Economic Analysis Team Project
TEAM 3
Home Financing Options
Team Members
From left to right
Jason de la Guerra – Organizer
Michael Jauregui – Summarizer
Jerry Lessley – Techie
Kevin Navares – Techie
The Big Questions???
You’re in the market to purchase a home.
What type of loan should you choose?
What is the difference between an FRM and
an ARM?
Definitions
FRM
(Fixed Rate Mortgage)
ARM
(Adjustable Rate Mortgage)
Rate is constant for 30
years
Fixed rate for 7 yrs then
indexed for 23 years
Current Rate 5.36
Fixed rate 4.36
Adjustable rate index of
2.25 – 3.0
** Both require a FICO score of 700 or above
Analysis Assumptions
Loan amount of $400,000
Down payments are equal to 10% of loan
Payment is based on a 30 year term
Options of selling at 7 and 10 years
Average tax benefit of 28%
All rates are based on current market values
and historical trends
Future Value
Assuming a Conservative California Average growth of 10%
FV of a $400,000 would be $716,339.08 in 10 years
FV of a $400,000 would be $601,452.10 in 7 years
Combined with monthly payments and our initial down
payment the amount owed at the end of 10 years would be:
FRM $296,646 ARM $273,871
For 7 year
FRM $113,181
ARM $124,120
Benefit Cost Ratio
The most beneficial option will have the highest ratio.
B/C = (sale benefit + tax benefit) / (down payment + total of amount paid)
10 yr FRM B/C = (316339+61280)/(40000+241503) = 1.34
10 yr ARM B/C = (316339+58531)/(40000+241503) = 1.33
7 yr FRM B/C = (201452+48271)/(40000+169052) = 1.19
7 yr ARM B/C = (201452+37332)/(40000+169052) = 1.14
Rate Of Return
Arm Interest 4.36%,5.51%,6.66%,7.81%
Cash Flow + Equity at 7 years
-40000
-40000
0
1
2
3
4
5
6
7
8
9
Years
10
245709
244127
5037
3888
4942
3760
-40000
-40000
0
5127
4010
ARM
5212
4127
ARM
5292
4240
FRM
5369
4347
FRM
4625
5143
4736
4430
4842
3626
4942
3760
5037
3888
5127
4010
5212
4127
5292
4240
5369
4347
Cash Flow + Equity at 10 years
424201
448337
FRM Interest 5.36%
1
2
3
4
5
6
7
Years
ROR based on initial down payment of $40,000 less our annual tax benefit and equity
earned at sale of the home
ROR at 10 years
ROR at 7 years
FRM
31%
36%
ARM
30%
35%
Principal vs. Interest Contribution
FRM Yearly Cash Flow
30000
Payment
25000
FRM Principal
Contribution
20000
15000
FRM Interest
Contribution
10000
5000
0
0
1
2
3
4
5
6
7
8
9
10
Year
ARM Yearly Cash Flow
30000
Payment
25000
20000
ARM Principal
Contribution
15000
ARM Interest
Contribution
10000
5000
0
0
1
2
3
4
5
Year
6
7
8
9
10
Principal and interest sum =
total yearly payment of $24,150
for both FRM and ARM
Fixed Rate Mortgage (FRM)
Benefits
Predictable cash flows for term of loan
Higher tax benefits
The rate of return after 10 years with no sale is
higher.
Greater investment return at 7 year sale
Higher profit than ARM after 10 year sale.
Adjustable Rate Mortgage (ARM)
Benefits
Initial interest rate is lower than FRM
Interest rate paid will generally decrease as
prevailing interest go down.
Typically offer lower down payment option
Generally easier qualification criteria
Competitive ARM market coupled with low
rates increase affordability.
Conclusions
FRM overall better alternative given analysis
assumptions
Long term home-owners receive greater benefit form
FRM
Assuming the same FRM and ARM payment the
FRM has greater return on investment.
Short Term home-owners benefit from ARM due to
lower initial costs and higher payments to principle.
Current market provides ARM advantage through
affordability and competitive markets
Resources
www.myfico.com
www.cnnmoney.com
www.hud.gov
www.lendingexpo.net
D. Newnan, J. Lavelle, and T. Eschenbach.
(2002). “Essentials of Engineering Economic
Analysis” Oxford University Press, Oxford,
NY.