3 How do lenders evaluate credit? What lenders really want to know iswill you pay me back? 5 Cs of credit: –Capacity(income vs. expenses) –Capital(net worth = assets - debts) –Character(credit report) –Collateral(can be repossessed) –Conditions(economy as a whole)
FICO Credit Score Calculation Scores range from 300 – 850 and are a snapshot in time; your score can change in either direction depending on your credit report
FICO Score Explanations Payment history – 35% –Do you pay on time? (Most important component) Amounts owed – 30% –Balance owed compared to available credit Length of credit history – 15% –Length of time since first credit account was opened New credit – 10% –Credit inquiries and recent account openings Credit types – 10% –Mortgage, installment (auto), revolving (credit card), and other – all of one type is bad
6 FICO Score Information Comes from Credit Bureau information: 3 national credit bureaus: –Equifax –Trans-Union –Experian (formerly TRW) Your credit file contains: –Name, social security #, age, # of dependents, all addresses –Employment & salary history –Loans, credit cards, credit lines with payment history & balances –Public records: bankruptcies, tax liens, foreclosures, civil suits, and criminal convictions –List of those requesting your file
7 Credit Bureaus: Who can see your credit report? –Potential issuers of credit –Potential employers –Insurance companies –Rental or leasing companies How long can they keep information? –7 years for most information –10 years for bankruptcies Before you apply for credit, know what is on your credit report !!! annualcreditreport.com gets you a free report from each of the 3 credit bureaus yearly
8 How much debt is too much? Debt safety ratio: total monthly non-mortgage consumer credit payments* monthly take home pay Ratio shouldnt be over 20%. (10-15% is better!) * Includes credit card debt, car payments, student loan debt, installment loans for furniture, appliances,etc.
9 Other debt ratios often used: Debt ratio: total debt total assets (Financial planners would recommend 50% or less) Debt Service Coverage: take-home pay debt service charges* Principal and interest on mortgage, car, furniture & appliance loans, student loans, and other installment payments (Financial planners would recommend a ratio of 3.0 or better.)
10 How much debt is too much? Freddie Mac recommends that your monthly housing expenses not exceed 28% of gross monthly income and that your total debt payment, including housing expenses, not exceed 36% of your gross monthly income. Example: Gross annual income = $48,000 Gross monthly income = $4000 House payment @ 28% x $4000 = $1120* Total debt @ 36% x $4000 = $1440* – car pmts. & other installments * prin. + interest + taxes + insurance
Cost of Home Ownership Down payment –Loan to value ratio (80% means 20% down) –Conventional loan requires 20% down –Special program such as FHA loans can reduce down payment to as little as 3-5% Requires PMI (property mortgage insurance) if loan to value ratio is more than 80%
Cost of Home Ownership: Mortgage payment PITI –Principal –Interest –Taxes (property taxes) –Insurance Example: $100,000 mortgage, 5% interest, 30 years - 100,000PV 360N.4166*i CPT PMT = $536.77 ( This is prin. & int. – add about $200 for taxes and insurance.) * 5% / 12 =.4166 Using a BAII+ Texas Instruments Financial Calculator
Cost of Home Ownership: Example: $100,000 mortgage, 5% interest per year, 30 years - 100,000PV 360N.4166*i CPT PMT = $536.77 (Taxes & insurance still must be added.) Total amount paid for house: –$536.77 x 360 months = $193,237.20 Total –Amount of interest: $193,237.20 Total – $100,000.00 Principal $93,237.20 Interest
Cost of Home Ownership: Example: $100,000 mortgage, 5% interest per year, 15 years - 100,000PV 180N.4166*i CPT PMT = $790.75 (Taxes & insurance still must be added.) Total amount paid for house: –$790.75 x 180 months = $142,335.35 Total –Amount of interest: $142,335.35 – $100,000 = $42,335.35 Int.
How rates affect the payment: $100,000 mortgage, 5% interest per year, 30 years - 100,000PV 360N.4166i CPT PMT = $536.77 $100,000 mortgage, 4% interest per year, 30 years - 100,000PV 360N.3333i CPT PMT = $477.39 $100,000 mortgage, 6% interest per year, 30 years - 100,000PV 360N.5i CPT PMT = $599.55
Car buying mistakes: Dont buy a NEW car !!! Consider this: –A new car loses 45% of its value in the first 3 years! –A car 3 years old is still a very good car – a used car is a much better buy. Dont try to lower payments by extending the number of payments !!! –You eventually become upside down and owe more against the vehicle than it is worth. If you cant afford the payments, sell the car. –Letting a lender repossess a car severely hurts your credit. Dont believe you are what you drive !!!
Car insurance buying mistakes: Liability insurance is required by lenders. Buy more liability than Texas minimums: –Texas minimum: 30/60/25 –$30,000 for each person injured or killed –$60,000 total for all people injured or killed –$25,000 for property damage If your minimum policy limits dont cover costs, you can be sued. –Current and future wages can be garnished to satisfy a civil judgment
19 Buying Life Insurance: Whole life vs. term life insurance –Whole life accumulates cash value. The premium stays the same and is higher to begin with. –Term is only insurance, not an investment. The premium rises over time. Why is term insurance the best choice? –Term is cheaperyou can get more insurance for a lower premium. –The cash value on whole life doesnt earn a high enough rate of return to be a good investment. Do not buy life insurance on a child.
Why do people have too little retirement income? They start too late They put away too little. They invest too conservatively.
They start too late: Saving $5000 per year: – $5000/year for 10 years @ 6% = $ 65,904 – $5000/year for 20 years @ 6% = $183,928 – $5000/year for 30 years @ 6% = $395,291 – $5000/year for 40 years @ 6% = $773,810
They save too little: Savings per year: – $2000/year for 40 years @ 6% = $309,524 – $3000/year for 40 years @ 6% = $464,286 – $4000/year for 40 years @ 6% = $619,048 – $5000/year for 40 years @ 6% = $773,810
They invest too conservatively: Saving $5000 per year at 10%: – $5000/year for 10 years @ 10% = $ 79,687 – $5000/year for 20 years @ 10% = $286,375 – $5000/year for 30 years @ 10% = $822,470 – $5000/year for 40 years @ 10% = $2,212,963
Selected Realized Returns, 1926 – 2009 Average Standard Return Deviation Small-company stocks16.6%32.8% Large-company stocks11.820.5 L-T corporate bonds 6.2 8.3 L-T government bonds 5.8 9.6 U.S. Treasury bills 3.7 3.1 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2010 Yearbook (Chicago: Morningstar, Inc., 2010), p23. Saving and Investing for Higher Returns (1926-2010):
27 Handling problems paying debt: 1 st contact the issuer of credit –Extension –Payment plans Debt consolidation (home equity loans) Credit counseling (CCC) –Many churches and other organizations do credit counseling –Others advertising to do credit counseling are often for-profits who take a fee and dont help very much Bankruptcy
28 Bankruptcy Cant discharge: –Student loans –Alimony or child support –Taxes to the IRS –Debt taken on in anticipation of bankruptcy –Certain suits for damages Chapter 7 – straight bankruptcy –All debts discharged Chapter 13 – wage earner plan –Must use this plan if your income is equal to or more than the median household income in your state ($49,646 in Texas currently) –You eventually pay off all debts, but you have an extended time to do it and your creditors cant sue you in the mean time