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Consumer Finance OutlineLindenwood CollegeWinter 2010 Kevin C. Kaufhold, AdjunctIBA32030 Consumer FinanceThis 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 Chapters 1 – 5 will be on the quizFor Quiz 2 Chapter 6 – 7 will be on the quiz1 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 cardsChapter 1 – Financial Planning ProcessRewards of Fin Planning Improve Standard of Livingnecessities, comforts, luxuriesOrganizational Planning Model – fin. Plans → fin actions → fin resultsSpending money wiselyCurrent needs vs future needsConsumption vs savingsConsumption today vs deferred consumption thru savings today and consuming tomorrowAverage propensity to consume --- % of each $, on average, that is spent on consume rather than savingsCan money buy happiness? Economists --- wealth increases utility Accumulating wealth Wealth = total value of all items owned Both real and personal and wherever situatedCould be financial assets (stocks, bonds, etc)Could be tangible assets (RE; cars; )Personal Financial Planning ProcessSteps in the processPlanning process is a systematic process that considers impt aspects of a person’s financial affairs in order to fulfill financial goals define financial goalsRole of moneyMoney is the medium of exchange used to measure value in fin transactionsUtility is the amount of satisfaction received from having goods and servicesWealth has psychological aspects to it --- emotion, personality, self-imageAssumption 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 goalsBe specific; should be realistic and attainableInvolves entire family Target Dates on Financial Goals ST / NT goalsFind a job S(ST)Repay student loans; buy a car (NT)LT goalsBegin investing (LT)Buy a house (LT)Worksheet I (page 14)From Goals to PlansLife cycle of financial planningVery good Graph at page 16 on life cycle Asset accumulationLiability / insurance planningSavings and investment planningGrowth of $1000 over time (8% and 10%) graph at 17. Employee benefitsTax planningRetirement planningEstate planningSpecial Areas Two incomesEmployee benefits Health, life, dib, LT care, pension, dental, vision, child careAdapting to life changes Marriage; children; death of spouse; divorceFinancial plannersPlanning EnvironmentFigure at 28Parties (legal) / Agents (economic)Government --- taxes, regulation, servicesBusiness --- output --- make goods and services; inputs --- land, labor, capitalConsumers --- buy products from businessesEconomyBusiness cycle --- expansion, recession, depression, recoveryBus cycle graph at page 30. Inflation CPI; purchasing powerWhat Determines Personal Income ?DemographicsAge, education, location, careerChapter 2 – Financial Statements & PlansPersonal Financial StatementsThese are balance sheets and income and expense sheets Balance sheet is develop the financial position at any one point in timeIncome and expense sheet measures financial performance over timeBudgets are forward lookingBalance SheetHow much are you worth today? P. 43 EXAMPLE AssetsLiquid assets – cash Investments Real propFair market value appraisal Pers propLiabilities ST or current liabilities (due within 1 year)Open account credit obligations --- current liab from credit linesLT liabilities (due beyond 1 year)Net worthA – L = net wrothIf NW > 0, equity exists; if NW < 0, insolvencyNet worth over time --- graph at 45 (becomes the life cycle graph from chapter 1)Preparation Assets at FMV as of date of preparation of balance sheetList ALL Current and LT liabilities = net worthIncome and Balance SheetThis is a cash basis, showing actual cash receipts statement on p. 48Income and expense patterns change over the life cycleIncomeWages, salaries, bonuses, interestCash inExpensesCash outFixed expenses – predetermined K typesVariable expenses --- amounts change form period to periodI – E = Cash surplus or deficitBreakdown of expenses pie chart p. 49PreparationIncome from all sources during the periodEstablish meaningful expense categories --- line items are not fixed in stoneI – E = surplus or deficitUse of the Financial StatementsKeeping good recordsOrganization of recordsRatio AnalysisSolvency ratio = NW / total assetsLiquidity ratio = liquid assets / current liabilitiesSavings ratio = cash surplus / income after taxesSavings ratio = cash surplus / NI (after taxes)Debt service ratio = monthly loan payments / before tax incomeBudgetWorksheet p. 58Purposes maintain nec infodecide how to allocate incomeimplement disciplines spending programreduce needless spendingachieve fin goalscash budget --- cash basisestimate income over timeestimate expenses over timeif in deficits ---if deficit in some months, try to balance cash flows by payments evenly doneuses savings, investments, or borrowing to cover temporary deficitsliquidate S and I or loan enough to meet shortfallreduce / eliminate low priority expenses from budgetincrease incomemoney in action boxenroll in 401 kraise car ins deductable (on older cars)pay of credit cardsreduce energy costs budgeting TV, phones, internetETCBudget control schedule WORKSHEET p. 63Compares actual income with expenses across budget categoriesTime Value of MoneyA dollar today is worth more than a dollar received in the futureTime lineSimple interest Compounding --- interest added to interestPrinciple 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 72How long does it take to double your money? # of years = 72 / annual compound interest rateAnnuity stream = amount each year (even and equal CF)As a perpetuity, PV = CF / r; PV = CF / 1+rThen, into the future a defined number of years (or periods), PV = FV / (1 +r)NFV = amount * FV factor FV factor is Appendix A, p. 543FV = PV * (1+r)FV = PV (1 = r)NFV, On calculator --- PV = 1000N = 5Y = 10Pmt = 0Cmpt FV = 1,610.5For FV Annuity stream with even CF Yearly Savings = amount of money desired / FV annuity factorFV annuity factor is Appendix B, p. 543FV = A [((1+r)N – 1) / r], FV annuity income stream on calculator ---PV = 1000N = 5Y = 10FV = 0CMPT PMT = 263.79PV = FV * PV factor, PV factor is found at Appendix C, p. 544 PV = FV / 1+ rPV = FV / (1+r)NPV on Calculator FV = 1610.5N = 5Y = 10PMT = 0PV = 1000PV annuity stream even CF, Appendix D, p. 544Annual withdrawal = initial deposit / PV annuity factorPV = 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 calculatorFV = 1610.5N = 5Y = 10263.79Note: PV, FV, and Annuities on PV and FV are summarized in a separate outline on Time Vlaue of Money.Three methods are enumerated (appendixes, financial calculator, equations)All four items of PV, FV, annuity PV, annuity FV are also enumeratedCan use any method to calculateAll four items are testableChapter 3 – TaxesFederal Tax PrinciplesTaxes fund federal governmental activities.> 1/3 of gross income in taxesGoal of tax planning --- LEGALLY minimize the taxes you payFederal tax is principally on income (import tariffs, etc also exist). Income tax is progressive in natureMarginal tax rate is the rate of taxes on the next dollar earnedAverage tax rate is the rate for your entire incomeFiling status --- single; married filing jointly / filing separately; head of household; widowsFederal withholding taxes are the amount withheld from the employee’s paycheckFICA tax is SSA; employer has a share and e/e have a % share (2008 7.65% each)Applies to only a certain amount ($102K in 2008)Taxable IncomeNot all income is taxed, only the portion that is considered taxableSubtract deductions and adjustmentsExhibit 3.1, p 80 has chart that goes from gross income to taxable income to tax liabilityGross income includes wages, bonuses, interests, dividends, alimony, pension income, etcActive, passive, portfolio income Passive is defined as RE, LP, etcPortfolio income is usually in the form of dividends and bond interestCan also be from capital gainsCapital gains is taxed at different rates and are flatPage 82, exhibit 3.2Adjustments to gross incomeEducational costsIRA contributionAlimony, etcAGI = gross income - adjustmentsThen, deductionsStandard deduction --- filing status, age (can range from 5450 to $15,100)Itemized --- medical costs, theft losses, job and moving expensesUse whichever way is greater. Then, ExemptionsDeductions from AGICan claim exemptions for himself, spouse, dependentsExemptions are phased out for high incomesThen, calculate tax rates --- tax rate schedulesTax credits reduces taxes due (not taxable income)And thus are very valuableAdoption creditElderly / disabilityMortgage interestQualified electric vehicleAvoiding common tax errors (p. 91)Other ConsiderationsCan estimate taxes due and pay on scheduleThis is for situations where insufficient withholding occurs to cover all tax liability (interest income, etc)Filing estimated taxes to avoid tax penaltyFiling deadline on April 15Can file an extension for 6 monthsCan also file amended return if prior year income or expenses are received or paid in current yearTax auditsTax planningTax evasionTax avoidanceMaximize deductionsIncome shifting --- move income to custodial accounts and other lower income levelsTax deferred income (retirement types)Tax free income (ROTH IRA)Chapter 4 – Cash ManagementRole of Cash Management in Financial PlanningCash management is the daily administration of cash and near-cash resources (liquid assets)Liquid assets include cash, checking accounts, savings accounts, money market, CD, US T bill, US savings bond Financial Services MarketplaceDepository financial institutions --- banks, S&L, credit unionsDeposit insurance exists against failure of institutionFDIC (banks and S&L); Natl Credit Union Admin (credit union)$250,000 per depositor (not per deposit account)Need to have accounts at two different banks if deposits > 250KCan have more than one name (i.e. spouse; trust; Keugh)Non-deposit financial institution – stock brokerage, mutual funds, DescriptionsChecking accounts is a demand deposit; pays no interest usually; service charge waived with a minimumSavings accounts are time deposits; interest payable, ranging on amount in accountMany withdrawals are immediateSome interest bearing checking accountsNOW accounts (neg order of withdrawal) (checking with interest)Money market deposit accounts – federally insured; sometimes ATM and checking privilegesMM mutual funds Pay above saving accounts because they can invest in US treasuries, corporate ST notes, etcChecking privilegesBut are NOT insured (breaking the buck in the recession)asset management accounts (AMA) usually offered by brokerages and mutual fundscombines checking, investing, borrowing; have ATM privileges but do not have branch type activities, being issued from a brokerage or mutualElectronic Banking ServicesElectronic Funds Transfer System (EFTS) Can transfer funds electronically Debit cards – allow xfr from bank acct to business acct to pay for goods & servicesATM’sAutomatic deposits and payments (SSA deposits; utility payments)Bank by phone accountsOn-line banking servicesPros and cons (p. 120)Regulation of EFTS Services (p. 121)Safety deposit boxesMaintaining Checking AccountOpening a checking accountCost and monthly service charges; min balance chargesIndividual or joint accountChecking account procedures (ledgers)Overdraft protection Stop payment order on a checkMonthly statementTypes of checksCashiers check -- drawn on a bank account. Traveler’s check – make purchases with this when travelingCertified check – bank guarantees the funds Establishing a Savings ProgramSpecific savings plan --- set aside same amount per monthTen strategies of savings – page 131Making savings a priorityLook at spending habitsPayroll deductionBank your bonus or raiseWork harderMake the loan payments on time !Watch the return ratesReinvest dividends and interest Set up retirement plan at workSplurge every once in a whileInterest conceptsInterest on interest (compounded)Simple interest Stated rate (nominal) --- promised rateEffective rate of interest (EAR) --- The interest that is actually earned during the periodEAR = interest earned during period / amount investedCompound interest is the same thing as FVVariety of ways to saveCD --- time deposits, with penalties for early withdrawalsUS Treasury Bills – ST bills (3 or 6 months)Issued by US govt to fund the national debtIssued at discount, and then paid at full value on maturityVery liquid; can be sold in secondary markets; brokerage feeCan purchase directlySeries EE bondsSavings bonds issued by US TreasuryBacked by full faith and credit of US govtLonger maturity datesInterest is paid by US govt when cashed in, or at maturityPurchase price is 50% of face valueExempt rom state and fedl taxesSeries HH bondsInterest paid semiannually at fixed ratesSimilar to a regular corporate bondI savings bondSavings bond issued at face value by US treasuryInterest 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 CPINo secondary market, transactions are only with TreasuryChapter 5 – Auto, Housing DecisionsBuying an AutoTen steps on buying a car, exhibit 5.1, p. 142Down payment, loan payment, making it part of the budgetOperating costsGas, diesel, fuel economyNew, usedSize, styleWarranties, Finding the best car for you, exhibit 5.3, at 147. Negotiating a priceSales KTrade inLeasing an AutoClosed end lease --- at end of term, turn the car inOpen ended lease – if the car is worth less than an estimated residual value, lessee owes the differenceResidual value – remaining value of car at end of leaseFactors in a lease payment calculationCapitalized cost of the car (price of car)Capital cost reduction (down payment)Forecast residual value of the carThe financing rate or money factor The lease termDepreciation = capitalized cost – residual valueMonthly payment = ((depreciation + sales tax) / months of lease) + lessor’s required monthly return (at the money factor)Multiply money factor * 2,400 = Annual percentage rateLease terms 2 to 4 yearsEarly termination penalties are often commonApplies in cases of theft or property loss of vehicleGap insurance for early termination caused by theft or lossYou are responsible for insurance and maintenanceWill pay for unreasonable wear and tearScheduled maintenance at dealer to avoid wear and tearPurchase optionAmount of purchase is Stated in the lease at the outset, at timesSometime market priceOr residual valueTry to negotiate a fixed priceWhether to buy at end of lease depends on whether purchase price is lower than the market valueAnnual mileage allowance (10 to 15,000 per year)10 to 25 cents per mile above the allowance; this is negotiableTo avoid this, some people will own a second vehicle if long trips are contemplatedOr rent a car for vacationsLease vs purchase analysisWorksheet 5.1, p. 153Housing – rent or buyTypes of homesSingle familyCondominiums – ownership of one unit in a multi-unit complexCo-ops (own a share of a corporation that owns the building)RentalsRental optionsLease KRestrictions on pets, children, sub-leases, etcSecurity depositRent; payment due date, penaltiesRent vs ownHousing prices, interest ratesTax credits for homeownersExpected change in home prices over timeWorksheet 5.2, p. 159Need to also consider esthetics, personal needs and desiresHow much can you afford? Mortgage interest deduction on taxes; property tax deduction tooBut must itemize (not use the standard deduction)Acts as an inflation hedge, with housing going up by CPI +Costs --- Down payment – loan to value ratio (20% down etc)Fannie Mae requires only 3% downPrivate mortgage insurance -- protects lender in case of a defaultTypically required if down is 20% or lessPMI must end under federal law once mortgage is down to 78% of orginal home valueMortgage points – 1 point = 1% of amount borrowedFees charged by lenders at time of mortgageRelated to lenders supply of loanable funds and demand for mortgagesGreater the demand, or less the supply, the more the pointsEx: 5 % + 3 points vs 6% + 1 pointPoints are paid at closing and increase the APR; each point increases APR by 0.11% on a 30 year loanPoints are tax deductable on a new mortgage, but must be amoritzied on a refinancingClosing costs are paid by borrowersMortgage fees, filling fees, title fees, attorney feesMortgage paymentsMost of payment goes to interest --- graph, p. 163Can figure payments by mortgage table, exh 5.8, p. 164 OR Annuity / PV keys on fin calculatorAffordability ratiosBorrower must be qualifiedOn 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 incomeProperty taxes / insurancePrincipal, interest, property taxes, homeowners insurance (PETI)Sometimes, monthly PETI goes into an escrow account for lender payment of taxes, insuranceProperty taxes vary by county, city, school, etcBased on assessed value Property taxes may range form 0.5% to 2% of market valueHomeowners insurance around 0.25% to 0.5% of market valueMaintenance costs on homeP. 169 box on home buying remodeling project paybacks Roadmap on buying a home --- p. 165 boxHome affordability analysisWorksheet 5.3, p. 166how much mortgage will monthly payment buy Fin calculator annuity / FV keys on fin calculator, p. 167Can also use table at 167 to estimate Home buying processShopping the marketReal estate short sales – sale < amount owed (aka distressed sales)Banks can recover as much of loan balance as possibleForeclosure – lender takes title to property after loan defaultForeclosure done over short sales where banks believe foreclosure will net more money than a distressed sale RE agentsMLS – agent listed RE commissions range from 5 to 6% on new homes, 6 to 7% on used homesBrokers represent the sellers usually, although buyers can line up a broker tooPrequalifying for a home mortgageKnow how much of a home you can buyRE sales KMust be in writingEscrow deposit – good faith when making an offerCan forfeit in case of withdrawalValid reasons for withdrawal do not forfeit; such reasons are stated in KContingency clause conditions offer upon certain events Passing termite inspection, obtaining financing, etcGood warranty titleDisclosure of closing costs and other items required by RE Settlements Procedure ActClosing statementAvoiding common RE buying mistakes Exh 5.10 at 172. Financing the transactionSources of mortgage loansMortgage bankerMortgage broker – solicits borrowers for youTypes of mortgage loansFixed rate loans -- traditional 15 or 30 year loan15 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 loanBalloon paymentsEntire 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%)Adjustable rate mortgage (ARM)Interest is adjusted on basis of market interest rate movementsMost ARM’s are 30 year lonas Adjustment period – the period that the interest rate can be adjusted (i.e. every 6 months)Initial rate may be 2% below the 30 year fixed rateIndex 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 rateInterest rate cap is the limit that the rate can increase each periodPayment cap is the payment increase that can increase each periodInitial monthly payment can be done via fin calculator p. 176 annuity FVNegative amortization --- when payment is set below the interest charge, the principal balance INCREASES over timeAvoid 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 ARMAttractive if general interest rates declineTwo step ARM’s – initial rate 5 to 7 years, and then a higher rate beyondIndex on the ARM dramatically affects the level and stability of the loan6 month T bill, LIBOR, CD indexes, etc, 11th Federal Home Loan DistrictThe 11th District is less volatile bc it averages costs of funds to S&L’sCD and LOBOR indexes are sharper and more frequent in changes in both directionsFixed rate or AR M?When rates are high and may come down, convertible ARM’s may be good, or even regular ARM’sDanger 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 2007Text – if the buyer expects to be in home 5 + years, fixed rates may be goodOther payment options Interest only mortgageAlso very popular in 2001 – 2006Graduated payment mortgageUnusually low payment and then increase to a fixed amountGrowing equityFixed rate with payments increasing over timeAllows principal to be paid off more quicklyShared appreciationLowe interest rate bc lender shares 30 to 50% of the appreciation in the home when soldBi – weekly mortgagesBuydown --- builder may subsidize the financing for a short time as an inducement o buy the home(also not in text – equity loans) (not in text --- reverse equity)Loan sourcesConventional mortgage lender assumes risk of default (need 20% down)FHA mortgage insuranceFHA reimburses lenders for a defaultInterest rate is also lower than on conventional loansLenders pay a premium VA loan guaranteeLike a FHA loan but lenders do not pay a premium for eth guaranteeRegional differences in VA loan requirements Refinancing the MortgageIf rates drop by 1 to 2% below the mortgage rate, it may make sense to refinanceWorksheet 5.4, p. 180May be able to reduce time period, or to reduce monthly paymentChapter 6 – Using CreditBasic ConceptsUse credit for ---avoiding paying cash for large outlaysfinancial emergenciesconvenienceinvestment purposes (margin buys)Good review of the collapse of credit, 2007 -2009Improper use of creditend up paying too much in interestdanger sign box, p. 191establishing creditopen checking and savings acctsopen the first credit card and charge small items each monthpay on timethis establishes a good credit hxbuilding up a strong credit hx5 c”s of credit box, p. 192Debt safety ratio = monthly consumer credit payments / monthly take home pay20% ratio is the MAXMore likely 10 to 15%, especially if there is a mortgageWorksheet 6.1, p. 194, loan payments and debt safety ratioForms of CreditOpen account credit consumers open credit ahead of the purchasecredit limits attacheddept stores, retail, industrial situations --- buy something from that one storeBank credit cardsThis is consumer credit, Visa, MC, etcCan pay for anything anywhere Can borrow money too thru cash advancesCredit limitsInterest chargesBase ratesGenerally higher than other forms of creditGrace period to payAdditional fees ATM feesLate payment feesOver the limit feesCredit Card Usage Act of 2009 changed many of these feesImpact of new law – box 6.4, p. 198Balance transfersTransfer feeMany times, monthly payments will be charged on the balance transfer (lower rates) and then the older balances (higher rates)Reward cardsairline mileage, car rebates, other merchandise rebatesAffinity cardscoordinate with a sponsor (non-profit, etc)CC checklist box, p/ 200Secured CCCollateralizedstudent ccretail cc (stores, gas)Debit cardscharges against a checking acctlike writing a check;essentially, paying with cash, not creditconvenience of credit but without the interest ratesdoes not provide a line of creditcan avoid interest by just paying off a cc on time in wholepre-paid cardsRevolving credit linescan write checks against the linesbanks, brokerages have thesecash advances thru the credit line established overdraft protection on credit available when linked to bank checking acctunsecured personal lineshome equity lineequity in home is the collateralinterest can be tax deducted up to 100K in principal (or up to FMV of home)usually cheapest form of creditObtaining open credit credit applicationcredit investigationcredit bureaucan obtain a copy of your credit reportcredit scoring evaluates creditworthinesskeeping the FICO score box, p. 210 FICO is fair, Isaac & Copayment hx (35%)amount owed (30%)length of credit hx (15%)new credit (10%)types of credit used (10%)300 to 850Finance charges annual percentage rate (APR) = actual or true rate of interest chargedaverage daily balance (ADB) = interest is charged on the ave daily balanceexcluding or including new purchases including new purchases has higher inters ratesManaging Creditminimum monthly paymentsUsing Credit Wisely shop around for the best dealannual fees, rate of interest, grace period length, method of calculatingidentity theft problems and suggestions, p. 217Bankruptcypersonal vs corporatewage earner planfor steady income, chapter 13creditor planstraight bankruptcymost debt is eliminateddebtor can retina equity in a home, toomust still make federal tax payments, alimony and child supportcan keep retirement and SSA paymentscredit counselorsChapter 7 – Using Consumer LoansBasic Featuresauto loansdurable goods loans (TV’s, etc)education loanscollateral on some loanspersonal loans consolidated loansstudent loansvarious student loan programs at a glance box, 228college savings planssingle payment vs installment loans; fixed vs variable paymentsobtain loans from --commercial banksconsumer finance companiescredit unionsS&LSales finance companiesCaptive finance companies (GMAC)Life insurance companiesCash value Friends / relativesManaging creditShopping for loansPredatory lender box, p. 233Finance chargesLoan maturityTotal cost of transactionCollateralNo payment no interest box, p. 234Consumer debt inventory worksheet, p. 235Loan paymentslien chattel mortgage collateral noteprepayment penaltyloan rollover into other loansloan disclosure statementsinterest calculationssimple interestcharge = principal * interest rate * term of loan stated in yearsfc = p * r * tAPR = ave annual finance charge / ave loan balance outstandingBook does not state at this point, but the principal is declining Discount methodInterest is computed and then subtracted from the principalCalculation the same way as with simple interest’Fiancé charges are paid in advanceDiscount method ends up having a higher APR than with simple interestExample page 241Installment loansheavily used in consumer financemost such loans have collateralrate of interest and loan maturity table, p. 243 – this is an amortization table, since interest charges are built into the tablecan figure out the monthly payment from a financial calculator, p. 244add on methodcomputes finance charges on original loan valuedeclining balance charges a lot less interest --- interest charged on only the existing balance (or simple interest), example at p. 246APR can be calculated with add-on method, p. 245 with fin calcPrepayment penaltiesSum of the digits method or rule of 78Higher interest rates charged on early paymentsTry to avoid such loans !Credit life or dib insChapter 8 – Life InsuranceNote: This was not covered in class, so ir will NOT be on Quiz 2. It will be on the Final AssessmentBasic ConceptsRisk Concepts Risk avoidanceLoss prevention --- reduction of probability that a loss will occurLoss control ---- lessening the severity of the loss once the risk occursAssumption of risk ---- assuming and bearing the riskInsurance --- contract between insured and insurer for the insurer to reimburse for losses Transfers the risk to the insurance companyInsurance companies will combine the losses, using actuarial data, and estimate the risk faced by the entire insured populationIncrease predictability of a loss and of the severity of a loss Accurately estimating the frequency and magnitude of losses is critical for insurance poolsUnderwriting basics This is the process to decide who will be insured and to charge appropriate premium ratesrate classification schedules are done so that people pay premiums reflecting their probability of a lossunderwriting – guards against adverse selection this occurs when only high risk people apply for insurance if underwriting stds are too high, people cannot get insurance; if stds are too low, insurance company is likely to go insolventExcellent health makes a preferred insured for health or lifeLife InsuranceProtects against financial loss in the event of the insured’s deathBenefits of insuranceFinancial protection of dependentsProtection from creditors This occurs when beneficiaries are named, avoiding probateLife ins benefits only go to the estate (and to creditors) when no beneficiaries are namedThis is bc life ins proceeds belong to 3rd party beneficiaries of an assignment K and not to the estateTax benefitsPayments are generally not taxable since they recoup for a loss and are not income Savings Can have investment aspects to themWho needs life ins? Anyone who has dependents in financial supportSpouse, childrenHow much life ins? Multiples of earnings method --- multiplying gross annual income * (number)rule of thumb --- 5 to 10 timesneeds analysis methodconsider the financial obligation and available resources in addition to life inssteps: 1) estimate total economic resources needed if person diesincome needed to maintain adequate lifestyleextra expense upon deathspecial needs for dependents debt liquidationliquidity2) determine all finl resources available after death, including life ins and pensionssocial security survivor benefits3) amount needed – amount avail = life ins neededWorksheet on this method, p. 263Buying life ins box, p. 261Types of Life PoliciesTerm 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 throughoutPremiums will increase over time, due to increasing prob of deathDecreasing term --- Same premium, decreasing benefitsPros and consFairly cheap (pro)Con --- usually not renewable on end of termConvertibility --- can convert to a comparable whole life ins (nice pro, if available)Has little or no cash value (con)Whole Life On-going life ins over the entire life of insuredCash surrender valueaccumulated refundable amount of the policy if you want to terminate the policy has modest savings valueis a non-forfeiture right to cash value in the event of an early termination of policygraph on increase in cash value vs death benefit, p. 268continuous premium policy this is straight life --- level premium each yearlower premiums for younger people – used as a marketing tool by ins agentsbut total ins premium paid over your life is likely to be higherlimited paymentpremium payment is for a specific period (usually work life), while benefits go onsingle payment (SPLI)this amounts to a tax sheltered investmentproceeds are tax deferredbut early withdrawal bf 59 ? or loans taken against SPLI have early withdrawal penalties attachedinsurance company ownership structure box, p. 269mutual company is owned by policy holders, with company dividends going to policy holdersstock company is owned by equity, with stock dividends going to shareholders low load life ins keeps sales commissions down from 20 – 25% of total ins premiums to 5 to 10% of premiumscash values grow more quickly pros and conspro --- death benefit and early termination cash value (unlike term)pro --- can borrow against the policy benefitpro --- savings / investment component to itcon --- very expensive ! con --- provides less death benefit per dollar than termdifference is the cash value / savings component of the policycon --- lower yields in the savings component than with alternative investments who needs whole life? Some analyst recommendations --- whole life / cash value for the perm needs for ins, regardless of ageThen, 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 InsurancePermanent 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 Cash portion earns varying interest rates with a stipulated minimumCost of term ins can then be withdrawn from the cash value to pay for death benefitTax laws require that that the death benefit > cash value Death benefits are tax freeOption A provides a level death benefitOption B will increase its death benefit along with the cash valuePros and cons Pro --- flexibility – cost of death benefit can be taken from premiums or cash valueLife cycle needsPro – savings component Con --- premiums may never disappear (if interest rates on cash value are too low)Con – universal life carries heavy fees compared to other policy typesOther types of Life InsVariable life --- benefits are a function of market level returns generated on investments Group life ---master life policy for a group; this is almost always term ins, with premium paid on characteristics of an entire groupemployers do this very often for all employeesmembers 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 beneficiarycost of the loan has built into it a credit life policy mortgage life --- will pay off the mortgage in the event of a mortgagee’s deathindustrial life ---whole life with small face amounts (1K; 5K, etc)cost much more per 1,000 of insurance than whole lifemarketed to day to low income families(KCK note: very popular after WWII as a way to insure costs of funerals, etc)Buying life InsNice box on pros and cons of each form of ins, p. 275Compare costs and featuresFeatures box, p. 276Select an ins companyIns medical exam box, p. 277Unethical ins sales box, p. 278Ins company ratings agencies, p. 278Choosing an agentFiling a life ins claim box, p. 282Key Features / Clauses of Life Ins Policies Insurance projections box, p. 280Beneficiary clause – primary and contingentSettlement / payout options Lump sum benefit payment (95% of beneficiaries choose this)Interest onlyFixed periodFixed amountLife incomePolicy loans Premium paymentsGrace periodNo-forfeiture options upon early termination Most state laws mandate some benefits for early term of whole lifeCompanies will offer as alternative to cash value –Paid up insuranceExtended term insPolicy reinstatementChanges of policiesIndemnification clausesDouble or triple value if death in an accidentDIB clauses Waiver of premium in the event of a DIBCould also insure DIB directly as a rider on life insSo, would be a DIB benefit + a life benefitGuaranteed purchase optionCan have the right to buy added ins without proof of insurability (another medl)Suicide clause voiding the policy Aviation, war, hazardous occupation exclusionsParticipation clauses allow policy dividend = actual premiums – premium necessary for actuary mortalityLiving benefits --- can receive a % of death benefit prior to death This occurs where LT health issues arise (nursing home, etc)Viatical settlementsterminally ill policy holders can receive % of death benefit for immediate use (commonly 60% of policy value)handled thru 3rd party investors after death, investor receives the policy on an assignment ................
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