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 18 - 25
• Second stage: career building
– Age 25 - 40
• Third stage: prime earning years
– Age 40 - 55
• Fourth stage: wealth accumulation
– Age 55 - 65
• 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