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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