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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jwalker@wtamu.edu