BOZO BUYS A HOUSE

Bozo Buffoon is trying to decide how to finance the purchase of his first home, a typical yuppie starter castle.He has asked you to provide some advice regarding loan choice and how much to borrow.The facts of the situation are as follows:

Price of house:$500,000

Bozo's salary:$160,000

Bozo's cash and other liquid assets$180,000

Bozo's marginal tax rate30%

Mortgage Option 1:

Fixed interest rate:.0375

Term:15 years

Front end fees2% of principal (no points)

Mortgage Option 2:

Variable interest rate:5/1 ARM

.0325 for first five years, adjustable annually thereafter

Max annual adj = +/-2%

Max total adj = +-6%

Rate adjusted to external benchmark

Term:30 years

Front end fees:2% of principal (no points)

Mortgage Option 3:

Fixed interest rate:.04

Term:30 years

Front end fees:2% of principal

For all loan options, the bank will loan up to 90% of the price of the house.Assume all fees are for transactions costs and hence not tax-deductible.Ignore mortgage insurance.

Bozo tells you he is unsure whether, under the 2018 income tax regime, he will have sufficient deductible expenses to warrant itemizing.Hence, he would like advice about which loan program to use and how much to borrow under under conditions (1) where he itemizes his deductions and (2) where he takes the standard deduction.

Learning Points:

1. Mortgage loan amortization
2. Variable interest rates
3. Cost of equity v. cost of debt and amount to borrow
4. Issues in selecting debt instrument