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53 Cards in this Set
- Front
- Back
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when debt makes sense
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Large purchases
Home mortgages Auto loans Emergencies Margin accounts – to partially finance purchase of securities Education Credit card float |
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When debt doesn’t make sense
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Bad debt: for basic living expenses, good & services with short life, spontaneous purchases
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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 |
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types of debt
credit lines |
Home equity
Over-draft Personal credit lines |
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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 |
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net investment debt =
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investment income – investment expenses
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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) |
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Points
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• 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 |
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mortgage deductions
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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 |
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APR
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Annual Percentage Rate
APR calculation = average finance charge/average loan balance outstanding |
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Fixed rate mortgage
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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 |
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Biweekly mortgage
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Fixed rate with due dates every 2 weeks (26 payments/year)
Higher frequency of payments = shorter loan live and lower interest costs |
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ARM = adjustable rate mortgage
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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 |
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Convertible ARM
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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 |
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Ballon mortgage
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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 |
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Graduated payment mortgage
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30 year/fixed rate
Payments lower in the first few years Possibility of negative amortization if payments don’t include total interest charged |
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Growing equity Mortgage (GEM)
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Monthly payments increase for specific period (5-7 years), then level off
Loan term is shorter because more principal is paid |
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Two-step mortgage
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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 |
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Reversed Annuity (Amortization) Mortgage (RAM) – reverse mortgage
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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 |
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source of mortgage
Conventional Mortgage Loans |
Commercial lenders
Down payment of 20% With PMI, can have lower down payment |
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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 |
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source of loans
VA |
For military and surviving spouses
VA guarantees |
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refinancing
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Decrease payments
Decrease time periods Consolidate debts |
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refinancing key variables
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Time intend to own home
Interest rate Difference in mortgage payments after tax Closing and refinancing costs |
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Refinancing options
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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 |
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Feasibility analysis
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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? |
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Home equity and lines of credit
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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 |
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home buy/lease variables
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Cost of home
Interest rates Income tax benefits Increase/decrease of home prices over time Time expected to live in home |
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Leasing cost =
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annual rent + annual insurance premium
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Housing cost =
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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) |
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downside of leasing autos
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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) |
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total cost of leasing auto
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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 |
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total cost of purchasing auto
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Down payment
Sales tax Total monthly payments Opportunity cost of down payment (interest earned) Subtract value of car at the end of loan payments |
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good credit
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no delinquency; loans and debts are paid based on the terms of the contract
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types of info on credit reports
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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 |
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credit score
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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 |
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Consumer Credit Protection (Truth in Lending Act)
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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 |
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Equal Credit Opportunity Act (ECOA)
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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 |
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Fair Credit billing Act
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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 |
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Fair debt collection act
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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 |
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Collectors are not permitted to
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Use abusive language
Misrepresent themselves Unfair tactics Contact anyone else about debt unless it is about location Collect a greater amount |
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Fair Credit & Charge card disclosure act
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Full disclosure of fees, grace periods, and other financial terms
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Consumer Credit Reporting Reform Act
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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 |
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Problematic debt
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Over-extension with credit cards
Loss job Health issues Assistance with debt |
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Assistance with debt
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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 |
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bankruptcy - chapter 13
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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 |
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bankruptccy - chapter 7
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Straight bankruptcy
To provide a new start Majority of filings Does not eliminate obligations or loss of assets |
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Chapter 7 - obligations not dischargeable
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• Child support
• Alimony • School loans • Government loans • Income taxes for 3 years • Income tax withholding • FICA obligations |
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Chapter 7 - Assets exempt from distribution
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• 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 |
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bankruptcy - Chapter 11
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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 |
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Bankruptcy - chapter 20
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Blend of chapter 7 & 13
Permits debtors to eliminate unsecured debt under chapter 7 and restructure secured debt under chapter 13 |
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Bankruptcy and FA responsibility
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Legal counsel be consulted
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leasing question
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compare the present value (PV) of the after-tax cash flows associated with each alternative
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