Topic 4 Financing Strategies

Topic 4: Financing Strategies Learning Objectives – (a) Analyze the various sources of borrowing available to a client and communicate the advantages and disadvantages of each for meeting a client’s financial goals. – (b) Create a debt management plan for a client that minimizes financing costs and maximizes the potential to reach goals. – (c) Explain appropriate housing financing strategies.

Topic 4: Financing Strategies Through Various Life Cycle Stages First stage: starting out – Age Second stage: career building – Age Third stage: prime earning years – Age Fourth stage: wealth accumulation – Age Fifth stage: retirement years – Age 65+

Topic 4: Use of Debt Financing in the Financial Plan May be used as an effective or efficient alternative to saving over time or utilizing current investments Advantages of debt financing – Goals may be achieved more quickly without the need to save over time – Borrowed funds may earn a return greater than the cost of borrowing Disadvantages of debt financing – Costs, including interest and fees – Mandatory cash outflow to service the debt

Topic 4: Long-Term vs. Short-Term Debt Long-term debt refers to loans that allow the borrower multiple years to repay the account balance – Example – A 30 year home mortgage – Long-term debts should be used to purchase assets with a useful life at least as long as the term of the repayment Short-term debt refers to loans that require the borrower to repay the account balance within a few weeks or up to one year – Example - Credit card debt

Topic 4: Secured vs. Unsecured Debt Secured debt is backed by an asset – Example – Home mortgage Unsecured debt is not backed by any asset – Example – Credit cards Secured loans normally carry lower interest rates since they pose less risk for the lender than unsecured loans

Topic 4: Managing the FICO Score Scoring system used by lenders to assess a potential borrower’s credit risk Clients with higher FICO scores will receive better terms for debt financing, including lower interest rates Score ranges from 330 to 850 – Best rates are offered to those with scores of 760 or higher

Topic 4: Managing the FICO Score Five categories of information affect the score: – Payment history (35% of the score) – Amount of debt (30%) – Length of credit history (15%) – New credit (10%) – Type of credit (10%)

Topic 4: Efficient Debt Repayment Plans Pay more than the minimum required on the loan with the highest rate first, while paying the minimum on loans with lower rates When highest rate loan is paid off, allocate the total being paid on that loan toward the loan with the next highest rate See example in textbook page 4.9

Topic 4: Financing Decisions: Buy vs. Lease or Rent The choice between buying and leasing a home requires a consideration of all the cash outflows and inflows associated with each option and how those cash flows may change over the planning period – Buy a home Outflows include the down payment, closing costs, principal and interest payments, property taxes, all insurance costs, utilities costs, and maintenance expenses Inflows include tax savings due to deductibility of interest, points, and property taxes, possibly some rental income, and capital gains (less any taxes – see below) on sale of the house – Lease a home Outflows include the security deposit, rent payments, some insurance costs, and utilities costs Inflows include return of the security deposit and possibly earnings on savings if the lease payment is low

Topic 4: Mortgage Financing Determining the size of the down payment and financing closing costs Conventional vs. adjustable-rate mortgage (ARM) Home equity loan and line of credit Refinancing cost-benefit analysis Reverse mortgage

Topic 4: Mortgage Financing: Determining the Size of the Down Payment and Financing Closing Costs Cash required for obtaining a mortgage will include the down payment and closing costs Borrowing more than 80% of the value will result in the borrower paying for Private Mortgage Insurance (PMI) – Protects the lender in case the borrower defaults – Cost can range from $30 - $90 per month for each $100,000 of debt – PMI may be cancelled when the loan-to-value ratio falls below 80% Closing costs are typically between 3% and 5% of the purchase price – May be financed into the loan or paid with external funds – Consumer Financial Protection Bureau “Know Before You Owe” documents

Topic 4: Conventional vs. ARM Conventional mortgage – Has a fixed interest rate for the duration of the loan Adjustable-rate mortgage (ARM) – Has an interest rate that changes (only within limits and only at specified intervals) with changes in the level of interest rates in the economy – Typically carry lower initial interest than fixed-rate mortgages because of the additional risk the ARM homeowner takes on Cost of financing may be reduced by making biweekly payments

Topic 4: Home Equity Loan and Line of Credit The home equity loan or line of credit is a second mortgage taken on the home equal to some percentage, such as 80%, of the homeowner’s equity – Appraised value minus first mortgage balance Interest on first $100,000 of debt is tax deductible

Topic 4: Refinancing Cost-Benefit Analysis The decision to refinance is usually based on a comparison of the up-front costs (especially points paid) to obtain a new mortgage with the ongoing benefits provided by the lower interest rate in it – The primary motivation usually is to lower the monthly payments because of lower interest rates – See the example on page 4.18 of the textbook

Topic 4: Reverse Mortgage With a reverse mortgage, an owner (age 62 or older) of a home that is fully paid for receives periodic income from a mortgage lender for a period of years or for life – At the homeowner’s death, the lender can sell the home to generate the cash to repay the loan – Any proceeds remaining after paying off the loan go to the homeowner’s estate

End of Topic 4