Personal Finance Exam 2

Monthly consumer credit payments should not exceed ____% of monthly net income

20%

Describe the basic operations and functions of a credit bureau.

A credit bureau is a type of reporting agency that gathers and sells information about individual borrowers. If, as is often the case, the lender doesn't know you personally, it must rely on a cost-effective way of verifying your employment and credit history. It would be far too expensive and time-consuming for individual creditors to confirm your credit application on their own, so they turn to credit bureaus that maintain fairly detailed credit files about you. Information in your file comes from one of three sources: creditors who subscribe to the bureau, other creditors who supply information at your request, and publicly recorded court documents (such as tax liens or bankruptcy records).

Bank Credit Cards

A credit card issued by a bank or other financial institution that allows the holder to charge purchases at any establishment that accepts it

Single-Payment Loans

A loan made for a specified period, at the end of which payment is due in full

Installment Loan

A loan that is repaid in a series of fixed, scheduled payments rather than a lump sum

Revolving Line of Credit

A type of open account credit offered by banks and other financial institutions that can be accessed by writing checks against demand deposit or specially designated credit line accounts

Factors to consider when purchasing a vehicle that affect your finances

Amount of down payment Size of the monthly loan payment Operating costs Type of vehicle Gas, diesel, or hybrid New or used Size, body style, and features Other considerations: Trading in/selling, fuel economy, safety measures

When might you request a loan rollover?

An individual will borrow money using a single-payment loan and then discover that he or she is short of money when the loan comes due—after all, making one big loan payment can cause a real strain on one's cash flow. Should this happen to you, don't just let the payment go past due; instead, inform the lender in advance so that a partial payment, loan extension, or some other arrangement can be made. Under such circumstances, the lender will often agree to a loan rollover, in which case the original loan is paid off by taking out another loan. The lender will usually require that all the interest, and at least part of the principal, be paid at the time of the rollover.

Why is it advisable for the prospective home buyer to investigate property taxes?

Because they're local taxes levied to fund schools, law enforcement, and other local services, the level of property taxes differs from one community to another. In addition, within a given community, individual property taxes will vary according to the assessed value of the real estate—the larger and/or more expensive the home, the higher the property taxes, and vice versa. As a rule, annual property taxes vary from less than 0.5 percent to more than 2 percent of a home's approximate market value. Thus, the property taxes on a $100,000 home could vary from about $500 to more than $2,000 a year, depending on location and geographic area.

What are closing costs, and what items do they include? Who pays these costs, and when?

Closing costs are all other expenses besides the down payment that borrowers ordinarily pay at the time a mortgage loan is closed and title to the purchased property is conveyed to them. The buyer typically pays the majority of the closing costs, although the seller may, by custom or contract, pay some of the costs. Closing costs are made up of such items as: (1) loan application fees, (2) loan origination fees, (3) points (if any), (4) title search and insurance, (5) attorneys' fees, (6) appraisal fees, and (7) other miscellaneous fees for things like mortgage taxes, filing fees, inspections, credit reports, and so on.

Financial costs that you should consider when purchasing a home

Down payment: Portion of the full purchase price provided by the purchaser when a house or other major asset is purchased Loan to value ratio: Maximum percentage of the value of a property that the lender is willing to loan Private mortgage insurance (PMI): Policy that protects the mortgage lender from loss in the event the borrower defaults on the loan Closing costs: Expenses that borrowers pay when a mortgage loan is closed and they receive title to the purchased property Property taxes: Levied by local governments on the assessed value of real estate for the purpose of Funding schools Law enforcement Local services Homeowner's Insurance Required by mortgage lenders and covers the replacement value of a home and its content Maintenance and operating expenses

Should you use cash or borrow to make a purchase? Depends on the interest rate.

Essentially, it all boils down to this: If it costs more to borrow the money than you can earn in interest, then withdraw the money from your savings to pay cash for the purchase; if not, you should probably take out a loan.

When does it make more sense to pay cash for a big-ticket item than to borrow the money to finance the purchase?

Essentially, it all boils down to this: If it costs more to borrow the money than you can earn in interest, then withdraw the money from your savings to pay cash for the purchase; if not, you should probably take out a loan.

Closing Costs

Expenses that borrowers pay when a mortgage loan is closed and they receive title to the purchased property Closing costs are like down payments: they represent money that you must come up with at the time you buy the house Closing costs are made up of such items as loan application and loan organization fees, mortgage points, title search and insurance fees, attorneys' fees, appraisal fees, etc.

What steps can you take to establish a good credit rating?

Here are some things you can do to build a strong credit history: • Use credit only when you can afford it and only when the repayment schedule fits comfortably into the family budget—in short, don't overextend yourself. • Fulfill all the terms of the credit. • Be consistent in making payments promptly. • Consult creditors immediately if you cannot meet payments as agreed. • Be truthful when applying for credit. Lies are not likely to go undetected.

Briefly describe the basic features of an installment loan.

Installment loans differ from single-payment loans in that they require the borrower to repay the debt in a series of installment payments (usually monthly) over the life of the loan. Installment loans have long been one of the most popular forms of consumer credit. As a financing vehicle, there are few things that installment loans can't do—which explains, in large part, why this form of consumer credit is so widely used. Most installment loans are secured with some kind of collateral—for example, the car or home entertainment center you purchased with the help of an installment loan usually serves as collateral on the loan. One rapidly growing segment of this market is installment loans secured by second mortgages referred to as home equity loans. Interest may be computed as simple and add-on interest to compute finance charges and monthly payments for installment loans.

Retail Credit Cards

Issued by department stores and oil companies Preset credit limits

What are the advantages and disadvantages of leasing a car?

Leasing is another way to pay for a car. You need to first look at the cost of leasing versus buying. Note the Financial Road sign in the chapter, "When Does it make Sense to Lease a Car?" The reasons are mostly not financial. If you plan to keep the car for 150,000 miles, buying will be better for you. Worksheet 5.1 gives a form for comparing the lease versus buy option.

Liens

Legal claim permitting the lender to liquidate the items serving as collateral to satisfy obligation

Consumer Loan

Loans made for specific purposes using formally negotiated contracts that specify the borrowing terms and repayment

Briefly describe the various benefits of owning a home. Which one is most important to you? Which is least important?

Major benefits of owning versus renting are: Tax shelter, that is, property taxes and mortgage interest are deductible for federal and state income tax, thus, these costs of ownership will reduce or "shelter" taxes on other income such as your salary. Costs of renting do not provide tax benefits. Inflation hedge, in general value of real estate increases over time. The major cost of ownership, mortgage interest, does not increase over time. Thus, the cost of ownership as a percent of the value of the house decreases over time. Within a certain time period, say a five year period, housing value may in fact decrease, but over longer period of time, the value will increase.

Debt Safety Ratio

Monthly consumer credit payments ____________________________________ Monthly take-home pay

What role does a real estate agent play in the purchase of a house? What is the benefit of the MLS? How is the real estate agent compensated, and by whom?

Most home buyers rely on real estate agents because they're professionals who are in daily contact with the housing market. Once you describe your needs to an agent, he or she can begin to search for appropriate properties. Your agent will also help you negotiate with the seller, obtain satisfactory financing, and, although not empowered to give explicit legal advice, prepare the real estate sales contract. Most real estate firms belong to a local Multiple Listing Service (MLS), a comprehensive listing, updated daily, of properties for sale in a given community or metropolitan area. Buyers should remember that agents typically are employed by sellers. Unless you've agreed to pay a fee to a sales agent to act as a buyer's agent, a realtor's primary responsibility, by law, is to sell listed properties at the highest possible prices. Agents are paid only if they make a sale, so some might pressure you to "sign now or miss the chance of a lifetime."

What is a lien, and when is it part of a consumer loan?

Most single-payment loans are secured by certain specified assets. For collateral, lenders prefer items they feel are readily marketable at a price that's high enough to cover the principal portion of the loan. The lenders don't take physical possession of the collateral but instead file a lien, which is a legal claim that permits them to liquidate the collateral to satisfy the loan if the borrower defaults. The lien is filed in the county courthouse and is a matter of public record.

Private Mortgage Insurance

Policy that protects the mortgage lender from loss in the event the borrower defaults on the loan; typically required by lenders when the down payment is less than 20%

Why should you investigate mortgage loans and prequalify for a mortgage early in the home-buying process?

Prequalification can work to your advantage in several ways. You'll know ahead of time the specific mortgage amount that you qualify for—subject, of course, to changes in rates and terms—and can focus your search on homes within an affordable price range. Prequalification also provides estimates of the required down payment and closing costs for different types of mortgages. It identifies in advance any problems, such as credit report errors, that might arise from your application and allows you time to correct them. Finally, prequalification enhances your bargaining power with the seller of a house you want by letting her or him know that the deal won't fall through because you can't afford the property or obtain suitable financing. And since you will have already gone through the mortgage application process, the time required to close the sale should be relatively short.

Fixed-Rate Mortgage

Rate of interest and the monthly mortgage payment are fixed The most common type of mortgage loan is the 30 year fixed-rate loan, although 10 and 15 year loans are becoming more popular as homeowners recognize the benefits of paying off their loan over a shorter period of time

Adjustable Rate Mortgage (ARM)

Rate of interest is adjusted based on market interest rate movements; therefore the size of the monthly payment is adjusted based on market interest rate movements

Describe how revolving credit lines provide open account credit.

Revolving lines of credit normally don't involve the use of credit cards. Rather, they're accessed by writing checks on regular checking accounts or specially designated credit line accounts. They are a form of open account credit and often represent a far better deal than credit cards, not only because they offer more credit but also because they can be a lot less expensive. The three major forms of open (non-credit card) credit are overdraft protection lines, unsecured personal lines of credit, and home equity credit lines.

How can you use the debt safety ratio to determine whether your debt obligations are within reasonable limits?

The easiest way to avoid repayment problems and ensure that your borrowing won't place an undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt! A useful credit guideline (and one widely used by lenders) is to make sure your monthly repayment burden doesn't exceed 20 percent of your monthly take-home pay. Most experts, however, regard the 20 percent figure as the maximum debt burden and strongly recommend a debt safety ratio closer to 15 percent or 10 percent—perhaps even lower if you plan on applying for a new mortgage in the near future. Note that the monthly repayment burden here does include payments on your credit cards, but it excludes your monthly mortgage obligation.

Identify several different types of federally sponsored student loan programs.

The federal government (and some state governments) have available several different types of subsidized educational loan programs. The federally sponsored programs are: • Stafford loans (Direct and Federal Family Education Loans—FFELs) • Perkins loans The Stafford and Perkins loans have the best terms and are the foundation of the government's student loan program. • Parent Loans (PLUS) PLUS (which stands for Parent Loans for Undergraduate Students) loans are supplemental loans for undergraduate students who demonstrate a need but, for one reason or another, don't qualify for Stafford or Perkins loans or need more aid than they're receiving. See Exhibit 7.1, Federal Government Student Loan Programs at a Glance for a concise explanation of the loan programs.

Briefly describe the two basic types of mortgage loans. Which has the lowest initial rate of interest? What is negative amortization, and which type of mortgage can experience it? Discuss the advantages and disadvantages of each mortgage type.

The fixed-rate mortgage still accounts for a large portion of all home mortgages. Both the rate of interest and the monthly mortgage payment are fixed over the full term of the loan. The payments are fixed and there is no uncertainty with the loan. The adjustable-rate mortgage (ARM) provides that the rate of interest, and therefore the size of the monthly payment, is adjusted based on market interest rate movements. Typically the ARM will have lower rated than the fixed-rate mortgage, at least initially. The rates will change as the general interest rates vary at each adjustment date, generally every five years. Some ARMs are subject to negative amortization— an increase in the principal balance resulting from monthly loan payments that are lower than the amount of monthly interest being charged. In other words, you could end up with a larger mortgage balance on the next anniversary of your loan than on the previous one.

What does the loan-to-value ratio on a home represent? Is the down payment on a home related to its loan-to-value ratio? Explain.

The loan-to-value ratio specifies the maximum percentage of the value of a property that the lender is willing to loan. For example, if the loan-to-value ratio is 80 percent, the buyer will have to come up with a down payment equal to the remaining 20 percent.

List and briefly discuss the different factors to consider when shopping for a loan. How would you determine the total cost of the transaction?

The major factors are: Finance Charges--What's it going to cost me? That's appropriate, because borrowers should know what they'll have to pay to get the money The rate of interest, known as the APR (annual percentage rate), includes not only the basic cost of money but also any additional fees that might be required on the loan. Loan Maturity--Make sure that the size and number of payments will fit comfortably into your spending and savings plans. As a rule, the cost of credit increases with the length of the repayment period. Thus, to lower your cost, you should consider shortening the loan maturity—but only to the point where doing so won't place an unnecessary strain on your cash flow. Total Cost of the Transaction--When comparison shopping for credit, always look at the total cost of both the price of the item purchased and the price of the credit. Retailers often manipulate both sticker prices and interest rates, so you really won't know what kind of deal you're getting until you look at the total cost of the transaction. Collateral--Make sure you know up front what collateral (if any) you'll have to pledge on the loan and what you stand to lose if you default on your payments. Using collateral often makes sense--it may result in lower finance charges, perhaps half a percentage point or so. Other Loan Considerations In addition to following the guidelines just described, here are some questions that you should also ask. Can you choose a payment date that will be compatible with your spending patterns? Can you obtain the loan promptly and conveniently? What are the charges for late payments, and are they reasonable? Will you receive a refund on credit charges if you prepay your loan, or are there prepayment penalties? You should see to it that the consumer debt you undertake does, in fact, have the desired effects on your financial condition.

Describe credit scoring and explain how it's used (by lenders) in making a credit decision.

Using the data provided by the credit applicant, along with any information obtained from the credit bureau, the store or bank must decide whether to grant credit. Very likely, some type of credit scoring scheme will be used to make the decision. An overall credit score is developed for you by assigning values to such factors as your annual income, whether you rent or own your home, number and types of credit cards you hold, level of your existing debts, whether you have savings accounts, and general credit references. The biggest provider of credit scores is, by far, Fair Isaac & Co.—the firm that produces the widely used FICO scores. Unlike some credit score providers, Fair Isaac uses only credit information in its calculations. There's nothing in them about your age, marital status, salary, occupation, employment history, or where you live. Instead, FICO scores are derived from the following five major components, which are listed along with their respective weights: payment history (35 percent), amounts owed (30 percent), length of credit history (15 percent), new credit (10 percent), and types of credit used (10 percent). FICO scores, which are reported by all three of the major credit bureaus, range from a low of 300 to a max of 850.

Factors that affect your credit score

Paying bills on time Knocking down your debt Avoid applying for multiple credit cards