Mortgage Crisis—the Home Buyer: A bank has a policy that it will approve a mortgage for someone only if they have a steady income that is sufficient to cover the costs of home ownership. In addition to monthly payments of interest and principal, the bank requires the homeowner to make monthly payments into an escrow account that the bank will used to pay property taxes, property insurance, and mortgage insurance. The bank requires this arrangement so that it can be certain that the property taxes are in fact paid on time, that the property is insured in the case of fire or other disaster, and that the mortgage payments will be made even if the homeowner dies. The bank uses two common rules of thumb in reviewing mortgage applications. First, the buyer should make a down payment of at least 20% of the cost of house (and homeowners are not allowed to borrow this money from someone else—they must be able to produce the cash from their own resources). Second, the sum of the mortgage payment plus the escrow payment should be no more than 30% of the homeowner’s income.

a. Consider a family with annual income of $60,000. Will they be able to obtain a 6%, 30-year mortgage for a house that costs $100,000, has property taxes of $3,000 per year, and will cost $1,200 per year for property insurance and mortgage insurance?

b. The couple decides they would like a bigger house. What is the largest amount that the bank would be willing to lend this family for purchasing a house with taxes and insurance that total $4,200 per year?

c. The family goes ahead and buys a bigger house for $300,000, and they take out a $200,000 mortgage at 6% for 30 years. After 10 years, they decide to move to California in order to get high-paying, high-tech IT jobs. If property values have risen 11% per year, how much will they be able to gain from the sale of their house? Assume that closing costs such as the real estate agent’s fee will be 5% of the sale price. Also assume that a portion of the proceeds from the sale will be used to pay off a total of $300,000, consisting of the remaining portion of their original mortgage plus the outstanding balance on their home equity loan.

d. When they reach California, the family finds that the housing market is much more expensive than they expected, but they have all that money from the sale of their previous house, and they now make $300,000 per year. They conclude that they really are rich, so they should buy the best house they can afford, maybe something with a view of the mountains. If they are willing to put all of their profits from the sale of their previous house into their new house, how much will they be able to afford to pay per year for mortgage and escrow payments?

e. Unfortunately, what the bank offers is not enough for them to purchase the $4 million house of their dreams, which has $30,000 per year for taxes and insurance. So they decide to go to a mortgage company. What they would like is a mortgage with only a 10% down payment, so that they could afford their dream house (and, it must be added, they decided to include their expected bonuses of $41,000 and $72,000) in their application, stating their income as $413,000 per year, even though they knew they were unlikely to get such good bonuses again.) They were not concerned about stretching to make ends meet, and the agent noted that the old 30% limit had been increased to 35%, reflecting the fact that housing prices were rising faster in California than anywhere else in the country. The agent and the couple agreed that even if things were tight for a couple of years, housing prices would rise, their salaries would rise, and they would be able to refinance their mortgage for an even larger amount. The agent for the mortgage company agreed to provide the mortgage under the suggested terms, and they bought their dream house. And, it turns out, the agent quietly rounded off their income to $450,000 per year when he forwarded their mortgage application to his home office for approval. Assuming the company required a 10% down payment and limited mortgage plus escrow to 35% of what was reported to be their income, how much would they be able to borrow?

f. Unfortunately for our intrepid IT experts, they happened to buy their dream house at the top of the market. Three years later, housing prices had dropped by 25%. And then their company went through a massive restructuring, and both of them lost their jobs, along with a great many others in the region. Their only option was to sell the house at a loss, move back to the east, and take up their old jobs at a huge cut in pay. Approximately how much will they lose?

NOTE: Problem 9 provides some insight into what motivated banks to create mortgage-backed securities, why these securities were riskier than anticipated, and how failure of these securities could lead to a larger financial crisis. Don’t get lost in the details, and make reasonable simplifications and approximations in trying to answer the questions.

Hint:

Changes to make this work:

In c they buy a $200,000 home not $300,000

In California their dream home is $2,000,000 not $4,000,000

a) If they want to buy a house that costs $100,000 then they need a down payment of 20% so the mortgage payment should be based on $80,000 for 30 years at 6%. Add the mortgage + taxes + insurance and see what percentage of their $60,000 income that is. If it is less than 30% then they can do it, if they can come up with the $20,000 down.

b) Their mortgage payment can be as high as 30% times their income of $60,000 minus the cost for taxes and insurance. Use their max mortgage payment to get a present value of the annuity for 30 years at 6%. This is the most they could borrow, but they would need 20% more as a down payment so add that in to get the max cost of a home they could buy.

c) They can’t afford a $300,000 home so use $200,000 here instead. Determine the new value of their home if it goes up 11%/year for 10 years? It’s a lot more, about triple! They would have to pay the closing cost fees of 5% so take that off the new value and subtract $300,000 they owe in mortgage and home equity loans (they must have bought a big new car or taken some exotic vacations – of course the problem originally assumed the cost of their home at $300,000) as well) and this how much they walk away with after selling – nice profit! (like about $200,000)

d) USE a value of $2,000,000 for their dream home. They have the money from the sale of their home as a down payment in California so divide that by .2 (20%) and you have the cost of a home they could afford there. They could afford to pay annually up to 30% of their new salary in mortgage plus taxes plus insurance.

e) If taxes and insurance are $30,000 then their max mortgage payment is $60,000 so convert that to a present value using a 6% interest over 30 years and they can’t afford the $2,000,000 home that a 10% down could get them into. With the more favorable conditions considering bonuses and a 35% allowable the should be able to get into their $2,000,000 dream home

f) Their mortgage from (e) should be around 1.7 million so now if they can only sell their $2,000,000 home for $1,500,000 they are $250,000 short of paying of their loan AND they lose all that down payment profit from the first home too L.