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Readings to the end of FIN 401 Chapter 12. Pages 262-268, 270-276. Chapter 13. Pages 294-297. PPTs will be available after the lessons have been taught.

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Presentation on theme: "Readings to the end of FIN 401 Chapter 12. Pages 262-268, 270-276. Chapter 13. Pages 294-297. PPTs will be available after the lessons have been taught."— Presentation transcript:

1 Readings to the end of FIN 401 Chapter 12. Pages , Chapter 13. Pages PPTs will be available after the lessons have been taught.

2 Debt Capacity (continued) Q.If there is no theory to measure debt capacity, where do we begin? We begin by looking at the variables (things that We can Change and things that We can Control) We apply our adult maturity to the discussion and realize that financial health is about Survival of the Fittest. Q.If there is no definite measure of debt capacity, what are the variables that we should begin looking at? 1.Liquidity 2.Solvency 3.Risk

3 Q.What are the formulas that we have already learned, that can be helpful? Look in your notes. The most useful tools for assessing debt capacity are: Budget of income and expenditure (Cash Flows income and expenses) Statement of Net Worth (assets minus liabilities = net worth). Budget Forms Tips:Budget for the entire period of your loans so that you can see your liquidity and solvency.

4 Quick Review Q.When you have created those forms, which ratios do you apply? A.Debt Ratio (not equity) = total debt / total assets B.Liquidity Ratio = liquid assets / monthly expenses C.Debt Payment Ratio = monthly credit / take home pay D.Savings Ratio = Monthly Savings / Gross Income

5 New Tools Debt Service Ratios are used by lenders to assess your ability to repay money that you borrow. Gross Debt Service Ratio (GDS) and Total Debt Service Ratio (TDS) Q.Think about what we have learned and tell me what the benefits are of measuring and knowing both the Gross Debt and the Total Debt.

6 Lenders will look to see that, Gross Debt Service is less than 30% Total Debt Service is less than 40%

7 Q.How useful are these ratios and when are they used? They are quick assessment tools that make sense for families in the average income brackets. $40,000 - $60,000 annually.

8 Q. Why is the budgeting process required? A1. Ratios do not allow for risk. A doctor earns more money than a non skilled laborer and can accept more risk. A2. These ratios are based on Gross Income and do not allow for the effect of taxes. After tax income (Net) will be higher for a family with two income streams of $25,000 versus one income stream of $50,000. Also, a self employed person will have more tax deductions and sometimes benefits that offset personal expenses (car, travel expense, meals, cell phone, etc).

9 A3. These ratios are most effective for average income earners and not those with very low or very high incomes. Example. A family with a $15,000 income can not afford to spend 40% of their income on debt because 40% of $15,000 is = $6,000. That would leave only $9,000 for everything else. A family with a $200,000 income can afford to spend 40% on debt. 40% of $200,000 = $80,000, leaving them with $120,000 for everything else.

10 There is a huge difference between the quality of life that $9,000 will afford as opposed to $120,000. However, remember that we used Gross (before tax) income. Q. What are some of the things that the low income family will have difficulty paying for? A. Food, housing, clothing, etc.

11 Plan for the Future by: Matching Your Assets to Your Debts Q.What does the borrower consider when thinking about how to match borrowed money to they type of asset? The MATCHING PRINCOPLE IN FINANCE suggests that you should match the Useful Life of an Asset to the Length of the Loan Period. Houses can last hundreds of years but your earning power will likely be strong for 25 years, so real estate should have long term debt to match that considers the life of the asset and your ability to pay. Cars usually last 5-7 years before they require frequent maintenance and repairs, which is why car loans are usually 4-6 years on length.

12 Q.Would you like to still be paying interest on the original purchase of a house or a car after it begins to demand regular maintenance expenses? Q. Name a few expenses that you will encounter on a house or car and the number of years that those expenses will begin to occur?

13 House Roofing Shingles: 25 years. Furnace: 15 years Water Heater: years. Windows: 20 years Driveway: 25 years Brick mortar: 50 years Foundation: 50 – 75 years Central Air Conditioning: 10 years Paint and caulking: 5 years Car Tires: 60,000 km (3 – 5 years) Brakes: 30,000 km Oil Changes, windshield wipers: 5,000 km Brake lines: 100,000 km Small repairs: turn signals, window washing fluid, snow brush, floor mats, mirrors, etc.

14 Q.What does the lender consider when making a loan? A.How long has the money been loaned to them? B.How much money, in total, do they expect to have in their control, for each and every year, into the future. C.Matching the life of a loan to the life of the asset.

15 Q.Why do you think that the lender is so concerned with matching the length of the loan with the life of the asset? A1.If the asset has no value and the borrower decides to stop paying, the bank will not even be able to repossess the asset. They will not be able to resell it because it will have no value. A2.To maximize the period in which they charge interest and make a profit.

16 Credit Scoring (Review) Q. How else will a lender measure your reliability and the probability that you will pay back your loans? 1. Character – Do you pay bills on time? 2. Capacity – Can you repay the loan? 3. Capital – What are your assets and net worth? 4. Collateral – What property do you have to pledge that the lender can repossess if you default on the loan? 5. Conditions – What economic conditions could affect your ability to repay the loan?

17 Additional Information Q.What other information, about you, will they collect, to assess your credit worthiness? 1.Age 2.Marital Status 3.Annual Income 4.Number of Years at your current job 5.Do you own or rent your home 6.Age of your cars 7.Amount of money in your bank accounts 8.Current debt 9.Type and amount of investments you own 10.Whether you have declared bankruptcy before

18 In Class Quiz – Multiple Choice

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