Consumer Finance Outline
Lindenwood College
Winter 2010
Kevin C. Kaufhold, Adjunct
IBA32030 Consumer Finance
This course surveys the economic factors and personal decisions that affect financial wellbeing: cash
and credit management, taxes, major expenditures, insurance, investments, and retirement and estate
planning. Emphasis is on practical knowledge for personal financial management and serving customers
of the banking, brokerage, insurance, and other consumer finance industries.
For Quiz 1
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Chapters 1 – 5 will be on the quiz
For Quiz 2
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Chapter 6 – 7 will be on the quiz
1 Question will also be an annuity of either PV or FV
For both the Consumer Finance and Investment portion of the quiz, can have 5 x 7 card for math
equations ONLY – no other items than math equations are permitted on the cards
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Chapter 1 – Financial Planning Process
Rewards of Fin Planning
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Improve Standard of Living
o necessities, comforts, luxuries
o Organizational Planning Model – fin. Plans → fin actions → fin results
Spending money wisely
o Current needs vs future needs
 Consumption vs savings
 Consumption today vs deferred consumption thru savings today and consuming
tomorrow
o Average propensity to consume --- % of each $, on average, that is spent on consume rather
than savings
o Can money buy happiness?
 Economists --- wealth increases utility
Accumulating wealth
o Wealth = total value of all items owned
 Both real and personal and wherever situated
 Could be financial assets (stocks, bonds, etc)
 Could be tangible assets (RE; cars; )
Personal Financial Planning Process
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Steps in the process
o Planning process is a systematic process that considers impt aspects of a person’s financial
affairs in order to fulfill financial goals
define financial goals
o Role of money
 Money is the medium of exchange used to measure value in fin transactions
 Utility is the amount of satisfaction received from having goods and services
o Wealth has psychological aspects to it --- emotion, personality, self-image
 Assumption of rationality in economics --- is this a good assumption?
 Types of people -- Spender (money for consumption)
 Builder (money is a tool)
 Giver (charities; volunteers)
 Saver (money for wealth building)
Identify & Develop Financial goals
o Be specific; should be realistic and attainable
o Involves entire family
Target Dates on Financial Goals
 ST / NT goals
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 Find a job S(ST)
 Repay student loans; buy a car (NT)
LT goals
 Begin investing (LT)
 Buy a house (LT)
Worksheet I (page 14)
From Goals to Plans
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Life cycle of financial planning
o Very good Graph at page 16 on life cycle
 Asset accumulation
 Liability / insurance planning
 Savings and investment planning
 Growth of $1000 over time (8% and 10%) graph at 17.
 Employee benefits
 Tax planning
 Retirement planning
 Estate planning
Special Areas
o Two incomes
o Employee benefits
 Health, life, dib, LT care, pension, dental, vision, child care
o Adapting to life changes
 Marriage; children; death of spouse; divorce
Financial planners
Planning Environment
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Figure at 28
Parties (legal) / Agents (economic)
o Government --- taxes, regulation, services
o Business --- output --- make goods and services; inputs --- land, labor, capital
o Consumers --- buy products from businesses
Economy
o Business cycle --- expansion, recession, depression, recovery
 Bus cycle graph at page 30.
o Inflation
 CPI; purchasing power
What Determines Personal Income ?
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Demographics
o Age, education, location, career
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Chapter 2 – Financial Statements & Plans
Personal Financial Statements
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These are balance sheets and income and expense sheets
Balance sheet is develop the financial position at any one point in time
Income and expense sheet measures financial performance over time
Budgets are forward looking
Balance Sheet
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How much are you worth today? P. 43 EXAMPLE
Assets
o Liquid assets – cash
o Investments
o Real prop
 Fair market value appraisal
o Pers prop
Liabilities
o ST or current liabilities (due within 1 year)
 Open account credit obligations --- current liab from credit lines
o LT liabilities (due beyond 1 year)
Net worth
o A – L = net wroth
o If NW > 0, equity exists; if NW < 0, insolvency
o Net worth over time --- graph at 45 (becomes the life cycle graph from chapter 1)
Preparation
o Assets at FMV as of date of preparation of balance sheet
o List ALL Current and LT liabilities
o = net worth
Income and Balance Sheet
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This is a cash basis, showing actual cash receipts statement on p. 48
Income and expense patterns change over the life cycle
Income
o Wages, salaries, bonuses, interest
o Cash in
Expenses
o Cash out
o Fixed expenses – predetermined K types
o Variable expenses --- amounts change form period to period
I – E = Cash surplus or deficit
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Breakdown of expenses pie chart p. 49
Preparation
o Income from all sources during the period
o Establish meaningful expense categories --- line items are not fixed in stone
o I – E = surplus or deficit
Use of the Financial Statements
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Keeping good records
Organization of records
Ratio Analysis
o Solvency ratio = NW / total assets
o Liquidity ratio = liquid assets / current liabilities
o Savings ratio = cash surplus / income after taxes
o Savings ratio = cash surplus / NI (after taxes)
o Debt service ratio = monthly loan payments / before tax income
Budget
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Worksheet p. 58
Purposes
o maintain nec info
o decide how to allocate income
o implement disciplines spending program
o reduce needless spending
o achieve fin goals
cash budget --- cash basis
estimate income over time
estimate expenses over time
if in deficits --o if deficit in some months, try to balance cash flows by payments evenly done
o uses savings, investments, or borrowing to cover temporary deficits
o liquidate S and I or loan enough to meet shortfall
o reduce / eliminate low priority expenses from budget
o increase income
money in action box
o enroll in 401 k
o raise car ins deductable (on older cars)
o pay of credit cards
o reduce energy costs
o budgeting TV, phones, internet
o ETC
Budget control schedule WORKSHEET p. 63
o Compares actual income with expenses across budget categories
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Time Value of Money
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A dollar today is worth more than a dollar received in the future
Time line
Simple interest
Compounding --- interest added to interest
Principle of discounting (to present value)
FV is the amount of money your savings will be worth at a future point in time when interest is
added;
PV is the value of money today that a future amount represents.
Rule of 72
o How long does it take to double your money?
o # of years = 72 / annual compound interest rate
Annuity stream = amount each year (even and equal CF)
As a perpetuity, PV = CF / r; PV = CF / 1+r
Then, into the future a defined number of years (or periods), PV = FV / (1 +r)N
o FV = amount * FV factor
 FV factor is Appendix A, p. 543
 FV = PV * (1+r)
 FV = PV (1 = r)N
 FV, On calculator --o PV = 1000
o N=5
o Y = 10
o Pmt = 0
o Cmpt FV = 1,610.5
 For FV Annuity stream with even CF
 Yearly Savings = amount of money desired / FV annuity factor
- FV annuity factor is Appendix B, p. 543
- FV = A [((1+r)N – 1) / r],
 FV annuity income stream on calculator --o PV = 1000
o N=5
o Y = 10
o FV = 0
o CMPT PMT = 263.79
o PV = FV * PV factor,
 PV factor is found at Appendix C, p. 544
 PV = FV / 1+ r
 PV = FV / (1+r)N
 PV on Calculator
o FV = 1610.5
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o N=5
o Y = 10
o PMT = 0
o PV = 1000
- PV annuity stream even CF, Appendix D, p. 544
o Annual withdrawal = initial deposit / PV annuity factor
PV = A [((1 – (1 / (1+r)N) / r]
PV = CF / 1+r + CF / (1+r)2 + CF / (1+r)3 ….
PV = ∑ (CF / (1+r)N)
 PV on calculator
o FV = 1610.5
o N=5
o Y = 10
o 263.79
Note: PV, FV, and Annuities on PV and FV are summarized in a separate outline on Time Vlaue of
Money.
o Three methods are enumerated (appendixes, financial calculator, equations)
o All four items of PV, FV, annuity PV, annuity FV are also enumerated
o Can use any method to calculate
o All four items are testable
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Chapter 3 – Taxes
Federal Tax Principles
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Taxes fund federal governmental activities.
> 1/3 of gross income in taxes
Goal of tax planning --- LEGALLY minimize the taxes you pay
Federal tax is principally on income (import tariffs, etc also exist).
Income tax is progressive in nature
Marginal tax rate is the rate of taxes on the next dollar earned
Average tax rate is the rate for your entire income
Filing status --- single; married filing jointly / filing separately; head of household; widows
Federal withholding taxes are the amount withheld from the employee’s paycheck
o FICA tax is SSA; employer has a share and e/e have a % share (2008 7.65% each)
o Applies to only a certain amount ($102K in 2008)
Taxable Income
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Not all income is taxed, only the portion that is considered taxable
Subtract deductions and adjustments
o Exhibit 3.1, p 80 has chart that goes from gross income to taxable income to tax liability
Gross income includes wages, bonuses, interests, dividends, alimony, pension income, etc
Active, passive, portfolio income
o Passive is defined as RE, LP, etc
o Portfolio income is usually in the form of dividends and bond interest
 Can also be from capital gains
 Capital gains is taxed at different rates and are flat
 Page 82, exhibit 3.2
Adjustments to gross income
o Educational costs
o IRA contribution
o Alimony, etc
AGI = gross income - adjustments
Then, deductions
o Standard deduction --- filing status, age (can range from 5450 to $15,100)
o Itemized --- medical costs, theft losses, job and moving expenses
o Use whichever way is greater.
Then, Exemptions
o Deductions from AGI
o Can claim exemptions for himself, spouse, dependents
o Exemptions are phased out for high incomes
Then, calculate tax rates --- tax rate schedules
Tax credits reduces taxes due (not taxable income)
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o And thus are very valuable
o Adoption credit
o Elderly / disability
o Mortgage interest
o Qualified electric vehicle
Avoiding common tax errors (p. 91)
Other Considerations
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Can estimate taxes due and pay on schedule
This is for situations where insufficient withholding occurs to cover all tax liability (interest income,
etc)
Filing estimated taxes to avoid tax penalty
Filing deadline on April 15
Can file an extension for 6 months
Can also file amended return if prior year income or expenses are received or paid in current year
Tax audits
Tax planning
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Tax evasion
Tax avoidance
Maximize deductions
Income shifting --- move income to custodial accounts and other lower income levels
Tax deferred income (retirement types)
Tax free income (ROTH IRA)
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Chapter 4 – Cash Management
Role of Cash Management in Financial Planning
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Cash management is the daily administration of cash and near-cash resources (liquid assets)
Liquid assets include
o cash,
o checking accounts,
o savings accounts,
o money market,
o CD,
o US T bill,
o US savings bond
Financial Services Marketplace
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Depository financial institutions --- banks, S&L, credit unions
o Deposit insurance exists against failure of institution
o FDIC (banks and S&L); Natl Credit Union Admin (credit union)
o $250,000 per depositor (not per deposit account)
o Need to have accounts at two different banks if deposits > 250K
o Can have more than one name (i.e. spouse; trust; Keugh)
Non-deposit financial institution – stock brokerage, mutual funds,
Descriptions
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Checking accounts is a demand deposit; pays no interest usually; service charge waived with a
minimum
Savings accounts are time deposits; interest payable, ranging on amount in account
o Many withdrawals are immediate
Some interest bearing checking accounts
o NOW accounts (neg order of withdrawal) (checking with interest)
o Money market deposit accounts –
 federally insured;
 sometimes ATM and checking privileges
o MM mutual funds
 Pay above saving accounts because they can invest in US treasuries, corporate
ST notes, etc
 Checking privileges
 But are NOT insured (breaking the buck in the recession)
asset management accounts (AMA)
o usually offered by brokerages and mutual funds
o combines checking, investing, borrowing; have ATM privileges
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o but do not have branch type activities, being issued from a brokerage or mutual
Electronic Banking Services
o Electronic Funds Transfer System (EFTS) Can transfer funds electronically
o Debit cards – allow xfr from bank acct to business acct to pay for goods & services
o ATM’s
o Automatic deposits and payments (SSA deposits; utility payments)
o Bank by phone accounts
o On-line banking services
 Pros and cons (p. 120)
o Regulation of EFTS Services (p. 121)
Safety deposit boxes
Maintaining Checking Account
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Opening a checking account
o Cost and monthly service charges; min balance charges
o Individual or joint account
o Checking account procedures (ledgers)
o Overdraft protection
o Stop payment order on a check
o Monthly statement
Types of checks
o Cashiers check -- drawn on a bank account.
o Traveler’s check – make purchases with this when traveling
o Certified check – bank guarantees the funds
Establishing a Savings Program
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Specific savings plan --- set aside same amount per month
Ten strategies of savings – page 131
o Making savings a priority
o Look at spending habits
o Payroll deduction
o Bank your bonus or raise
o Work harder
o Make the loan payments on time !
o Watch the return rates
o Reinvest dividends and interest
o Set up retirement plan at work
o Splurge every once in a while
Interest concepts
o Interest on interest (compounded)
o Simple interest
o Stated rate (nominal) --- promised rate
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Effective rate of interest (EAR) -- The interest that is actually earned during the period
 EAR = interest earned during period / amount invested
o Compound interest is the same thing as FV
Variety of ways to save
o CD --- time deposits, with penalties for early withdrawals
o US Treasury Bills – ST bills (3 or 6 months)
 Issued by US govt to fund the national debt
 Issued at discount, and then paid at full value on maturity
 Very liquid; can be sold in secondary markets; brokerage fee
 Can purchase directly
o Series EE bonds
 Savings bonds issued by US Treasury
 Backed by full faith and credit of US govt
 Longer maturity dates
 Interest is paid by US govt when cashed in, or at maturity
 Purchase price is 50% of face value
 Exempt rom state and fedl taxes
o Series HH bonds
 Interest paid semiannually at fixed rates
 Similar to a regular corporate bond
o I savings bond
 Savings bond issued at face value by US treasury
 Interest compounds seminannually for up to 30 years )like an EE bond)
 But I bonds are sold at face value (not discount like an EE bond)
 Interest = fixed rate + semi-annual rate changing with the CPI
 No secondary market, transactions are only with Treasury
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Chapter 5 – Auto, Housing Decisions
Buying an Auto
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Ten steps on buying a car, exhibit 5.1, p. 142
Down payment, loan payment, making it part of the budget
Operating costs
Gas, diesel, fuel economy
New, used
Size, style
Warranties,
Finding the best car for you, exhibit 5.3, at 147.
Negotiating a price
Sales K
Trade in
Leasing an Auto
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Closed end lease --- at end of term, turn the car in
Open ended lease – if the car is worth less than an estimated residual value, lessee owes the
difference
o Residual value – remaining value of car at end of lease
Factors in a lease payment calculation
o Capitalized cost of the car (price of car)
o Capital cost reduction (down payment)
o Forecast residual value of the car
o The financing rate or money factor
o The lease term
o Depreciation = capitalized cost – residual value
o Monthly payment = ((depreciation + sales tax) / months of lease) + lessor’s required
monthly return (at the money factor)
o Multiply money factor * 2,400 = Annual percentage rate
Lease terms 2 to 4 years
Early termination penalties are often common
o Applies in cases of theft or property loss of vehicle
o Gap insurance for early termination caused by theft or loss
You are responsible for insurance and maintenance
o Will pay for unreasonable wear and tear
o Scheduled maintenance at dealer to avoid wear and tear
Purchase option
o Amount of purchase is Stated in the lease at the outset, at times
o Sometime market price
o Or residual value
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Try to negotiate a fixed price
Whether to buy at end of lease depends on whether purchase price is lower than the
market value
Annual mileage allowance (10 to 15,000 per year)
10 to 25 cents per mile above the allowance; this is negotiable
o To avoid this, some people will own a second vehicle if long trips are contemplated
o Or rent a car for vacations
Lease vs purchase analysis
o Worksheet 5.1, p. 153
Housing – rent or buy
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Types of homes
o Single family
o Condominiums – ownership of one unit in a multi-unit complex
o Co-ops (own a share of a corporation that owns the building)
o Rentals
Rental options
o Lease K
o Restrictions on pets, children, sub-leases, etc
o Security deposit
o Rent; payment due date, penalties
Rent vs own
o Housing prices,
o interest rates
o Tax credits for homeowners
o Expected change in home prices over time
o Worksheet 5.2, p. 159
o Need to also consider esthetics, personal needs and desires
How much can you afford?
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Mortgage interest deduction on taxes; property tax deduction too
o But must itemize (not use the standard deduction)
Acts as an inflation hedge, with housing going up by CPI +
Costs --o Down payment – loan to value ratio (20% down etc)
o Fannie Mae requires only 3% down
o Private mortgage insurance -- protects lender in case of a default
 Typically required if down is 20% or less
 PMI must end under federal law once mortgage is down to 78% of orginal home
value
o Mortgage points – 1 point = 1% of amount borrowed
 Fees charged by lenders at time of mortgage
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Related to lenders supply of loanable funds and demand for mortgages
Greater the demand, or less the supply, the more the points
Ex: 5 % + 3 points vs 6% + 1 point
Points are paid at closing and increase the APR; each point increases APR by
0.11% on a 30 year loan
 Points are tax deductable on a new mortgage, but must be amoritzied on a
refinancing
o Closing costs are paid by borrowers
 Mortgage fees, filling fees, title fees, attorney fees
o Mortgage payments
 Most of payment goes to interest --- graph, p. 163
 Can figure payments by mortgage table, exh 5.8, p. 164
 OR Annuity / PV keys on fin calculator
o Affordability ratios
 Borrower must be qualified
 On conventional mortgages, mortgage payments cannot exceed 25% to 30% of
monthly gross taxable income;
 Total payments (including autos, furniture, etc) cannot exceed 33 to 38% of
monthly gross taxable income
o Property taxes / insurance
 Principal, interest, property taxes, homeowners insurance (PETI)
 Sometimes, monthly PETI goes into an escrow account for lender
payment of taxes, insurance
 Property taxes vary by county, city, school, etc
 Based on assessed value
 Property taxes may range form 0.5% to 2% of market value
 Homeowners insurance around 0.25% to 0.5% of market value
o Maintenance costs on home
 P. 169 box on home buying remodeling project paybacks
Roadmap on buying a home --- p. 165 box
Home affordability analysis
o Worksheet 5.3, p. 166
o how much mortgage will monthly payment buy
 Fin calculator annuity / FV keys on fin calculator, p. 167
 Can also use table at 167 to estimate
Home buying process
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Shopping the market
Real estate short sales – sale < amount owed (aka distressed sales)
o Banks can recover as much of loan balance as possible
Foreclosure – lender takes title to property after loan default
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Foreclosure done over short sales where banks believe foreclosure will net more money
than a distressed sale
RE agents
o MLS – agent listed
o RE commissions range from 5 to 6% on new homes, 6 to 7% on used homes
o Brokers represent the sellers usually, although buyers can line up a broker too
Prequalifying for a home mortgage
o Know how much of a home you can buy
RE sales K
o Must be in writing
o Escrow deposit – good faith when making an offer
 Can forfeit in case of withdrawal
 Valid reasons for withdrawal do not forfeit; such reasons are stated in K
o Contingency clause conditions offer upon certain events
 Passing termite inspection, obtaining financing, etc
 Good warranty title
o Disclosure of closing costs and other items required by RE Settlements Procedure Act
o Closing statement
Avoiding common RE buying mistakes
o Exh 5.10 at 172.
Financing the transaction
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Sources of mortgage loans
o Mortgage banker
o Mortgage broker – solicits borrowers for you
Types of mortgage loans
o Fixed rate loans -- traditional 15 or 30 year loan
 15 year loan pays substantially less interest than a 30 year loan (example in box
at 175)
 Can also make extra payments (make sure there is no pre-payment penalty)
 Rule of thumb: one extra payment per year may cut off 7 + years on a
30 year loan
 End up replicating a 15 year loan with a 30 year loan
o Balloon payments
 Entire principal is due in 5, 7, 10 years
 Payments are the same as a 30 year fixed, but slightly lower interest rate (.25 to
.50%)
o Adjustable rate mortgage (ARM)
 Interest is adjusted on basis of market interest rate movements
 Most ARM’s are 30 year lonas
 Adjustment period – the period that the interest rate can be adjusted (i.e. every
6 months)
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Initial rate may be 2% below the 30 year fixed rate
Index rate is the baseline rate that captures the interest rate movements (i.e. 6
month treasuries)
 Margin is the % points a lender adds to the index rate to determine the
mortgage rate
 Interest rate cap is the limit that the rate can increase each period
 Payment cap is the payment increase that can increase each period
 Initial monthly payment can be done via fin calculator p. 176 annuity FV
 Negative amortization --- when payment is set below the interest charge, the
principal balance INCREASES over time
 Avoid this option on an ARM !
 Convertible ARM --- can convert form an ARM to an fixed rate loan, usually
between the 13th and 60th month.
 Somewhat higher interest rate than a regular ARM
 Attractive if general interest rates decline
 Two step ARM’s – initial rate 5 to 7 years, and then a higher rate beyond
 Index on the ARM dramatically affects the level and stability of the loan
 6 month T bill, LIBOR, CD indexes, etc, 11th Federal Home Loan District
 The 11th District is less volatile bc it averages costs of funds to S&L’s
 CD and LOBOR indexes are sharper and more frequent in changes in
both directions
Fixed rate or AR M?
 When rates are high and may come down, convertible ARM’s may be good, or
even regular ARM’s
 Danger occurs when the borrower is at 25% of AGI in the initial loan payments,
and then interest rates go up --- this was the scenario in 2007
 Text – if the buyer expects to be in home 5 + years, fixed rates may be good
Other payment options
 Interest only mortgage
 Also very popular in 2001 – 2006
 Graduated payment mortgage
 Unusually low payment and then increase to a fixed amount
 Growing equity
 Fixed rate with payments increasing over time
 Allows principal to be paid off more quickly
 Shared appreciation
 Lowe interest rate bc lender shares 30 to 50% of the appreciation in the
home when sold
 Bi – weekly mortgages
 Buydown --- builder may subsidize the financing for a short time as an
inducement o buy the home
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(also not in text – equity loans)
(not in text --- reverse equity)
Loan sources
o Conventional mortgage
 lender assumes risk of default (need 20% down)
o FHA mortgage insurance
 FHA reimburses lenders for a default
 Interest rate is also lower than on conventional loans
 Lenders pay a premium
o VA loan guarantee
 Like a FHA loan but lenders do not pay a premium for eth guarantee
 Regional differences in VA loan requirements
Refinancing the Mortgage
o If rates drop by 1 to 2% below the mortgage rate, it may make sense to refinance
o Worksheet 5.4, p. 180
o May be able to reduce time period, or to reduce monthly payment
o
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Chapter 6 – Using Credit
Basic Concepts
Use credit for --- avoiding paying cash for large outlays
- financial emergencies
- convenience
- investment purposes (margin buys)
Good review of the collapse of credit, 2007 -2009
Improper use of credit
- end up paying too much in interest
- danger sign box, p. 191
establishing credit
- open checking and savings accts
- open the first credit card and charge small items each month
- pay on time
- this establishes a good credit hx
- building up a strong credit hx
o 5 c”s of credit box, p. 192
Debt safety ratio = monthly consumer credit payments / monthly take home pay
- 20% ratio is the MAX
- More likely 10 to 15%, especially if there is a mortgage
- Worksheet 6.1, p. 194, loan payments and debt safety ratio
Forms of Credit
Open account credit
- consumers open credit ahead of the purchase
- credit limits attached
- dept stores, retail, industrial situations --- buy something from that one store
Bank credit cards
- This is consumer credit, Visa, MC, etc
- Can pay for anything anywhere
- Can borrow money too thru cash advances
- Credit limits
- Interest charges
o Base rates
o Generally higher than other forms of credit
o Grace period to pay
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Additional fees
o ATM fees
o Late payment fees
o Over the limit fees
Credit Card Usage Act of 2009 changed many of these fees
o Impact of new law – box 6.4, p. 198
Balance transfers
o Transfer fee
o Many times, monthly payments will be charged on the balance transfer (lower rates)
and then the older balances (higher rates)
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Reward cards
o airline mileage, car rebates, other merchandise rebates
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Affinity cards
o coordinate with a sponsor (non-profit, etc)
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CC checklist box, p/ 200
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Secured CC
o Collateralized
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student cc
retail cc (stores, gas)
Debit cards
- charges against a checking acct
- like writing a check;
- essentially, paying with cash, not credit
- convenience of credit but without the interest rates
- does not provide a line of credit
o can avoid interest by just paying off a cc on time in whole
pre-paid cards
Revolving credit lines
- can write checks against the lines
- banks, brokerages have these
- cash advances thru the credit line established
- overdraft protection on credit available when linked to bank checking acct
- unsecured personal lines
- home equity line
o equity in home is the collateral
o interest can be tax deducted up to 100K in principal (or up to FMV of home)
o usually cheapest form of credit
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Obtaining open credit
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credit application
credit investigation
credit bureau
o can obtain a copy of your credit report
credit scoring
o evaluates creditworthiness
o keeping the FICO score box, p. 210
o FICO is fair, Isaac & Co
 payment hx (35%)
 amount owed (30%)
 length of credit hx (15%)
 new credit (10%)
 types of credit used (10%)
 300 to 850
Finance charges
- annual percentage rate (APR) = actual or true rate of interest charged
- average daily balance (ADB) = interest is charged on the ave daily balance
o excluding or including new purchases
o including new purchases has higher inters rates
Managing Credit
- minimum monthly payments
Using Credit Wisely
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shop around for the best deal
annual fees, rate of interest, grace period length, method of calculating
identity theft problems and suggestions, p. 217
Bankruptcy
- personal vs corporate
- wage earner plan
o for steady income, chapter 13
o creditor plan
- straight bankruptcy
o most debt is eliminated
o debtor can retina equity in a home, too
o must still make federal tax payments, alimony and child support
o can keep retirement and SSA payments
-
credit counselors
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Chapter 7 – Using Consumer Loans
Basic Features
-
auto loans
durable goods loans (TV’s, etc)
education loans
collateral on some loans
personal loans
consolidated loans
student loans
o various student loan programs at a glance box, 228
o college savings plans
o single payment vs installment loans;
o fixed vs variable payments
obtain loans from -- commercial banks
- consumer finance companies
- credit unions
- S&L
- Sales finance companies
- Captive finance companies (GMAC)
- Life insurance companies
o Cash value
- Friends / relatives
Managing credit
-
-
Shopping for loans
o Predatory lender box, p. 233
o Finance charges
o Loan maturity
o Total cost of transaction
o Collateral
o No payment no interest box, p. 234
Consumer debt inventory worksheet, p. 235
Loan payments
-
lien
chattel mortgage
collateral note
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-
prepayment penalty
loan rollover into other loans
loan disclosure statements
interest calculations
- simple interest
o charge = principal * interest rate * term of loan stated in years
o fc = p * r * t
o APR = ave annual finance charge / ave loan balance outstanding
o Book does not state at this point, but the principal is declining
- Discount method
o Interest is computed and then subtracted from the principal
o Calculation the same way as with simple interest’
o Fiancé charges are paid in advance
o Discount method ends up having a higher APR than with simple interest
o Example page 241
Installment loans
- heavily used in consumer finance
- most such loans have collateral
- rate of interest and loan maturity table, p. 243 –
- this is an amortization table, since interest charges are built into the table
- can figure out the monthly payment from a financial calculator, p. 244
- add on method
o computes finance charges on original loan value
o declining balance charges a lot less interest --- interest charged on only the existing
balance (or simple interest), example at p. 246
o APR can be calculated with add-on method, p. 245 with fin calc
- Prepayment penalties
o Sum of the digits method or rule of 78
o Higher interest rates charged on early payments
o Try to avoid such loans !
- Credit life or dib ins
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Chapter 8 – Life Insurance
Note: This was not covered in class, so ir will NOT be on Quiz 2. It will be on the Final Assessment
Basic Concepts
Risk Concepts
- Risk avoidance
-
Loss prevention --- reduction of probability that a loss will occur
-
Loss control ---- lessening the severity of the loss once the risk occurs
-
Assumption of risk ---- assuming and bearing the risk
-
Insurance --- contract between insured and insurer for the insurer to reimburse for losses
o Transfers the risk to the insurance company
o Insurance companies will combine the losses, using actuarial data, and estimate the risk
faced by the entire insured population
o Increase predictability of a loss and of the severity of a loss
o Accurately estimating the frequency and magnitude of losses is critical for insurance
pools
Underwriting basics
- This is the process to decide who will be insured and to charge appropriate premium rates
- rate classification schedules are done so that people pay premiums reflecting their probability of a
loss
- underwriting – guards against adverse selection
o this occurs when only high risk people apply for insurance
- if underwriting stds are too high, people cannot get insurance;
o if stds are too low, insurance company is likely to go insolvent
- Excellent health makes a preferred insured for health or life
Life Insurance
-
Protects against financial loss in the event of the insured’s death
Benefits of insurance
- Financial protection of dependents
- Protection from creditors
o This occurs when beneficiaries are named, avoiding probate
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o
-
Life ins benefits only go to the estate (and to creditors) when no beneficiaries are
named
o This is bc life ins proceeds belong to 3rd party beneficiaries of an assignment K and not to
the estate
Tax benefits
o Payments are generally not taxable since they recoup for a loss and are not income
Savings
o Can have investment aspects to them
Who needs life ins?
- Anyone who has dependents in financial support
- Spouse, children
How much life ins?
- Multiples of earnings method --- multiplying gross annual income * (number)
o rule of thumb --- 5 to 10 times
- needs analysis method
o consider the financial obligation and available resources in addition to life ins
o steps:
 1) estimate total economic resources needed if person dies
 income needed to maintain adequate lifestyle
 extra expense upon death
 special needs for dependents
 debt liquidation
 liquidity
 2) determine all finl resources available after death,
 including life ins
 and pensions
 social security survivor benefits
 3) amount needed – amount avail = life ins needed
o Worksheet on this method, p. 263
- Buying life ins box, p. 261
Types of Life Policies
Term insurance
- This is ins that provides death benefits for a specified period of time
- Straight term -- written for a specific number of years, with coverage unchanged throughout
o Premiums will increase over time, due to increasing prob of death
- Decreasing term --o Same premium, decreasing benefits
- Pros and cons
o Fairly cheap (pro)
o Con --- usually not renewable on end of term
o Convertibility --- can convert to a comparable whole life ins (nice pro, if available)
o Has little or no cash value (con)
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Whole Life
- On-going life ins over the entire life of insured
- Cash surrender value
o accumulated refundable amount of the policy if you want to terminate the policy
o has modest savings value
o is a non-forfeiture right to cash value in the event of an early termination of policy
o graph on increase in cash value vs death benefit, p. 268
- continuous premium policy
o this is straight life --- level premium each year
o lower premiums for younger people – used as a marketing tool by ins agents
 but total ins premium paid over your life is likely to be higher
- limited payment
o premium payment is for a specific period (usually work life), while benefits go on
- single payment (SPLI)
o this amounts to a tax sheltered investment
o proceeds are tax deferred
o but early withdrawal bf 59 ½ or loans taken against SPLI have early withdrawal penalties
attached
- insurance company ownership structure box, p. 269
o mutual company is owned by policy holders, with company dividends going to policy
holders
- stock company is owned by equity, with stock dividends going to shareholders
-
-
low load life ins
o keeps sales commissions down from 20 – 25% of total ins premiums to 5 to 10% of
premiums
o cash values grow more quickly
pros and cons
o pro --- death benefit and early termination cash value (unlike term)
o pro --- can borrow against the policy benefit
o pro --- savings / investment component to it
o
o
-
con --- very expensive !
con --- provides less death benefit per dollar than term
 difference is the cash value / savings component of the policy
o con --- lower yields in the savings component than with alternative investments
who needs whole life?
o Some analyst recommendations --- whole life / cash value for the perm needs for ins,
regardless of age
o Then, term ins for the amount of lfie ins needed while dependents are typically involved
(during work life and until children become self-sufficient)
Universal Life Insurance
- Permanent cash value with term ins components with a tax shelter savings component
- Death benefit and the savings portion are separately ID in the premiums (this is unbundling)
- Part of premium goes to cash surrender value
o Cash portion earns varying interest rates with a stipulated minimum
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-
o Cost of term ins can then be withdrawn from the cash value to pay for death benefit
Tax laws require that that the death benefit > cash value
o Death benefits are tax free
Option A provides a level death benefit
Option B will increase its death benefit along with the cash value
Pros and cons
o Pro --- flexibility – cost of death benefit can be taken from premiums or cash value
 Life cycle needs
o Pro – savings component
o Con --- premiums may never disappear (if interest rates on cash value are too low)
o Con – universal life carries heavy fees compared to other policy types
Other types of Life Ins
- Variable life --- benefits are a function of market level returns generated on investments
- Group life --o master life policy for a group; this is almost always term ins, with premium paid on
characteristics of an entire group
o employers do this very often for all employees
o members can often convert (after leaving the group) and can continue as an individual
term life policy
- credit life --- sold as part of an installment loan, often naming the credit company as the beneficiary
o cost of the loan has built into it a credit life policy
- mortgage life --o will pay off the mortgage in the event of a mortgagee’s death
- industrial life --o whole life with small face amounts (1K; 5K, etc)
o cost much more per 1,000 of insurance than whole life
o marketed to day to low income families
o (KCK note: very popular after WWII as a way to insure costs of funerals, etc)
Buying life Ins
-
-
Nice box on pros and cons of each form of ins, p. 275
Compare costs and features
o Features box, p. 276
Select an ins company
o Ins medical exam box, p. 277
o Unethical ins sales box, p. 278
o Ins company ratings agencies, p. 278
o Choosing an agent
Filing a life ins claim box, p. 282
Key Features / Clauses of Life Ins Policies
-
Insurance projections box, p. 280
Beneficiary clause – primary and contingent
Settlement / payout options
o Lump sum benefit payment (95% of beneficiaries choose this)
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-
-
-
o Interest only
o Fixed period
o Fixed amount
o Life income
Policy loans
Premium payments
Grace period
No-forfeiture options upon early termination
o Most state laws mandate some benefits for early term of whole life
o Companies will offer as alternative to cash value –
 Paid up insurance
 Extended term ins
Policy reinstatement
Changes of policies
Indemnification clauses
o Double or triple value if death in an accident
DIB clauses
o Waiver of premium in the event of a DIB
o Could also insure DIB directly as a rider on life ins
 So, would be a DIB benefit + a life benefit
Guaranteed purchase option
o Can have the right to buy added ins without proof of insurability (another medl)
Suicide clause voiding the policy
Aviation, war, hazardous occupation exclusions
Participation clauses allow policy dividend = actual premiums – premium necessary for actuary
mortality
Living benefits --- can receive a % of death benefit prior to death
o This occurs where LT health issues arise (nursing home, etc)
Viatical settlements
o terminally ill policy holders can receive % of death benefit for immediate use (commonly
60% of policy value)
o handled thru 3rd party investors
o after death, investor receives the policy on an assignment
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