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1 Chapter 7 Debt. 2 Chapter Goals Develop debt strategies. Understand the many facets of debt. Calculate and comprehend the rates charged on loans. Identify.

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Presentation on theme: "1 Chapter 7 Debt. 2 Chapter Goals Develop debt strategies. Understand the many facets of debt. Calculate and comprehend the rates charged on loans. Identify."— Presentation transcript:

1 1 Chapter 7 Debt

2 2 Chapter Goals Develop debt strategies. Understand the many facets of debt. Calculate and comprehend the rates charged on loans. Identify the factors that enter into selecting credit. Evaluate a fixed versus a variable rate mortgage. Specify the advantages and disadvantages of a credit card loan. Interpret debt financial ratios.

3 3 Risk and Leverage The higher the debt, the higher the household’s risk. People who have too much debt are said to be overleveraged. Operating risk arises from uncertainties in connection with household activities. Financial risk comes from the amount of debt outstanding relative to your assets.

4 4 Risk and Leverage, cont. Operating leverage is the degree to which you have fixed costs in your budget that come from household operating functions. The greater the percentage of your non-discretionary costs, the greater your operating leverage. When you have high fixed costs, a modest increase or decrease in your income can have a material impact on your free cash flow.

5 5 Risk and Leverage, cont. Financial leverage arises from the amount of debt outstanding and its contribution to household fixed costs. The greater the amount of your interest expense and debt repayment commitments, the greater your financial leverage. When you have high fixed financial costs, a change in your income can have substantial effects on your free cash flow.

6 6 Financial Leverage and Returns Financial leverage can increase potential rewards for the household. Many first time homebuyers undertake significant financial leverage by making an expensive purchase of a dwelling. Should the home subsequently rise sharply in price, that financial leverage can enable the member- owners to make a high return on their household investment. Undertaking additional debt has two effects: It not only raises risk; it also increases potential returns.

7 7 Financial Leverage and Returns, cont. The amount of money a household borrows depends on: – The cost of borrowing in relation to the returns received. – The owners’ risk profile. The higher the tolerance for risk, the greater the amount of debt it will be willing to borrow.

8 8 Financial Leverage and Returns, cont. Debt borrowed for items that increase household cash flows may be less risky. These cash flows provide resources to support future household operations. unless it led to significantly higher cash flows. When expectations of materially higher future income are not realistic, substantial borrowing over a period of time to maintain or increase the household's current life style is generally not considered desirable. Therefore, an ongoing pattern of borrowing for such things as a vacation or fashion-right clothing may best be put off until it can be financed internally.

9 9 Determining Simple Interest Rates Interest rate: The cost for money borrowed. To calculate the real interest rate, you need to know the time period for the loan and the actual amount of money that is made available. Consider the following case: – A $5,000 loan. – A $600 yearly cost to borrow. – A one year investment.

10 10 Determining Simple Interest Rates, cont. If the interest is paid at the end of the period, then: If the interest is paid at the beginning of the period, then:

11 11 Determining Simple Interest Rates, cont. Under an installment loan, repayments may be made in equal sums throughout the year. Assuming a one-year loan retired in 12 equal monthly installments of interest and principal of $466.67, the cash available would decline by that amount per month. The interest cost can be approximated as follows:

12 12 Determining Simple Interest Rates, cont. The actual cost can be calculated in the following manner: Inputs 12 5,000 -466.67 Solution 1.7882 Press i =1.7882% (Monthly interest) Annual interest =1.7882 × 12 months = 21.5% The actual annual rate is 21.5%. NI/YPVPMTFV

13 13 Determining Simple Interest Rates, cont. The annual percentage (APR) rate must be given to borrowers under a federal law that requires lenders provide an effective interest rate on consumer loans and the total amount of finance charges. The APR includes all defined costs such as closing fees, points, and appraisal fees on mortgage loans on a time-weighted basis. It serves as a useful method for comparing costs on loan alternatives.

14 14 Sources of Debt The broader availability of credit cards and home equity loans has resulted in greater credit availability to a wider cross-section of households. Two sources of debt are as follows: Closed-end retail credit is generally limited to a specific loan with a specific repayment schedule. – Example: an auto loan. Open-end credit provides a loan limit, which can be utilized for multiple purchases over a period of time. – Example: credit card loan.

15 15 Interest Rates Charged by Lenders In theory, lenders should present an array of interest rates with the rate offered appropriate to the risk of non-payment that the individual household presents. Instead there often appears to be one interest rate offered per lender. Loan applicants are placed into two risk classes, with one rejected and the other accepted. There is some indication that for certain types of loans, the interest rate charged may not be highly sensitive to changes in market rates.

16 16 Types of Borrowers Unrationed borrowers have sufficient internal cash flow and assets to be able to select the loan maturity offering the most attractive rates. When rates change, their decisions on amount, type, and repayment period for credit may change. Rationed borrowers are short of internal cash flow and would like to borrow more credit at comparable interest rates than is available. These borrowers may have to take any payment terms offered.

17 17 Credit Standards A number of items are used to assess whether credit should be extended to a household; these include: – The amount of income earned, – The amount of debt outstanding, – The history of timely repayments of debt owed, and – Whether the loan is secured.

18 18 Outcome The outcome is that households often have a variety of borrowing alternatives at various interest rates. The ultimate selection is generally to take the lowest cost alternative. For example, a home equity loan may be used to finance the purchase of a car instead of an auto loan. As the amount of debt increases, the household will qualify for fewer loan alternatives and the cost of credit will increase. At some point, the cost of credit discourages further borrowing, or it can reach the government- sanctioned limit of a 24 percent annual rate.

19 19 Long-Term vs. Short-Term Debt Short-term debt is money owed that is payable in a relatively brief period. For accounting purposes it is debt due within the current year, while in investment usage it is debt payable within three years. Examples of short-term debt are general credit card debt and credit extended by particular stores.

20 20 Long-Term vs. Short-Term Debt, cont. Long-term debt involves financial obligations whose terms call for final payment to be made many years from now. While for accounting purposes it is any debt not due in the current year, it can be thought of as debt payable in four years or longer. Examples are home mortgages, bank debt, and other loans such as those from friends and family members.

21 21 Secured vs. Unsecured Debt Secured debt is borrowing that has a separate asset serving as collateral. Examples of secured debt are a mortgage and an auto loan. Unsecured debt is borrowing whose repayment is based solely on the full faith and credit of the debtor. Examples of unsecured debt are credit card debt and student loans.

22 22 Mortgages Mortgages: Loans secured by real property. Income tax deductions are allowable for up to $1 million of debt for the purchase of a house and up to another $100,000 in loans for any other purpose. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) buy mortgages from lenders. The Government National Mortgage Association (Ginnie Mae), guarantees payment for buyers of bonds. The Federal Housing Authority (FHA) and the Veterans Administration (VA) insure selected mortgages against default.

23 23 Mortgages, cont. As a borrower you would go through the following process in making a loan: The Loan Application: Includes factors such as current job, current income, bank accounts, and assets owned. Assessment of the Borrower: Factors include household income in relation to size of loans; household assets, particularly marketable ones; other debt outstanding; and credit history. Home Appraisal: The appraised valuation is based on the current market value.

24 24 Mortgages, cont. Commitment: The lender agrees to supply the agreed-upon sum to the borrower. Generally, the interest rate on the loan is not set until closing unless an additional sum is paid to lock it in. Other: Other factors include: – The buyer will inspect the home. – A title search and title insurance will be implemented. – The realtor receives a commission. – Attorneys coordinate the process. Closing: All parties meet, and all terms are set per contract including the interest rate, which is based on market factors at the time. The contract is signed, and title is passed to the buyer.

25 25 Mortgages, cont. Points are fees paid to the bank to cover their administration fees. Borrowers are often allowed to reduce the interest cost on the loan by selecting the number of points they will pay at the time of closing. The greater the points, the lower the interest rate will be; sometimes there will be a one-quarter point decrease in rate for each point paid at the time of closing. These points can be tax deductible in the year the house is purchased for first-time financing of a home. Otherwise, it is deductible in equal amounts over the life of the mortgage.

26 26 Mortgages, cont. The vast majority of mortgage loans are amortizing loans as is true of most long-term consumer debt. This means both interest and principal are paid off over time. At the beginning of the term of the loan the largest part of the payment is interest. Toward the end of the mortgage the overwhelming amount is usually applied to repayment of principal: The most common period for mortgages is fifteen or thirty years.

27 27 Mortgages, cont. For example, if: Mortgage amount: $200,000 Annual Interest rate:7% Monthly Interest rate:0.5833% Loan term (in years):15 Loan term (in months):180 Monthly payment:$1,797.66 Annual payment:$21,571.88 Then the payments are as follows:

28 28 Mortgages, cont.

29 29 Prepayments on Mortgage Debt Prepayments of mortgage debt can be considered by any household generating the necessary cash flow to do so. The after-tax interest cost on the debt retired should be compared with the after-tax return on investment alternatives. Prepayment and the investment alternative should have approximately the same risk, or the returns should be adjusted for difference in risk. Paying off debt can reduce the amount of money available in the event of an unforeseen need for cash. This is liquidity risk.

30 30 Types of Mortgages Fixed rate mortgages: Mortgages whose interest costs remain stable over time. Because interest rates don't fluctuate there is no interest rate risk for the borrower. Adjustable rate mortgages: Mortgages whose interest rates to the borrower fluctuate yearly based on overall market rates of interest at the time. Based on a benchmark rate of interest. To compensate for assuming the risk of fluctuations in interest rates, the borrower receives a lower rate.

31 31 Types of Mortgages, cont. Summary of mortgage characteristics:

32 32 Refinancing Refinancing is most often exercised by holders of fixed rate loans. Holders of adjustable rate loans may also switch to a fixed rate loan if they expect rates to rise. To determine whether it is profitable to refinance, the savings in interest cost over the term of the loan held is compared against the current outlay for refinancing. Refinancing costs including points, lawyer, title insurances, and so on are significant. In calculating the cumulative savings from refinancing, the possibility of selling the home and repaying the mortgage prior to the end of the mortgage period should be incorporated.

33 33 Home Equity Loans Home equity loan: A loan that is secured by the house you own. In the event of non payment, the lender gets the proceeds left after the first mortgage is paid off. Because of this higher risk the interest charged will be higher than that on a first mortgage.

34 34 Home Equity Loans, cont. When give the choice to borrow through a home equity loan or refinance the first mortgage for a larger amount, two relevant factors are: The interest rate on the mortgage outstanding; and The amount by which the interest rate on the proposed home equity loan exceeds the current market rate on a new first mortgage. It is often best to take out a home equity loan when the rate on your existing first mortgage is well below the market rate and the total sum of the original mortgage is large relative to the total amount of housing debt that will be outstanding after the additional borrowing.

35 35 Home Equity Line of Credit A home equity line of credit (HELOC) allows you to draw down part or all of a maximum amount as you wish, and is a second mortgage. Advantage: The flexibility to take out only what you need and the ability to pay just interest not principal for an extended period of time. Disadvantage: Potentially higher level of interest, and the lender can withdraw the line of credit periodically. A HELOC is similar to a credit card which is secured by your home.

36 36 Credit Card Debt Credit card debt is the most common form of consumer loan debt in the United States. Credit card debt typically comes from purchasing consumer goods, although withdrawals for cash are permitted. If repayments are made within a grace period, say 25 days, no interest is charged. Thereafter, monthly interest is charged using varying methods that may be based on the previous month’s closing balance or those sums outstanding, which more accurately reflect payments during the month. Interest on credit cards is often offered at a high rate relative to interest on other consumer loans.

37 37 Credit Card Debt, cont. Many advisors view credit cards as an “evil lure,” tempting people to spend more than they should and then charging them double digit rates that can make it difficult to repay the loan. But credits card are popular as: – They are convenient, – Can be used to even out flows of expenditures without disrupting normal income and savings patterns, and – Can be employed as an alternative to holding larger cash balances. Further, bank loans are more costly than credit card debt for amounts under a few thousand dollars when fixed costs and transaction costs are included.

38 38 Margin Debt Margin debt: Money, generally offered by securities dealers, to help finance purchase of marketable investments such as individual stocks, bonds, and mutual funds. The securities serve as collateral. The Federal Reserve sets the maximum at 50 percent of the fair market value of the securities on margin upon original purchase and 50 percent of the value of the collateral on an ongoing basis. Margin rates are relatively low due to liquid collateral. Margin debt for investment purposes is tax deductible up to the interest and dividend income for the year. The interest expense that is greater than this income can be carried forward to the next year.

39 39 Other Secured Debt A loan that is secured by a valuable asset can have a relatively low rate. That asset can be liquidated by the lender to pay off the loan in the event of nonpayment. For example, in assessing auto loan rates, a credit subsidy by the manufacturer or dealer should be separated from interest rates for this type of loan. The rate can be a disguised discount on purchase of the automobile. When a cash purchase has no benefit for discount purposes, the subsidized interest rate can be very competitive.

40 40 Bank Loans, Credit Unions, Pension Loans Bank loans can be made for purposes other than purchase of a home. They come in many forms and are either amortized over the life of the loan or are due by a specific date. Credit unions are set up by individuals or companies who lend money to their members. The association’s non profit status, the absence of marketing expenses, and, often, the above-average credit quality of its members may make these rates competitive. A loan against 401(k) or other pension assets can be taken if the employee plan permits it.

41 41 Life Insurance and Other Market Loans The cash value of life insurance policies can be borrowed. Repayment terms are less stringent than for pension plans. Other market loans include those from retail establishments to purchase their goods, from consumer finance companies to receive cash, and from pawnbrokers who require assets deposited as collateral.

42 42 Educational Loans and Loans from Relatives and Friends College loans are often made based on need. The rates on these loans granted by the federal government or the college attended by full-time students can present an attractive alternative for those who qualify. Mandatory payments are set up once income- producing activities begin. Loans from relatives and friends can be a significant source of financing. The loan must contain a market-related interest rate. If it doesn’t, the loan can be considered a gift, and the borrower will not be able to deduct the interest paid.

43 43 Overall Procedure Once the money has been borrowed the interest expense is generally considered a non-discretionary cost in the cash flow statement, regardless of the purpose of the loan. A summary of the relevant characteristics of loan alternatives is presented in the following slide.

44 44 Overall Procedure, cont.

45 45 Overall Procedure, cont.

46 46 Contingent Liabilities Contingent liabilities are potential cash outflows dependent on the occurrence of a possible event. For example, if you cosign for a loan with others, you will be obligated if they default. When the likelihood of payment is high or the exposure very large and not covered by insurance or other practices, the amounts should be incorporated in debt considerations.

47 47 Credit Reports Credit reports: The factual printout and evaluation of a person’s creditworthiness. Creditworthiness is developed using a scoring system. The higher your score, the more likely you are to receive credit and, in some cases, the lower will be the interest rate. The system developed by Fair Isaac Co. (FICO) is used by the major credit bureaus, Equifax, Experian, and Trans Union, to develop credit scores. The factors considered in scoring by the companies include:

48 48 Credit Reports, cont.

49 49 Credit Reports, cont. Steps that can improve your credit score:

50 50 Financial Difficulties Financial difficulties: Problems in simultaneously supporting normal household operations and paying interest and principal on debt owed when due. When a cash flow problem is just temporary, a partial liquidation of investments or a consolidating loan may be enough. Under a consolidating loan, the proceeds from one lender are used to repay many loans, such as debt outstanding from a variety of credit card sources. When the problem is more fundamental, either an additional source of revenues or a cutback in overall expenses must be implemented. Often it is helpful to restrict the use of credit cards.

51 51 Bankruptcy Bankruptcy is a way for people to lessen or eliminate the burdens of debt. Two forms of personal bankruptcy: – Chapter 7: All existing debts are wiped out. – Chapter 13: Provides an extension in time to pay off debts and frequently a reduction in the amount of obligations. Although income taxes survive after bankruptcy, penalties for late payment of them are not imposed under Chapter 13. A bankruptcy proceeding is supervised by a bankruptcy judge and involves a private trustee appointed by a U.S. government trustee from the U.S. Justice Department.

52 52 Bankruptcy,cont. Whether you will be able to keep your possessions will depend on the state you live in and whether assets are secured. In the event of default the creditor often has a legal right to that asset regardless of bankruptcy. If loans are in good standing, the asset cannot be repossessed by that creditor. As a practical matter, few homes, cars, or other relatively inexpensive possession are said to be repossessed in bankruptcy. In 2005 the Federal Government passed the Bankruptcy Abuse Prevention and Consumer Act of 2005. The result of this Act is expected to make it more difficult to file for bankruptcy.

53 53 Bankruptcy,cont. Advantages of debt: – Relief from financial burdens. – Elimination of worry and calls from creditors. – Can stop removal of some assets. Disadvantages of debt: – Some assets may be taken. – Social stigma of bankruptcy. – Can result in rejection from a new job, though illegal. – Can contribute to poor self image. – A guarantor of your debt will be personally liable. – The money for repayments one year prior to bankruptcy will have to be turned over to the trustee. – Bankruptcy involves costs including legal fees.

54 54 Financial Ratios Mortgage Cost as a Percentage of Income: Lenders often use a 28 percent benchmark as a percentage of gross income as the limit to which they will extend credit. The rate may be adjusted upward depending on circumstances such as living in a high cost area such as the Northeast or the West Coast.

55 55 Financial Ratios, cont. Installment Debt as a Percentage of After-Tax Income: Keeping such debt under 20 percent of so-called take-home pay is often desirable - and a 15 percent limit even more attractive. These benchmarks are particularly relevant when there are other types of debt outstanding such as mortgage debt.

56 56 Financial Ratios, cont. Total Debt as a Percentage of Income: Total debt payments should be under 50 percent of net salary. Where investment income is a substantial contributor to cash flow, it may be added on an after-tax basis to net salary.

57 57 Financial Ratios, cont. Debt Coverage Ratio: The higher the ratio, the safer the household is against negative unexpected occurrences. The ratio adds back after-tax interest payments since both pretax interest and its effect on lowering taxes were deducted to arrive at cash flow from operations.

58 58 Financial Ratios, cont. Debt as a Percentage of Total Assets: The ratio should decline over time since as people age other assets should accumulate, the home should appreciate, and the mortgage should be drawn down. If debt payments become onerous, securities could be sold to help repay the debt. For people who are middle-aged or older, a debt figure of less than 50 percent of total equity may be desirable.

59 59 Financial Ratios, cont. Current Ratio: The use of credit card debt as an alternative to having high precautionary liquid savings has somewhat lessened the importance of this ratio.

60 60 Chapter Summary Two types of leverage are financial and operating. Mortgages which are a relatively low cost way to obtain funds, come in fixed and variable rate forms. Credit card debt can actually be a favorable way to obtain funds, but too often it is used inefficiently. Consumer protection laws require safeguards and also mandate disclosures that can assist in maintaining favorable credit ratings. Bankruptcy is an alternative that creates opportunities but also has substantial negative ramifications. Financial ratios provide objective benchmarks of financial health with regard to debt levels.


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