Debt

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 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
Risk and Leverage

• The higher the debt, the higher the households
  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
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
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
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
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
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
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
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
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
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.

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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
Mortgages, cont.
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
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
Types of Mortgages, cont.

• Summary of mortgage characteristics

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
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
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
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
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 months 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
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
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
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
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
  associations 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
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
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 doesnt, the loan can be considered
  a gift, and the borrower will not be able to
  deduct the interest paid.

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
Overall Procedure, cont.
45
Overall Procedure, cont.
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
Credit Reports

• Credit reports The factual printout and
  evaluation of a persons 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
Credit Reports, cont.
49
Credit Reports, cont.

• Steps that can improve your credit score

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
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
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
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
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
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
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
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
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
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
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.