Download Lecture 3 - UCSB Economics

Introduction to Economics
Elements of Personal Finance
Llad Phillips
1
3. Thursday, Oct. 3, Lecture Three: "Housing loans; demand fo
mortgage credit; determinants of personal income"
Housing loans: interest and equity
demand for mortgage credit
Determinants of personal income
tastes for leisure and income
Reading Assignment:
O’Sullivan and Sheffrin: Ch.3, “ Markets in
the Global Economy”
emphasis: comparative advantage and circular flow
O’Sullivan and Sheffrin, Appendix to Ch. 7, " Consumer
Choice Using Indifference Curves”, pp. 155-162
Internet Resource: http://www.mortgage101.com
Llad Phillips
2
Problems O & S Text
p. 60: 2, 4, 5, 6
p. 162: 1, 2, 3
Llad Phillips
3
Econ 109 Class Page

Econ Home Page:
http://www.econ.ucsb.edu
Llad Phillips
4
Announcements

E-mail addresses
 Llad
Phillips <[email protected]>
 Donghun Cho<[email protected]>
 Taeil Kang<[email protected]>
 Kirk Lesh<[email protected]>
Llad Phillips
5
Concepts
Lecture: Assets, Liabilities, Net Worth
 Lecture: Demand for Housing Loans
 Lecture: The Importance of Saving
 Lecture: Learning and Earning
 Text: Markets, the Magic and the Mantra

Llad Phillips
6
Chapter 3
Markets and Government
in the Global Economy
Llad Phillips
7
Markets as a Social Institution

Adam Smith: The Wealth of Nations(1776)
 argues
for free markets and free exchange
Markets allocate resources so supply meets
demand
 If markets are competitive, then the value
that the last consumer entering the market is
willing to pay equals the additional cost of
producing one more unit of the good

 this
is the magic of markets: efficiency
The political mantra is that markets solve all
problems: false if there is monopoly power
Llad Phillips
8

Current Economic Events

Labor Dispute between the shipping
association and the longshoremen
 lockout
 cost

to the economy: $1 B per day
What is at stake?
Major Trading Partners
of the United States, 1999
Llad Phillips
10
World Economy
Japan
Japan
European
Union
Mexico
US Economy
YOU
Llad Phillips
Me
11
Part I: Wealth (Net Worth) and Debt

Personal Wealth
a
million millionaires
 ordering the population form the poorest fifth to
the richest fifth by income and net worth
 the home is the big ticket asset

Liabilities: credit card debt
 consumer
debt service as a % of personal
disposable income (after taxes)
Llad Phillips
12
Net Worth in 1995
# of Wealth Holders
13,000
27,000
82,000
249,000
1,202,000
Net Worth Millions
> 20
10-20
5-10
2.5-5
1-2.5
Source: http://www.irs.gov
Llad Phillips
13
Families: Average Income and
Average Net Worth, 1995
Quintile
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Av. Income
$8,032
$17,916
$28,965
$43,930
$73,058
Av. Net Worth
$3,000
$14,600
$31,185
$51,133
$118,171
Source: Consumer Federation of America
Llad Phillips
14
Demographics and Per Capita Wealth
Llad Phillips
15
A Household’s Home Is By Far the Most Frequent Asset
http://www.census.gov/hhes/www/wealth/1995/wealth95.html.
Llad Phillips
16
Net Worth = Assets -Liabilities
Net Worth
Cash (inter.)
stocks
bonds
insurance
(surrender)
other
house equity
personal
property
Total
Llad Phillips
Amount
9.6%
8.4%
?
?
29.3%
44.4%
8.3%
100 %
17
Assets-Liabilities Statement
Amount
Amount Liability
Asset
bank loan
cash
margin loan
stocks
bonds
policy loans
insurance
(surrender)
card balances
other
mortgage
house equity
car loan
personal
property
Total
Total
Llad Phillips
18
Household Credit Market Debt in $ Billions, Seasonally Adjusted
10000
9000
y = 1E-75e0.0908x
8000
7000
Billions
6000
5000
4000
3000
2000
1000
0
1950
1960
1970
1980
1990
2000
2010
Date
http://research.stlouisfed.org/fred/data/business/cmdebt
Llad Phillips
19
Consumer Debt Service Payments as a Percent of Diposable Personal Income
10
9
8
7
Percent
6
5
4
3
2
1
0
1975
1980
1985
1990
1995
2000
2005
Date
http://research.stlouisfed.org/fred/data/business/cdsp
Llad Phillips
20
Credit Cards Have High Interest Rates On Average: 15-20%
You pay 15 % to borrow and you get, currently, 1-2%, to lend
Llad Phillips
21
Llad Phillips
22
Llad Phillips
23
Planning Tools
 Assets-Liabilities
Assets
Statement
Minus Liabilities = Net Worth
 measure
of wealth
 Income-Expenditure
Income
Minus Expenditures = Saving
 measure
Llad Phillips
Statement
of change in wealth
24
Part II: Housing Loans, Demand
Llad Phillips
25
Life Cycle Approach: Planning
Education: Investment in Accumulating Assets Spending
Human Capital or Earning
cars
Power
appliances
furnishings
---------------------
house
financial assets
Nurturing High School College
Education
Work
Age
Retirement
Life Cycle Approach: The Planners
100%
You
50%
Parents
0%
Infancy Adolescence Young Adult Adult Senescence
Age
Strategies for Meeting Future Expenses

Buy a House
 most
valuable asset for most US households
 commitment to monthly payment

Tax-Sheltered Savings Plans
 commitment

to monthly payment
Stocks and Bonds
Llad Phillips
28
Buying a House

Positives
 provides
space
 builds equity
 interest is
deductible
Llad Phillips

Negatives?
 down
payment
requires saving for
this goal
 interest payments
are front-loaded,
equity growth
delayed
 opportunity cost of
not investing in
stocks
29
Median Housing Price: Santa Barbara South Coast
700000
2000
600000
572000
500000
$
400000
300000
200000
100000
41500
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
Llad Phillips
30
Example for an $80,000 House
price: $80,000
 down payment: $20,000
 loan: $60,000
 interest rate: 10%
 loan term: 25 years

Llad Phillips
31
Equity in an $80,000 House, $20,000
Down .
80000
25 years
70000
60000
20 years
Equity
50000
40000
15 years
30000
5 years
20000
10 years
1 year
10000
0
0
Llad Phillips
50
100
150
200
Payment Number
250
calculated using TKSOLVER Level Debt Service Module
300
32
Slow Growth In Equity
Interest is front loaded
 Start with $20,000 equity in example
 After 10 years, gained about $10,000 equity
 After 20 years, gained about $35,000 equity
 Last 5 years, gain last $25,000 in equity

 less
interest payments for tax deductions
 may not want to refinance, since you are paying
off principal
Llad Phillips
33
Interest as a Fraction of the Monthly
Payment
1
0.9
Fraction
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0
Llad Phillips
50
100
150
200
Payment Number
250
300
34
Interest Cost of $60,000 Loan Vs. Term in Years
120000
monthly
payment, $545.22
Total Interest
100000
80000
monthly
payment, $579.01
60000
monthly
payment, $644.76
40000
20000
0
0
Llad Phillips
5
10
15
Loan Term
20
25
35
Total Interest Cost of $60,000-25 Year Loan Vs.
Interest Rate .
120000
Total Interest
100000
80000
60000
40000
20000
0
0
Llad Phillips
2
4
6
Interest Rate
8
10
36
Interest Cost
 You
if
may not care so much
you are experiencing capital gains
 i.e.
Llad Phillips
the value of the house is rising
37
Median Housing Price, Santa Barbara South Coast
1999
500000
475100
450000
400000
350000
300000
$ 250000
200000
150000
100000
41500
50000
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
Llad Phillips
38
Llad Phillips
39
Demand for Housing Loans

You are more likely to buy a house if the
mortgage rate is low
 your
behavior is sensitive to the national
economy
More people will be buying houses and
demanding mortgage credit if the mortgage
rate is low
 More people will be buying houses and
demanding mortgages if their income is
rising

 they
can afford a higher monthly payment and a
Llad Phillips
40
lower loan term
Price,
Mortgage
Rate
10 %
Demand for Mortgage Credit
7%
Quantity of Mortgage Credit
Llad Phillips
41
Demand for Mortgage Credit
Price,
Mortgage
Rate
Higher Personal Income
10 %
Quantity of Mortgage Credit
Llad Phillips
42
Expressing The Demand For Mortgage Credit
1. Words
Quantity of Mortgage Credit Mortgage Rate, Personal
Income
2. Symbols
Q = f(r, Y)
rule of correspondence: if you know the mortgage
rate, r, and if you know personal income, Y, then you
can determine the demand for mortgage credit, Q
3. Pictures
r
Q
Llad Phillips
43
Price,
Mortgage
Rate
10 %
Demand for Mortgage Credit
7%
Quantity of Mortgage Credit
Llad Phillips
44
The importance of saving
 commitment
discipline
 personal
income
determinants
 managing
expenses
income-expense
statement
 budgeting
Llad Phillips
45
Part III: Learning and Earning,
the Human Capital Story

Stocks
 assets
 debts
 net

worth(wealth)
Flows
 income
 saving
Llad Phillips
(this flow is the increase inyour wealth)
46
Determinants of Personal Income
The Life Cycle Model
Llad Phillips
47
An Individual’s Life Cycle for a
Socially Productive Life
Learning over the life cycle
 Accumulating earning power or human
capital
 Earnings depend upon

 ability
 knowledge
 work
Llad Phillips
experience
48
Productive Life Cycle
Social Institution
Family - PreSchool - School - College - Job - Retirement
Function
Learning: Accum. Human Capital - Earning - Spending
Age Line
0
Llad Phillips
4
6
18
23
65
49
Accumulating Human Capital
Inflow
Llad Phillips
Stock
Outflow
50
Accumulating Human Capital
Inflow + Net Inflow
Stock
Outflow
-
Llad Phillips
51
Accumulating Human Capital
Learning
+ Investment
-
Human
Capital
Depreciation
Human Capital: An Asset Like a Car or a House:
It Depreciates
Llad Phillips
52
Allocation of Your Time
Build Capital
by Learning
Human Capital
Use Capital
for Earning
Llad Phillips
53
24 hours
Time Endowment
Llad Phillips
54
0 hours
Llad Phillips
Leisure
24 hours
(learning)
55
Allocation of Your Time
Build Capital
by Learning
Human Capital
Use Capital
for Earning
Llad Phillips
56
Earnings
$480
Opportunities for trading leisure
for earnings (income) at a rate,
$20 per hour, the market wage,
determined by your stock of human
capital(step one of the paradigm:
describing the alternatives for choice)
$0
0 hours
Llad Phillips
24 hours
Leisure
(learning)
57
Salaries by Education Level, CA
Full Time* Workers
Education
No HS Dipl.
HS Dipl.
Bachelor’s
Master’s
Doctorate
Professional
Salary
$26,115
$27,326
$44,426
$52,787
$59,348
$77,877
Wage
$13.06
$13.69
$26.39
$26.97
$29.67
$38.94
*Full Time: >35 hrs/wk, >48 wks/yr.; Source: LA Times, 1-10-93
Llad Phillips
58
The Rich Get Richer and the
Poor Get Poorer

Why does poverty persist in an affluent
country like the US?
Llad Phillips
59
Comparative market wages as determined by accumulated
knowledge
Earnings
$480
college grad
$240
dropout
$0
0 hours
Leisure
24 hours (learning)
Choosing Between Learning and
Earning
How much time for learning?
 How much time for earning?
 This choice, like all choices depends on
your tastes

 Do
you want to earn and consume now?
 Do you want to learn, earn more in the future,
and consume more in the future?
Llad Phillips
61
Depicting your tastes graphically: iso-preference or
indifference curves
Earnings
$480
Iso-Preference Curves:
You value all points on
a curve equally(step two of
the paradigm: valuing the
alternatives for choice)
$0
0 hours
24 hours Leisure
(learning)
Depicting your tastes graphically
Earnings
low value
$480
high
Iso-Preference Curves:
You value all points on
a curve equally
high value
$0
0 hours
Leisure
24 hours (learning)
The choice between leisure and earning now:picking the
best alternative
Earnings
high
$480
alternatives
Iso-Preference Curves:
You value all points on
a curve equally
high value
low value
$0
0 hours
24 hours
Leisure
(learning)
Individual’s Supply of Labor
Earnings
low value
$480
$180
for 9 hrs
of work
high
Optimum
high value
Leisure
(learning)
$0
0 hours
15 hours
of leisure
24 hours
Earnings low value
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$0
0 hours
Leisure
24 hours (learning)
Earnings low value
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$96
$0
0 hours
Leisure
24 hours (learning)
dropout is unwilling to work for $4/hr
Why does the youth drop out?
may not like school
 may receive bad or no advice

 parents
 counselors
Llad Phillips
68
Life Cycle Approach: The Planners
100%
You
50%
Parents
0%
Infancy Adolescence Young Adult Adult Senescence
Age
Participation in the Labor Force:
Willing to look for work

If your market wage exceeds your
reservation wage
 college
grad, @$20/hr, participates
 the junior high dropout, @ $4/hr, does not
We assumed the college grad and the
dropout both have the same values for
income and leisure
 Only their learning histories differ

Llad Phillips
70
Earnings low value
$480
high
slope of the iso-preference
curve through the 24 hour
endowment is the lowest
wage at which you are
willing to work
$96
$0
0 hours
Leisure
24 hours (learning)
dropout is unwilling to work for $4/hr
low value
$480
$96
Higher value
high
Savings,
$ from
home
$0
0 hours
Llad Phillips
24 hours
72
Summary-Vocabulary-Concepts






median
demand curve
mortgage rate
personal income
mortgage credit
rule of correspondence





stock
inflow
outflow
time endowment
allocation of your time
 learning(leisure)

earning in future
 earning


Llad Phillips
now
iso-preference curves
reservation wage
73