Hidden Costs in Hidden Costs in Home LoansHome Loans©2002 Dr. Bradley C. Paul©2002 Dr. Bradley C. Paul

The Home Loan Payments The Home Loan Payments GameGame

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

The payments considerThe payments consider Principle (paying off part of the debt each month)Principle (paying off part of the debt each month) Interest (paying investors each month for the gratification Interest (paying investors each month for the gratification

they are giving up by keeping money in Herby’s House)they are giving up by keeping money in Herby’s House)

Banks Charge Other Fees as part of the Banks Charge Other Fees as part of the payments.payments.

The Escrow CostsThe Escrow Costs There is that homeowners insurance payment There is that homeowners insurance payment

$600 per year including a chunk right up front$600 per year including a chunk right up front There is the private mortgage insurance $280 There is the private mortgage insurance $280

per year (first year was covered in closing)per year (first year was covered in closing) There is property taxThere is property tax The bank doesn’t trust you to save this money The bank doesn’t trust you to save this money

so they charge it to you each monthso they charge it to you each month They stash it in an escrow account (where they They stash it in an escrow account (where they

usually make the interest)usually make the interest)

The Insurance CostsThe Insurance Costs Insurance $280 + $600 = $880Insurance $280 + $600 = $880 12 payments = $880/12 = $73.3312 payments = $880/12 = $73.33

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

with convoluted formulas to keep them too with convoluted formulas to keep them too confused to fussconfused to fuss

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

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

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

jack up the property valuejack up the property value

Herby’s Property TaxHerby’s Property Tax DeSoto values Herby’s house at $27,000DeSoto values Herby’s house at $27,000 Next you get the “Assessed Valuation”Next you get the “Assessed Valuation”

By law in Illinois - this is 1/3rd of fair market By law in Illinois - this is 1/3rd of fair market valuevalue $9,000$9,000 (People really think they’re getting a deal when (People really think they’re getting a deal when

the realize they are only paying taxes on this little the realize they are only paying taxes on this little amount - never mind the tax rate is about 3 times amount - never mind the tax rate is about 3 times as high as in states that don’t do this step)as high as in states that don’t do this step)

Figuring Herby’s Figuring Herby’s Property TaxProperty Tax

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

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

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

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

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

Banks usually charge you 1.5 times the estimated Banks usually charge you 1.5 times the estimated amount to accumulate money in the escrow accountamount to accumulate money in the escrow account Official reason - so if rates go up there is money thereOfficial reason - so if rates go up there is money there Unofficial reason - since they get to collect the interest on the Unofficial reason - since they get to collect the interest on the

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

$220/month $220/month

More on EscrowMore on Escrow Banks adjust escrow payments each year Banks adjust escrow payments each year

based on actual tax and insurance ratesbased on actual tax and insurance rates They don’t charge 1.5 times forever but they do get They don’t charge 1.5 times forever but they do get

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

Escrow payments can drastically alter what you Escrow payments can drastically alter what you thought your mortgage wasthought your mortgage was 30 year internet mortgage is $157.49 + $220 = $377.49/month30 year internet mortgage is $157.49 + $220 = $377.49/month

Herby Looks at Later Herby Looks at Later Year Mortgage PaymentsYear Mortgage Payments

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

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

it again.it again.

Herby’s InsuranceHerby’s Insurance Herby has Private Mortgage InsuranceHerby has Private Mortgage Insurance

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

$280$280

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

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

Herby’s Taxes and Herby’s Taxes and EscrowEscrow

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

year 2000year 2000 This can be a problem for buying because you This can be a problem for buying because you

will get a tax bill for when you didn’t own the will get a tax bill for when you didn’t own the househouse Solved by giving you a “credit” at closing (adjusts Solved by giving you a “credit” at closing (adjusts

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

which loan was bestwhich loan was best

Payments Out of Herby’s Payments Out of Herby’s EscrowEscrow

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

Insurance at the end of the year $904Insurance at the end of the year $904 Money out of accountMoney out of account

$1,784.20$1,784.20 Money into accountMoney into account

$220 * 12 = $2640$220 * 12 = $2640 Balance in account $855.20 Balance in account $855.20

Billy Banker Reviews Billy Banker Reviews Next Years Tax and Next Years Tax and Insurance CostInsurance Cost

Insurance was $904.00Insurance was $904.00 TaxesTaxes

$880.20 this year$880.20 this year Each year the State estimates the increase in Each year the State estimates the increase in

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

governmentgovernment (Also used by appraisers)(Also used by appraisers)

State Issues a multiplierState Issues a multiplier say (1.05)say (1.05)

The State Multiplier The State Multiplier Strikes AgainStrikes Again

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

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

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

Figuring Year II EscrowFiguring Year II Escrow Taxes will be $924.21Taxes will be $924.21 Insurance will be $904Insurance will be $904 Total Payout estimated for end of year IITotal Payout estimated for end of year II

$1,828.21$1,828.21 Billy Banker Would Like twice that in accountBilly Banker Would Like twice that in account

about $3,657about $3,657 Billy Banker has $855.20 in there nowBilly Banker has $855.20 in there now

Setting Next Years Setting Next Years EscrowEscrow

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

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

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

Estimating Escrow for Estimating Escrow for Later YearsLater Years

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

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

Assume taxes up 5% per yearAssume taxes up 5% per year

Taxes and InsuranceTaxes and Insurance Year #3 homeowners insuranceYear #3 homeowners insurance

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

PMI stays the same at $280PMI stays the same at $280 Taxes will go up 5% each yearTaxes will go up 5% each year

Taxes and EscrowTaxes and Escrow Year 2 taxes were $924.21Year 2 taxes were $924.21 Year 3 taxes $924.21*1.05 = $970.42Year 3 taxes $924.21*1.05 = $970.42 Year 4 taxes $970.42*1.05 = $1,018.94Year 4 taxes $970.42*1.05 = $1,018.94 Year 5 taxes $1,018.94*1.05 = $1,069.89Year 5 taxes $1,018.94*1.05 = $1,069.89 Year 6 taxes $1069.89*1.05 = $1123.38 Year 6 taxes $1069.89*1.05 = $1123.38

Future Years EscrowFuture Years Escrow Year 3 $280 + $649 + $970.42 = $1899.42Year 3 $280 + $649 + $970.42 = $1899.42 Year 4 $280 + $675 + $1,018.94 = Year 4 $280 + $675 + $1,018.94 =

$1973.94$1973.94 Year 5 $280 + $702 + $1,069.89 = Year 5 $280 + $702 + $1,069.89 =

$2051.89$2051.89 Year 6 $280 + $730 + $1,123.38 = Year 6 $280 + $730 + $1,123.38 =

$2133.88$2133.88

Important Inflation FeaturesImportant Inflation Features Note that the Taxes and Insurance Payments Note that the Taxes and Insurance Payments

are just going up by 3.9% over-all each yearare just going up by 3.9% over-all each year Many Times in Inflation Scenarios you see a Many Times in Inflation Scenarios you see a

cost that grows and compounds with inflationcost that grows and compounds with inflation If the costs grow at a steady rate through each If the costs grow at a steady rate through each

compounding period you have something like an compounding period you have something like an annuity with inflationannuity with inflation can’t use P/A or A/P because payment amount can’t use P/A or A/P because payment amount

changeschanges

The Geometric GradientThe Geometric Gradient In some engineering econ problems we see In some engineering econ problems we see

what would be an annuity except that it what would be an annuity except that it grows at a steady rate each compounding grows at a steady rate each compounding period.period. Some equipment maintenance expenses Some equipment maintenance expenses

behave this waybehave this way Most common source is inflation in the cash Most common source is inflation in the cash

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

Special Features for Special Features for Special ProblemsSpecial Problems

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

done with a large number of different P/F valuesdone with a large number of different P/F values We got P/A because it let us treat an obnoxious We got P/A because it let us treat an obnoxious

series of numbers as one cash flow element that series of numbers as one cash flow element that can be dealt with all at oncecan be dealt with all at once

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

Another Super HeroAnother Super Hero

P/AP/Ag,i,ng,i,n

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

The first two numbers look like interest ratesThe first two numbers look like interest rates Actually what you have is a rate of Actually what you have is a rate of

inflation or cost escalation, and an inflation or cost escalation, and an interest rate, and a number of payments interest rate, and a number of payments or compounding periodsor compounding periods

Super Hero FormulaSuper Hero Formula Look in the front of the book “Geometric Look in the front of the book “Geometric

Series Present Worth”Series Present Worth” In our case we won’t be able to use the In our case we won’t be able to use the

hero because Herby’s escrow payments hero because Herby’s escrow payments are made monthly, while the growth is are made monthly, while the growth is yearlyyearly

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

growing annuitiesgrowing annuities Also I don’t like inflation in engineering cash flow analysis and so Also I don’t like inflation in engineering cash flow analysis and so

I’m not putting out a lot of emphasisI’m not putting out a lot of emphasis

Back from the DetourBack from the Detour Annual Escrow PaymentsAnnual Escrow Payments

Year #3 $1,899.42/12 = $158.29Year #3 $1,899.42/12 = $158.29

Year #4 $1973.94/12 = $164.50Year #4 $1973.94/12 = $164.50

Year #5 $2051.89/12 = $170.99Year #5 $2051.89/12 = $170.99

Year #6 $2133.88/12 = $177.78Year #6 $2133.88/12 = $177.78

Adjusting the Mortgage Adjusting the Mortgage PaymentsPayments

Basic Loan will be for $25,200Basic Loan will be for $25,200 The Bank also charges pointsThe Bank also charges points

(an up front premium in exchange for a lower (an up front premium in exchange for a lower interest rate - interest rate - or a good way for bankers to make their or a good way for bankers to make their loan look like a better deal and still make the same moneyloan look like a better deal and still make the same money))

$378$378 But Herby gets credit for last years taxes But Herby gets credit for last years taxes (since (since

he’ll end up paying them)he’ll end up paying them) $880.20$880.20

Herby’s Loan with Tax Herby’s Loan with Tax AdjustmentAdjustment $25,200 + $378 - $880.2 = $24,698$25,200 + $378 - $880.2 = $24,698 A/P is 0.006157 for 360 payments with 6.25% A/P is 0.006157 for 360 payments with 6.25%

annual interestannual interest (divided by 12 for monthly compounding)(divided by 12 for monthly compounding) $24,698*0.006157 = $152.06$24,698*0.006157 = $152.06 Mortgage PaymentsMortgage Payments

Year #1 - $152.06 + $220 = $372.06Year #1 - $152.06 + $220 = $372.06 Year #2 - $152.06 + $233.50 = $385.56Year #2 - $152.06 + $233.50 = $385.56 Year #3 - $152.06 + $158.29 = $310.35Year #3 - $152.06 + $158.29 = $310.35 Year #4 - $152.06 + $164.50 = $316.56Year #4 - $152.06 + $164.50 = $316.56 Year #5 - $152.06 + $170.99 = $323.05Year #5 - $152.06 + $170.99 = $323.05 Year #6 - $152.06 + $177.78 = $329.84Year #6 - $152.06 + $177.78 = $329.84

Building the Home Buy Building the Home Buy Cash FlowCash 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