Preparing for the Final Exam –

Review #1

Personal Finance: Another Perspective

Preparing for the Final Exam

How to do well on my exams (by order of what I think is most important):• 1. Review the PowerPoints for each class

• These are the things I consider important• Especially look for application problems

and know how to do them• 2. Review the previous quizzes and exams

• Check your quiz answers from Blackboard• 3. Review the homework problems and readings

• Think through the purpose for each problem• 4. Write up a good reference card (8.5” x 11”)

• It is an open reference card but closed everything else test

Financial Statements

Data: Mickey and Minnie, both recent BYU graduates in

2004, together get paid $4,500 every month. Monthly expenses include $750 on taxes, $1,200 on housing and utilities, $750 on transportation, $350 on food, and an average of $1,000 on clothing and other expenses.

Calculations: Prepare an income statement and then calculate and

interpret their net and gross savings ratio.

Application: How are they doing?

Both get $4,500 every month. Monthly expenses include $750 on taxes, $1,200 on housing and utilities, $750 on transportation, $350 on food, and an average of

$1,000 on clothing and other expenses. Calculate and interpret their net and gross savings ratio. How are they doing?

Both get $4,500 every month. Monthly expenses include $750 on taxes, $1,200 on housing and utilities, $750 on transportation, $350 on food, and an average of

$1,000 on clothing and other expenses. Calculate and interpret their net and gross savings ratio. How are they doing?

Income Statement Income before Tax 4,500 Expenses Taxes 750

Utilities/Housing 1,200 Transportation 750

Food 350

Clothing/other 1,000

Income for Savings $450

Net Savings Ratio (2)Income for Savings 450 = 12%Income for Living 3,750

Gross savings ratio: Income for savings / Total Income: 450 / 4,500 = 10%

They save 12% of their net living expenses and 10% of their gross. While this can be high or low, depending on the age and situation of the family, it is the minimum for us. I would hope it is closer to 20% for those in this class!

Consumer Loans

Data: Jonathan needs approximately $2,500 to buy a new

computer. A 2-year unsecured loan is available with in-store financing for 10%. The current rate on his revolving home equity line of credit is 5.75%, although he is reluctant to use it. Jon is in the 28% federal tax bracket and the 5.75% state tax bracket.

Calculations and Application• a. What are the advantages and disadvantages of each

loan? b. Regardless of the loan chosen, Rich wants to pay off the loan in 24 months. Calculate the monthly payments for him, assuming both loans use the simple interest calculation method. c. Which loan should he choose?

Jonathan needs $2,500. A 2-year in-store unsecured loan is 10 percent. The revolving home equity line of credit is 5.75%. Jon is in the 28% federal and the 5.75% state tax bracket. a. What are the advantages and disadvantages of each loan? b. Rich wants to pay off the loan in 24 months. Calculate the monthly payments.

Jonathan needs $2,500. A 2-year in-store unsecured loan is 10%. The revolving home equity line of credit is 5.75%. Jon is in the 28% federal and the 5.75% state tax bracket. a. What are the advantages and disadvantages of each loan? b. Rich wants to pay off the loan in 24 months. Calculate the monthly payments. c. Which loan should he take?

A. Advantages and Disadvantages• Unsecured line of credit

• + No collateral needed• + Cheaper than a credit card• + Does not put the house at risk• - Expensive

• Home equity loan• + interest may be tax deductible• + secured loan so lower rate• - Fail to repay loan--may lose the house

Jonathan needs $2,500. A 2-year in-store unsecured loan is 10%. The revolving home equity line of credit is 5.75%. Jon is in the 28% federal and the 5.75% state tax bracket. a. What are the advantages and disadvantages of each loan? b. Rich wants to pay off the loan in 24 months. Calculate the monthly payments. c. Which loan should he take?

B. The unsecured loan monthly payment would be: PV = -2,500, I = 10/12, N = 24, PMT = ? • $115.36

The home equity loan monthly payment would be: PV = -2,500, I = 5.75/12, N = 24, PMT = ? • $110.52

The home equity loan would save $116.16. In addition, the loan would save $51.46 in taxes based on the deductibility of the interest: [($110.52*24)] -$2500] * .3375 (28%+5.75%). • What Jonathan has to decide is whether or not the

$167.62 in total savings is worth the risk of losing the house if he cannot repay the loan. I would be very very very careful

Jonathan needs $2,500. A 2-year in-store unsecured loan is 10%. The revolving home equity line of credit is 5.75%. Jon is in the 28% federal and the 5.75% state tax bracket. a. What are the advantages and disadvantages of each loan? b. Rich wants to pay off the loan in 24 months. Calculate the monthly payments. c. Which loan should he take?

C. Either answer is ok, depending on the why. The home equity loan is cheaper, with tax savings. The unsecured debt does not risk losing the house. Helpful would be to know whether his is living on a budget and if he has the discipline to pay back the loan quickly.• The after-tax cost of the 5.75% home equity loan

would be 3.81% using the following calculation that considers the tax savings on both federal and state taxes

• 3.81% = 5.75% [ 1 -(.28 + .0575)]

The Housing Decision

Data: You have made the decision to purchase a house, and you found the house

you want for $200,000 (assume no down-payment for the sake of this problem). You and your wife have agreed to a 30-year loan, but expect to pay it off in 7 years as your work looks extremely promising (assume annual payments). Your wife looked on the web, and found a $200,000 loan with no points and no fees at 6.5%, which she is sure, she can lock in. You talked with you friend who is a mortgage broker, and he knows he can get you a 6.0% loan for the $200,000, but it has 2 points and a loan origination fee of $1,500. Assume you can get either of these loans.

Calculations and Application Calculate the (a) total costs for each loan assuming you pay them both off in

7 years (assume you make the final balloon payment at the end of year 7). (b) What is the effective interest rate of each loan? (c) Which is the cheaper alternative? (d) Your broker comes back and says she can offer you 5.75% but with 3 points and the same $1,500 fees. What is effective cost to you (i.e. the impact on your effective interest rate) of that third point (i.e. calculate it with the three points and fees, then compare that to your calculation with 2 points and fees, and subtract the difference)?

Quick Review of EIR Process

1. Calculate the Payments of the

total on the total amount of

the loan

2. Calculate the amount

received after subtracting all

your costs

3. Calculate the balloon payment due at the end

of the prepayment period

4. Set PMT to payment, -PV to

amount received, FV to balloon payment, N to

years before prepayment, and solve

for I or your EIR

Loan A: $200,000, 30-year, no points and no fees, 6.5%, Loan B $200,000, 6%, 2 points, 1,500 fees, all pay it off in 7. Calculate total costs each loan, effective rate, cost of 2nd point.

Loan A: $200,000, 30-year, no points and no fees, 6.5%, Loan B $200,000, 6%, 2 points, 1,500 fees, all pay it off in 7. Calculate total costs each loan, effective rate, and Loan C of 5.75%, 3 points, 1,500 fees, all pay it off in 7.

Loan A: since no points and fees, the EIR = APR Loan B 1. Calculate the Payment

• I = 6.0% N = 30 PV = -200,000, PMT = 14,529.78 2. Calculate the amount received

• Points = 2 for $4,000 plus 1,500 fees = 200,000 - 5,500• Loan receipt less points of = 194, 500

3. Calculate balloon at the end of year 7• N=23 (30 - 7 years), I= 6%, PMT = 14,529.78, PV = ?• PV Remaining = $178,765.42

4. Calculate the effective interest rate • PMT = $14,529.78, FV = $178,765.42, PV = $-194, 500,

N = 7 I=?• EIR = 6.52%

Loan A: $200,000, 30-year, no points and no fees, 6.5%, Loan B $200,000, 6%, 2 points, 1,500 fees, all pay it off in 7. Calculate total costs each loan, effective rate, and Loan C of 5.75%, 3 points, 1,500 fees, all pay it off in 7.

Total Costs: Loan A: 7 x 15,315.49 + 180,265.39 = $287,474

• EIR = 6.5% Loan B: 7 x 14,529.78+178,765.42 + 5,500 = 285,974

• EIR = 6.52Cost of the Loan C and third point Loan C: 7 x 14,143.25 + 177,981 + 7,500 = 284,484 PMT = 14,143.25, FV = 177,981, PV = -192, 500, N =

7, I = ? EIR = 6.46%Cost of the third point = 6.52 – 6.46 = .06% Loan C is the cheapest loan both in rate terms and in

dollar terms

Tax StrategyData: Using the married filing jointly status and their income and expense statement

below, calculate the 2006 tax liability for Mork and Mindy Williams (they have five children, ages 4, 8, 12, 16, and 18). Mindy is the Young Women’s President of her ward and has calculated that she drove her car 300 miles last year to girls’ camp, which was not reimbursed. Exemptions are $3,300 per person, the standard deduction for married filing jointly is $10.300, medical expenses over 7.5% of AGI and job-related expenditures over 2% of AGI are deductible, charitable deductions for mileage are .12 per mile, and the child-tax credit is $1,000 per child under 17. a. Calculate their tax liability first using the standard deduction and then using itemized deductions. b. Write a paragraph explaining to the Williams which method they should use and why? In that paragraph, comment on their marginal and average tax rates on taxable income.

Income ExpensesEarned Income $74,000 Home Mortgage interest 6,200Interest Income 2,100 Un-reimbursed Medical Bills 4,900 Retirement Plan Contributions DI and other donations 250Mork’s IRA 3,000 Job-related expenditures 1,800Mindy’s Roth IRA 2,000 Tithing and other offerings 7,000

Tax Table for Married Filing Jointly for 2006:Amount Tax

• 0 to $15,100 10% • $15,100 to $61,300 $1,510 plus 15% of the amount over $15,100• $61,300 to $123,700 $8,440 plus 25% of the amount over $61,300

Quick Review of Tax Process

1. Start with income from all

sources less exclusions = Total Income

2. Subtract adjustments to Total Income = Adjusted Gross Income (AGI)

3. Minus Standard

Deduction or Itemized

deductions

4. Minus exemptions = Taxable

Income

5. Look up tax on tax table = Tentative Tax

6. Minus credits = Total Tax

Owed

7. Minus taxes already paid = Balance Due or

Amount of Refund

Tax Liability (standard deduction)

1.+2. AGI =74000+2100-3000 (IRA) = $73,100

Only the IRA is subtracted to get your AGI

3. Less standard deduction 10,300

4. Less personal exemptions (7 * 3,300) 23,100

Taxable income $39,700

Tax liability

$15,100*10%= 1,510

(39,700 -15,100)*15%= 24,600*.15 3,690

5. Total tax liability $5.200

6. Child tax credit -4,000

7. Total $1,200

Average tax rate = Total taxes due / Taxable income

Average tax rate = $1,200 / 39,700 = 3.0%

Marginal tax rate = 15% for both

Tax Liability (Itemized deductions)

1. + 2. AGI 73,100 3. Less itemized deductions:Home mortgage Interest 6,200 Un-reimbursed Medical

0Job related expenditures 338 Tithes & other offerings

7,000DI & other donations 250 Mileage 36• Total itemized (13,824)

4. Less personal exemptions (same as before) (23,100) Taxable Income $36,176 Tax liability

• 14,100*10%= 1,510 + [(36,176-15,100)*15%] = 3,161• 5. Total tax liability

$4,671• 6. Child tax credit less -

4,000• 7. Tax 671 • Average tax rate = $671 / 36,176 = 1.9%

Paragraph should include the savings ($529), recommendation, and average and marginal tax rates on taxable income, not gross income.