BA questions
UVA-F-1887 Rev. Jan. 27, 2021
This case was prepared by Safiya Sinclair, Research Assistant, under the supervision of Ken Eades, Paul Tudor Jones Research Professor of Business Administration and Gregory B. Fairchild, Isidore Horween Research Associate Professor of Business Administration, with generous support of the Bankard Fund. It was based on the prior case “Buying That First House” and was written as a basis for class discussion rather than to illustrate effective
or ineffective handling of an administrative situation. Copyright © 2020 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality, so please submit any errata to editorial@dardenbusinesspublishing.com.
Tamara’s New House (B)
Introduction1
After painstakingly weighing her options between buying and renting, Tamara had recently decided she was going to buy a new home. Her reasons for choosing to buy were mainly the distance between the new home and the schools her kids would attend, the beautiful yard space they would enjoy there, and the stability they would have when their mother owned a place of her own. Now her next step was to meet with Marsha, a loan officer recommended by her real estate agent, to discuss financing her new home.
After they exchanged hellos and pleasantries, Tamara sat with Marsha in her office, and they started going over the basics of financing her home.
“How much do you make annually? And how’s your credit?” Marsha asked, getting straight down to business.
“I make $60,000 a year. And my credit is good; my husband and I kept separate accounts before he passed away,” Tamara said with a sigh. “And I pay all my bills on time—my credit card bills, student loans, my utility bills, and car payments, all on time.”
“Wonderful!” Marsha said, while typing on her keyboard, “Let me just check it right now for you, and put both our minds to rest.” Marsha worked on her computer for a short while longer, and then said, “It’s a 720! That’s an excellent score—it shows you have great debt management and pay all your bills and loans consistently and on time. You’ve also been at your job for more than five years. This all shows reliability, responsibility, and consistency. Tamara, you are an excellent candidate for a mortgage.”
“I’m so glad to hear that!” Tamara said. “I’m happy I can finally start moving forward with financing my new home. I’ve chosen a property that is $150,000, but I’m also considering another one that is $135,000. I also have some savings ready for a down payment. In our last meeting, Linda, my real estate agent, started telling me about the different mortgage options available. But I also want to hear from an expert about all the things I should know, and what we should do next.”
“That’s great,” Marsha said with a smile. “It seems you really know what you want. Before we talk about your mortgage options, we should talk more about your other financial information.”
1 Resilience Education, a nonprofit founded at the Darden School of Business, provides high-quality, customized education for vulnerable populations.
For more information, contact info@resilience-education.org.
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How Much Home Can You Afford?
Tamara had all her paperwork and figures ready to go. She knew banks take buying a home as seriously as buyers do, since great risk was undertaken by both parties.
“In my business, we like to do a calculation called ‘How Much Home Can You Afford?’” Marsha said.
“That sounds funny,” Tamara said. “But I think you mean do my budget, savings, and salary cover the house I want to buy?”
“That’s almost it,” Marsha replied. “Usually, you can get a rough estimate of the home price you can afford by calculating 2.5 times your annual gross income. But that’s a simplified way of looking at it. Finding out how much home you can afford is a bit more complicated. Having a good credit score is critical, since it shows responsibility and good financial management. Good credit scores can also lower your interest rates when you get a mortgage.”
Marsha continued, “However, the most important indicator is a percentage that lenders use to calculate how much you can afford to spend on a mortgage. This percentage relates your gross pay to the amount of mortgage we estimate that you can afford comfortably. Here at our bank, we use 27%. So the dollar amount of your monthly homeowner costs (including mortgage payments, property taxes, insurance, and condominium or cooperative fees, if applicable) should be no more than 27% of your gross pay (before taxes). So for example, if your monthly gross pay is $5,000, the maximum cost of your mortgage, plus taxes, insurance, and fees, must be below 27% of $5,000, which is $1,350. I would like to make sure that number is within the price range of the home you are trying to buy, and see how much you have available for a down payment. Most lenders require a down payment that is at least 20% of the cost of the home, and if you can’t afford a 20% down payment, you will have to pay something called private mortgage insurance, or PMI.”
Private Mortgage Insurance (PMI)
“Linda briefly explained PMI to me before,” Tamara said. “How will it affect me?”
“Well,” Marsha replied, “if a buyer can’t make a down payment of at least 20% on the total cost of the home, we require them to pay a monthly PMI. This is an additional insurance fee to protect lenders from the risk of foreclosure—a homeowner not making their monthly payments, or defaulting on their loan. It also deters buyers from purchasing homes they simply cannot afford in the long run—sure, everyone dreams of a mansion, but a modest-sized home is just as good. The PMI is there to protect the banks, but it protects buyers from making poor financial decisions as well.”
“Okay, I’m starting to see how this all works,” Tamara said. “I have a down payment of $30,000 from my savings ready to go, so if I buy the $150,000 house, I will be able to avoid PMI, right?”
“That’s correct,” Marsha answered. “You have 20% of the cost of the home exactly, so you will avoid PMI. But you can also choose to pay a smaller down payment with PMI if that might be better for you financially. It’s up to you to decide whether you’d prefer to use a large portion of your savings on the down payment of the house, or if you would rather use only some of your savings, and pay the PMI fee. Both are viable options. PMI fees vary depending on the size of the down payment and the loan, but most banks charge from 0.3% to 1.15% of the original loan amount per year. PMI fees usually cost $50 to $60 a month, and PMI premiums are tax-deductible. PMI will also automatically cancel once you’ve made a certain amount of payments on time,” Marsha said.
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“I see. So do you think I should make a smaller down payment, and pay a monthly PMI?” Tamara asked.
“That has to be your decision,” Marsha said. “Have you already taken into account the extra costs of moving into a new house, such as buying furniture? And have you thought about the emergency funds you would have in case something happened to the kids, or to you? You have to ask yourself—would you rather keep some money in savings, even if it means paying a small PMI every month, or would you rather buy a cheaper, smaller house, pay a smaller down payment, and try to avoid PMI? There are many different scenarios to consider. It’s your call.”
“That’s a lot to think about,” Tamara said. “You make some really good points. I will have to weigh my options about PMI before I choose a house and a mortgage. So exactly how much home do you think I can afford?”
“Before we make that calculation,” Marsha began, “I’d like to go to the next important step, which is to take a closer look at your debt.”
Debt Ratio
Marsha continued, “Now, along with our housing expense ratio of no more than 27% of your gross income, most banks also use a debt-to-income ratio. This means that before we even consider giving you a loan, we need to know how much debt you have. I need to know that all your other debts—which include credit cards, student loans, car loans, housing expenses, as well as alimony and child support—are less than 30% to 40% of your monthly gross income. How much monthly debt do you currently have, Tamara?”
“I have $625 in debt that I pay monthly—I have car payments, lingering student loans, and two credit cards. But I pay them all on time,” Tamara said, a little bit anxious.
“Don’t worry, Tamara, I know you pay on time,” Marsha said. “This is less about when you pay, and more about how much you have to pay, and how long you will have to pay it. So if we add your estimated housing expenses—mortgage and interest, along with insurance, taxes, and fees—to your other debts, the total expense should be less than 30% to 36% of your monthly gross income.”
“Oh really?” said Tamara. “This is much more in depth than I anticipated. Linda estimated my monthly mortgage cost to be around $650, so my total debt would be below 30% of my income, wouldn’t it?”
Monthly Mortgage Estimate (Principal and Interest)
“Well,” Marsha replied, “Linda’s estimate might be a little bit off, and that’s because each lender has their own private interest rate, as I mentioned earlier. Ours is actually a bit higher than the 5% Linda quoted you— at this bank, the interest rate for a 30-year fixed-rate mortgage (FRM) is 5.25%. Let’s use a 30-year FRM for now to crunch the numbers and see where that puts you. You said the properties you were looking at cost $135,000 and $150,000. If we use the $150,000 property as an example, using all your $30,000 down payment leaves us with a principal mortgage of $120,000. With a 30-year FRM, your monthly mortgage payment would be $663.”
“Oh, that’s only $13 higher than Linda quoted me,” Tamara said. “I thought the cost would be a bit higher than that. If I decide not to pay PMI, I guess that’s not so bad—and I’ll still be within my debt-to-income ratio, right?”
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Additional Costs and Escrow
“It’s true that if you decide to avoid PMI, your cost will be marginally lower,” agreed Marsha. “But we still have to calculate your debt-to-income ratio. It’s important to remember that the $663 figure is only the monthly cost of the mortgage principal and interest, and that doesn’t include additional expenses like property taxes and homeowner’s insurance. I estimate your homeowner’s insurance and property taxes to be around $200 a month.”
“Oh wow. So that puts my monthly payment up to $863,” Tamara said, a bit deflated, “That brings my monthly debt to $1,485, just under the 30% debt-to-income ratio.”
“Yes, you will be right at that perfect ratio, and with your salary of $60,000, you are well within the approval bracket of at least 2.5 times your monthly income,” Marsha reminded her. “It is also a general rule of thumb that your monthly housing costs, plus other long-term debts, should not exceed more than 36% of your monthly gross income. And you are well within that number. This information is always good to know for staying within your budget and not collecting too much debt. The main thing you should know is that banks will allow a higher debt-to-income ratio when you put more money down on the house, and when your credit is good. The higher the down payment and your credit score, the higher the debt ratio the bank will allow.”
“That’s definitely good to know,” Tamara said. “There are a lot of extra expenses that come with owning a house too, aren’t there? I suppose I could always lower my mortgage by getting a cheaper house as well. And will I have to pay those additional tax and insurance costs separately to different companies, or do I pay them to you?”
“Well,” Marsha began, “lenders make it easier to pay your property tax and insurance along with your mortgage by providing a service called escrow. This means your monthly mortgage payment will automatically include amounts for taxes and insurance, which we will hold for you here at the bank, and then once a year, we will send the taxes to the tax assessor, and the insurance premium to your insurance agent. We perform this service free of charge. It’s convenient for you because it spreads the large annual cost over 12 monthly payments, and because the bank takes care of the transactions for you. However, you don’t have to use the escrow service if you don’t want to. If you prefer to pay your taxes and insurance separately from your mortgage payment, you’re certainly welcome to do so, though some banks may charge you an additional fee to do this. Just let me know if that’s what you want to do.”
“No, I think I will keep those additional costs in escrow, because it seems much easier to have all my monthly finances in one place,” Tamara said. She was thinking especially about taxes on the mortgage. She knew, unlike most people, that the mortgage itself wasn’t tax-deductible; it was the annual interest charged on the mortgage that was deductible, and when tax season came around, it would be much easier to file those deductions if the bank had all the housing figures ready at hand.
“Great point,” Marsha said. “And escrow will also make sure you don’t get caught off guard at tax time— the banks will take care of your finances, because it is in our best interest that you don’t lose the house that we are financing.”
“Of course, that makes sense,” said Tamara. “Now that we’ve gone through these calculations, how much home do you think I can afford?”
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Choosing a Mortgage
FRMs and ARMs
“Well, now that we’ve established certain financial foundations, let’s revisit our mortgage options, so I can give you the best estimate. First, there are two categories that mortgages are divided into: fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). Most mortgages are spread out over 15- or 30-year terms, meaning you have 15 or 30 years to repay the amount you borrowed for your mortgage. The differences between FRMs and ARMs are very important when choosing a mortgage. FRMs have the same interest rate and the same monthly payment for life—these rates and payments will never change. But ARMs are different; their interest rates start off with a fixed rate that’s lower than most FRMs for a certain number of years, and then those rates will increase and change over time based on the conditions of the housing market.”
“‘Based on the conditions of the housing market’ seems much too vague and dangerous to me,” Tamara said. “Does that mean these rates could keep increasing without a limit? Sounds like how the 2008 financial crash happened.”
“Good observation,” Marsha said. “In the past, there was no ceiling for how high the interest rates could go, but now the US Department of the Treasury sets the limit for the maximum interest rates on ARMs. For example, there are different types of ARMs based on the duration of the fixed rate: “10/1” or “7/1.” If I were to offer you a 10/1 ARM, that means that you would pay a fixed rate (say 3.5%) on your monthly payments for 10 years, and then the rate would be adjusted to a higher rate (say 7%) after year 10, and would continue to be adjusted every year for the next 20 years. The last 20 years will have you paying a higher rate than the first 10 years, but there will be a limit to how high the interest rates can go.”
“Interesting,” Tamara said. “So it seems as though ARMs might seem more tempting at first because their interest rates and payments usually start off quite low—lower than FRMs—but their interest rates increase to much higher sums later on in the life of the mortgage. Meaning I would end up paying back much more on an ARM in the long run than on an FRM, especially since I won’t know what mortgage interest rates will be in the future.”
“That’s true,” Marsha said. “Interest rates will fluctuate state by state, month by month, or lender by lender; it’s a free market after all. So you have to make sure you find a lender that will give you the best interest rate and won’t bleed you dry. Even though I work for the bank, I will tell you this—some people hire a mortgage broker for this very reason: to shop around and research every lender out there to find the buyer the best interest rate for their mortgage.”
“That’s good to know,” Tamara said. “But I’d also prefer to deal with a loan officer directly and cut out the middleman—after all, I will just have to pay 6% fees to the broker once I’ve made the deal.”
“Seems like you know your stuff!” Marsha said, quite impressed. Tamara smiled. She had been researching and doing her homework all week to make sure she would make the best possible decision. “It’s true, brokers and realtors get 6% commission,” Marsha continued, “but only if they make the sale, so they have their own incentives for wanting you to buy and sign on the dotted line. Always remember that.”
“I’ll be sure to remember that, thanks for the advice,” Tamara said. “So what are your interest rates on these different loan options?”
“Well, for the 30-year FRM,” Marsha began, “we charge an interest rate of 5.25%. For our 15-year FRM, we charge a rate of 4%. Although a 15-year FRM will generally have a smaller loan from the bank, and carry a
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higher monthly payment, you will end up paying off your home sooner, and will pay less money in the long run. A 30-year FRM will have a bigger loan from the bank, and your monthly payments will be lower because you will have more time to pay it off, but over the course of 30 years, you will end up paying much more than the original price of your home.”
Marsha continued, “The ARMs are a bit harder to quantify, since our 10/1 ARM starts with a low rate of 3.5%, but then around year 11, the rate increases to 7%. Now that we’ve covered all of that, I can give you some estimates on how much home I think you can afford.”
“OK,” Tamara said. “So if I get a 15-year FRM with a $15,000 down payment, what can I afford?”
Marsha started writing some numbers down. “You would be able to afford a house in the $180,000 price range, or even higher, if you choose a 30-year FRM. Overall, your monthly payments would be between a maximum of $1,572 (15-year FRM) or $1,262 (30-year FRM), including estimated taxes, PMI, and insurance. But remember, the higher the home value, the higher the property taxes, insurance, and other expenses usually are. Of course, if you make a larger down payment, your monthly payments will be lower. You can always go online and use a mortgage calculator to help you determine the most you can afford to spend on a home. And the last bit of financial advice I will give you is not to forget the closing costs in all your budget calculations— these are the fees you pay at the end of your purchasing your home, and most first-time home buyers often get surprised by them. They usually cost anywhere from $3,000 to $7,000, depending on the final cost of the house itself.”
Marsha grabbed some papers from her desk, and handed one to Tamara. “Here is a brochure that has our rates to help you make a decision on which loan is right for you. We’ve been chatting for quite some time, so I’ll go get us some water,” Marsha said, and left the room.
While she was gone, Tamara studied the brochure, made notes, and went over her budget again (Exhibit 1). She thought about her financing options (Exhibit 2). Tamara studied the information on FRMs and ARMs, and laid out the basics of the numbers she needed to calculate. Then she wrote out the questions she needed to answer to make the best financial decision (see Task 1 in Exhibit 2). After scribbling some calculations, Tamara had made a decision on which loan option was best for her situation.
When Marsha returned, Tamara gave her all the required documentation, and told her she was ready to move forward on getting preapproved for a loan.
“I’m so happy to hear that!” Marsha exclaimed. She handed Tamara a Universal Loan Application and a pen. “Fill this out, and I’ll be back.”
As Tamara filled out the application, although it was a bittersweet moment, she was ecstatic to be making this first significant step, and looked forward to calling her real estate agent to go see the two houses.
When Marsha returned, she handed Tamara a preapproval letter from the bank.
“I’ve signed and completed this preapproval letter for you,” Marsha said. It represents our utmost confidence that you will qualify for a $150,000 mortgage. It’s not a loan commitment yet, but include this with any bid that you submit on a property, and both sellers and realtors will understand that your offer is serious and won’t take your presence lightly. Once you’ve visited a few properties, chosen a new home, made an offer, and signed on the dotted line, come back and see me.”
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“I will, Marsha, and thanks so much!” Tamara said. She wished Daryll was here for this moment they had talked about so often. Still she was confident about her financing option, and was ready to view some properties and make an offer as soon as possible.
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Exhibit 1
Tamara’s New House (B)
Tamara’s Projected Monthly Budget
Gross Monthly Income: $5,000
Monthly Expenses Monthly Cost Annual Cost
Car payments $300
Credit card bills $125
Student loans $200
Electricity $90
Gas and oil $20
Water, sewer, and trash $10
Telephone and internet $30
Television $50
Food and entertainment $850
College funds $320
Additional costs $500
Savings $800+
Total mortgage payments
Total Cost
Source: Created by author.
1. What is Tamara’s debt-to-income ratio?
2. What percentage of her income goes toward her monthly debt?
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Exhibit 2
Tamara’s New House (B)
Tamara’s Loan Payment Estimator
Task 1
1. What would Tamara’s mortgage payments (principal and interest) be for the 15-year FRM on house #1?
2. What would Tamara’s total monthly payments be for the 15-year FRM on house #2?
3. What would Tamara’s mortgage payments (principal and interest) be for the 30-year FRM on house #2?
4. What would Tamara’s total monthly payments be for the 30-year FRM on house #1?
5. What would Tamara’s mortgage payments (principal and interest) be for year 7 on a 10/1 ARM?
6. What would Tamara’s mortgage payments (principal and interest) be for year 25 on a 10/1 ARM?
7. What would Tamara’s total monthly payments be for year 5 on a 10/1 ARM?
8. What would Tamara’s total monthly payments be for year 15 on a 10/1 ARM?
9. Should Tamara choose to pay PMI, or should she choose to make a bigger down payment?
10. How much money from her savings should Tamara use for a down payment?
11. Should Tamara take out a 15-year FRM, a 30-year FRM, or an ARM?
12. In your best estimation, using all the facts, figures, and circumstances, what loan do think Tamara should choose, and why?
Source: Created by author.
Loan Term Home
Price #1 Home
Price #2 Down
Payment Interest
Rate Loan
Amount
Mortgage Payment (Principal & Interest)
Monthly Taxes and Insurance
PMI Total
Monthly Payment
15-Year FRM $150,000 $135,000 $15,000 4%
30-Year FRM $150,000 $135,000 $30,000 5.25%
10/1 ARM Years 1–10 $150,000 $135,000 $30,000 3.5%
10/1 ARM Years 11–30 $150,000 $135,000 $30,000 7%
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