monthly cost for initial repairs– 0.020278 * $5000 = $101.39

• Also an initial fee of $200

Herby’s Credit Card

• Credit cards usually do not charge a fixed monthly payment (except for some minimum usually around $10 to $15)– Instead they charge a fixed percentage of the

outstanding balance• will produce a declining monthly payment like a

reverse geometric gradient going down

• We have no super hero for that

• We do have a spreadsheet

Working with Credit CardsPayoff of a Credit Card

Annual Percentage Rate 15Days per year for periodic rate 362Daily Periodic Rate 0.000414Minimum Payment % 2

Minimum Monthly Principle NewDays in Month Monthly Rate Balance Payment Interest Paid Balance

Credit Cards usually compound interest monthly, but they use a “Daily PeriodicRate” so that months with more days have a higher monthly rate.

Credit Cards frequently play games with the rate. They quote an annual rate,charge interest for each day, but divide the annual rate by a number of dayssmaller than 365.Credit cards usually charge 2% or 3% of your outstanding balance as a minimumpayment.

Developing the SpreadsheetPayoff of a Credit Card

Annual Percentage Rate 15Days per year for periodic rate 362Daily Periodic Rate 0.000414Minimum Payment % 2


31 0.012845328 0.0116022131 0.012845330 0.0124309431 0.012845330 0.0124309431 0.012845331 0.012845330 0.0124309431 0.012845330 0.0124309431 0.0128453

The Monthly Rate is Calculated bytaking the number of days in thebilling cycle (month) * the dailyperiodic rate.

A Spreadsheet for Credit CardsPayoff of a Credit Card

Annual Percentage Rate 15Days per year for periodic rate 362Daily Periodic Rate 0.000414Minimum Payment % 2Minimum Payment 15


31 0.0128453 5000 10028 0.0116022131 0.012845330 0.0124309431 0.012845330 0.0124309431 0.012845331 0.012845330 0.01243094

Credit Cards Charge a fixed % of theoutstanding balance or a minimum monthlypayment.

The minimum payment cell contains an if statement=if(c11*f$6/100>f$7, c11*f$6/100, f$7)

The PayoffPayoff of a Credit Card

Annual Percentage Rate 15Days per year for periodic rate 362Daily Periodic Rate 0.000414Minimum Payment % 2Minimum Payment 15


31 0.0128453 5000 100 64.22652 35.77348 4964.22728 0.01160221 4964.22731 0.012845330 0.0124309431 0.012845330 0.0124309431 0.012845331 0.012845330 0.01243094

Interest is the average daily balance * themonthly rate.

Principle paid is of course the monthlypayment minus the interest.

New balance is the old balance minus the paymentagainst the principle.

Or Is ItMinimum Monthly Principle New

Days in Month Monthly Rate Balance Payment Interest Paid Balance31 0.0128453 5000 100 64.22652 35.77348 4964.227 Year #128 0.01160221 4964.227 99.28453 57.596 41.68853 4922.53831 0.0128453 4922.538 98.45076 63.2315 35.21926 4887.31930 0.01243094 4887.319 97.74637 60.75396 36.99241 4850.32631 0.0128453 4850.326 97.00653 62.30392 34.70261 4815.62430 0.01243094 4815.624 96.31247 59.86273 36.44975 4779.17431 0.0128453 4779.174 95.58348 61.38994 34.19354 4744.9831 0.0128453 4744.98 94.89961 60.95072 33.94889 4711.03230 0.01243094 4711.032 94.22063 58.56255 35.65808 4675.37331 0.0128453 4675.373 93.50747 60.05659 33.45088 4641.92330 0.01243094 4641.923 92.83845 57.70346 35.13499 4606.78831 0.0128453 4606.788 92.13575 59.17559 32.96017 4573.82731 0.0128453 4573.827 91.47655 58.7522 32.72435 4541.103 Year #228 0.01160221 4541.103 90.82206 52.68683 38.13523 4502.96831 0.0128453 4502.968 90.05936 57.84199 32.21737 4470.7530 0.01243094 4470.75 89.41501 55.57563 33.83938 4436.91131 0.0128453 4436.911 88.73822 56.99347 31.74475 4405.16630 0.01243094 4405.166 88.10333 54.76035 33.34297 4371.82331 0.0128453 4371.823 87.43647 56.1574 31.27907 4340.54431 0.0128453 4340.544 86.81089 55.75561 31.05528 4309.48930 0.01243094 4309.489 86.18978 53.571 32.61878 4276.8731 0.0128453 4276.87 85.5374 54.9377 30.59971 4246.27130 0.01243094 4246.271 84.92541 52.78513 32.14028 4214.13

Credit CardMonthly PaymentsDecline over time

But so does yourpayment againstprinciple - unlike loans which paydown faster overtime.

In Fact30 0.01243094 202.8063 15 2.521073 12.47893 190.327431 0.0128453 190.3274 15 2.444813 12.55519 177.772230 0.01243094 177.7722 15 2.209876 12.79012 164.982131 0.0128453 164.9821 15 2.119245 12.88075 152.101331 0.0128453 152.1013 15 1.953788 13.04621 139.0551 Year #2828 0.01160221 139.0551 15 1.613347 13.38665 125.668531 0.0128453 125.6685 15 1.61425 13.38575 112.282730 0.01243094 112.2827 15 1.39578 13.60422 98.678531 0.0128453 98.6785 15 1.267555 13.73244 84.9460630 0.01243094 84.94606 15 1.055959 13.94404 71.0020231 0.0128453 71.00202 15 0.912042 14.08796 56.9140631 0.0128453 56.91406 15 0.731078 14.26892 42.6451430 0.01243094 42.64514 15 0.530119 14.46988 28.1752631 0.0128453 28.17526 15 0.36192 14.63808 13.5371830 0.01243094 13.53718 15 0.16828 14.83172 -1.29454 27 Years 11 months

If Herby pays minimum payments on his credit card it will takehim 27 years 11 months to pay off the credit card.

The Game Afoot

• Why are credit cards so hard to pay-off– The minimum payments are generally set to be

competitive with signature loans at banks– But the modest payment hides a high interest

rate and results in slow payment of the debt

• The Declining Payment - Why?– Official Answer - to better service the customer

by minimizing demands made upon him

Its A TRAP

• By directing a high percentage of your payments to interest and then slowly declining those payments - credit card debt takes a long time to pay-off

• The Credit Card Company’s bet you a life time of debt that if you ever get a good credit card debt - you won’t be able to avoid using your card again for 25 years - You'll recharge the debt.

Other Credit Card Games

• Credit Cards have “Cash Advance Fees”– Credit Card Checks or getting cash from an ATM is

considered a “Cash Advance”

– Cash advances are usually 3% of the amount advanced (or a minimum fee of $5 or $10)

• some cards do have a maximum fee also

• If Herby gets a cash advance on his credit card he will pay– $5,000 * 0.03 = $150

• so much for getting out of that loan initiation fee

More Games

• If Herby Charges supplies at Lowe’s or Home Depot he does not pay a cash advance fee.– But the credit card company charges a couple

percent to the merchant (hidden in higher prices)

• Reason some gas stations have a higher price for credit cards than cash

• Reason that not every store takes credit cards

Cash Advance vs. Purchase

• In addition to cash advance fee credit cards charge a higher interest rate for cash advances than purchases– purchases are often 9.9% to 18.9%

– cash advances are typically 18.9 to 24%

• If you get a cash advance on your credit card - all your payments will go to cover purchases (lower rate) until the low rate stuff is paid off (never if you fall in the declining payment trap)

– About the only way to get a cash advance off your back is to pay-off the entire card.

The Promotional Offer

• Many credit cards offer promotional interest rates– They last around 3 to 12 months depending on

the card - And then they jump to a higher interest rate

• The idea is to get you to run up a balance that you won’t be able to dig out of

• Often they will charge a cash advance fee with a promotional interest rate check

The Grace Period• Most cards offer a grace period

– If you pay-off your balance in full each month there is no interest BUT

• Many credit cards are shortening grace period from 25 days to 20– They wait about a week to 10 days after your “statement date” to send the

bill

– Takes about 3 or 4 days in the mail

– They warn you in fine print that it may take 3 to 5 days to credit your payment

– Takes you about 3 or 4 days to get payment to their office

– Result - you may have only a day or two to have the money in your checking account ready to pay them.

Bankers Grace

• If your payment doesn’t make it on time (I wonder how much hustle they put into processing your payment if its close - I wonder how you’d prove it)

– Credit Cards Charge a late fee (usually $29) in addition to interest

– If they can catch you several times, most will raise the interest rate that they charge on your account (after all you’re a bad credit risk because you don’t pay on time)

Billing Cycle Tricks• Some credit cards change the way the calculate the

“average daily balance”– They do the average daily balance as a two cycle average (ie

the average over two months instead of each billing cycle)

• Results– If you try to take a promotional offer and then pay off the balance before

the rate goes up - they get to zap you even after the balance is paid.– They can continue to charge you interest on purchases after they are paid

off– You have to keep your credit card paid off for many months straight to

stop monthly interest charges.

Back to Herby Choosing a Personal Loan or Credit Card

• Assume that Herby will buy the supplies at Lowe’s so he will not be on a credit card cash advance.

• How do we compare two financial alternatives to the same problem when both will cost you money?

The Cash Flow Comparison Trick

I have a hunch Herby would rather have the bank loan to fix up his house so Iwill get the cash flow from choosing the bank loan instead of the credit card

Herby pays a $200 loan application fee

$0 - $200

Bank loan payments stay thesame while the credit card paymentsgo down with time.

They start at -$1.39 and end at -$36.87

After the bank loan is paid offHerby would still have credit cardbills so now Herby is saving moneyby having the bank loan instead ofthe credit card.

Savings start at $64.05 and decline to$60.35 when the house sells

We’ll assume Herby would pay off thecredit card when the house sold. Byhaving the bank loan instead of the creditcard, Herby keeps money he wouldotherwise have to use to pay off the creditcard$3,017.62 - $0.

Getting Ready for NPV

Since none of these cash flows is an annuity, I have 70 cash flow elements tosweep back one at a time with a P/F. - You can bet I’m planning to use myspreadsheet for that one.

Herby pays a $200 loan application fee

$0 - $200

Bank loan payments stay thesame while the credit card paymentsgo down with time.

They start at -$1.39 and end at -$36.87

After the bank loan is paid offHerby would still have credit cardbills so now Herby is saving moneyby having the bank loan instead ofthe credit card.

Savings start at $64.05 and decline to$60.35 when the house sells

We’ll assume Herby would pay off thecredit card when the house sold. Byhaving the bank loan instead of the creditcard, Herby keeps money he wouldotherwise have to use to pay off the creditcard$3,017.62 - $0.

Big Cash Flows with a Spread Sheet

Payoff of a Credit Card

15362

0.0004142 Annual % 2

15 Monthly i 0.001667 NPV1790.521

Principle New cash flow n P/F cash*P/FPaid Balance -200 0 1 -20035.77348 4964.227 Year #1 -1.39 1 0.998336 -1.3876941.68853 4922.538 -2.10547 2 0.996675 -2.0984735.21926 4887.319 -2.93924 3 0.995017 -2.9245936.99241 4850.326 -3.64363 4 0.993361 -3.6194434.70261 4815.624 -4.38347 5 0.991708 -4.3471336.44975 4779.174 -5.07753 6 0.990058 -5.0270534.19354 4744.98 -5.80652 7 0.988411 -5.7392333.94889 4711.032 -6.49039 8 0.986766 -6.404535.65808 4675.373 -7.16937 9 0.985124 -7.0627233.45088 4641.923 -7.88253 10 0.983485 -7.7523535.13499 4606.788 -8.55155 11 0.981849 -8.39633

I just stuck my cash flow rightalong side my credit card payoffschedule

What Interest Rate to Use

• We’ve looked at what peoples marginal rate of interest may be

• We’ve looked at feeling around with NPVs using different interest rates to see what happens

• Another tool is the IRR– Internal Rate of Return– It is the interest rate that makes NPV zero

The IRR• The IRR is popular because it tells you what

interest rate the investment makes– Can make complicated cash flow into an interest rate like is

posted at a bank

• Very simple flows have a formula for IRR but most cash flow IRRs are computed iteritivly until the NPV is zero– The way financial calculators do it– Excel has an IRR function that works same way.– Where going to do manual iteration this time

Lets Try 2%Payoff of a Credit Card

15362

0.0004142 Annual % 2

15 Monthly i 0.001667 NPV1790.521

Principle New cash flow n P/F cash*P/FPaid Balance -200 0 1 -20035.77348 4964.227 Year #1 -1.39 1 0.998336 -1.3876941.68853 4922.538 -2.10547 2 0.996675 -2.0984735.21926 4887.319 -2.93924 3 0.995017 -2.9245936.99241 4850.326 -3.64363 4 0.993361 -3.6194434.70261 4815.624 -4.38347 5 0.991708 -4.3471336.44975 4779.174 -5.07753 6 0.990058 -5.0270534.19354 4744.98 -5.80652 7 0.988411 -5.7392333.94889 4711.032 -6.49039 8 0.986766 -6.404535.65808 4675.373 -7.16937 9 0.985124 -7.0627233.45088 4641.923 -7.88253 10 0.983485 -7.7523535.13499 4606.788 -8.55155 11 0.981849 -8.39633

NPV is stillPositive - theinterest rate ishigher.

Lets Try 6%

Annual % 6Monthly i 0.005 NPV

1291.104cash flow n P/F cash*P/F

-200 0 1 -200-1.39 1 0.995025 -1.38308

-2.10547 2 0.990075 -2.08457-2.93924 3 0.985149 -2.89559-3.64363 4 0.980248 -3.57165-4.38347 5 0.975371 -4.27551-5.07753 6 0.970518 -4.92783-5.80652 7 0.96569 -5.6073

Still Positive -We’re makingover 6%

Lets Try 12%



-200 0 1 -200-1.39 1 0.990099 -1.37624

-2.10547 2 0.980296 -2.06398-2.93924 3 0.97059 -2.8528-3.64363 4 0.96098 -3.50145-4.38347 5 0.951466 -4.17072-5.07753 6 0.942045 -4.78326-5.80652 7 0.932718 -5.41585-6.49039 8 0.923483 -5.99377-7.16937 9 0.91434 -6.55524

Interest Rate isStill higher.

Lets Try 30%


-46.3627cash flow n P/F cash*P/F

-200 0 1 -200-1.39 1 0.97561 -1.3561

-2.10547 2 0.951814 -2.00402-2.93924 3 0.928599 -2.72938-3.64363 4 0.905951 -3.30094-4.38347 5 0.883854 -3.87435-5.07753 6 0.862297 -4.37833-5.80652 7 0.841265 -4.88482-6.49039 8 0.820747 -5.32697-7.16937 9 0.800728 -5.74072-7.88253 10 0.781198 -6.15782

So its gone negative.The interest rate isless than 30%, butprobably not much.

Lets Try 28%



-200 0 1 -200-1.39 1 0.977199 -1.35831

-2.10547 2 0.954917 -2.01055-2.93924 3 0.933144 -2.74273-3.64363 4 0.911867 -3.3225-4.38347 5 0.891075 -3.90601-5.07753 6 0.870758 -4.42129-5.80652 7 0.850903 -4.94079-6.49039 8 0.831501 -5.39677-7.16937 9 0.812542 -5.82542-7.88253 10 0.794015 -6.25885

We’re Close. It’s alittle above 28%.

I’ll Call this Close Enough

Annual % 28.0774Monthly i 0.023398 NPV


-200 0 1 -200-1.39 1 0.977137 -1.35822

-2.10547 2 0.954797 -2.0103-2.93924 3 0.932968 -2.74222-3.64363 4 0.911637 -3.32166-4.38347 5 0.890795 -3.90477-5.07753 6 0.870428 -4.41962-5.80652 7 0.850528 -4.93861-6.49039 8 0.831082 -5.39405-7.16937 9 0.812081 -5.82211-7.88253 10 0.793515 -6.25491-8.55155 11 0.775373 -6.63064

Conclusion

• Picking the bank loan instead of a credit card to pay for his home repairs is like Herby investing at around 28.1% interest– I doubt Herby has many opportunities for that kind

of return

• You can see how wise choices about needed expenses can help you to accumulate wealth

• Do not confuse this to mean that spending money for anything makes you wealthy.

Interpreting IRR

• The IRR represents the rate of interest paid by the project (or the selection of the preferred cost scenario over its alternative)

• The IRR is compared to the Rate of Return that the investor requires (or the interest rate for the investor’s other opportunities)– If the rate is greater or equal to the target rate then

GO FOR IT– If not spit in the pot and walk away

Herby’s Home Buy Cash Flow

$2,800Down Payment



$230.31 $227.52 $224.55 $221.39 $218.03 $161.18$132 $139 $146 $153 $161 $169

$372.06/mo.

$385.56/mo.

$310.56

$316.56

$323.05

$329.84

$200 Home improvementloan initiation.

$75/month for Home Repairs

$101.39/month Bank Loan for Repairs

$79.22/month Sinking Fund for Roof

One More Issue

• Herby will sell the house when he graduates• Herby hopes to have built some equity

– Herby’s has $22,792.47 left on his home loan– Herby’s house should have grown in value

• according to tax assessment records the home value has increased 27.63% since he bought it

• $28,000 + 1.2763 = $35,736

• Herby has also made some home improvements since he got the house

Home Improvements and Equity

• Many home maintenance items are needed to keep a salable house but add little to the selling value– There are guides on what kinds of things add

value• example new Kitchen usually returns value

• finishing a basement often does not

– Many items add part, but not all of their cost to the homes value

Herby’s Home Improvements

• Herby bought $5,000 in goods and put a lot of sweat into installing them.– Lets assume Herby gets his cash out, but not his sweat

– Value increases $5,000

• Herby has just reroofed– Herby may get 50% out of that

– Value increases $2,100

• Herby’s new home value– $35,736 + $7,100 = $42,836

Herby’s Equity• Home Value is $42,836• Buyers will usually try to hack at the price

– In a sellers market you can get what you ask (if its reasonable)

– In a buyers market you often have to be dickered down (Southern Illinois is a buyers market)

– Lets assume Herby will get $40,000

• Herby’s Equity– $40,000 - $22,792.47 = $17,207.53

Not So Fast

• It costs money to sell a house– Real Estate Brokers Commission

• 7% of selling price $2,800

– Title Insurance $400– Dead Preparation $200– Mortgage Release Recording $15– Real Estate Stamps (about 75cent/$100)

• $40,000/$100 = 400 * 0.75 = $300

Taxing Questions

• Property Taxes are in arears - Buyer will get a credit– Next years taxes will be about 5% higher than

last years– $1,123.38 * 1.05 = $1,179.58– Herby sold part way through the year so he

only covers 9 months of the 12• $1,179.58 * 9/12 = $884.66

Herby’s Windfall• Sellers Costs

– $2800 + $400 + $200 + $15 + $300 + $884.66 +$22,792.47 = $27,392.13

• Home Sells for $40,000– $40,000 - $27,392.13 = $12,607.87 Cleared

• Herby can also cash in that Escrow Account– Account will have $3,657 - $2,051.89 + $177.78*9 = $3205.13

• Herby can also cancel his homeowners insurance for last 3 months of year– $730 * 0.25 = $182.50

–

Herby’s Homey Cash Flow

$2,800Down Payment



$230.31 $227.52 $224.55 $221.39 $218.03 $161.18$132 $139 $146 $153 $161 $169

$372.06/mo.

$385.56/mo.

$310.56

$316.56

$323.05

$329.84

$200 Home improvementloan initiation.

$75/month for Home Repairs

$101.39/month Bank Loan for Repairs

$79.22/month Sinking Fund for Roof

$15,995.50from sale ofhome

Now How Do We Decide Whether to Buy or Rent?

• That’s Right - The old subtract one alternative from the other trick

• Our Thought would probably be that Herby Should Buy Rather than Rent.– Lets try to cash flow

• Hand Out the Cash Flow

Look At Flow

Comparative Cash Flow if HerbyBuys Instead of Rents

BuyingRenting Buying Over Rent

Initial Cost -1300 -4860 -3560Month # 1 -650 -627.67 22.33

2 -650 -627.67 22.333 -650 -627.67 22.334 -650 -627.67 22.335 -650 -627.67 22.336 -650 -627.67 22.337 -650 -627.67 22.338 -650 -627.67 22.339 -650 -627.67 22.33

10 -650 -627.67 22.3311 -650 -627.67 22.3312 -670 -627.67 42.33

Note that the cashflow of thePreferredAlternative is justPreferred - Alternate.

Look at the Cumulative Cash Position

Comparative Cash Flow if HerbyBuys Instead of Rents

Buying CashRenting Buying Over Rent Position

Initial Cost -1300 -4860 -3560 -3560Month # 1 -650 -627.67 22.33 -3537.67

2 -650 -627.67 22.33 -3515.343 -650 -627.67 22.33 -3493.014 -650 -627.67 22.33 -3470.685 -650 -627.67 22.33 -3448.356 -650 -627.67 22.33 -3426.027 -650 -627.67 22.33 -3403.698 -650 -627.67 22.33 -3381.369 -650 -627.67 22.33 -3359.03

10 -650 -627.67 22.33 -3336.711 -650 -627.67 22.33 -3314.3712 -670 -627.67 42.33 -3272.0413 -670 -278.86 391.14 -2880.914 -670 -641.17 28.83 -2852.0715 -670 -641.17 28.83 -2823.2416 -670 -641.17 28.83 -2794.4117 -670 -641.17 28.83 -2765.5818 -670 -641.17 28.83 -2736.7519 -670 -641.17 28.83 -2707.9220 -670 -641.17 28.83 -2679.0921 -670 -641.17 28.83 -2650.2622 -670 -641.17 28.83 -2621.4323 -670 -641.17 28.83 -2592.624 -690 -641.17 48.83 -2543.7725 -690 -199.65 490.35 -2053.4226 -690 -566.17 123.83 -1929.5927 -690 -566.17 123.83 -1805.7628 -690 -566.17 123.83 -1681.9329 -690 -566.17 123.83 -1558.130 -690 -566.17 123.83 -1434.2731 -690 -566.17 123.83 -1310.4432 -690 -566.17 123.83 -1186.6133 -690 -566.17 123.83 -1062.7834 -690 -566.17 123.83 -938.9535 -690 -566.17 123.83 -815.1236 -710 -566.17 143.83 -671.2937 -710 -201.62 508.38 -162.9138 -710 -572.17 137.83 -25.08

Payback Period 39 -710 -572.17 137.83 112.75

Point at Which the CumulativeCash Position Goes Positive isCalled the Payback Period

What are the Chances of Getting YourRate of Return from a Cash Flow thatnever pays back?Payback Period can be a quick check fora looser proposition.

Documents

Herby Builds a Cash Flow