need help with finance.. need to compete 3 diff mortgage scenarios, which I think I did correctly. I have some questions.

Next i need to compare if I invest my money elsewhere.

EXERCISE 3 youBUYS A HOUSE x is trying to decide how to finance the purchase of his first home, a typical yuppie starter castle. He has asked you to provide some advice regarding loan choice and how much to borrow. The facts of the situation are as follows: Price of house: X salary: x cash and other liquid assets x marginal tax rate $500,000 $160,000 $180,000 30% Mortgage Option 1: Fixed interest rate: Term: Front end fees .0375 15 years 2% of principal (no points) Mortgage Option 2: Variable interest rate: Term: Front end fees: 5/1 ARM .0325 for first five years, adjustable annually thereafter Max annual adj = +/-2% Max total adj = +-6% Rate adjusted to external benchmark 30 years 2% of principal (no points) Mortgage Option 3: Fixed interest rate: Term: Front end fees: .04 30 years 2% of principal For all loan options, the bank will loan up to 90% of the price of the house. Assume all fees are for transactions costs and hence not tax-deductible. Ignore mortgage insurance. Learning Points: 1. Mortgage loan amortization 2. Variable interest rates 3. Cost of equity v. cost of debt and amount to borrow 4. Issues in selecting debt instrument 2 Exercise 3, an individual assignment, is the first assignment in the second major part of the course, namely, financing. Recall the financing decision is the decision about where to go to get the money you need to make an investment or set of investments you have decided to pursue. Here are some general points regarding financing: 1. Financing decisions are separate from investment decisions. Make sure you keep the cash flows separate. In the ex, X has already decided to buy the house; i.e., he has made the investment decision. The cash flows associated with the house purchase are not part of your analysis to inform selection of financing option. 2. Financing decisions almost always involve comparing two or more mutually exclusive options. The most common way to make the cost comparison among financing options is to calculate the IRR of all options. In a financing decision (in contrast to an investment decision), the option with the lowest IRR is the one with the lowest cost (and typically the one using the least cash). In Exercise 3, you definitely want to calculate the IRRs of all the loan options. In the exercise, you have three loan options and effectively one equity option, in the sense that using more of Bozo's equity on the house can lower the debt. Think about Bozo's cost of equity, after taxes. It is likely the higher of the rate he can earn on funds he invests in fairly low risk instruments and the value he places on liquidity. You are given neither of these numbers, so you will need to think about a reasonable rate. We can discuss. 3. One of the loan choices is a variable rate note. This situation is an example of uncertainty in the financing decision. I suggest you construct a couple of scenarios: (1) A good case, where the initial rate pertains for the whole term of the loan. (It is pretty easy to set up the amortization schedule in this case (and for the two fixed rate notes in the exercise), following the instructions provided in video 15.) (2) A bad case, where the rate increases 2% per year beginning in year 6, reaching the limit in year 8 and remaining there. To construct the cash flows for the bad case, you will have to follow these steps: 1. Start with the initial rate, term, and loan principal and develop the 30-year amortization schedule. 2. Amend the schedule in year 6. Change the rate (to 5%), term (to 25 years), and principal balance (which equals the balance at year end five), and calculate a new PMT. Develop the full 25-year amortization schedule, leaving the years 1-5 lines in place. There is an error in the plan document. So, you are correct that the year 6 rate is, in the worst case, 5.25%. Sorry for confusion. , but the rate would just once at year 6, again at year 7, and once more at year 8 before hitting the max 6% jump. So year 6 would hit 5.25%, year 3 7 would be 7.25% and year 8 and beyond would be 9.25%. 3. Amend the schedule in year 7 ... 5. Remember that selection of a debt option depends on three sets of issues: (1) cost (or effective interest rate); (2) term (length of financing needed v. available); (3) conditions of loan, such as covenants and risk differences. You will want to consider all three in making your recommendation to Bozo. guess my question is more related to does the treatment of fees change if the fees are with points versus no points. If some of the front end fees are "points", then there is an income tax deductibility; that is, points paid to reduce the stated interest rate (but likely as Rebika notes increase the effective interest rate) are tax deductible in the year that the loan is taken out. In the exercise analysis, you are to assume that none of the fees represent points; hence, the fees are not tax deductible. ne additional question when reading through the X materials. There is a section that notes: "Think about X's cost of equity, after taxes. It is likely the higher of the rate he can earn on funds he invests in fairly low risk instruments and the value he places on liquidity." Is this statement saying to look at the return X could get on low risk equity investments (such as T-bills) and compare it to the effective rate of the mortgage options? Answer :You ask a very important question. As noted, you are to make two recommendations to X: 4 1. Which loan 2. How much to borrow The answer to the second question depends largely on a comparison of the effective interest rate on the selected loan and X's cost of equity. Where do we get his cost of equity? It could be the opportunity cost, in terms of a rate of return, that he could earn by investing his funds. Where might he invest his funds? The answer depends on his risk aversion. If he is highly risk-averse, he might go for treasuries or some insured bank account, both of which carry a very low interest rate. In this case, it is highly likely that his rE