Faisal Kanji-101015969

Spreadsheet Assignment
Introduction For the spreadsheet assignment I chose to create a document to analyze the long-term monetary result for a young couple deciding on renting or buying a new home. The scenario was based on a fictitious young couple in order to emphasis all the variables at play, but in reality this is a decision I will soon be undertaking and this model (decision support system) was created to help me with my decision. The basic problem can be framed as: given certain assumptions, would a young couple be better served by purchasing a house and building equity over the next 25 years or renting an equivalent home and investing the excess income? This question is fairly complex because there are an infinite number of variables at play over the course of the 25 year period, therefore certain binding assumptions must be made: The couple are considering buying or renting the same house at market value and are assumed to be paying the asking price/rent for the property. In the case of purchasing the property the price is $699 0001 and in the case of renting the cost is $50002/month. These prices are assumed to be inclusive of all related fees and expenses such as moving, real estate, lawyer, etc. The couple has an initial savings of $100 000.00 which they will chose to either use as a down payment on the home or as an initial deposit into the investment account. The couple are both assumed to be working steady jobs from where they will be deriving income for the next 25 years. Though the couple have many financial obligations they have set aside $7000/month to make payment to rent/savings or mortgage. This amount will increase with inflation annually at a rate of 3%3 in order to account for the raise in rent over time. The couple will seek a high interest savings account as not to expose themselves to any market risk. The interest rate is considered to be equivalent for both lending and investing purposes at a rate of 3%. This rate will be locked for the entire duration of the investment or loan. The mortgage will be compounded annually for 25 years and the payment will be a blend of both principal and interest. In the case of purchasing the home, it will be assumed that any money in excess of the mortgage payment will be spent on up keeping, taxes, furniture, upgrades and the many other expenses associated with owning a home. In the case of renting, all income in excess of rent will be invested. House prices will be assumed to be growing at a rate of 4.5%4, while rent will be assumed to be increasing at a rate of 3%5 annually. The rates and prices identified are all factual and based on the historical prices associated with Whitby, Ontario, Canada.

http://www.realtor.ca/propertyDetails.aspx?PropertyId=11512164&PidKey=-1846506278 http://www.realtor.ca/propertyDetails.aspx?PropertyId=11664185&PidKey=-1777361209 http://www.tradingeconomics.com/canada/inflation-cpi http://multimedia.thestar.com/acrobat/50/79/d004eda0453f8443bb506994c2ad.pdf

http://www.checkfirstonline.com/rent_increases.htm

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Faisal Kanji-101015969

Variables

KEY

Home Equity

Dependent Variable

Mortgage Mortgage Balance Balance Outstanding Outstanding

House House Resale Resale Value

Dependent Variable

Independent Variable (see assumptions)

Excess Income

Interest Rate

House Price Appreciation

Inflation

Rent Rent

Savings Interest Interest Earned

Rent increase

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Faisal Kanji-101015969 As shown by the diagram above the relevant dependent variables to be considered in this scenario are the savings balance and the home equity after 25 years. These are both dependent on interest rate and the level of excess income, which is intern dependent on the rate of inflation. Should the interest rate increase, mortgage payment would become more expensive and thus a higher level of income would be needed to sustain the mortgage payments, but on the other hand savings would grow at a higher rate or return. Should interest rates fall the interest earned on savings would decline, but more income would go towards paying the mortgage principal and thus more home equity would be unlocked quicker. Under normal circumstances the more income available the quicker the mortgage can be paid off or the more savings can grow, but since we have fixed the level of income to only grow with inflation no changes can be made to this variable under our scenario. Other Variables to consider are rent increase, which can lead to a lower savings investment and house price appreciation, which can ultimately lead to a higher level of home equity. It is worthwhile to note that should interest rate increase quicker than the rate of inflation the discrepancy between home equity and savings after 25 years will be fairly substantial. Design Criteria In creating the spreadsheet there are essentially two different scenarios that need to be separately analyzed. The first relates to the equity built through purchasing a house. In order to calculate the equity as it evolves from year to year, we must first determine the mortgage value outstanding and the current house value. The current house value is determined though the purchase price adjusted for appreciation. To determine the mortgage outstanding we must determine the amount of payment being used towards the principal. The second scenario that must be considered is of the current value of savings as it grows through time. This is simply amount invested into saving plus the interest earned. The spreadsheet layout is organized in a logical manner to display the information dealing with home equity in a section on the left hand side of the page and a section on the right hand side of the page dealing with the growth in savings. The top right hand portion displays all the given variables from the assumption listed above. Cell formatting has been used throughout the spreadsheet as most cells had to be identified as currency or percentage (all to two decimal places). Cells containing text have been centre justified to create a more visual appeal. In terms of graphing the various analyses, a line chart showing the two alternatives against each other was used as this provides the best representation of the data in a meaningful and useful manner. For example a bar chart or pie graph of the two alternatives would not make logical sense nor would it provide any insight about the data. Key Formula Home Equity=Resell value-Mortgage outstanding Eg) I6=H6-F6 Resell Value=House purchase price + Appreciation Eg) H6=(D1*D3)+D1 Mortgage outstanding=Mortgage amount Payment towards principal Eg) F6=D2-C6 Payment towards principal=Mortgage payment-Payment towards interest Eg) C6=E6-D6 Interest payment=Mortgage outstanding x Interest rate Eg) D6=D2*B3 Mortgage payment= (Mortgage amount x Interest rate)/(1-(1+Interest rate)^(-Amortization period)) Eg) E6=(D2*B3)/(1(1+B3)^(-B4)) Page 3 of 9

Faisal Kanji-101015969 Income = Income + Inflation adjustment Eg) B7=(B6*F3)+B6 House rental = Rental price + Rent increase adjustment Eg) K7=(K6*F2)+K6 Contribution to savings = Initial investment + Income after paying rental Eg) L6=(B2+(B6-K6)) Interest earned=Contribution to savings x Interest rate Eg)M6=(L6*B3) Savings Balance = Initial investment and interest + New investment and interest Eg)N6=L6+M6 Data Validation Due to the various variables at play and the need for accuracy many steps were taken in order to ensure that the data is both valid and its integrity is upheld. First all basic calculation were double checked by hand at random in order to ensure the overall integrity of the calculations. Other quick tests to insure the integrity include observing the outstanding mortgage equaling zero in the final year, at any point the house equity will equal the resell value minus the mortgage outstanding and the mortgage outstanding will equal the sum of payments to that point. All data was double checked when entered into the spreadsheet and cross checked with the basic calculations. The logical layout of the spreadsheet ensured that the two laws of modeling were clearly followed, as all data appears only once and each cell contains either a variable or a formula. Also the cross checking of each cell reference individually ensures that none of the cells were incorrectly calculated. System Operation With layout in place and the various data and formula successfully inputted, it is fairly intuitive the manner in which the spreadsheet can be operated. As it is meant to be a decision support system immediate conclusions can be made with regards to the home equity and savings levels earned after the 25 year period using the given assumptions. The benefit of having this problem outlined in a spreadsheet is that we can now preform various analyses on the data, as well as making changes to our assumptions. We can perform various sensitivity and what if analyses on our assumption to see how changes in them will affect our results. Any changes made to the variables (interest rate, inflation, house price appreciation and rent increase) will all affect the outcome of the model. I have chosen to complete a few different analyses in the next section. Conclusion Overall the spreadsheet shows that it would be wise for the couple to invest in purchasing a house, since after 25 years it will have the higher monetary output level. As shown by Figure 1 (Appendix B) at all points house equity exceeds the total savings making this option seem to be the obvious choice, but this is dependent on all of the assumption remaining constant. The entire model can endure radical changes with even the slightest variations to Interest rate, Inflation or house price/rent increases. As shown by Figure 2 (Appendix B) if house prices appreciated at 1.5% per year (and all other variables remain constant), which is a far more reasonable rate to expect over a long period of time, at about the 10 year mark savings will exceed home equity and this trend will continue until the 25th year at which point it will be more than 50% greater than home equity. Figure 3 (Appendix B) shows the result of an increase in interest rates by 2% to 5%( and all other variables remaining constant), thus making it more expensive to borrow while earning a greater rate of return. This results in house equity exceeding savings in the early years, but as the savings are compounded at a greater rate around the 15th year savings surpasses house equity and be the 25th year savings is around 25% greater than house equity. A final analysis is done in Figure 4 (Appendix B) to show the effects of eliminating all variables except interest Page 4 of 9

Faisal Kanji-101015969 rate. With house prices no longer appreciating the couple will be left with their original investment after 25 years while a savings account would have continued to grow with the interest rate. Thus the decision on whether to invest in a house or a savings account depends entirely on the couples outlook of the future market and the accuracy of their estimations. As shown even a small variance to any of the variables or multiple variables can lead to not only a different decision, but the potential to miss out on a large profit margin.

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Faisal Kanji-101015969 Appendix A: Screenshot

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Faisal Kanji-101015969 Appendix B: Graphs

Home Equity vs Savings Balance

$2,500,000.00

$2,000,000.00

Cash Value

$1,500,000.00 Savings $1,000,000.00 Home Equity $500,000.00

$0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year

Figure 1 (above) shows the output of the originally designed spreadsheet. Given the parameters to work within house equity stays above the total saving though the entire 25 year period. This makes logical sense given that the house prices are appreciating at a rate of 4.5% while savings are only appreciating at the interest rate of 3%.

Home Equity vs Savings Balance With House Appreciation at 1.5%

$1,800,000.00 $1,600,000.00 $1,400,000.00 Cash Value $1,200,000.00 $1,000,000.00 $800,000.00 $600,000.00 $400,000.00 $200,000.00 $0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year Savings Home Equity

Figure 2 (above) In order to reconcile the gap created in Figure 1 due to house price appreciation being greater then then interest rate we now reduce the appreciation rate from 4.5% to 1.5%. As we predicted, now savings is greater throughout the course of 25 years thus leading to the conclusion that the choice between the two alternatives is dependent on level of house appreciation and interest rate.

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Faisal Kanji-101015969

Home Equity vs Savings Balance With Interest Rate At 5%

$2,500,000.00

$2,000,000.00

Cash Value

$1,500,000.00

Savings

$1,000,000.00 Home Equity $500,000.00

$0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year

Figure 3 (above) To emphasis the conclusion made from Figure 2, we now look at the change if we increase interest rates to 5%. As we can see savings once again produces a greater yield then home equity but this time the discrepancy is not as large. This can be due to the fact that both home equity and savings are tied to the level of interest rate, but since the rate is greater than the rate of house appreciation, saving in the end remains greater.

Home Equity vs Savings Balance With No Inflation or House Price/Rental Increases

$1,200,000.00 $1,000,000.00 Cash Value $800,000.00 $600,000.00 $400,000.00 $200,000.00 $0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year
Figure 4 (above)- since we were unable to derive a clear picture of the effects of interest rate in Figure 3, we now remove all other variables and look at the result of having an interest rate at 3%. As you can see this yields a much greater level of savings thus confirming our conclusion that house appreciation levels were distorting our full view of the change in interest rates in Figure 3.

Savings Home Equity

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Faisal Kanji-101015969

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