Financial Planning: Setting Goals, Creating Budgets, and Managing Debt - Prof. Green, Study notes of Economics

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Issue #5: Personal Financial Planning 10/09/

Spending Money Wisely  Current Needs o Based on necessities of life and your average propensity to consume  Average Propensity to Consume (APC)  The % of each $ of income, on average, that a person spends for current needs rather than savings  Housing = 30%  Future Needs o Setting aside a portion of current income in savings or investments for future spending  Retirement  Home  New Car  $ for college for your kids  Future health cost needs  Planning for the unexpected
Steps in the Financial Planning  Define financial goals  Develop financial plans and strategies to achieve goals  Implement financial plans strategies  Periodically develop and implement budgets to monitor and control progress toward goals  Use financial statements to evaluate results of plans and budgets, taking corrective action as required

 Redefine goals and revise plans and strategies as personal circumstances change

Define Financial Goals  Results that an individual wants to attain  Without goals it is impossible to effectively manage your financial resources  Goal Statement: o Long-Term Goals  6+ Years  Future Value Estimates (counting for inflation)  Time Horizon – How many years are we looking at?  Prioritized (high, low, etc) o Intermediate Goals  2-5 years  Time horizon  Prioritized o Short-Term Goals  1 year  Time Horizon  Prioritized
3 Important Ideas When Setting Effective Goals  Prioritize

 Attach time horizon or target date  Attach $ value (in future value)

Tim & Andrea Sheppard’s Financial Goals (pg. 252)

Plans to Achieve Your Financial Goals  Asset Acquisition Planning o Acquiring assets – liquid, investment, personal property and real property assets  Liability and Insurance Planning o Things we owe on  Savings and Investment Planning  Employee Benefit Planning  Tax Planning o Earned income is taxed differently then what you get from an investment  Retirement and Estate Planning o Time Value of Money – the earlier that you save, the more you are gonna get  Pg.253 – Life Cycle Hypothesis Theory

Personal Financial Statements  Taking stock of your current financial situation

o Up-to-date evaluation of your financial well-being o Point out potential financial problems o Make better informed financial decisions  2 Types of Personal Financial Statements: o Balance Sheet  Describes your financial position at a given point in time; snap shot on that one day  “How much are you worth today?”  Assets:  What you own; the value of owned items, stated in $  Liabilities, of debts:  What you owe; financial obligations for which an individual or family is responsible  Net Worth  Format & Preparation:  List your assest at their fair o Income and Expense Statement

Balance Sheet  Current Status o Describe your financial position at a given point in time; snap shot on that one day o “How much are you worth today” o Assets:

 What you own; the value of owned items, stated in $’s o Liabilities, or Debts:  What you owe; financial obligations for which an individual or family is responsible o Net Worth  Format and Preparation o List your assets at their fair market value as of the date you are preparing the balance sheet o List all current and long-term liabilities o Calculate net worth o Calculate solvency ratio & liquidity ratio  Assets o Liquid Assets  Assets held in the form of cash or “near cash” (those that can be readily converted to cash with little or no loss in value) o Investments  Assets that earn a return rather than provide a service o Real Property (tangible assets)  Immovable property; mostly appreciate in value o Personal Property (tangible assets)  Movable; mostly depreciate in value o Fair Market Value  Price at which we can reasonably expect to sell an asset  Liabilities

o Current (Short-term) – owned & due within 1 year o Long-Term – debt due 1 year or more from the date of the balance sheet; on larger assets o Outstanding Balance o Types:  Short-Term: bills outstanding, revolving credit  Long-Term: include only principal portion of loan on mortgage, installment debt, mortgage, other debt  Net Worth o Measure of you financial worth o Equity in owned assets o The difference between one’s total assets and total liabilities o What remains after selling all your owned assets and paying off all your liabilities o Net worth = Total Assets – Total Liabilities o Insolvent:  Condition in which you owe more money than your assets are worth  Net worth is 0 or negative

Income/Expense Statement (Past Behavior)  Income (Cash In) o Earned income o Non-earned income  Expenditures (Cash Out)

o Fixed vs flexible o Certain vs uncertain o Results in 4 types of expenditures  Fixed, certain (a necessity, amount known)  Fixed, uncertain (a necessity, amount not known)  Flexible, certain (not a necessity, amount known)  Flexible, uncertain (not a necessity, amount not known)  Preparing the Income & Expense Statement o Record your income from all sources for the chosen period o Establish meaningful expense categories o Subtract total expenses from total income to get cash surplus (a positive number) or deficit (a negative number)

Evaluating a Family’s Financial Status  Solvency Ratio o Shows how much of a decline in the market value of their assets a family can have before becoming insolvent (solvency = more assets than liabilities) o Solvency Ratio = Net Worth/ Total Assets o The higher the better o Desirable solvency ratio = >. o The Sheppard’s Solvency Ratio = .281 or 28.1%  Liquidity Ratio o Shows how much of their one-year liabilities they could pay with their liquid assets

o Pulled from current liabilities (income and expense statement) and from the balance sheet o Liquidity Ratio = Liquid Assets / Total Current Debt o Total current debt = all unpaid bills; all of the revolving credit card bills; one year’s worth of mortgage, installment loans, and other loans o The higher, the better o Desirable liquidity ratio = >. o The Sheppard’s Liquidity Ratio = .099 or 9.9% o 1/12 = 8.3% o 9.9/8.3 = 1.2 months of liquid assets to cover current liablilties  $2,225/$22,589 = 9.9% o Desirable: 3-6 of your after-tax income available or put away to cover your current debts to increase your liquidity ratio (pg. 283)

Evaluating a Family’s Financial Behavior  Savings Ratio o Shows the family’s level of preparation for the future o Savings Ratio = cash surplus (+ amount saved) / Annual Net Income  Net = after taxes (gross – taxes) o The higher, the better o Desirable savings ratio = >. o The Sheppard’s savings ratio = .197 or 19.7%  Debt Service Ratio o Shows the burden that the family’s debt is relative to their income (their ability to repay that debt)

o Debt Service Ratio = (monthly debt payments) / (monthly gross income) o The lower, the better o Desirable debt service ratio = <. o We will include credit card obligations paid this year’s debt service ratio o Sheppard’s debt service ratio = .297 or 29.7%

Budget Development  Income and expense statements and balance sheets are used to develop budgets o Past  The income and expense statement provides a record of what was earned and spent in a previous period o Present  The balance sheet shows a peron’s current financial situation o Future  The BUDGET  Based on previous and forecasted cash flows (income/expenses)  A tool to help one  Anticipate surpluses and deficits  Allocate future spending based on short-term and long-term goals  Developing a budget:  Estimate income  Estimate expenditures

o “Building Wealth” from FRB of Dallas  See if budget balances o If not, make adjustments  Finalize budget  Implement budget and keep records

Factors that Affect Cash Flow  Stage in your career (closely related to stage of life cycle)  Type of job or career  Number of earners in your households  Size of household  Age  Personal consumption behavior

What if Predict Deficit?  Increase income  Decrease expenditures o Flexible, uncertain o Flexible, certain o Fixed, uncertain

o Fixed, certain  Sell assets

Credit Abuse  Non-revolving credit (mortgages, car loans, school/student loans, consumer loans) have increased from 1970-  Revolving credit outstanding increased from 1990-2007 (239 to 939.5 (in billions)) o A little bit harder to get credit o People are not spending as much  Non-Business Bankruptcy Fillings 1980-2008: steady increased through 2004,then spike, and then a sharp decrease through 2005-2006 and then rise again in 07 o Household Filing  Highest: CA, OH, GA  Lowest: RI, NH, ME

Types of Bankruptcy  Chapter 7 – Straight Bankruptcy o Person’s assets given to trustee to be sold – distributed to creditors  Some exclusions for housing and cars.  If you only have one car, you are most likely to keep it.  Only take some of your equity (not all of it) from your house.  Chapter 13 – Wage Earner Plan (Repayment plan) o Develop plan to pay off (over 3-5 years)

o Based on government decision of what categories you need to budget; no saving allowed o If you fail to make a payment, then you have to start all over again. o Some creditors simply lose out  Since 2005 – if you file, you have to take a financial education class within 2 months of filing  Cap put on the amount of debt if you file Chapter 13, of over a million $s  If you stop making payments on a loan, it is considered income, and will be taxed on the “income” o Forgiven loans and debts will not be taxed

Types of Credit  Consumer debt o Charge accounts: revolving o Credit Cards: revolving o Installment Loans (fixed term – non-revolving) o Single payment loans: 30-day, 90-day note  All due in one lump sum  Mortgage Debt o 1 st^ Mortgage o 2 nd^ Mortgage (equity installment loan)  using your equity to “make” the 2nd^ mortgage loan  suggested to use to rebuild your equity (home improvements) o Equity credit line

 Line of credit on your equity (credit card on your equity) – “mortgage”
Objective Benefits of Credit  It’s cheaper to buy when interests rates are low  (Sometimes) tax advantages of buying on credit (i.e. equity loan) o tax implications if you borrow more than the value of your loan  When traveling abroad, better exchange rate
Subjective Benefits of Credit  Obtaining expensive goods NOW while spreading out payments for them over time (immediate gratification)  Convenience of purchasing and record-keeping, particularly with credit card  Safety and security of not carrying large amounts of cash
Objective Cost of Credit  It’s more expensive to buy when interest rates are HIGH  (Sometimes) price increases with credit purchase  Increasingly common application fees membership costs, points, miscellaneous charges
Subjective Costs of Credit  Risk of overspending, impulse buying, overextension of debt  Psychological distaste of owing money, apart from any danger of overspending  With variable rate credit, greater risk from increases in interest rates
Danger Signals in Credit Use  Having to borrow to meet normal or necessary living expenses  “Bouncing” checks regularly

 Paying only minimum balance on credit card(s)  Using one form of credit to pay off another (pyramiding debt)  Realizing all revolving credit cares are “at the limit”  Having no cash reserves or emergency fund or additional borrowing capacity  Being regularly hounded for payment by creditors or their collection agencies

10 Steps to a Debt-Free Life:  Stop using credit cards  Find out how bad it is  Evaluate your spending  Cut your spending  Beware of easy answers  Pay off most expensive card 1st  Try to lower the cost of credit  Boost your payments  Use automatic payment plans  Celebrate
Remedies for Debt Trouble  Reexamine family budget  Discuss debt with creditors  Investigate consolidation loan(s)  Consider sale of assets/return of assets for secured debts  Visit consumer credit counseling o Budget/debt counseling o Debt repayment plan o Consumer Credit Counseling of Atlanta  Consider filing legal bankruptcy

Issue #6: Re-Evaluating the Housing Decisions 10/09/

Re-Evaluating the Housing Decisions

 Family Factors o The typical family owns 3 dwellings in their lifetime  Starter Home – low cost, small  Full-nest Home – high cost, more space  Empty Nest – smaller, low upkeep  Macroeconomic Factors o Wide range of financing options (1,000s) o Economic conditions – can’t always be in control, but they control what the mortgage market is, driving our decisions

Three Characteristics to Consider When Financing a Home  Mortgage Loan Principal o Can you afford it?  Maturity or Term of the Loan o What is the term of the loan? 30 yrs? 15 yrs?  Interest Rate o Who do they function? How much are we gonna pay?

Increasingly Important Characteristics  Whether interest rate &/or monthly payment changes over the life of the loan, and if it can (only talk about the principal and interest) o How often can it change?

o How much can it change?

Fixed Rate Mortgage  PI never changes  Once they get older, the % of their income towards their mortgage decreases.  Advantages: o Stable Payment o Long-term tax advantages o Shield from future interest rate increases  Disadvantages: o Interest rate higher o Monthly payment higher o Non benefits if marker interest rates decrease o May be more difficult to qualify for
How It Works: Mortgage Principal and Interest Payment  How it Works: o $50,000 loan o 8%, 30yr, monthly payment = $366.88 (8/12=.00666666)  Month 1 o Interest Payment = 50,000 X .0066666 = 333.

o Principal Payment = 366.88-333.33 = 33. o New Outstanding Loan Balance =$49,966.  Month 2 o Interest Payment = 49,966.45 X .0066666 = 333. o Principal Payment = 366.88-333.11 = 33. o New Outstanding Loan Balance = $49,932.

40-Year Fixed Rate  Similar to 30-yr fixed rate mortgage o Borrower stretches out payments o Slightly higher interest rate o Pros:  Lower monthly payment o Cons:  Over life of mortgage increases amount paid in interest o Good for: only first-time buyers who don’t plan to stay in the house for more than a few years

Alternative Mortgages  Graduated Payment Mortgage (GPM) – Negative Amortization (1st^ 5-7yrs) o 7% on $100,000 mortgage  1 st^ month:

 Principal = $18.  Interest = $583. o 4% on $100,000 mortgage  1 st^ month:  Principal = $144.  Interest = $333. o Difference in Interest = $250. o So, lower payment is not large enough to cover the interest costs  o Advantages:  Lower initial monthly payment  Families may qualify for this and not others  Known, moderate increases in monthly payments  For families that want their mortgage payments to more closely match their rising income o Disadvantages:  Higher total interest costs over life of loan  Negative Amortization  Occurs when the mortgage interest rate rises but the mortgage payment remains the same  Monthly payment does not cover all the interest owned. The lender adds this difference to the balance of the mortgage.  No benefits if interest rates decrease (same concept as fixed rate)  Adjustable Rate Mortgages (ARM)

o Interest Rate on ARM is made up of 2 parts:  Index  Margin o Index  Might be attached to a particular index  Measure of interest rates generally (baseline that captures the movement in interest rates)  Rates on 1-yr constant-maturity Treasury securities (1-yr T-bills)  Cost of Funds Index (COFI) – less volatile  London Interbank Offered Rate (LIBOR) – more volatile o Margin  Extra amount that lenders add (lenders fees) o Index + Margin = ARM interest rage o Teaser Rates: initial ARM interest rate which is lower than that derived from adding the INDEX & MARGIN o Frequency of rate change or adjustment interval  Tells you how often the ARM mortgage interest rate can change  As often as every 3 months to 3-5years o Rate Caps:  Periodic cap – in a given interval can only change by X% points  Overall or Lifetime Cap – maximum the interest rate can ever go  Example:

 2/5: where 2 = maximum increase/decrease in rate each time it changes (periodic); 5 = maximum increases/decrease in lifetime of the ARM  1 Year Adjustable – 5.5%, 2/6; $100,000 mortgage;  Year 1 (5.5%) = 568(P.I Payment)12 = -6816  Increase Max – periodic (7.5%) = 69912 = -8388  Decrease Max – periodic (3.5%) = 499*12 = -5388  Max Increase on 5.5%: 2/6 = 11.5% o Beware of These Possibilities  Frequency of payment change  How often ARM payment can change  Problem of negative amortization  Payment might not change at the same time that the interest rate changes  Payment Caps  Limit on the monthly payment increase that may result from a rate adjustment  Problem of negative amortization o Advantages:  Initial interest rate lower  Initial monthly payment lower  Tax advantages  Deduct interest from your taxable income  More available during certain periods  Caps reduce uncertainty

 When interest rates are high and you expect the rates to drop, ARM avoid the cost of refinancing to get lower rate o Disadvantages:  Uncertainty about future interest rate and monthly payments  Negative Amortization  May be higher total cost than fixed if rates increase  **Hybrid ARMS **** o These ARMs are a mix – or a hybrid – of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first several years of the loan; after that, the rate could adjust annually. o 5/1 hybrid ARM  +5 = number of years fixed  +1 = year ARM after the first fixed time period  (can move once a year after those first 5 years) o Interest rate will be very low for the 1st^ 5 years.  **Payment-Option ARM **** o ARM that allows you to choose among several payment options each month o Options Typically Include:  A traditional amortizing payment of principal and interest  An interest-only payment  A minimum payment that may be less than the amount of interest due that month (GPM)  Would result in negative amortization o Advantages  Flexible to deal with economic circumstances

o Disadvantages  Potentially lose much of tax advantages (determined by which method used predominantly)  **Balloon Mortgage **** o Like a fixed rate for the first 3-5 years (low interest rate); at the end of the 3-5 year period you must pay off the rest of your mortgage at one time  **Growing Equity Mortgage **** o Pre-payment is automatically planned o Applies to conventional or fixed rate mortgages o Advantages  Allows homeowner to pay mortgage down more quickly (equity grows faster) o Disadvantages  Less flexible than just prepaying your fixed rate mortgage  **Assumable Mortgage **** o A mortgage that a buyer can assume, or take over, from the seller of the property

** A series of equal monthly payments and a large final payment = balloon mortgage
** Interest rate is fixed for 1st^ several years and after that the rate can adjust annually = hybrid ARM
** T/F: an assumable mortgage is one which the borrower can assume that the interest rate can assume that the interest rate cannot go up over 5% points over the life of the loan = FLASE

10/09/2009