Buying vs Leasing Flashcards
Housing Cost Ratio
As a rule of thumb, your PITI costs shouldn not exceed 28% of your pre-tax monthly income. This ratio, which compares monthly housing expenses to the borrower’s gross monthly income, is called the Housing Cost Ratio (also referred to as the front-end or Primary Housing Ratio).
Total Cost Ratio
(also referred to as the back-end or Total Obligation Ratio). This is a total debt ratio that compares the borrower’s PITI plus other monthly debt payments to the borrower’s gross monthly income. If the lender’s requirement is that the back-end ratio cannot exceed 36%, then total monthly debt cannot exceed 36% of the gross (pre-tax) monthly income.
What is the rule of thumb for annual maintenance and operation costs?
Practitioner Advice: As a rule of thumb, many financial planners estimate annual maintenance and operation costs to be 1% of the fair market value (FMV) of the home.
What is the general rule of thumb for determining what you can afford is to spend on housing expenses?
The general rule of thumb for determining what you can afford is to spend no more than 25% of your after-tax income on housing expenses. As a buyer, this normally implies a home purchase price of about two and one-half times annual after-tax income.
Tax Advantages of buying a home
The immediate and long-term tax advantages associated with buying a home are:
If you itemize deductions, both the state and local taxes on the property and the interest on the mortgage that you pay may be deductible from the adjusted gross income when you calculate your federal taxable income (up to applicable limits). If you are in the 24% marginal tax bracket, each dollar you pay in property taxes and interest saves you 24 cents in federal income taxes. Therefore, the higher your marginal tax rate, the greater the income tax advantage.
For a renter, the taxes on the property and the interest on the mortgage are included in the price of the rent, but you cannot take them as a deduction on your income tax return.
Following federal law changes in 2017, mortgage interest is fully deductible only on first and second homes. That is, if total home mortgages do not exceed $750,000. For all interest on a second mortgage, such as a home equity loan, to be deductible, total mortgages must be both less than the market value of the home and the funds can only be used to make capital improvments on the house. No longer can you use a home equity loan to pay off credit card or other debts and then deduct the interest on your taxes!
Special tax treatment accorded capital gains provides an additional long-term tax advantage to home owners. Under the provisions of Section 121 of the IRC, you can exclude up to $250,000 ($500,000 if filing jointly) of the gain from your taxable income. This exclusion is applicable to each sale of a home if you have owned the home for two of the last five years (ownership test) and have used it as your main home for two of the last five years (use test). The exclusion is proportionately reduced for shorter periods of ownership under certain exceptions (e.g., relocation for a new job, unemployment).
Mortgage Interest
Mortgage interest is fully deductible on primary and secondary homes for all loans used to acquire or improve the real estate up to a $750,000 threshold (Acquisition or Improvement Indebtedness), provided the loans do not exceed the fair market value of the home.
For all loans secured by your primary residence that are used for purposes other than acquiring or improving the property, the interest is no longer tax-deductible. Note that the manner in which the money is borrowed is not the relevant factor here. It doesn’t matter if the loan is a fixed rate 1st mortgage or a home equity line of credit. What matters is what the borrower used the money for.
For example, Imani has a $500,000 home which she owns free and clear. If she took out a 1st mortgage for $150,000 to buy an airplane, the interest would not be deductible. If she took out a $150,000 home equity line of credit and used it to put an addition on the home, the interest on that loan would be fully deductible because she used the proceeds of the loan to improve the real estate.
Prepayment Option
The prepayment option allows the borrower to make early cash payments that are applied toward the principal, thus reducing the amount of interest due. Many mortgages restrict prepayment by limiting the amount that can be prepaid or charging a penalty for prepayment.
Adjustable Rate Mortgage
With an adjustable-rate mortgage (ARM), the interest rate fluctuates based on the movement of whatever index the ARM is tied to, within limits and at specific intervals.
Borrowers should be aware of then following ARM Components
The index to which the loan movements are tied.
The margin on the loan.
The interest rate caps which govern just how much the rate can change at any given adjustment period.
The initial, or start rate that the loan offers at inception.
Initial Rate
The initial rate is sometimes called the teaser or start rate. This rate could last for a limited period of time, such as 3 months or 1 year. It could also last for a longer period of time: 3, 5 or 7 years.
Interest Rate Index
The rate on ARMs is tied to an interest rate index not controlled by the lender. As that index rises and falls, so does the ARM rate. When shopping for an ARM, you should ask your lender for some historical data on the index.
Common Index Rates
The rate on 6 or 12 month U.S. Treasury securities.
The Federal Housing Finance Board’s National Average Contract Mortgage rate, which is the national average mortgage loan rate.
The average cost of funds as measured by either the average rate paid on CDs or the 11th Federal Home Loan Bank District Cost of Funds.
LIBOR (London Interbank Offered Rate).
Adjustment Interval
The adjustment interval defines how frequently the rate on the ARM will be reset. One year is the most common adjustment period, although some ARMs have adjustment intervals as low as 3 months and as long as 7 years.
Rate Cap
The rate cap limits how much the interest rate on an ARM can change. Most ARMs have both periodic and lifetime caps
Periodic Cap
A periodic cap limits the amount by which the interest rate can change during any adjustment.
