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Mortgage Advice

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kellen2811
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Mortgage Advice  Reply with quote  

I need a little advice from the board. We are in the process of getting a construction loan to build a house in our home town.

I have a few options and would like to know what you guys would do in this situation.

Assumptions - Total Loan 337,600
Interest Rate is variable for one year during construction after which it will be turned into a fixed rate of whatever the interest rate will be in 1 year from now.
This is a construction project done by me and my father the hous estimate is going to come in around 350,000. We expect to be able to build it for less then 300,000 but have budgeted for overruns.

Option 1: 10% down 3.75% interest for the construction year. Closing costs 10,176. PMI 150.00 a month

Option 2: 5% down 3.75% interest for the construction year. CLosing costs 10,176. PMI 250.00 a month

Option 3: 10% down. 3.88% interest for the construction year. Closing Costs 14,614.00. PMI-150.00

My initial thought is to take the 5% and put the 16,000 into the market to allow it to compound and just take the initial hit for the first few years paying the PMI. The payments a month are affordable either way I go. Just wondered what everyone elses plan would be with a scenario like that. THanks

Kellen
Post Fri Feb 22, 2013 7:56 am
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smk
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not sure i understand. you want to effectively borrow 16k for 1 year at 3.75% and pay an additional 100/month in pmi to invest it at something like 0.75%? where is the advantage?

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Fri Feb 22, 2013 4:31 pm
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kellen2811
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We would not be borrowing the 16,000. It would be from our down payment that we have saved up. The investment would not be in a regular bank account. It would be in a mutual fund and stockmarket.
Post Fri Feb 22, 2013 4:55 pm
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kellen2811
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No I realize that there is risk involved and accept that but over time say I leave it in for 30 years the risk of it being less then when I started is lower. I have a long time frame to invest.
Post Fri Feb 22, 2013 8:21 pm
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smk
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the risk of it being lower than the cost of the loan actually goes up over time, not down. so in 30 years the risk of loss is much greater. the idea that the risk declines over time is a common myth circulated by people who try to encourage others to buy stocks.

as far as suitability is concerned, i don't know your personal circumstances. but if a financial institution proposed borrowing to buy stocks, which is the actual position you are looking to put on your balance sheet, they could only pull it off if they already had little or no stocks to begin with. otherwise their regulators would be all over them...

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Fri Feb 22, 2013 8:37 pm
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littleroc02us
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quote:
Originally posted by kellen2811
No I realize that there is risk involved and accept that but over time say I leave it in for 30 years the risk of it being less then when I started is lower. I have a long time frame to invest.


So your not using the 16k as a downpayment? I'm confused. So first you stated that it's a down payment on a house and then you say you want to invest it for 30 years possibly. Please explain.

Risk comes from not knowing what you're doing. (Warren Buffet)
Post Fri Feb 22, 2013 10:15 pm
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oldguy
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quote:
My initial thought is to take the 5% and put the 16,000 into the market to allow it to compound and just take the initial hit for the first few years paying the PMI. The payments a month are affordable either way I go.


I like that choice. Ie, retain the use of your $16,000 and pay the extra $1200 for the use of it. When you transition to the fixed rate 30-yr loan a years from now, one goal is to lock in as much fixed rate <4% 30-yr capital as you can, ie a 'keeper' loan.

The $16k in reserve gives you the option of paying down the loan if rates move against you - or using the $16k if required for construction.

As Coaster says - the $16k could be anything at the end of one yr, the market often moves 50% either way. But no matter if you don't need it, at the end of 30 years the probable outcome is around $350,000. All of those +/- years have time to statistically average and converge on a more predictable outcome. (I know smt worries that 'time adds risk' but in my world, 30 yrs is an adequate basis for a prediction, 30 data points is considered 'statistically signifcant for a normal distribution'). There is risk of course - but no one ever became wealthy w/o taking risk.
Post Fri Feb 22, 2013 10:55 pm
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kellen2811
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Ok please allow me to clarify. We have saved up enough for the 10% down payment I the loan ie the 33,000. Plus closing costs. We can make the 10% that is where my dilemma is. To either chose the 5% route and invest the 16,000 with the main penalty being 100 extra dollars of pmi and added interest charge from the extra financing. The mortgage will automatically convert to a fixed rate loan at the end of construction without any further down payment or closing fees.

My though is to keep the 16,000 and invest it for a 30 year period. While also adding in extra payment monthly. Using it as a start up for a taxable account.
Post Sat Feb 23, 2013 1:45 am
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oldguy
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quote:
My though is to keep the 16,000 and invest it for a 30 year period. While also adding in extra payment monthly. Using it as a start up for a taxable account.


Hopefully you mean adding extra monthly payments to the Taxable account, not the nortgage? Very Happy

That's what I did over the past 35+ years. I kept mortgages (refi's) on each of our rental houses and used that as seed money to fund our taxable account, plus regular additions from our income.
Post Sat Feb 23, 2013 3:40 am
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kellen2811
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Oldguy- Yes i mean adding the extra to the taxable account. I don't see a reason to pay the mortgage down faster if I go with the 5% option. How did your results turn out? Where they similar to calculations you did at the beginning? Was it successful in your opinion?

Coaster- From my calculations

PMI would be paid on the 5% option for 86 payments while on the 10% option it would be 58.

28 extra payments =7,000
58 payments of 100 dollars more then the 150 PMI=5,800
Total extra in PMI cost- 12,800

Interest Difference from the 5% to the 10%= 14,920 cost of the extra interest for the 5% down payment paid over the life of the loan.

Total extra cost to use the 16,000=27,720
Post Sat Feb 23, 2013 8:54 am
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smk
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your breakeven internal rate of return is 11.44%. this puts the analysis in terms of the time value of money which you need to do to be fair. you calculate this by taking your payment on each loan and subtracting them from each other over the life of the loan. using 337600 and that less 16k at 3.75% for a 30 year period you get 1489.38 & 1563.48 respectively. then you add the pmi. if you have your tax rate you would be able to tax effect it. but without the taxes you would have a payment of 1639.38 for 58 periods and then 1489.38 for the balance and the same thing for 86 periods with the other appraoch. put them all in a spreadsheet and subtract one column from the next. in the first period you have additional payments of 174.1 and at the end the difference is 74.1. at the top of the column use put the 16k you take out from the loan. in the middle the additional payments are 324.1. then you use the formula =irr(.01,column with differences). this comes out to be 11.44% (annualized - (1+r)^12). This means if you earn 11.44% for stocks over 30 years you make nothing by doing this. another way to look at this is the first part of the loan is 3.75% (plus a little for closing). the additional loan for the 16k comes out at 11.44%...

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Sat Feb 23, 2013 10:06 pm
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kellen2811
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Steve,
You lost me there. I dont understand what you are saying in that post weather I am not on that level or what. But if i take you 11.44% presumed need the 16,000 would come out to 487,033.43. That is without the added in extra payment that is just the 16,000 for the down payment. You say that is break even point which I do not understand maybe my math is to simple and you can maybe educate me?

Total Interest on 321,600 @3.75% over 30 years =214,576.80
Total Payments on 321,600@3.75% over 30 years = 536,176.80

Added in the extra 27,720 that costs for PMI and extra interest compared to the 10 % down option.

The total cost with interest, PMI and excluding principle payments = 242,296.80

242,296.80<487,033.43.

Now if you took the total cost of the loan it would be 536,176.80.
I guess I am confused to see how we would have to achieve 11.44% to break even can you maybe explain a little better in la-mans terms.

Coaster,
I would do the middle of the road option, the problem is that I make to much and can not contribute to a Traditional IRA. Roth IRA would be at a reduced contribution level also. That is the reason I was looking at a taxable account. 403b is also maxed out yearly so is not an option either.
Post Sun Feb 24, 2013 8:21 am
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smk
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kellen, you will start to get to the same place via coaster's calculations if you do them correctly. however, there is a fundamental flaw in your thinking. $1 today does not equal $1 in say 10 years. they cannot buy the same things. also, if you invest $1 today at a certain riskless rate, you will get something more than $1 in 10 years. this concept is called the time value of money. you can understand the math better here: http://www.tvmcalcs.com/tvm/tvm_intro . this should explain how you can reduce a series of payments over time to one amount today called the net present value (NPV).

the key point you are missing is that each payment you make on the loan and pmi needs to be deducted from the 16k extra loan amount WHEN YOU MAKE the payments and not at the end of the period. you will then no longer be earning money on those amounts.

the internal rate of return calculation (IRR) is the easiest way to solve this problem and excel will do it for you. just list the incremental changes in payments at each moment in time (cash in from extra loan and all the extra payments over the life). then use =irr(guess, values) to come up with the monthly return numbers. this calculation is an iterative process that sets the npv of what you spend in payments equal to what you receive in cash from the loan. it is therefore the breakeven return that you need to beat to make money. you can guess whatever you want, but 1% is fine. the values are the different cash flows. then you just need to annualize the number from monthly.

my example showed the breakeven is 11.44%. if coaster's approach is correct, you will find you lose money until you reach 11.44%.

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Sun Feb 24, 2013 3:04 pm
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smk
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ps...coaster...oldguy was the one who missed me on valentine's day Smile

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Sun Feb 24, 2013 3:56 pm
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smk
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that can be quite helpful. i think that is what you were doing before. but when you have a lot of moving parts, it is a good idea to do the simple form as well just to check to make sure you didn't steer off course...

Steve Kanney, CFA
http://www.integratedfinancialny.com/index.html
Any comments made are designed to help you make your own decisions and do not consititute investment advice.
Post Mon Feb 25, 2013 12:39 am
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