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Personal Finance in 30
MinutesJean 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 (income vs. expenses)– Capital (net worth = assets - debts)– Character (credit report)– Collateral (can be repossessed)– Conditions (economy as a whole)
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
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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
Homes - Cars - Insurance
Spending:
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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 Total
– $100,000.00 Principal
$93,237.20 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
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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.
Retirement As An Example
Saving & Investing
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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
Selected Realized Returns, 1926 – 2009 Average Standard
Return Deviation
Small-company stocks 16.6% 32.8%
Large-company stocks 11.8 20.5
L-T corporate bonds 6.2 8.3
L-T government bonds 5.8 9.6
U.S. Treasury bills 3.7 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2010 Yearbook (Chicago: Morningstar, Inc., 2010), p23.
Saving and Investing for Higher Returns (1926-2010):
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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