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CHAPTER 8
THE HOME AND AUTOMOBILE DECISION
CHAPTER CONTEXT: THE BIG PICTURE
This chapter is the last in the four-chapter section titled “Part 2: Managing Your Money.” Other
chapters in this section considered financial products and strategies for managing cash and credit
within the financial plan. This chapter introduces the four-step Smart Buying Process and
applies it to the purchase of housing and transportation. The home-buying process, including the
associated costs and variety of mortgage loans, is a primary focus of this chapter. Significant
student messages include (1) the importance of assessing personal needs and wants when
selecting transportation and housing, and (2) the need to consider these costs in the context of
the financial plan.
CHAPTER SUMMARY
This chapter uses the four-step Smart Buying Process to illustrate planned purchases of
automobiles and housing. Comparison-shopping to make a selection that fits personal and
financial needs is stressed. Both leasing and financing of automobiles is considered. Different
housing options are considered, as are the advantages and disadvantages of owning and renting
housing. Costs of housing ownership are reviewed and categorized as initial or one-time costs,
recurring costs, and maintenance and operating costs. The chapter concludes by describing the
process of selecting a home, negotiating the price and contract, and securing financing.
LEARNING OBJECTIVES AND KEY TERMS
After reading this chapter, students should be able to accomplish the following objectives and
define the associated key terms:
1. Make good buying decisions.

2. Choose a vehicle that suits your needs and budget.
a. holdback
b. closed-end lease or walk-away lease
c. purchase option
d. open-end lease
3. Choose housing that meets your needs.
a. cooperative or co-op
b. homeowner’s fee
c. condominium (condo)
d. planned unit developments (PUDs)
Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall
143 Chapter 8
e. down payment
f. closing or settlement costs
g. points or discount points
h. loan origination fee
i. loan application fee
j. appraisal fee
k. title search
l. PITI
m. escrow account
4. Decide whether to rent or buy housing.
5. Calculate the costs of buying a home.
6. Get the most out of your mortgage.
a. mortgage banker
b. mortgage broker
c. conventional mortgage loan
d. government-backed mortgage loan
e. assumable loan
f. prepayment privilege
g. adjustable-rate mortgage (ARM)
h. initial rate
i. negative amortization
j. balloon payment mortgage loan
k. graduated payment mortgage
l. growing equity mortgage
m. shared appreciation mortgage
n. interest only mortgage
o. private mortgage insurance
p. independent or exclusive buyer broker
q. earnest money
r. closing
s. settlement or closing statement
CHAPTER OUTLINE
I. Smart Buying
A. Step 1: Differentiate want from need
B. Step 2: Do your homework
C. Step 3: Make your purchase
D. Step 4: Maintain your purchase
II. Smart Buying in Action: Buying a Vehicle

The Home and Automobile Decision 144
A. Step 1: Differentiate want from need

B. Step 2: Do your homework
1. How much can you afford?
2. Which vehicle is right for you?
C. Step 3: Make your purchase
1. Financing alternatives
D. Step 4: Maintain your purchase
III. Smart Buying in Action: Housing

A. Your housing options
1. House
2. Cooperatives and condominiums
3. Apartments and other rental housing
B. Step 1: Differentiate want from need
C. Step 2: Do your homework
1. One-time costs
2. Recurring costs
3. Maintenance and operating costs
D. Renting versus buying
E. Determining what you can afford
1. Financial history
2. Calculating Your Mortgage Limit: Method 1 – Ability to pay – PITI to
Monthly Gross Income
3. Calculating Your Mortgage Limit: Method 2 – Ability to pay – PITI Plus
Other Debt Payments to Monthly Gross Income
4. Calculating Your Mortgage Limit: Method 3 – Appraised home value
5. Calculating your mortgage limit
6. How much should you borrow?
F. Financing the purchase—the mortgage
1. Sources of mortgages
G. Conventional and government-backed mortgages
H. Fixed rate mortgages
I. Adjustable rate mortgages
1. Initial rate
2. Interest rate index
3. Margin
4. Adjustment interval
5. Rate cap
6. Payment cap
7. ARM innovations
J. Adjustable-Rate Versus Fixed-Rate Morgages
K. Specialty Mortgage Options
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1. Balloon payment mortgage

2. Graduated payment mortgages
3. Growing equity mortgages
4. Shared appreciation mortgages
5. Interest only mortgages
6. Option Payment ARM Mortgages
7. Risks Associated with Specialty Mortgages
L. A Word of Warning: Beware of Subprime Mortgages and Predatory Lending
M. Mortgage decisions: Term of the loan
N. Coming up with the down payment
O. Prequalifying
P. Step 3: Make your purchase
1. The contract
Q. Step 4: Maintain your purchase
APPLICABLE PRINCIPLES
Principle 1: The Best Protection is Knowledge

It is your responsibility to protect yourself my including contingencies in the sales contract,
to seek out home inspections and to carefully review estimates of closing costs against the
final documents. It also is your responsibility to ascertain the best housing alternative,
mortgage loan, and interest rate for your particular situation. If you are renting—read the
lease and know what the contract says. The same applies to buying or leasing a car.
Comparison shop, read the contracts, and understand what this commitment means for your
financial future. Protecting yourself depends on what you know and how you use that
knowledge. Also, the best way to avoid predatory lending is with knowledge
Principle 9: Mind Games and Your Money

You’ll find that the price you set for your car or house will impact the price a buyer is
willing to pay. When you set a high price, buyers use that information when they determine
how much they thing the car or house is actually worth. However, if you set the price
ridiculously high, the impact of the price will be much less than if you set a high, but
realistic price. Your choice of price can also give the impression of prestige (use a round
number) or a bargain (use a precise number).
CLASSROOM APPLICATIONS
1. Individually or in small groups, ask the students to implement the four-step Smart Buying
Process to buy an automobile—either their dream car or a realistic purchase to be
considered in the near future. Encourage students to consult a wide range of
product/consumer information sources, including the Internet and personal visits to auto
sales lots. Remind them to locate sources that would be helpful in each step of the process.
Ask students to share their results through papers, posters, or oral presentations.
2. Invite a banker or mortgage professional to guest lecture on new mortgage products, such as
the interest only mortgage, or other special homebuyer programs that might be available
locally. What are the advantages and disadvantages of using a less traditional mortgage?
What factors are contributing to the demand for such products or other special homebuyer
programs? Ask the speaker to describe the various price segments of the market and the
availability of housing in different price ranges.
3. Ask a local real estate professional to prepare a sample estimated closing costs sheet for a
specific piece of real estate that you can describe to the class. Share the closing cost sheet
with the class to illustrate actual costs for points, fees, and other costs. How much down
payment would be required? How much would the purchaser need at closing? Who gets
paid at closing? Out of closing?
4. Too often, consumers only consider if they can meet a monthly payment within the monthly
budget. The decision to purchase or lease housing or transportation is much more complex.
Use the categories of initial costs, recurring costs, and maintenance and operating costs to
further explore this decision. Discuss the implications of these “other” costs as a part of a
planned purchase that meets individual needs and fits the household budget.
REVIEW QUESTION ANSWERS
1. The end result of the smart buyer process is buying decisions that are well thought out and
well researched. As such the process attempts to control:
• purchasing, or differentiating need from want and limiting purchasing to needs;
• product selection—a needed product, that is the best choice for the price and at a
cost that fits your budget; and
• impulse buying.
2. The four steps of the smart buying process entail:

• Differentiate want you want from what you need. As Principle 9 dictates the
use of mental accounting and the sunk-cost effect can sway your view of a
realistic purchase.
• Pre-shopping homework to explore personal needs and wants, to identify
product alternatives, and to consider the relationship between your budget and
the product’s cost.

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• Making your selection, after detailed comparison-shopping to consider price,

product features, quality, warranty, and after negotiating the price and
evaluating alternatives for financing.
• Maintaining the purchase or resolving any product, service or quality complaints
with the seller, manufacturer, or government, after the purchase.

3. To make an effective complaint, briefly but clearly include the following five
key points:
• Note the date and place of the purchase or service.
• Describe the product or service (e.g., serial or product number, warranty
information, etc.).
• Describe the specific problem with the product or service (e.g., what is the
problem?).
• Explain your attempts, and with whom, to correct the problem, including
specific details.
• Explain what you want done to correct the problem and identify a reasonable
date for action, including your next step if the problem is not resolved.
Type your letter and include copies, not originals, of any relevant documents
describing the product or service and your attempts to resolve the problem. Sending
your letter with return receipt requested insures that your complaint was received
and the identity of the person who signed for it. If the company does not respond in
a reasonable time, take the next step by filing a complaint with the local or state
consumer protection office, the Better Business Bureau, or the appropriate state or
federal regulatory agency.
4. Some factors that help determine personal preferences in vehicles include:

• Amount buyer can afford to spend on the vehicle.
• What the vehicle will be used for.
• Lifestyle of the owner.
• How long the vehicle will be kept.
• The reliability of the vehicle.
• How many people the vehicle needs to accommodate.
• The operating costs of the vehicle.
• The physical “fit” between car and driver. Is the vehicle comfortable?
• The climate in which the vehicle will be used.
5. The three factors that determine the monthly auto loan payment are:
• Amount of the loan.
• Length of the loan.
• Interest rate on the loan, which will depend on the source of the loan.
6. A holdback is a payment from the manufacturer, typically 2 to 3 percent of the

new car retail price, paid to the dealer after the car is sold. Holdbacks increase the
dealer’s profit, as do markups. Rebates are typically paid to the customer, while
dealer incentives may or may not be shared with the customer. In sum, these issues
complicate the auto purchase and pricing. The best defense is knowledge—of the
dealer cost or invoice price on the vehicle as well as the related holdback and any
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available rebate or incentive. In negotiating the price, use the guideline of paying no
more than $100 to $500 over invoice price for a new American-made auto or
slightly more for a foreign-made vehicle, after any available rebate. Remember that
this guideline is contingent on the demand for the vehicle and the amount of the
holdback.
7. The purpose of an auto lease is to allow the lessee to have a new car every few years
without the up-front costs of purchasing. The two types of leases are closed-end and open-
end. With a closed-end lease, the lessee is required to return the vehicle in good condition
with only normal wear and tear. Under these conditions, no further payment is required and
the lessor carries all responsibilities for the vehicle at lease end. In contrast, with an open-
end lease, the consumer assumes all responsibility for the vehicle at the end of the lease. At
the end of an open-end lease, the value of the vehicle is compared with the estimated end-
of-lease value of the auto. If the vehicle is worth less at turn-in than the lease had specified,
the lessee must pay the difference. For this reason, open-end leases are not recommended.
8. A financially stable person, who has good credit but lacks the funds for a down payment,
drives less than 15,000 miles annually, takes good care of the vehicle but wants to avoid
maintenance and trade-in, and does not mind the idea of never ending vehicle payments is a
good candidate for a lease. The six factors that determine monthly lease payment are:
• Price of vehicle.
• Up-front fees such as taxes, insurance, or service contracts.
• Amount of the down payment or trade-in.
• Vehicle value at the end of the lease.
• Rent or finance charges.
• Length of lease.
9. Maintaining your purchase is always important (Step 4 of Smart Buying), but especially so
with the investment involved in an auto—new or used. Consider the following maintenance
tips (the five tips listed by the student may vary):
• Read the owner’s manual
• Follow the suggested maintenance instructions
• Be alert to warning signs—anything that looks (e.g., drips, leaks, smoke), feels
(e.g., performance, gas mileage), or sounds different (e.g., engine sounds, squeaks)
• Be prepared to accurately and completely describe the symptoms
• Identify a repair facility before you need one by seeking recommendations
• Check the qualifications and training of the technicians
• Talk with the repair shop owner or manager if not satisfied with the service to
resolve the problem and avoid jumping from shop to shop
10. In a co-op, the residents own shares in the corporation that gives them rights to their living
space and reflects the dollar value of their “space.” In contrast, condominium residents
actually own their living space and jointly own the land, common areas, and facilities. Both
require a monthly maintenance fee. Advantages and disadvantages of both forms of
ownership, as listed, are common with two major exceptions. Co-ops (1) offer less
opportunity for capital appreciation than a home or condominium where the owner can
improve the unit and (2) co-op shares can be more difficult to sell.
Advantages include:
• Affordability and amenities such as pools, tennis courts, and health centers
• Low maintenance
Disadvantages include:
• Lack of privacy
• Lack of choice about style and decoration
11. A planned unit development (PUD) is a variation on condos and cooperatives, where the
individual homeowners not only own their house and the site on which it sits but also own a
portion of the entire development. This ownership has a fee to cover common expenses and
maintenance. The major difference between PUDs and condos is that condo-owners own the
land directly under their home.
12. The major expense categories of home ownership include:

• Initial (one-time) costs (e.g., discount points, origination fees, application fees,
appraisal fees, title search fees, attorney fees, title insurance, and down
payment).
• Recurring costs (e.g., mortgage payments for principal, interest, property taxes,
and homeowner’s insurance).
• Maintenance and operating costs (e.g., painting, roof repairs, appliance
replacement, and landscaping).
13. The one-time costs of home ownership are:

• Down payment: Up-front equity “purchased” at the time of closing. Depending on
the lender, the proportion of the sales price required for down payment ranges from
5 percent to 20 percent or more. Typical down payment is 20 percent for a
traditional mortgage.
• Discount points: These are one-time additional interest payments charged by
the lender. Each point is one percent of the mortgage amount. Often these points
are used to “buy down” the interest on the mortgage. These points are tax
deductible.
• Loan Origination Fee: Normally one percent of the loan amount. This fee is
considered payment to the lender for finalizing the loan and is not tax
deductible.

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• Loan Application Fee: This fee covers the costs that the lender incurs in
processing the loan.
• Appraisal Fee: Lenders require that the exact value of the home be established
before the mortgage is finalized. This fee pays for having the dwelling
appraised.
• Title Search Fee and Title Insurance: Fee paid to an attorney to verify that the
person selling the house actually owns that house. Title insurance may be
required in some instances to protect against challenges to the title.
• Attorney, Notary, and Other Recording and Inspection Fees: These various fees
include charges for recording the deed, credit reports, preparing and notarizing
the legal paperwork, and various property inspections.
14. The mortgage payment consists of principal (P), interest (I), taxes (T), and insurance (I).
Therefore, the payment is given the acronym PITI.
15. The advantages of buying include tax deductions, value appreciation, equity, personal
freedom, forced savings, and a potential loan source in built-up equity. The disadvantages
include a large up-front monetary commitment, maintenance, property taxes, selling costs,
and potential problems with resale.
For those who move often, renting is advantageous because of the costs and hassles
associated with buying and selling a house. It takes owners a number of years of price
appreciation and tax benefits to offset the initial costs of purchasing a home. Renters pay no
down payment, no maintenance, and no property taxes. In addition, renting may provide
some amenities like pools and fitness facilities. Renting allows for more financial and
lifestyle flexibility.
16. Two primary factors to consider when deciding to buy or rent are timing and taxes. First,
you must plan to stay in the home for a minimum of several years to recover initial purchase
costs, to benefit from price appreciation, and to repay a significant portion of the mortgage
to increase equity. Second, buying offers substantial benefits to those who itemize their
taxes, as owners get to take advantage of the points, mortgage interest and real estate tax
deductions. Since these costs may exceed the standard deduction for many households, all
other itemized deductions are “icing on the cake.”
17. Owning is better than renting over a seven-year period. This is true because over seven
years, the up-front costs of the purchase are offset by the price appreciation and the tax
advantage of being able to itemize housing-related expenses, such as mortgage interest and
real estate taxes.
18. The lending institution specifically looks at three factors when qualifying a prospective
homebuyer for a mortgage.
• Financial history to determine the steadiness of income and credit rating.

• Ability to pay to determine qualification ratios comparing (1) PITI to monthly
gross income and (2) PITI plus other debt payments to monthly gross income.
• Appraised value of the home to determine 80 percent of the value, the mortgage
loan limit for most lenders.
19. Using IRA accumulations for up to $10,000 of a down payment offers the
benefit of no penalties on the withdrawal. Also, the funds had been growing tax-
deferred which allows for a little faster accumulation than in a taxable account.
However, if the down payment is withdrawn from a Traditional IRA, income taxes
will likely be due on the contribution (depending on whether the contribution was
originally fully or partially tax deductible) and taxes will be due on the earnings.
With a Roth account, the withdrawal is tax-free if the 5-year period has been
satisfied. Other disadvantages include the trade off of one goal for another, and
once withdrawn from the IRA account, the funds cannot be later replaced and
allowed to grow tax-free for retirement.
20. A real estate agent traditionally represents the seller, and it is the seller who pays the agent’s
commission. Because of this potential conflict of interest, the buyer needs to know the
difference between advice and sales pitch. An independent buyer/broker, on the other hand,
exclusively represents the prospective buyer. These independents are obligated to get the
buyer the best possible deal. Buyer/brokers show buyers potential houses that are listed with
a firm or that are being sold by the owner. This exclusive relationship tends to promote
more objective and critical home buying. All of these factors are advantages for the
prospective homebuyer.
21. Before signing a lease or rental agreement, be sure to:

• Determine if the unit is affordable. What percentage of take-home pay will be
needed for housing costs?
• Review the location for safety and convenience features.
• Understand the lease and all restrictions (e.g., who is responsible for the
utilities).
• Get any changes in the lease in writing. Do not accept a verbal agreement.
• Determine the reliability of the landlord for handling complaints and repairs.
• Purchase renter’s insurance for personal property and liability protection.
22. Provisions to be outlined in a real estate contract include:

• The buyer, seller, selling price, and method of payment.
• The legal description of the property.
• The date of possession.
• The provisions for the title search payment.
• Listing of necessary inspections (e.g., termites, radon) and actions to be taken.
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• That purchase is contingent on suitable funding of specific amount, interest rate,

and term.
• Provisions for the partial year payment for utilities, taxes, insurance.
• Condition of house at closing, with provisions for a final inspection to insure
compliance.
• Any other agreed-upon contingencies.
23. Mortgage bankers originate mortgage loans and sell them to investors for a fee. Mortgage
brokers work as middlemen who place mortgages with investors but do not originate the
mortgages. The advantage mortgage brokers offer to prospective homebuyers is that they
comparison shop to find the best terms and rate available.
24. Advantages of FHA and VA financing include:

• Lower down payment.
• Lower interest rates.
• More lenient lending requirements.
Disadvantages of FHA and VA financing include:
• Increased paperwork for loan qualification.
• Higher closing costs (with the exception of the down payment).
• Limits on the maximum mortgage funding available.
25. Option ARMs are just that – an adjustable-rate mortgage that offers different options for a
payment. In some cases the payment might be required payments to amortize the loan over
a certain period, in other cases it may only be the debt-service or interest portion of the
payment, in still other cases it might be even less than that. The advantages and
disadvantages are the same – flexible payment structure. However, there is one huge
additional disadvantage – uncertainty. As with an ARM the rate will adjust; however, with
the flexibility of payment an unknowing borrower could unwittingly begin negatively
amortizing their mortgage, because their payment didn’t increase along with the rate
change.
These loans on the surface appear to be a great way to stretch a mortgage payment;
however, unsuspecting or unknowledgeable homeowners have been hurt due to rate changes
and then become stuck because of the penalty or fess associated early repayment when
trying to refinance the loan.
26. The two factors that determine the rate for an ARM are the interest rate index and the
margin of “X” percent of interest that is arbitrarily added to the index rate. In this instance,
the ARM rate equals the index rate plus the margin. Annual and lifetime caps are common
and limit the maximum percentage points of interest that a rate could increase on an annual
basis (e.g., 2.0 percent per year) and over the life of the mortgage (e.g., 6.0 percent). The
adjustment interval, ranging from three months to several years, determines how often the
rate on the ARM can be adjusted. After a number of adjustment intervals, an ARM rate
could fluctuate below or above the initial rate. Consumers are best protected by:
• An index that is more stable so radical rate shifts do not occur.
• A longer adjustment interval so mortgage payments are more stable.
• Smaller periodic and lifetime caps.
• If applicable, a payment cap in conjunction with a rate cap, not just a payment cap.
27. Stable indices, or ones that are tied to more stable interest rates that do change often, will
not result in radical mortgage rate shifts or corresponding payment changes.
28. Fixed-rate mortgages offer the benefit of planning and control—your payments are known
and will not change, except for small increases in the taxes and insurance. Adjustable rate
mortgages (ARMs) offer the benefit of interest rates that are initially lower than fixed rate
mortgages in exchange for the risk of changing mortgage payments. Lower rates mean you
can qualify for a larger mortgage and buy a bigger house. But consider the lifetime cap and
the maximum mortgage payment you could face. If the maximum mortgage payment is too
high, then the bigger house may not be worth the potential financial strain and uncertainty.
The ARM may be a better choice if (1) you do not plan to stay in the house for a long
period of time, and therefore would not have to face the higher mortgage payment, or if (2)
interest rates are extremely high.
29. The choice of mortgage term is influenced by a number of factors, including interest rates,
financial discipline, competing financial goals, financial flexibility, the time value of
money, and taxes. The time value of money suggests that the 30-year mortgage is the better
option, as the latter payments are made with dollars that are worth less due to inflation. The
lower payment also means more dollars may be available for alternative investments as
opposed to making the larger payment required for the 15-year term. Conversely, all of the
payment at the end of the 15-year period would be available for investment. Earnings on
both scenarios would vary with the assumptions made. Finally, the longer the term, the
longer the homeowner can benefit from the tax advantage of itemized deductions. In sum,
the lower interest rate associated with the shorter-term mortgage should not be the only
deciding factor when considering mortgage term.
30. Two rules of thumb guide the decision to refinance. First, are rates at least two percentage
points lower than the existing mortgage? Second, does the homeowner expect to live in the
house more than two years? If the answers are “yes,” then it is probably cost effective to
pay the closing costs necessary to refinance. Regardless of the rules of thumb, the
homeowner must determine if the costs of refinancing can be paid back in a reasonable
amount of time.

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PROBLEM AND ACTIVITY ANSWERS
1. Using the Auto Loan Calculator on the text Website to determine a monthly payment of
$370.79, the first year total cost would equal $8,739.48, as itemized below:
Loan payments for one year $4,449.48
Property taxes $ 300.00
Sales tax assessed at purchase $ 450.00
Title and tags $ 40.00
Use and maintenance $1,500.00
Insurance $2,000.00
2. Note that all solutions require that the calculator is reset to 12 payments per year.
Using the calculator, the monthly payment on the 5-year auto loan is -$405.52.
FV = $0 PV = $20,000 I/Y = 8.0% N = 60 months PMT = ?
As the time period gets shorter the payment increases.
3. Use Appendix E Monthly Installment Loan Tables ($1,000 loan with interest payments
compounded monthly) to find the following factors:
Factor Monthly Payment Total Payments

$15,000, 7% 23.95 x 15 = $359.25 x 48 = $17,244.00
$15,000, 8% 24.41 x 15 = $366.15 x 48 = $17,575.20
$15,000, 9% 24.89 x 15 = $373.35 x 48 = $17,920.80
The total spent on the vehicle increases by $676.80 if financed at 9 percent rather than at 7
percent. Shopping for the lowest-cost financing available can significantly reduce interest
costs as reflected in the monthly payments and total cost for the vehicle.
4. An escrow account is a special reserve account used to accumulate the annual property (real
estate) tax payments and homeowner’s insurance premiums for the homeowner. Assuming
no quarterly or semi-annual tax withdrawals from the account, the account should total
$850.68 = [($94.52 x 3) + ($94.52 x 6)] and include the 6 months of escrow payments plus
the 3 months collected in advance.

Using the calculator, the monthly payment on the 30-year mortgage is -$615.72.
The total amount of interest paid is the total of the loan payments minus the original amount
of the loan.
Total of payments = Payment amount x total number
$221,659.20 = $615.72 x 360
Total interest = total of payments – loan amount
$121,659.20 = $221,659.20 - $100,000
Using the Mortgage Payoff Calculator from the text website, the payment is rounded to
$616 per month with a total interest payment of $121,656 over the life of the loan.
Increasing the monthly payments by $184 would yield interest savings of $59,480.74 and
reduce the mortgage by 13 years and 1 month.
6. The total closing costs of $23,800 are itemized below:

$20,000 = Down payment (20 percent of the selling price)
$1,600 = Discount points (2 percent of the $80,000 loan amount)
$800 = Origination fee (1 percent of the $80,000 loan amount)
$1,400 = Other fees
$23,800 = Total
Using the calculator, the monthly payment on the 30-year, 8.5% mortgage is -$768.91.
Mortgage Monthly Payment Total of Payments

30 year, 8.5% $768.91 $276,813.51
15 year, 7.5% $927.01 $166,862.60
20 year, 8.0% $836.44 $200,745.53
The safest financial option would be the 20-year fixed rate mortgage at 8.0 percent. It
allows the prospective homebuyer to pay off the home in ten less years than the 30-year
mortgage and to save $76,067.98 in interest payments. The only question is the possible
opportunity costs. Ultimately, the best option is a function of the homeowner’s risk
tolerance. The 20-year mortgage allows for quicker growth of equity in the home, which

157 Chapter 8
might offer a nice return in the future. However, the 30-year mortgage allows for the
difference to be invested, which might offer a better return on investment.
8. Using the online Adjustable Rate Mortgage calculator yields the following answers:
Payment after 1st Maximum

Loan Initial Payment Total Interest Adjustment Payment
a. $899.33 $334,788.35 $995.81 $1,396.84
b. $899.33 $326,431.53 $1,087.11 $1,395.31
c. $899.33 $334,034.59 $1,077.31 $1,456.44
d. $899.33 $328,764.06 $1,171.36 $1,449.37
9. Assuming maximum annual decreases in Kalid’s mortgage rate, his first year rate was 8.375
percent, his second year rate fell to 6.375, and his third year rate hit the floor rate of 5.5
percent. This would give him an average annual interest rate of 6.75 percent (8.375 + 6.375
+ 5.5) / 3.
10. According to method one the maximum 30-year, 9.5 percent, fixed-rate mortgage for which
the homebuyers could qualify is $111,389; however, using method 2 results in a mortgage
of $88,001. The qualification process that most lenders use would be the one that yielded
the lower amount. Therefore, the couple would be limited to approximately an $88,001
mortgage. See Worksheet 11: Worksheet for Calculating the Maximum Monthly Mortgage
Loan for Which You Can Qualify on page 161 for details.
DISCUSSION CASE 1 ANSWERS
1. Sources of vehicle buying information include: (answers may vary)

• Consumer’s Resource Handbook—Listing of organizations to help with a
complaint and other buying tips.
• Consumer Reports—Comparisons of product quality, features, price.
• Edmund’s Car Buying Guide, Edmund’s Used Car Prices, or the Edmund’s
Internet Site—Price information.
• Internet sites such as AutoSite—Product, price, insurance, and resale
information.
• Center for the Study of Services’ Cars Bargains Service—Competitive bids
from auto dealers in your local area.
• National Automobile Dealers Association (NADA) Official Used Car Guide—
Price information.
• Kelley Blue Book or the Kelley Blue Book Internet Site—Price information.
2. Answers will vary; however, the following is representative:

For the vehicle to meet Samuel’s business needs, it should either be a truck or a van. Factors
important to them are low ownership costs for: insurance, gas, and maintenance. When
comparison-shopping, the Paganellis should look for information on insurance costs, gas
mileage, and body and mechanical reliability. Considering these factors in their vehicle
choice will help to insure lower operating costs for their new vehicle.
3. The highest priced vehicle they can afford is $26,746.07 ($22,746.07 + $4,000 down
payment).
Using Table E to determine the maximum loan:

Monthly payment $550
Sales Pr ice = ×$1,000 = ×$1,000 = $22 ,746 .07
Table E factor 24 .18
Using the calculator to determine the maximum 7.5%, 48 month loan would be $22,747.10.
FV = $0 I/Y = 7.5% N = 48 months PMT = -$550 PV = ?
4. The Paganellis are better off selling their car because they will get more money than they
would by trading it. However, trading in the vehicle offers the convenience of not having to
list, show, or sell the vehicle on their own.
5. Answers will vary; however, key factors important to a good lease include the following:
• Negotiate a fair agreed-upon value of the car. Often best to do before disclosing an
interest in leasing instead of buying.
• Keep the down payment low.
• Negotiate a warranty that covers the lease period, so you avoid major repair costs.
• Define and understand “normal wear and tear” within the lease contract.
• Define and understand the termination fee, or fee for ending the lease early.
• Include insurance for early lease termination as a result of the vehicle being totaled
in an accident.
• Lease a vehicle that does not rapidly depreciate.
• Secure a low rent, or finance charge, within the lease.
6. Financing is most likely the better alternative to leasing for the following reasons:
• No restrictions, or end of lease fees, for “wear and tear”: Working as a
plumber, Samuel would probably put everything, including the kitchen sink, in
the vehicle, causing at least some dents and dings.
• No mileage restrictions: Driving for work normally puts excess miles on the
vehicle, especially for an independent businessman like Samuel. For a cost-effective
lease, the consumer should drive less than 15,000 miles annually.
• No modification restrictions: Again as a plumber Samuel is likely to want to
modify the truck to suit is business needs.
159 Chapter 8
7. Lemon laws vary from state to state, but most states allow for a refund on your purchase.
However, the following conditions normally apply: (1) you made four attempts to fix the
problem, and (2) the car must have been out of service for at least 30 days within the first
year or within the first 12,000 miles.
DISCUSSION CASE 2 ANSWERS
1. The four types of housing available to Seyed to own are:

• A House: Single-family dwelling that is purchased. Allows for more space,
privacy, control over living space, and equity accumulation.
• A Cooperative: Apartment building owned by a corporation in which the tenants
are the stockholders. Instead of owning an apartment, a resident owns shares,
which reflect the value of their portion of the building. These residents normally
pay a fee to the co-op corporation for upkeep and taxes.
• A Condominium: A variety of housing forms including apartments, townhouses,
and high-rise buildings where the residents own their individual dwelling units
but jointly own the land and common areas. Residents normally pay a
maintenance fee.
• A Planned Unit Development (PUD): Similar to cooperatives and
condominiums except the home and land on which it sits are individually
owned, in addition to a share of all common features of the development.
Residents normally pay a homeowner’s fee for any commonly shared expenses
and maintenance.
2. Several sources of real estate purchase information include:

• Internet sites like HUD’s Buying a Home, Neighborhood Search at Homes.Com or
Homefair.com
• Real estate agent or independent buyer/broker (for the latter check for referrals
from Buyers’ Resources, Buyers’ Agents, or the National Association of
Exclusive Buyer Agents at www.naeba.org)
• Professional building inspectors for the structure, systems, radon, termites, etc.
• Attorney
• Traditional lenders (e.g., banks, S&Ls, credit union)
• Specialized lenders (e.g., mortgage bankers or mortgage brokers)
Prequalification with a lender confirms the maximum mortgage amount for which
Seyed would be eligible and may reduce his anxiety about financial risk. The
prequalification letter provided by the lender reduces uncertainty for the buyer and
the seller. It establishes Seyed as a legitimate purchaser and averts any concerns

from the seller about Seyed’s ability to qualify for financing, should the seller
accept his contract. For these reasons, prequalifying could be a good idea.
3. According to the 28 percent guideline, Seyed could qualify for a maximum monthly
mortgage payment, including taxes and insurance, of $1,470.00. However, the 36 percent
guideline that includes existing consumer debt payments, further limits him to $1,290.
Front-end Ratio = gross monthly income x 28%

$1,470 = ($63,000/12) x 0.28
Back-end Ratio = (gross monthly income x 36%) - current credit repayments

$1,290 = (($63,000/12) x 0.36) - $600
4. Seyed’s projected PITI payment would be $912.72 ($792.73 + $97.07 + $22.92)
Step 1: Determine the principal and interest payment per month

PV = $112,000 I/Y = 7.625% N = 360 months FV = $0 PMT = ?
PI Payment = $792.73 (Shown as positive, although the calculator will display as negative.)
Step 2: Determine the tax payment per month

Taxes per month =
( Assessed value $100 ) × Tax rate = $1,280 × 0.91 = $1,164 .80
12 12 12
Tax Payment = $97.07
Step 3: Determine homeowners’ insurance payment per month

$275 .00
Insurance per month =
12
Insurance Payment = $22.92
5. Seyed would not realize gains after the first year, as is typically true, but would be better off
to buy when the longer time frame is considered. This is true regardless of whether he
chooses to itemize or take the standard deduction. The latter approach results in smaller
gains. See completed Worksheet 10, Worksheet for the Rent Versus Buy Decision on page
162.
6. Seyed should be prepared to pay $45,000 on the day of closing.

• Down payment = [$180,000 (purchase price) x 0.20 (percentage down)] =
$36,000
• Closing Costs = [$180,000 (purchase price) x 0.05 (percentage closing cost)] =
$9,000

161 Chapter 8
7. Since the maximum monthly payment for which Seyed can qualify is $1,290 (from question
3), then he can only afford this home if he chooses to finance the purchase over 30 years,
which gives him a monthly PITI payment of $1,279.44 ($136.50 + $22.92 + $1,120.02).
Step 1: Determine the tax payment per month

$1,800 × 0.91 $1,638 .00
Taxes per month = = Tax Payment = $136.50
12 12
Step 2: Determine homeowners’ insurance payment per month

$275 .00
Insurance per month = Insurance Payment = $22.92
12
Step 3: Determine the principal and interest payment per month based on a loan amount of
$144,000 ($180,000 – $36,000) from question 6.
The monthly payment on the 15-year, 8.625% mortgage is -$1,428.60.

Worksheet 11 (see an example worksheet on page 163), or the Mortgage Qualifier

Calculator on the text website may also be used in solving this question.
8. Assuming Seyed pays a 20 percent down payment private mortgage insurance will not be
required. A gift letter will not be needed, as he has personally saved all of his funds without
benefit of any gifts.
9. Due to his risk tolerance, a fixed-rate mortgage is recommended. Other mortgage variations
do not offer the same control for his financial future because of the uncertainties associated
with the payment amount and the equity build up.
Given Seyed’s situation he should probably not consider an interest only mortgage. The
advantage of an interest only mortgage is significantly lower payments for the initial interest
only period. However, once the mortgage is fully amortized over the remaining period of
the mortgage the payments increase to cover principal and interest—and in the case of an
adjustable rate mortgage the payment may need to reflect a higher interest rate than during
the initial period. Fixed rate interest only mortgages are available, but have the same
problem of significantly higher principal and interest payments once the loan is fully
amortized, albeit based on a constant interest rate. Optional principal payments may be
made to reduce the balance and build equity with interest only mortgages; however interest
only mortgages are based on two premises: significant home value appreciation to build
equity and the ability of the consumer to pay the future higher payments. Seyed is
attempting to control his financial situation, given his concerns over investment returns and
financial risk, and he can find a house with a payment that fits his current budget.
Furthermore, he has no indication of significant future salary increases to accommodate the
higher payments required. Seyed’s best option is a fixed rate mortgage with a known
payment structure (except for annual tax and insurance increases) and equity accumulation.

163 Chapter 8
W 11 WORKSHEE
Method 1 Dete
Ability to Pay,
a. Monthly inco
b. Times 0.28:
W 10 WORKSHEE
a. Total monthly ren

b. Total renter's ins
c. After-tax opportu
165 Chapter 8
W 11 WORKSHEE
Method 1 Det
Ability to Pay
a. Monthly inc
b. Times 0.28:

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CHAPTER 8

THE HOME AND AUTOMOBILE DECISION

CHAPTER CONTEXT: THE BIG PICTURE

LEARNING OBJECTIVES AND KEY TERMS

1. Make good buying decisions.

II. Smart Buying in Action: Buying a Vehicle

A. Step 1: Differentiate want from need

III. Smart Buying in Action: Housing

1. Balloon payment mortgage

Principle 1: The Best Protection is Knowledge

Principle 9: Mind Games and Your Money

REVIEW QUESTION ANSWERS

2. The four steps of the smart buying process entail:

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

• Making your selection, after detailed comparison-shopping to consider price,

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

4. Some factors that help determine personal preferences in vehicles include:

6. A holdback is a payment from the manufacturer, typically 2 to 3 percent of the

12. The major expense categories of home ownership include:

13. The one-time costs of home ownership are:

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

• Financial history to determine the steadiness of income and credit rating.

21. Before signing a lease or rental agreement, be sure to:

22. Provisions to be outlined in a real estate contract include:

• That purchase is contingent on suitable funding of specific amount, interest rate,

24. Advantages of FHA and VA financing include:

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

PROBLEM AND ACTIVITY ANSWERS

Factor Monthly Payment Total Payments

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

6. The total closing costs of $23,800 are itemized below:

Mortgage Monthly Payment Total of Payments

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Payment after 1st Maximum

DISCUSSION CASE 1 ANSWERS

1. Sources of vehicle buying information include: (answers may vary)

2. Answers will vary; however, the following is representative:

Using Table E to determine the maximum loan:

DISCUSSION CASE 2 ANSWERS

1. The four types of housing available to Seyed to own are:

2. Several sources of real estate purchase information include:

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Front-end Ratio = gross monthly income x 28%

Back-end Ratio = (gross monthly income x 36%) - current credit repayments

4. Seyed’s projected PITI payment would be $912.72 ($792.73 + $97.07 + $22.92)

Step 1: Determine the principal and interest payment per month

Step 2: Determine the tax payment per month

Step 3: Determine homeowners’ insurance payment per month

6. Seyed should be prepared to pay $45,000 on the day of closing.

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Step 1: Determine the tax payment per month

Step 2: Determine homeowners’ insurance payment per month

The monthly payment on the 15-year, 8.625% mortgage is -$1,428.60.

Worksheet 11 (see an example worksheet on page 163), or the Mortgage Qualifier

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

a. Total monthly ren

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