To be accurate, the cost of a mortgage to a borrower must be personalized to the borrower. Given the price of the mortgage, there are three borrower characteristics that affect the cost. The most important is how long the borrower expects to have the mortgage. Even though few borrowers can ever be certain of this, their best guess is the proper period over which to measure cost. It is why the professor calls it “time horizon cost”, or THC.
The second relevant characteristic is the borrower’s marginal income tax rate. Because interest and loan origination fees are tax deductible, tax savings are a deduction from total cost.
The third factor is opportunity cost – the return the borrower could earn on the money if it were not spent on the mortgage. Opportunity cost is a recognition that a dollar paid upfront costs more than a dollar paid 10 years later.
The THC over the period the borrower expects to be in the house is:
| Upfront Costs Paid in Cash | |
| + | Monthly Payments of Principal, Interest and Mortgage Insurance |
| + | Lost Interest on Upfront Costs, Monthly Costs, and Down Payment at the Borrower’s Opportunity Cost |
| - | Tax Savings at the Borrower’s Tax Rate |
| - | Reduction in the Loan Balance |
| = | THC |
On ARMs, THC is measured on two assumptions about future interest rates; “no-change” which assumes current market rates remain unchanged; and “worst case”, which assumes that rates on the ARM increase to the maximum extent permitted by the note.
For more information, read Fourth of a Series on Certified Lender Networks: Providing Decision Support.
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