Financial Products and Choices - Essay Example

Financial Products and Choices When thinking of financial products the focus is on the contract between two or more agents and targeted at the movements of cash at present and the future. There are many available financial products including insurance, credit and loans, banking and cash, and investments. Different individuals and couples will choose different financial products based on their circumstances, preferences, and age (Ken, 1992). In this paper, I will discuss an investment as financial product by offering a solution to a couple in its retirement age. Reverse Mortgage and its Features Ken (1992) says that a reverse mortgage is a type of an investment product that allows the conversion of equity on an individual’s home into cash without the individual necessarily paying additional monthly bills or selling the home. A reverse mortgage differs from a regular mortgage in the sense that; an individual receives money from the lender in the case of a “reverse” mortgage while an individual makes monthly payments to the lender in the case of a “regular” mortgage. The loan in a reverse mortgage is usually paid when an individual sells his home or dies. The good thing with a reverse mortgage is that its proceeds are tax free and there is no income restrictions involved (Ken, 1992) Features of a Reverse Mortgage Homeownership: Under the reverse mortgage package, the mortgagee remains the owner of the house as if he had a “forward mortgage”. The owner also retains the responsibility of paying home-owner insurance, property taxes, and also doing repairs. Once the loan is over, the mortgagee will be required to repay all the advancements given and the interest earned (Ken, 1992). Essentially, the lender is focused on recovering his full amount and the interest and not taking the home of the mortgagee. Fees on Financing: The mortgagee may use the funding from a reverse mortgage to pay for the fees charged on the loan. In the investment world, this is termed as “financing” the cost of the loan. These costs are usually compiled as part of the loan balance and the mortgagee will pay back when the loan is fully paid plus interest (Vishaal, 2011). The Amount of the Loan: The loan amount to be issued mainly depends on the selected program and the reverse mortgage plan selected. The cash advances selected is also an important point of consideration. In some other mortgage plans the amount mainly depends on the age of the mortgagee (Vishaal, 2011). For example, the more the individual’s home is worth, the more will be the loan amount. Similarly, the older the mortgagee is the more cash he/she will get. The other feature of the reverse mortgage is that following the 12 months of closing, the mortgagee will only access a limited amount of funds contrary to the case in a regular mortgage. How the Mortgage would Work under 20 years Maturity Period If the couple decides to go for a reverse mortgage with 20 years maturity period, the annual payments may be calculated using the formula below. We are already given that the couple is in its retirement age (65 years) and the value of their home stands at $HK 9,000,000 The monthly interest rate will be r = (3/12) / 100 Number of monthly payments will be N = 20 × 12 = 240 Fixed Monthly Payment will be = ((3/100/12) × 9,000,000) / (1 – ((1+ (3/100/12)) ^ (-20 ×12)) Fixed monthly payment will = $HK 49,913.78 This means that the annual payment will be = Monthly payment × 12 = 49,913.78 × 12 = $HK 598,965.36 Interpretation: From the calculations made above, we find that if the couple decides to take a reverse mortgage on their home, valued at $HK 9,000,000 the couple will receive up to $HK 49,913.78 from the mortgager every month that they can use to finance their needs and monthly expenses. This is at an estimated monthly interest rate of (3/12) / 100 or 3% annually. The monthly annual payments will not change given that the couple has signed for “Fixed” reverse mortgage. Otherwise, the monthly and annual payments would change if the couple wished to take a “floating” reverse mortgage that is usually calculated at current market value (Ballman, 2003). How Reverse Mortgages Look from Bank’s Perspective The mortgagee (borrower) and the mortgager (the bank) will develop different perspectives on the reverse mortgage. As the borrower sees it as a tool to assist him take care of the bills and monthly expenses, using his home as collateral, the bank sees it as an opportunity to assist its clients meet such needs after retirement and also as an opportunity to make a profit! Here below, I will discuss the bank’s perspective from three major outlooks. A commitment with the Customer (Mortgagee): The bank sees a reverse mortgage as created commitment and responsibility with the customer (Ballman, 2003). This commitment is sealed when the bank signs an agreement with the client and actually goes ahead to meet its commitment through issuing of a line of credit, an annuity, or lump sum. In some cases, usually based on the value of the home, the bank may consider issuing all the three mortgage forms. The Difference between 5% and 6% Interest Rate We can use the formula below (same formula used above) to show the difference between a 5% and 6% interest rate. From this formula, we will proceed with the calculations as follows; At 5% Interest Rate Fixed Monthly Payment will = ((5/100/12) × 9,000,000) / (1 – ((1+ (3/100/12)) ^ (-20 ×12)) = 59,396.02 Annual payment will = Monthly payment × 12 = 59,396.02 × 12 = $HK 712,752.20 Payment after 20 years will = 712,752.20 × 20 = 14,255,044 Amount of Interest paid = cN – P = 14,255,044 – 9,000,000 = $HK 5,255,043. 96 At 6% Interest Rate Fixed Monthly Payment will = ((6/100/12) × 9,000,000) / (1 – ((1+ (3/100/12)) ^ (-20 ×12)) = 64,478.80 Annual payment will = Monthly payment × 12 = 64,478.80 × 12 = $HK 773,745.54 Payment after 20 years will = 773,745.54 × 20 = 15,474,910 Amount of Interest paid = cN – P = 15,474,910 – 9,000,000 = $HK 6,474,910.80 Interpretation: Going with the interest calculations done here above, it is evident that a higher interest rate at 6% yields a higher interest amount ($HK 6,474,910.80) than the interest amount paid on a 5% interest at ($HK 5,255,043. 96) after 20 years. The implication is that a mortgagee would prefer a 5% interest rate as he/she will end up paying a relatively lower interest amount compared with the amount he/she would pay with 6% interest rate. However to the bank, the 6% interest rate will be the best since the bank has a chance of recovering higher profits with the increased interest amount after a period of 20 years. Features of a Variable Rate Reverse Mortgage The reason for choosing between a fixed rate and adjustable rate reverse mortgage mainly depends on the homeowner’s reason for seeking a mortgage. All that need to be understood for now is that using a fixed versus an adjustable reverse mortgage will greatly impact the disbursements of the mortgage’s proceeds. In the case where the homeowner wishes to pay off an already existing mortgage, he/she may prefer a fixed rate reverse mortgage with lump sum. On the other hand, a homeowner will prefer an adjustable rate reverse mortgage in the situation where he/she wishes to have a guaranteed line of credit or monthly check for the rest of his/her life. Below are the major features of a variable/adjustable rate reverse mortgage (Tom, 2005). A growing Line of Credit Feature: By having a growing line of credit, the meaning is that the guaranteed monthly payment or line of credit to be paid will be dragged along the anticipated remaining life years of the borrower (Tom, 2005). This implies that age is a determining factor in the sense that, the older the borrower is, the more monthly payments he/she will receive as there is technically “fewer life years” compared to the case of a relatively younger person. Calculation of Rates under the Adjustable Rate Reverse Mortgage: The rates under the adjustable rate reverse mortgage are usually calculated in accordance with the London Interbank Offered Rate (LIBOR). This is of course in addition to a given “business” margin applied by the lender. Different lenders will apply different margins based on their popularity, trust, competitiveness, and circumstance among other factors. Typically, there is an application cap of between 5% and 10% above the normal starting rate. Although lenders are allowed to apply their own margins to the rate stipulated by LIBOR, they must do so in accordance with the governing rules of LIBOR or the financial regulatory body within their region (Tom, 2005). The margins applied also need to be “realistic”. This is of course without forgetting that exemplary higher margins will drive away customers in accordance with the rule of demand and supply. Accrual of Interest based on Outstanding Loan Balance: In most cases, homeowners will acquire their homes through debt. It is thus possible to find that couples have not yet fully paid their home loans at their retirement period. The retirement of the couple means that there is no income coming in and paying for their living expenses becomes a challenge, not to mention that they still owe money to the bank on their home (Tom, 2005). The couple can in this case take a reverse mortgage to pay off the outstanding loan balance in their home. At this point, the interest to be accrued by the reverse mortgage lender will be dependent upon the outstanding loan balance. The higher the loan balance the higher will be the accrued interest. Specific Situations where a Reverse Mortgage would not be Beneficial to the Bank It is indeed true that there are some specific situations where a reverse mortgage would not be beneficial to the bank. Being unbeneficial to the bank may mean beneficial to the borrower, and given that the bank is the lender it may choose to back out. The backing out argument in such cases may be supported by the idea that all lenders/banks are in business to make a profit (Tom, 2005). Below are specific situations of a reverse mortgage not being beneficial to the bank If the Mortgage is in Term of no Negative Equity Guarantee: In the situation where the bank and the borrower signs a “No Negative Guarantee” term contract, the bank will end up suffering losses, especially in the situation where the borrower’s home price is valued lower than the loan amount. Given that following the death of the borrower in a reverse mortgage, the bank takes over the home, the bank will lose if it gives more money in the loan amount that it would actually get selling the home after the death of the borrower. This scenario would like “giving more” to “gain less”, which is not a very good idea in business. A further Loan Period: A longer loan time period would not be beneficial to the bank as it may mean an increased loss. In other words, the longer the loan time period, the more loss the lending bank will face. This will be primarily because of two main changes namely; economic and physical changes. Warren (2006) says that under economic changes, a longer period creates room for changes such as drop in value of houses in the real estate market. If this happens and continues over time, the amount paid to the borrower may end up being higher than what the bank may recover from the house, following the death of the borrower. Under physical changes, the house may dilapidate rapidly or a dump site be constructed adjacent to the home. If either of this happens, the value of the home goes down rapidly taking the bank to losses. With these ideas in mind, most banks would prefer a shorter period; say below fifteen years (Warren, 2006). Couple Changes Mind and want to get out at 2020 It is not the bank’s motive to get the owner’s house in a reverse mortgage agreement. What this means is that the homeowner/couple may get out of the reverse mortgage deal anytime they wish as long as they pay out the amount given by the bank plus interest. It is however important to know that the agreements stipulated will be a guide in the case where a borrower decides to get out of a reverse mortgage deal (Warren, 2006). Some agreements are so tight that getting out of either party is almost impossible. In our case 3, we will examine the situation where the couple wants to get out at 2020. Remember that getting out will mean that the couple will have to pay out the given amount and the interest earned from the given amount. The calculations are led by the formula below. Using the formula above, we will calculate the amount that the couple should pay under a 5% fixed interest rate and the other under a 6% fixed interest rate. Getting out at 2020 means getting out in 5 years from today Using a 5% Interest Rate Under 5% interest rate, the calculation will proceed as follows Annuities = 9,000,000 × 0.05 / (1-1/ (1 + 0.05/12) ^ 20) = 712,752.20 Total payment (After 5 years at 5%) = 712,752.20 × ((1+0.05) ^ 5-1) / 0.05 = $HK 3,938,405.83 Using a 5% Interest Rate Under 5% interest rate, the calculation will proceed as follows Annuities = 9,000,000 × 0.06 / (1-1/ (1 + 0.06/12) ^ 20) = 773,745.54 Total payment (After 5 years at 5%) = 773,745.54 × ((1+0.06) ^ 5-1) / 0.05 = $HK 5,234,011 Interpretation Using the 5% interest rate, the couple would pay back a total amount of $HK 3,938,405.83 (Amount + interest) relatively lower compared with the $HK 5,234,011 (Amount + interest) total amount that the couple would have to pay using the 6% interest rate. Just like the other interest calculations done earlier, the couple would do well with the 5% interest as they would pay relatively less. The bank on the other hand would prefer the 6% as it has more profits. Works Cited Ballman, T E. The Reverse Mortgage Handbook: A Consumers Guide for Senior Homeowners. Kissimmee, FL: Jawbone Pub, 2003. Print. Bhuyan, Vishaal B. Reverse Mortgages and Linked Securities. Hoboken, NJ: Wiley, 2011. Print. Boroson, Warren. The Reverse Mortgage Advantage: The Tax-Free, House-Rich Way to Retire Wealthy! New York: McGraw-Hill, 2006. Print. Kelly, Tom. The New Reverse Mortgage Formula: How to Convert Home Equity into Tax-Free Income. Hoboken, N.J: Wiley, 2005. Print. Scholen, Ken. Retirement Income on the House: Cashing in on Your Home with a "reverse" Mortgage. Marshall, Minn: NCHEC Press, 1992. Print. Read More