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Personal Financial Management. Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.uk. Reading. Callaghan: Chapter 6 McRae: Chapter 3. Investing in Real Assets. The three major real assets purchased are: Housing Cars Leisure goods
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Personal Financial Management Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.uk
Reading • Callaghan: Chapter 6 • McRae: Chapter 3
Investing in Real Assets The three major real assets purchased are: • Housing • Cars • Leisure goods • Second homes • Yachts, planes, motorhomes, • The link between these is typically the need to finance the purchase using a loan • In addition each has unique features
Real Assets and the Portfolio • In financial planning all real assets should be counted as part of the investment portfolio • They contribute to wealth • Real assets have returns and risks • For most people their house is the major asset they own • Evaluation of return should include use value (proxied by rental rate) less maintenance costs
Housing • Risks: the risk from housing is derived mainly from variations in prices • The housing market has been very cyclical in the past • In the past this has lead to “negative equity” • Such cycles cannot occur for a financial asset • Housing Data
House Finance • Repayment Mortgages • Each monthly payment covers the interest and reduces the outstanding capital • Initially mostly interest is paid but towards the end of the mortgage mostly capital is paid • Variety comes through alternative interest structures • Fixed Rate: rate fixed for some or all of life of mortgage • Variable Rate: rate changes usually in line with base rate • Capped Rate: place an upper limit on rate • Flexible mortgages: some flexibility in reducing/increasing payments
House Finance • Interest Only Mortgages • The monthly mortgage payment only pays the interest on the loan • Alongside the mortgage an investment policy is purchased • The investment policy is planned to repay the capital • These mortgages were popular until recent failure of investment policies to deliver
House Finance • This is a complete account • A-Z of mortgages
Repayment Mortgage • Consider repaying 100 over 3 years at 5% interest • Let the yearly payment be x • End of year 1: 100(1.05) – x • End of year 2: (100(1.05) – x)(1.05) – x • End of year 3: ((100(1.05)– x)(1.05) – x)(1.05) – x = 0 or 100(1.05)3 – x(1+ (1.05) + (1.05)2) = 0 • The yearly payment is x = £36.72
Repayment Mortgage • Over n years with interest rate r and with monthly payments this generalizes to: • So
Repayment Mortgage • For example, a £100,000 loan over 25 years at 6% • The calculation of this value requires the sum of 25 terms in the denominator
Interest-Only Mortgage • Interest is paid but no principal • For a £100,000 loan at 6%, interest is £6000 per annum, so monthly payment is £500 • Payments can also be made into an investment policy • Assume investment return of 7% then annual payment solves • So monthly payment is £123.13 Total cost is £500 + £123.13 = £623.13
Issues • An interest-only mortgage with a savings policy is often called an endowment mortgage • A repayment mortgage is certain to repay • An endowment mortgage is not • For the example: 4% gives £63,996 5% gives £74,046 6% gives £85,930 7% gives £100,000 8% gives £116,660 9% gives £136,41 • Alternatively: an FT100 of 1000 in 1979 would need to be 5427 now
Issues • Tax treatment made endowment mortgages popular • Mortgage interest payments were tax deductible (MIRAS) but this has now been eliminated • Many holders of endowment mortgages are left with a shortfall at the end of the term
Purchasing a Car • There are two major distinctions between cars and houses • Cars loans are not viewed as being as safe as house mortgages so the interest rate tends to be about 3-5% above base rate • Houses tend to rise in line with wages but cars depreciate • A 2005 BMW 760 cost £78000 new. In 3 years it will be worth only 39% of its new value - £30420 • This is a monthly loss of £1321 • Currently worth £15000
Other Assets • Boats • These can be purchased on mortgages • “Balloon mortgages” are available: payments are low (not enough to pay off mortgage) so unpaid capital and interest “inflate” to end of mortgage • The outstanding sum can be financed by sale of asset • Hence turns ownership into rental • Marine Mortgages