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53 Cards in this Set

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when debt makes sense
Large purchases
Home mortgages
Auto loans
Emergencies
Margin accounts – to partially finance purchase of securities
Education
Credit card float
When debt doesn’t make sense
Bad debt: for basic living expenses, good & services with short life, spontaneous purchases
Types of debt
consumer debt
consumer debt
* should not exceed 20%of net
* Open-account credit: pre-authorized credit limit, such as retail or financial institution
* Bank credit cards: form of open-account credit:
costs: interest rates; transaction fees; have add-ons, such as buyer protection plans, rental coverage, lost-card registration; have high interest rates; annual fees
opportunities: interest free loans, single record keeping, easy returns, easily dispute purchases
types of debt
credit lines
Home equity
Over-draft
Personal credit lines
types of debt
investment
Using margin accounts to leverage owned securities as collateral for the purchase of additional securities
The interest rate should be less than the potential rate of return from the investment
Requires some of the purchase to be in cash
Margin calls: request of additional cash deposits when value of securities declines significantly
net investment debt =
investment income – investment expenses
types of debt
Mortgage debt
Interest is affected by prevailing rates in the market
Additional fees
• Appraisal
• Credit reporting
• Title searches
• Escrow deposits
• Points (loan origination fees)
Points
• 1% of the mortgage loan
 Example: 2.5 points on $150,000 loan, costs of points = $3750
 .025 * 150,000
 Higher the points; the lower the interest rate
 Example: if staying a short time in the home, pay the higher interest rate and lower cash outlay by keeping points low
mortgage deductions
 Primary residence is deductible in year home was purchased
 2nd home/refinance: point deduction is prorated over life of mortgage
 Home improvements: points allocated toward home improvement can be deducted during year paid
APR
Annual Percentage Rate
APR calculation = average finance charge/average loan balance outstanding
Fixed rate mortgage
Interest rate does not change over the repayment period
Monthly payment is fixed based on interest rate, life of loan & origination amount
Monthly payment includes interest and principal
Interest portion declines and principal portion increases during the life of loan
Biweekly mortgage
Fixed rate with due dates every 2 weeks (26 payments/year)
Higher frequency of payments = shorter loan live and lower interest costs
ARM = adjustable rate mortgage
Adjustment period = time between rate and/or payment changes
• Usually 6 months or one year
Index rate = proxy for interest rates
Treasury securities (T-bills)
CD rate for 6 months
Cost of funds for savings institutions – less volatile than above
Margin = number of percentage points added to index rate to get ARM
ARM = margin + index rate
Caps
Periodic = limit rate increase from one adjustment period to the next (eg 1-2 points)
Overall caps = limit rate increase over life of loan (eg 5-8 points)
Payment caps = limit percentage increase in the monthly payment from one adjustment period to the next
Negative amortization
Can occur especially with a payment cap because the adjusted interest rate requires an increase beyond the payment cap. Therefore, the underpaid amount is added to the principal
Convertible ARM
Converts to a fixed-rate any time between 13th and 60th month, if interest rates decrease
Usually fee paid at time of conversion
Fixed rate is usually .25-.50 above current fixed-rate loans
Ballon mortgage
Payments are made based on a fixed rate for long-term mortgage, typically 30 years
Except: payments are only made for a limited time (5-7 years)
Generally lower interest than what would be charged on 30 year fixed
Good for borrower who plans to sell in short time period, before balloon is due
Graduated payment mortgage
30 year/fixed rate
Payments lower in the first few years
Possibility of negative amortization if payments don’t include total interest charged
Growing equity Mortgage (GEM)
Monthly payments increase for specific period (5-7 years), then level off
Loan term is shorter because more principal is paid
Two-step mortgage
5/25 or 7/23
30 years with fixed rate during the first five or seven years; then adjusted rate
Usually lower than fixed rate than normal (regular) & good for folks who plan to sell before the initial 5 or 7 years
Reversed Annuity (Amortization) Mortgage (RAM) – reverse mortgage
For retiree, who doesn’t want to move
Use equity in personal residence
Provide income (monthly or lump sum)
Loan is for the percentage of equity
Lending institution is repaid by sale of property
source of mortgage
Conventional Mortgage Loans
Commercial lenders
Down payment of 20%
With PMI, can have lower down payment
source of mortgage loan
FHA - Federal Housing Authority
Offers lenders insurance on high loan-to-value loans
Insurance premium, similar to PMI, is paid by borrower at closing plus on an annual bases thereafter
source of loans
VA
For military and surviving spouses
VA guarantees
refinancing
Decrease payments
Decrease time periods
Consolidate debts
refinancing key variables
Time intend to own home
Interest rate
Difference in mortgage payments after tax
Closing and refinancing costs
Refinancing options
Replacing fixed-rate loan with lower-interest fixed-rate loan with same term. The effect is a reduced monthly payment
Replacing 30 year with15 year; loan is re-paid more quickly
Replacing fixed-rate with ARM; reduced monthly payments but exposed to possibly higher payments in the future
Replace ARM with fixed-rate; maybe higher payments, but consistent
Feasibility analysis
is more complex when the goal is to reduce total costs of mortgage over the life of loan, rather than reducing the monthly payment.
Key points
• Terms – example: is 30 year loan, that has been paid for 10 years, being replace with another 30 year loan?
Home equity and lines of credit
Home equity is the difference between the FMV and unpaid balance
Lender will permit total debt up to 70%-80% of FMV
Secured by a 2nd loan on the house
Usually adjustable interest rate
Deduct interest charges up to $100,000 and cannot exceed FMV
FA should be cautious with clients about supporting this
home buy/lease variables
Cost of home
Interest rates
Income tax benefits
Increase/decrease of home prices over time
Time expected to live in home
Leasing cost =
annual rent + annual insurance premium
Housing cost =
Annualized mortgage payments
Annualized tax payments
Annualized insurance payments
Annualized maintenance
Opportunity cost = annualized interest income on investments
Subtraction
• Payment to principal (because = savings due to increase in home’s equity)
• Annualized interest payment * tax bracket
• Tax savings due to property taxes
• Appreciation of home (after the above have been added and subtracted from the costs of buying)
downside of leasing autos
Question: is lease tax deductible - usually a business with an operational lease
contrast to Financial or capital lease: shown as a fixed asset on corporation balance sheet and deductible thur depreciation only

Usually costs more than purchasing auto with cash
May cost more than purchasing an auto with loan
Mileage restrictions
Cost of breaking a lease
Other considerations: used for business (lease payments are deducted)
total cost of leasing auto
Down payment = capital cost reduction
Security deposit
Total amount of lease payments
Opportunity cost = interest rate earned on funds for down payment and security deposit (applied to the term of the lease)
Open-ended lease
Add/subtract the assumed market value adjustment (based on such things as condition, miles, etc)
Closed-end lease
No market value adjustment
May have additional charges for excess miles
total cost of purchasing auto
Down payment
Sales tax
Total monthly payments
Opportunity cost of down payment (interest earned)
Subtract value of car at the end of loan payments
good credit
no delinquency; loans and debts are paid based on the terms of the contract
types of info on credit reports
Name, ss, age, dependents, current and previous addresses
Employment record & income data (if available)
Credit history: loans, credit lines, credit cards, payment records, account balances
Public record information: bankruptcies, tax liens, foreclosures, civil suits, criminal convictions
Firms and financial institutions that have recently requested copies of file
credit score
Fair, Issac, and Companiy, Inc. (FICO)
Calculated based on info in credit report
No cut-off score
Other scores can be used
Score reason codes are included to explain why score is not higher
Delinquencies are kept for 7 years
Bankruptcies are kept for 10 years
Consumer Credit Protection (Truth in Lending Act)
Regulation Z
Requires lenders, prior to extending credit, to disclose dollar amount of finance charges and APR (w/ in ¼ of 1%) and other terms and conditions
APR calculation = average finance charge/average loan balance outstanding
Credit card must include ID = picture or signature
Credit card holder maximum liability for lost/stolen card = $50/card
Equal Credit Opportunity Act (ECOA)
Prohibits discrimination
Sex
Marital status
Childbearing plans
Race, national origin
Religion
Age
Income (public assistance, alimony)
Joint debt is report to credit companies to both parties
Fair Credit billing Act
Consumers notify creditor of billing errors within 60 days of date of receipt
Creditors have 30 days to respond & 90 days to resolve complaint – payment cannot be collected and no unfavorable credit reports
Consumers can withhold payment to bank for unsatisfactory goods/services
Merchants are permitted to give cash discounts
Fair debt collection act
Creditors notify consumers in writing within 5 days of the first contact by a collector of the amount owed, to whom, and how to dispute the claim
Consumer can prevent can prevent communication by notifying collector in writing
Collectors are not permitted to
Use abusive language
Misrepresent themselves
Unfair tactics
Contact anyone else about debt unless it is about location
Collect a greater amount
Fair Credit & Charge card disclosure act
Full disclosure of fees, grace periods, and other financial terms
Consumer Credit Reporting Reform Act
Credit bureaus must retain accurate, relevant & recent information
Applicants denied credit/borrowing costs increase must be told why & be given name of credit agency
Consumers can personally review credit report
Credit information disputes must be resolved in 30 days
Problematic debt
Over-extension with credit cards
Loss job
Health issues
Assistance with debt
Assistance with debt
Reduce spending (needs/wants)
Eliminate credit card balances
Transfer to different creditor with cheaper rates, equity line, working with consumer loan counselor to develop repayment schedule
Switch from credit card to debit cards
Pay off debts with savings (not emergency fund)
Borrow from relatives/friends a cheaper interest rate
bankruptcy - chapter 13
Wage earner plan
Restructured debt plan with repayment schedule coincides with debtor ability to repay
Usually approved if:
Pay off debt within 3-5 years
Debtor has steady source of income
Secured debt is < $750K and unsecured is <$250K
bankruptccy - chapter 7
Straight bankruptcy
To provide a new start
Majority of filings
Does not eliminate obligations or loss of assets
Chapter 7 - obligations not dischargeable
• Child support
• Alimony
• School loans
• Government loans
• Income taxes for 3 years
• Income tax withholding
• FICA obligations
Chapter 7 - Assets exempt from distribution
• Federal or state exemptions
• Personal residence (subject to excludible amount)
• Nominal personal property
• Pension and retirement benefits
• Wages for family member who is providing support of dependent
bankruptcy - Chapter 11
Individuals who don’t qualify for chapter 13 because they exceed debt limitations or don’t have regular source of income but want to restructure debt
Creditors vote on reorganization plan and can vote in block, causing delays
Bankruptcy - chapter 20
Blend of chapter 7 & 13
Permits debtors to eliminate unsecured debt under chapter 7 and restructure secured debt under chapter 13
Bankruptcy and FA responsibility
Legal counsel be consulted
leasing question
compare the present value (PV) of the after-tax cash flows associated with each alternative