Ms. Sally Firth has worked as a design engineer since graduating from Northcentral University. She has shifted jobs twice, and expects to switch again in the near future. All of these jobs are in the same area where she has decided she wants to live for at least the next five years. Thus, she is ready to buy herself a small home and move out of her rented apartment. Ms. Firth has found a home she likes, and she believes that she should buy it before she changes jobs. If she waits to buy, some financial institutions may down rate her due to a short of time on the job in spite of the salary increase she expects. She knows she could get a mortgage, but difficulties in qualifying might restrict her choice of home. This really concerns her because the home she wants to buy will cost about $96,500 plus closing costs. In fact, the current owner has accepted her offer and given her six weeks to finalize the financing and arrange for closing. He also provided details on the upkeep costs of the house, which she included in her budgeting. She has set aside about $7,500 for a down payment, and she has budgeted for a monthly payment of about $900. She expects that her salary will increase about 5% per year in real terms, but she would like to use that increase for fun purposes. Until last year, she was still paying off her student loans, and she has not been able to live in the style to which she would like to become accustomed. She has identified the three basic financing possibilities described below: 1. New mortgage: Current mortgages cover a 30-year period and are available at 10% APR (annual rate compounded monthly) with a 5% down payment. With new

1 Appearing in Newnan, Eschenbach, Lavelle, and Lewis.

financing, title insurance is 0.5% of the propertys value, and the loan origination fee is 1% of the loans face value.2 2. Assume homeowners current mortgage and get a second mortgage: When the current owner purchased the home, interest rates were only 7% APR. That mortgage has 25 years to run, with a remaining balance of $65,000. The monthly payments also include a reserve allowance for fire and liability insurance and for property taxes. Annually these total $675 for insurance and $850 for taxes. The monthly allowances are 1/12th of the totals. While the mortgage can be assumed, with the only cost being a $500 charge for credit checks and paperwork, the current owners equity has to be covered somehow. The bank with the original loan will issue a second mortgage at 12% APR for a term to match the first mortgage. The requirements for down payments, title insurance, and loan origination fees match those for new first mortgages. 3. Assume homeowners first and second mortgages: The current owner is also willing to accept a second mortgage directly. While the upfront fees can be omitted, the loan has a 12% APR and a 10-year term. Exotic Alternatives In addition to the basic options outlined above, through various channels, Ms. Firth also becomes aware of more exotic alternatives as outlined below: 1. The loan office at the bank has just called Ms. Firth to mention another financing possibility the graduated payment mortgage. Terms, interest rates, and fees are the same as a normal mortgage. However, by lowering the payments in the early years, it is somewhat easier to qualify for and to afford the home of your dreams. For the first 4 years, the payments are only 80% of the level of a normal mortgage; then for the next 6 years, the payments for both mortgages are the same; and then for the last 20 years, the graduated payment mortgage has the higher payments needed to pay off the loans balance. 2. Although she ignored inflation initially, Ms. Firth recognizes that the rates of the various mortgages include allowances for expected levels of future inflation. This 2 The loans face value is the actual principal of the loan, i.e., the cost of the property minus the down payment.

was really made obvious when a friend, George, described his new variable rate mortgage. Everything was similar to what she was used to except that the initial rate (last month) was only 6%. In turn, he agreed that once a year the bank could adjust his rate according to movement of the prime rate. Thus, if inflation is high or money is tight, his rate could rise as much as 1% per year. There is a lifetime cap of 5% on these increases. Analysis of this alternative requires specifying a few likely scenarios. 3. Ms. Firth is also wondering whether she is better off using some of her extra savings to reduce the loan by increasing her down payment, or whether she should use it on early payments. Given the number of options and possible long-term implications of the decision, Ms. Firth has decided to hire your team to help her decide which financing alternative she should pursue. The assignment is to write a short report that states and provides support for your recommendation, and to design an Excel Spreadsheet that allows Ms. Firth to easily consider changes to the key parameters that determine the terms of the financing alternatives under consideration.