Personal
Finance in
30 Minutes
Jean Walker, Director
West Texas Center for Economic Education
College of Business
West Texas A&M University
Credit & Debt
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How do lenders evaluate credit?
• What lenders really want to know is
“will you pay me back?”
• 5 “C’s” of credit:
–
–
–
–
–
Capacity
Capital
Character
Collateral
Conditions
(income vs. expenses)
(net worth = assets - debts)
(credit report)
(can be repossessed)
(economy as a whole)
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FICO Credit Score Calculation
Scores range
from 300 – 850
and are a
snapshot in time;
your score can
change in either
direction
depending on
your credit report
FICO Score Explanations
• Payment history – 35%
– Do you pay on time? (Most important component)
• Amounts owed – 30%
– Balance owed compared to available credit
• Length of credit history – 15%
– Length of time since first credit account was opened
• New credit – 10%
– Credit inquiries and recent account openings
• Credit types – 10%
– Mortgage, installment (auto), revolving (credit card),
and other – all of one type is bad
FICO Score Information Comes
from Credit Bureau information:
• 3 national credit bureaus:
– Equifax
– Trans-Union
– Experian (formerly TRW)
• Your credit file contains:
– Name, social security #, age, # of dependents, all addresses
– Employment & salary history
– Loans, credit cards, credit lines with payment history &
balances
– Public records: bankruptcies, tax liens, foreclosures, civil suits,
and criminal convictions
– List of those requesting your file
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Credit Bureaus:
• Who can see your credit report?
–
–
–
–
Potential issuers of credit
Potential employers
Insurance companies
Rental or leasing companies
• How long can they keep information?
– 7 years for most information
– 10 years for bankruptcies
• Before you apply for credit, know what is on
your credit report !!!
annualcreditreport.com gets you a free report from
each of the 3 credit bureaus yearly
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How much debt is too much?
• Debt safety ratio:
total monthly non-mortgage consumer credit payments*
monthly take home pay
Ratio shouldn’t be over 20%.
(10-15% is better!)
* Includes credit card debt, car payments, student loan debt, installment loans
for furniture, appliances,etc.
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Other debt ratios often used:
• Debt ratio:
total debt
total assets
(Financial planners would recommend 50% or less)
• Debt Service Coverage:
take-home pay
debt service charges*
•
Principal and interest on mortgage, car, furniture & appliance loans,
student loans, and other installment payments
(Financial planners would recommend a ratio of 3.0 or better.)
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How much debt is too much?
• Freddie Mac recommends that your monthly housing
expenses not exceed 28% of gross monthly income and
that your total debt payment, including housing
expenses, not exceed 36% of your gross monthly
income.
• Example:
•
•
•
•
Gross annual income = $48,000
Gross monthly income = $4000
House payment @ 28% x $4000 = $1120*
Total debt @ 36% x $4000 = $1440* – car pmts. & other installments
* prin. + interest + taxes + insurance
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Spending:
Homes - Cars - Insurance
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Cost of Home Ownership
• Down payment
– Loan to value ratio (80% means 20% down)
– Conventional loan requires 20% down
– Special program such as FHA loans can
reduce down payment to as little as 3-5%
• Requires PMI (property mortgage insurance) if
loan to value ratio is more than 80%
Cost of Home Ownership:
• Mortgage payment
• PITI
–
–
–
–
Principal
Interest
Taxes (property taxes)
Insurance
• Example:
$100,000 mortgage, 5% interest, 30 years
- 100,000
PV
360
N
.4166*
i
CPT PMT = $536.77 (This is prin. & int. – add about $200 for taxes and insurance.)
* 5% / 12 = .4166
Using a BAII+ Texas Instruments Financial Calculator
Cost of Home Ownership:
•
Example: $100,000 mortgage, 5% interest per year, 30 years
- 100,000
PV
360
N
.4166*
i
CPT PMT = $536.77
(Taxes & insurance still must be added.)
• Total amount paid for house:
– $536.77 x 360 months = $193,237.20 Total
– Amount of interest:
$193,237.20
– $100,000.00
$93,237.20
Total
Principal
Interest
Cost of Home Ownership:
• Example: $100,000 mortgage, 5% interest per year, 15 years
- 100,000
PV
180
N
.4166*
i
CPT PMT = $790.75
(Taxes & insurance still must be added.)
• Total amount paid for house:
– $790.75 x 180 months = $142,335.35 Total
– Amount of interest: $142,335.35 – $100,000 = $42,335.35
Int.
How rates affect the payment:
•
$100,000 mortgage, 5% interest per year, 30 years
- 100,000 PV
360N
.4166i
CPT PMT = $536.77
•
$100,000 mortgage, 4% interest per year, 30 years
- 100,000 PV
360N
.3333i
CPT PMT = $477.39
•
$100,000 mortgage, 6% interest per year, 30 years
- 100,000 PV
360N
.5
i
CPT PMT = $599.55
Car buying mistakes:
• Don’t buy a NEW car !!!
• Consider this:
– A new car loses 45% of its value in the first 3 years!
– A car 3 years old is still a very good car – a used car is a
much better buy.
• Don’t try to lower payments by extending the
number of payments !!!
– You eventually become “upside down” and owe more
against the vehicle than it is worth.
• If you can’t afford the payments, sell the car.
– Letting a lender repossess a car severely hurts your credit.
• Don’t believe “you are what you drive” !!!
Car insurance buying mistakes:
• Liability insurance is required by lenders.
• Buy more liability than Texas minimums:
–
–
–
–
Texas minimum: 30/60/25
$30,000 for each person injured or killed
$60,000 total for all people injured or killed
$25,000 for property damage
• If your minimum policy limits don’t cover
costs, you can be sued.
– Current and future wages can be garnished to
satisfy a civil judgment
Buying Life Insurance:
• Whole life vs. term life insurance
– Whole life accumulates cash value.
• The premium stays the same and is higher to begin with.
– Term is only insurance, not an investment.
• The premium rises over time.
• Why is term insurance the best choice?
– Term is cheaper—you can get more insurance for a lower
premium.
– The cash value on whole life doesn’t earn a high enough rate
of return to be a good investment.
• Do not buy life insurance on a child.
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Saving &
Investing
Retirement As An Example
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Why do people have too little
retirement income?
• They start too late
• They put away too little.
• They invest too conservatively.
They start too late:
• Saving $5000 per year:
–
–
–
–
$5000/year for 10 years @ 6% = $ 65,904
$5000/year for 20 years @ 6% = $183,928
$5000/year for 30 years @ 6% = $395,291
$5000/year for 40 years @ 6% = $773,810
They save too little:
• Savings per year:
–
–
–
–
$2000/year for 40 years @ 6% = $309,524
$3000/year for 40 years @ 6% = $464,286
$4000/year for 40 years @ 6% = $619,048
$5000/year for 40 years @ 6% = $773,810
They invest too conservatively:
• Saving $5000 per year at 10%:
–
–
–
–
$5000/year for 10 years @ 10% = $ 79,687
$5000/year for 20 years @ 10% = $286,375
$5000/year for 30 years @ 10% = $822,470
$5000/year for 40 years @ 10% = $2,212,963
Saving andRealized
Investing for
Higher
Selected
Returns,
Returns
(1926-2010):
1926
– 2009
Average Standard
Small-company stocks
Large-company stocks
L-T corporate bonds
L-T government bonds
U.S. Treasury bills
Return
16.6%
11.8
6.2
5.8
3.7
Deviation
32.8%
20.5
8.3
9.6
3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2010 Yearbook
(Chicago: Morningstar, Inc., 2010), p23.
Final Points
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Handling problems paying debt:
• 1st contact the issuer of credit
– Extension
– Payment plans
• Debt consolidation (home equity loans)
• Credit counseling (CCC)
– Many churches and other organizations do credit
counseling
– Others advertising to do “credit counseling” are
often for-profits who take a fee and don’t help
very much
• Bankruptcy
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Bankruptcy
• Can’t discharge:
–
–
–
–
–
Student loans
Alimony or child support
Taxes to the IRS
Debt taken on in anticipation of bankruptcy
Certain suits for damages
• Chapter 7 – straight bankruptcy
– All debts discharged
• Chapter 13 – wage earner plan
– Must use this plan if your income is equal to or more than the median
household income in your state ($49,646 in Texas currently)
– You eventually pay off all debts, but you have an extended time to do it
and your creditors can’t sue you in the mean time
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jwalker@wtamu.edu
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