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Economics 366 Midterm #2 Answer Key

Economics 366 Midterm #2 Answer Key - Economics 366 Urban...

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Economics 366: Urban Economics Date: November 10, 2008 Assignment: Midterm 2 Time 1.30 hrs Instructor: Sarbajit Sengupta Answer any 5 questions (5 x 10 =50) 1. (a) Why is the calculation of Housing Price different from the pricing of an ordinary commodity. (b) Explain the relationship between Value price and Rental Price of housing. (c) How are housing prices determined in the short run and in the long run? 2. (a) Differentiate between Fixed Rate and Adjustable Rate Mortgages. Answer : A fixed rate mortgage is a mortgage that a consumer locks in with a rate that does not fluctuate. An adjustable rate mortgage is a mortgage in which a consumer agrees to an interest rate at the beginning of the term (typically known as a “teaser rate”), but the interest rate can easily fluctuate unlike a fixed rate mortgage. The burden for a fixed rate mortgage can be on the lender if the consumer prepays because although the consumer initially pays off the interest in the mortgage, there comes a time when the principal is paid off later in the term. Prepaying allows the consumer to ultimately pay less than the scheduled amount first agreed to. (b) Under what conditions would one of them be preferable to the other? Answer : As hinted earlier in the case of prepayment, a fixed rate mortgage would be preferably compared to an adjustable rate mortgage. A case in which an adjustable rate mortgage would be favorable is if the interest rate actually dropped over the course of the mortgage term. However, this approach is considered very risky because it requires quite a deal of foresight. For example, if the consumer went with an adjustable rate mortgage but the interest rates increased, then the consumer took a risky play and lost. Finally, fixed rate mortgages have the characteristic that the interest rate for the term is known. This tends to decrease the level of anxiety among borrowers who would otherwise worry about rising interest rates. (c) Explain the role played by the Secondary Mortgage Market in the housing finance sector. Answer : The secondary mortgage market ultimately plays three important roles: 1) original, 2) investing, and 3) servicing. Origination is essentially the marketing and other similar associations with it. It can include the likes of advertising and such. Investing is basically the funding aspect of the secondary mortgage market. Without it, there simply is no way to continue providing mortgages. Servicing deals with the more administrative aspects of mortgages, such as collection of payments and so forth. The dynamics of the secondary mortgage market have changed over the past quarter-century or so. Although origination for the most part remains the same, the main differences are in investing and servicing. In terms of investing, the originator no longer has to be the sole investor. Now, other financial institutions help with mortgage investment. In terms of servicing, it is worth noting that the top servicer services 2% of all mortgages in the United States.
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