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FINC 349 Lecture 14

Chapter One and Chapter Two Overview

  • Introduction to the responsibilities associated with Chapters One and Two.

  • Emphasis on their importance without providing personal notes.

  • Subsequent focus on later chapters (Three, Four, Five, Seven).

Chapter Five Overview

  • Advisement against deep diving into adjustable rate mortgages (ARMs) due to complexity.

  • Focus primarily on fixed-rate mortgages.

  • Acknowledgment of various other chapters that cover financial knowledge (Chapter Three, Four).

  • Mention of covering definitions and software aspects.

  • Importance of practice on Excel spreadsheet for midterms (Calculating Present Value, Future Value, etc.).

Key Financial Concepts to Know

  • Excel Formulas: Importance of mastering Excel formulas for calculations related to

    • Present Value

    • Future Value

    • Weighted Average Cost of Capital

    • Cost of Equity via CAPM (Capital Asset Pricing Model).

  • Understanding the implications of business decisions on financial performance.

Understanding Mortgages

Fixed-Rate Mortgages

  • Definition: Fixed-rate mortgages charge a constant interest rate throughout the term of the loan.

Adjustable-Rate Mortgages (ARMs)

  • Definition: Mortgages where the interest rate may change over time based on market conditions, requiring more knowledge.

  • Comparatively dealt with briefly but understanding is essential.

Types of Fixed Income Mortgage Structures

  • Bullet Mortgage:

    • Definition: A loan in which the principal amount is repaid at the end of the term.

    • Clarification that subtracting points can affect the amount paid to the bank which functions as a commission.

  • Level Principal Payment:

    • Definition: A fixed amount of principal is paid back in each installment, resulting in varying total payments including interest.

    • Example: For a ten-year loan of $1,000,000, $100,000 is paid back annually.

    • If paid semiannually, payments are adjusted to $50,000 every six months.

Key Concepts for Midterm Preparation

  • Date of Midterm: October 17

  • Importance of practicing calculations on:

    • Present Value (PV)

    • Future Value (FV)

    • Understanding the difference between fixed and variable rates, risks, and their implications on returns.

Risk and Return in Mortgages

Variable Rate Risks

  • Definition: The risk associated with adjustable rate mortgages due to interest rate volatility.

  • Consequence: Variable payment amounts; less predictability for borrowers.

  • Consideration: Choose a fixed rate when interest rates are low, and a variable rate may be more beneficial in high-rate situations.

Yield Curve Structure

  • Definition: Representation of interest rates across different loan maturities.

  • Typical expectation: Longer terms generally yield higher returns due to increased risk.

  • Understanding risk-return proposition when considering borrowing options.

Default Risk

  • Definition and Types:

    • Technical Default: Minor breaches like late payments.

    • Default: More severe; potential for banks to claim collateral or assets.

    • Dissolution or Bankruptcy: Severe financial issues leading to loss of all assets.

  • The implications of default risk on mortgage agreements and the legal repercussions involved (remedy and recourse).

Interest Rate Risk and Risk Premiums

Management of Risks

  • Interest Rate Risk: Fluctuations can heavily impact cash flows associated with variable rate loans.

  • Definition of Risk Premiums: Additional return expected for taking on increased risk associated with high-interest rates or uncertain economic conditions.

  • Fundamental takeaway: More risk typically aligns with higher potential returns.

Housing Market Considerations

Economic Indicators

  • Importance of population growth and employment rates on housing prices.

  • Strong relationship between economic performance and housing market dynamics.

The Basics of Renting vs. Owning

  • Homeownership provides tax advantages like deductibility of property taxes and mortgage interest.

  • Renting often requires straightforward cash flow without the risk of depreciation or maintenance costs.

Evaluating Real Estate

  • Consideration of environmental factors, accessibility to amenities, and proximity to schools when assessing property values.

Conclusion

  • Key chapters to focus on: Chapter One, Two, Five, and Seven.

  • Consolidation of knowledge around definitions, structures, risks, and return expectations in the real estate and finance sectors.

  • Importance of continual practice especially with Excel for financial calculations in upcoming evaluations.