Saturday, October 27, 2007

Builder Incentives and Arbitrary Pricing

A home builder is offering the following incentives in an advertisement found in the Edmonton Journal:
  • 3.95% 3-year fixed mortgage
  • No payments until May 2008
They value these incentives at $37,317 Based on the following:
  • sales price of $519900
  • 10% down, 40 year amortization
  • compared to a rate of 6.05%.
With a $52,000 down payment and ignoring the months effected by the incentives, the monthly payment would be $2,566*. For 40 years!

What happens if we lower the price and reduce the amortization to 30 years?
  • sales price of $482,583 (original price - incentive value)
  • same $52,00 down payment
  • 30 year amortization
  • Rate of 6.05%.
The monthly payment would be $2,575. Virtually the same as above. Bottom line is a lower price is much more useful to the consumer than incentives. In this example a person could use the estimated cash value of the incentive to pay off the mortgage 10 years sooner.

Why use incentives then? With prices being arbitrarily high the psychological effect of incentives valued at $37,317 is greater than a price decrease. On paper the difference between $519,900 and $482,583 does not get as much attention. Also the incentive may cost the builder less than the estimated value in the ad.

*using TD's mortgage calculator.

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