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Wednesday, October 31, 2018

Personal Financial Planning: An "How-To" Guide (part 28)


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Establishing Credit
by
Charles Lamson

The willingness of lenders to extend credit depends on their assessment of your creditworthiness---that is, your ability to repay the debt on a timely basis. They look at a number of factors in making this decision, such as your present earnings and net worth. Equally important, they look at your current debt position and your credit history. Thus, it is worth your while to do what you can to build a strong credit rating.
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First Steps in Establishing Credit

First, open checking and savings accounts. They signal stability to lenders and also indicate that you handle your financial affairs in a businesslike fashion. Second, use credit---open one or two charge accounts and use them periodically, even if you prefer paying cash. For example, get a Visa card and make a few credit purchases each month (do not overdo it, of course). You might pay an annual fee or interest on some (or all) of your account balances, but in the process, you will become identified as a reliable credit customer. Third, obtain a small loan, even if you do not need one. If you do not actually need the money, put it in a liquid investment, such as a money market account or certificate of deposit. The interest you earn you should offset some of the interest expense on the loan; you can view the difference as a cost of building good credit. (It goes without saying that you should repay the loan promptly, perhaps even a little ahead of schedule, to minimize the difference in interest rates---do not pay off the loan too quickly, though, as lenders like to see how you perform over an extended period of time.) Keep in mind, your ability to obtain a large loan in the future will depend in part on how you managed smaller ones in the past.


Build a Strong Credit History

From a financial perspective, maintaining a strong credit history is just as important as developing a solid employment record! Do not take credit likely, and do not assume that getting the loan or the credit card is the toughest part. It's not. That is just the first step; servicing it (i.e., making payments) in a prompt and timely fashion---month in and month out---is the really tough part of the consumer credit process. And in many respects, it is the most important element of consumer credit, as it determines your creditworthiness. By using credit wisely and repaying it on time, your establishing a credit history that tells lenders you are a dependable, reliable, and responsible borrower.

The consumer credit industry keeps very close tabs on your credit and your past payment performance. So the better job you do in being a responsible borrower, the easier it will be to get credit when and where you want it. The best way to build up a strong credit history and maintain your creditworthiness is to consistently make payments on time, month after month. Being late occasionally---say two or three times a year---might label you a "late payer." When you take on credit, you have an obligation to live up to the terms of the loan, including how and when the credit will be repaid.

If you foresee difficulty in meeting a monthly payment, let the lender know and usually some sort of arrangements can be made to help you through the situation. This is especially true with installment loans that require fixed monthly payments. If you have one or two of these loans and, for some reason or another, you encounter a month that is going to be really tight, the first thing you should try to do (other than trying to borrow some money from a member of the family) is get an extension on your loan. Do not just skip a payment, because that is going to put your account into a late status until you make up the missed payment---in other words, until you make a double payment, your account/loan will remain in a late status, subject to a monthly late penalty. The alternative of trying to work out an extension with your lender obviously makes a lot more sense.

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Here's what you do. Explain the situation to the loan officer and ask for an extension of one (or two) months on your loan. In most cases, so long as this has not occurred before, the extension is almost automatically granted. The maturity of the loan is formally extended for a month (or two), and the extra interest of carrying the loan for another month (or two) is either added to the loan balance or, more commonly, paid at the time the extension is granted (such an extension fee generally amounts to a fraction of the normal monthly payment). Then, in a month (or two), you pick up where you left off and resume your normal monthly payments on the loan. This is the most sensible way of making it through those rough times because it does not harm your credit record. Just do not do it too often. To summarize, 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, do not overextend yourself.
  • Fulfill all the terms of the credit.
  • Be consistent in making payments promptly.
  • Consult creditors immediately if you meet payments as agreed.
  • Be truthful when applying for credit. Lies are not likely to go undetected.


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The American Banker’s Association provides helpful information about shopping for credit and managing debt at its site, www.aba.com.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 230-232*

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Monday, October 29, 2018

Personal Financial Planning: An "How-To" Guide (part 27)


THE BASIC CONCEPTS OF CREDIT
by
Charles Lamson

Just say "Charge it." With those two little words and a piece of plastic, you can buy gas for your car, have a gourmet meal at an expensive restaurant, or furnish an apartment. It happens several hundred million times a day across the United States. Credit, in fact, has become an entrenched part of our everyday lives, and we as consumers use it in one form or another to purchase just about every type of good or service imaginable. Indeed, because of the ready availability and widespread use of credit, our economy is often called a "credit economy."

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Consumer credit is important in the personal financial planning process because of the impact it can have on (1) the attainment of financial goals, and (2) cash budgets. For one thing, various forms of consumer credit can help you reach your financial objectives by enabling you to acquire some of the more expensive items in a systematic fashion, without throwing your whole budget into disarray. But there is another side to consumer credit: It has to be paid back! Unless credit is used intelligently, the "buy-now-pay-later" attitude can quickly turn an otherwise orderly budget into a budgetary nightmare and lead to some serious problems---even bankruptcy! So, really, the issue is one of moderation and affordability.

In today's economy, consumers, businesses and governments alike use credit to make transactions. Credit helps businesses supply the goods and services needed to satisfy consumer demand. In addition, business credit provides higher levels of employment and helps raise our overall standard of living. Local, state, and federal governments borrow for various projects and programs that also increase our standard of living and create additional employment opportunities. Clearly, borrowing helps fuel our economy and enhance the overall quality of our lives. Consequently, customers in a credit economy need to know how to establish credit and how to avoid the danger of using it improperly.


Why Borrow?

People typically use credit as a way to pay for goods and services that cost more than they can afford to take from their current income. 
People tend to borrow for several major reasons:
  • To avoid paying cash for large outlays: Rather than pay cash for large purchases, such as houses and cars, most people borrow a portion of the purchase price and then repay the loan on some scheduled basis. Spending payments over time makes big-ticket items more affordable and consumers get the use of an expensive asset right away. Most people consider the cost of such borrowing a small price to pay for the immediate satisfaction they get from owning the house, car, or whatever it happens to be. In their minds, at least the benefits of current consumption outweigh the interest costs on the loan. Unfortunately, while the initial euphoria of the purchase may wear off over time, the loan payments remain---and perhaps for many more years to come.
  • To meet a financial emergency: For example, people may need to borrow to cover living expenses during a period of unemployment, or to purchase plane tickets to visit a sick relative. However, use of savings (not credit) is a more preferred way to provide for financial emergencies.
  • For convenience: Merchants as well as banks offer a variety of charge accounts and credit cards that allow customers to charge just about anything---from gas and oil or clothes and stereos to doctor and dental bills and even college tuition. Further, in many places---restaurants, for instance---using a credit card is far easier than writing a check. Although such transactions usually incur no interest (at least initially), these credit card purchases are still a form of borrowing, because payment is not made at the time of the transaction.
  • For investment purposes: It is relatively easy for an investor to partially finance the purchase of many different kinds of investment vehicles with borrowed funds.
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 Improper Uses of Credit

Many people use consumer credit to live beyond their means. Overspending is the biggest danger in borrowing, especially because it is so easy to do. Once, hooked on "plastic," people may use their credit cards and can still afford to pay the minimum amounts each month.

Unfortunately, such spending eventually leads to mounting bills. And by making only the minimum payment, borrowers pay a huge price in the long run. Look at Exhibit 1, which shows the amount of time and interest charges required to repay credit card balances if you make only a minimum payment of 3 percent of the outstanding balance. For example, if you carry a $3,000 balance on a card that charges 15.0 percent annually, it would take you 14 years to retire the debt, and your interest charges would total some $2,000---or more than 66 percent of the original balance! Incredibly, some cards offer even lower minimum payments of just 2 to 2.5 percent of the outstanding balance. While such small payments may seem like a good deal, clearly they do not work to your advantage and only increase the time and amount of interest required to repay the debt!


To avoid the possibility of future repayment shock, you should keep in mind the following types of transactions for which you should not (routinely, at least) use credit: (1) to meet basic living expenses; (2) to make impulse purchases, especially expensive ones; and (3) to purchase nondurable (short-lived) goods and services. Except in situations where credit cards are used occasionally for the sake of convenience (such as for gasoline and entertainment) or payments on recurring credit purchases are built into the monthly budget, a good rule to remember when considering the use of credit is that the product purchased on credit should outlive the payments.
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Unfortunately, people who overspend eventually arrive at the point where they must choose to either become delinquent in their payments or sacrifice necessities, such as food and clothing. If payment obligations are not met, the consequences are likely to be a damaged credit rating, lawsuits, or even personal bankruptcy. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 

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Saturday, October 27, 2018

Personal Financial Planning: An "How-To" Guide (part 26)


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Refinancing Your Mortgage
by
Charles Lamson

After you have purchased a home and closed the transaction, interest rates on similar loans may drop. If rates drop by 1 to 2 percent or more, you should consider the economics of refinancing after carefully comparing the terms of the old and new mortgages, the anticipated number of years you expect to remain in the home, any prepayment penalty on the old mortgage, and the closing costs associated with the new mortgage.
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Worksheet 1 presents a form to use when analyzing the impact of refinancing. The data for the Philipatos family's analysis is shown. Their original $80,000, 10-year-old, 10 percent mortgage, has a current balance of $72,750 and monthly payments of $702 for 20 more years. If they refinance the $72,750 balance at the prevailing rate of 7 percent, over the remaining 20-year life of the current mortgage, the monthly payment would drop to $564. The Philipatos plan to live in their house for at least 5 more years. They will not have to pay a penalty for prepaying their current mortgage, and closing and other costs associated with the new mortgage are $2,400 after taxes. Substituting these values into Worksheet 1 reveals (in Item 7) that it will take the Philipatoses 23 months to break even with the new mortgage. Because 23 months is considerably less than their anticipated minimum 5 years (60 months) in the home, the economics easily support refinancing their mortgage under the specified terms.


There are two basic reasons to refinance---to reduce the monthly payment or to reduce the total interest cost over the term of the loan. If a lower monthly payment is the objective, the analysis is relatively simple: Determine how long it will take for the monthly savings to equal your closing costs (see Worksheet 1).

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If your objective is to reduce the total interest cost over the life of the loan, the analysis is more complex. The term of the new loan versus the existing loan is a critical element. If you refinance a 50-year loan that is already 10 years old, with another 30-year loan, you are extending the total loan maturity to 40 years. Consequently, even with a lower interest rate, you may pay more interest over the life of the newly extended loan. Therefore, you should refinance with a shorter-term loan, ideally one that matures no later than the original loan maturity date. (The example in Worksheet 1.)

Many homeowners want to pay their loans off more quickly to free up funds for their children's college education or for their own retirement. By refinancing at a lower rate and continuing to make the same monthly payment, a larger portion of each payment will go toward reducing the principal so the loan will be paid off more quickly. Alternately, the borrower can make extra principal payments whenever possible. Paying only an additional $25 per month on a 30-year, 9 percent, $80,000 mortgage reduces the term to about 25 years and saves about $30,000 in interest.

Some people consider the reduced tax deduction associated with a smaller mortgage interest deduction as a disadvantage of refinancing. Although the interest deduction may indeed be reduced as a result of refinancing, the more important concern is the amount of the actual after-tax cash payments. In this regard, refinancing with a lower-interest-rate mortgage (with all other terms assumed unchanged) will always result in lower after-tax cash outflows and is therefore economically appealing. Of course as demonstrated in Worksheet 1, the monthly savings should be compared with the refinancing costs to make the final refinancing decision.

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Because lenders offer new mortgage products regularly, you should carefully check all your options before refinancing. Remember that when you refinance, most lenders require that you have at least 20 percent equity in your home, based on a current market appraisal. Many financial institutions are willing to refinance their existing loans often charging fewer points and lower closing costs than a new lender would charge, so be sure to check with your existing lender first.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 215-217*

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Tuesday, October 23, 2018

Personal Financial Planning: An "How-To" Guide (part 25)




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The Cost of Home Ownership
by
Charles Lamson

Although there definitely are some strong emotional and financial reasons for owning a home, there is still the question of whether you can afford to own one. There are two important aspects to the consideration of affordability: You must produce the down payment and other closing costs, and also be able to meet the cash-flow requirements associated with monthly mortgage payments and other home maintenance expenses. In particular, there are five items you should consider when evaluating the cost of home ownership to determine how much you can afford: the down payment, points and closing costs, mortgage payments, property taxes and insurance, and maintenance and operating expenses.

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The Down Payment

The first major hurdle is the down payment. Most buyers finance a major part of the purchase price of the home, but they are required by lenders to invest money of their own, called equity. The actual amount of down payment required varies among lenders, mortgage types, and properties. To determine the amount of down payment that will be required in specific instances, lenders use the loan-to-value ratio, which 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.

Generally, first-time homebuyers must spending a number of years accumulating enough money to afford the down payment and other costs associated with a home purchase. You can best accumulate these funds if you plan ahead, using future value techniques to determine the monthly or annual savings necessary to have a stated amount by a specific future date. A disciplined savings program is the best way to obtain the funds needed to purchase a home or any other big-ticket item requiring a sizable down payment or cash outlay.

If you do not have enough savings to cover the down payment and closing costs, you can consider several other sources. You may be able to obtain some funds by withdrawing (subject to legal limitations) your contributions from your company's profit sharing or thrift plan. Your IRA is another option. The Taxpayer Relief Act of 1997 permits first-time homebuyers to withdraw $10,000 without penalty before age 59.5. However, using retirement money should be a last resort because you must still pay income tax on retirement distributions. Thus, if you are in the 25 percent income tax bracket, your $10,000 IRA withdrawal would net you only $7,500 ($10,000 - $2,500) for your down payment.

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The Federal National Mortgage Association (known as "Fannie Mae") has several programs to help buyers who have limited cash for the down payment and closing costs. The "Fannie 3/2" program is available from local lenders. Borrowers who meet certain income criteria may qualify for a 95 percent loan-to-value mortgage, and may obtain up to 2 percent of their 5 percent down payment from a public or nonprofit agency or relative. "Fannie 97" helps the homebuyer who can handle monthly mortgage payments but does not have cash for the down payment. It requires only a 3 percent down payment from the borrower's own funds, and the borrower needs to have only 1 month's mortgage payment in cash savings, or reserves, after closing.

As a rule, when the down payment is less than 20 percent, the lender will require the buyer to obtain private mortgage insurance (PMI), which protects the lender from loss if the borrower defaults on the loan. Usually, PMI covers the lender's risk above 80 percent of the price of the house. Thus, with a 10 percent down payment, the mortgage will be a 90 percent loan, and mortgage insurance will cover 10 percent of the home's price. The cost of mortgage insurance varies from about 0.5 percent to 1.0 percent of the loan balance each year, depending on the size of your down payment. It can be included in your monthly payment, and the average cost ranges from about $40 to $70 per month. You should contact your lender to cancel the mortgage insurance once the equity in your home reaches 20 to 25 percent. Under federal law, private mortgage insurance on most loans made on or after July 29, 1999, end automatically once the mortgage is paid down to 78 percent of the original value of the house.

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To find out how much more house you could
afford with private mortgage insurance, visit
the Mortgage Insurance Companies of America
site on this subject: www.privatemi.com.

Points and Closing Costs

A second hurdle to home ownership relates to mortgage points and closing costs. Mortgage points are fees charged by lenders at the time they grant a mortgage loan. In appearance, points are like interest in that they are a charge for borrowing money. They are related to the lender's supply of loanable funds and the demand for mortgages; the greater the demand relative to the supply, the more points you can expect to pay. One point equals 1 percent of the amount borrowed. If you borrow $100,000 and loan fees equal 3 points, the amount of money you will pay in points will be $100,000 x .03 = $3,000.

Lenders typically use points as a way of charging interest on their loans. They can vary the interest rate along with the number of points they charge to create loans with comparable effective rates. For example, a lender might be willing to give you a 7 percent rather than an 8 percent mortgage if you are willing to pay more points; that is, you choose between an 8 percent mortgage rate with 1 point or a 7 percent mortgage rate with 3 points. If you choose the 7 percent loan, you will end up paying a lot more at closing (although the amount of interest paid over the life of the mortgage may be considerably less).

Points increase the effective rate of interest on a mortgage. The amount you pay in points and the length of time you hold a mortgage determine the increase in the effective interest rate. For example, on an 8 percent, 30-year, fixed-rate mortgage, each point increases the annual percentage rate by about .11 percent if the loan is held for 30 years, .17 percent if held for 15 years, .32 percent if held 7 years, and .70 percent if held 3 years. you pay the same amount in points regardless of how long you keep your home. Therefore, the longer you hold the mortgage, the longer the period over which you amortize the points and the smaller the effect of the points on the effective annual interest rate.

According to recent IRS rulings, the points paid on a mortgage at the time a home is originally purchased are usually considered immediately tax deductible. The same points are not considered immediately tax deductible if they are incurred when refinancing a mortgage; rather, the amount paid in points must be written off (amortized) over the life of the new mortgage loans.

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Closing costs are all expenses that borrowers ordinarily pay at the time a mortgage loan is closed and title to the purchased property is conveyed to them. Closing costs are like down payments. They represent money 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 paid to the lender, mortgage points, title search and insurance fees, attorney's fees, appraisal fees, and other miscellaneous fees for things such as mortgage taxes, filing fees, inspections, credit reports, and so on. These costs can amount to 50 percent or more of the down payment. For example, with a 10 percent down payment on a $100,000 home, the closing costs are nearly 70 percent of the down payment, or $6,625. Simple arithmetic indicates that this buyer will need nearly $17,000 to buy the house (the $10,000 down payment plus another $6,625 in closing costs).

  
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005,  LAWRENCE J. GITMAN, MICHAEL ED. JOEHNK, PGS. 194-196*                                                                                                                    
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Saturday, October 20, 2018

Personal Financial Planning: An "How-To" Guide (part 24)


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Meeting Housing Needs: Buy or Rent?
by
Charles Lamson

Knowing when to buy your first home is not always clear-cut. There are many factors to consider before taking on such a large financial responsibility. In the next few posts, we will explore some of these, and how to approach the home buying process.

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Because you have your own unique set of likes and dislikes, the best way to start your search for housing is to list your preferences and classify them according to whether their satisfaction is essential, desirable, or merely a "plus." This exercise is important for three reasons. First, it serves to screen out housing that will not meet your minimum requirements. Second, it helps you recognize that you may have to make trade-offs because seldom will you find a single home that meets all your needs. Third, it will help you focus on those needs for which you are willing and able to pay.

Housing in America is diverse, and everybody's housing needs differ. Some people prefer quiet and privacy; others like the hustle and bustle of big-city life. The features you prefer vary as well, from gourmet kitchens to an extra bedroom for a home office. You will find single-family homes, townhouses, condominiums, corporate apartments, or numerous types of rental units that meet your needs.


What Type of Housing Fits Your Needs?

One of the first decisions you will have to make is the type of housing unit that meets your needs. Several of the following may be suitable:
  • Single-family homes: These are the most popular choice. They can be stand-alone homes on their own legally defined lots or row houses or townhouses that share a common wall. As a rule, single-family homes offer buyers privacy, prestige, pride of ownership, and maximum property control.
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  • Condominiums: The term condominium, or condo, describes a form of ownership rather than a type of building. Condominiums can be apartments, townhouses, or cluster housing. The condominium buyer receives title to an individual residential unit and joint ownership of common areas and facilities such as lobbies, swimming pools, lakes, and tennis courts. Buyers arrange their own mortgages and pay their own taxes for their units. They are assessed a monthly homeowners' fee for their proportionate share of common facility maintenance costs. The homeowners' association elects a board of managers to supervise the buildings and grounds. Condominiums generally cost less than single-family, detached homes because they are designed for more efficient land use and lower construction costs. Many home buyers are attracted to condominiums because they do not want the responsibility of maintaining and caring for a large property. Exhibit 1 lists some of the key things to check before buying a condominium.

  • Cooperative apartments: In a cooperative apartment, or co-op, building, each tenant owns a share of the nonprofit corporation that owns the building. Residents lease their units from the corporation and pay a monthly assessment in proportion to ownership shares based on the space they occupy. These assessments cover the cost of service, maintenance, taxes, and the mortgage on the entire building and the actions of the board of directors, which determines the corporation's policies. The cooperative owner receives the tax benefits resulting from interest and property taxes attributable to his or her proportionate ownership interest. Drawbacks of co-op ownership include difficulty in obtaining a mortgage (because many financial institutions do not like taking shares of a corporation rather than property as collateral), rent increases to cover maintenance cost of vacant units, and the need to abide by the capital improvement decisions of the co-op board of directors which increases the monthly assessment.
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  • Rental units: Some individuals and families choose to rent or lease their place of residence rather than own it. They may be just starting out and have limited funds for housing, or they may be uncertain where they want to live. Perhaps they like the short-term commitment and limited maintenance. The cost and availability of rental units varies from one geographic area to another. Rental units range from duplexes, four-plexes, and even single-family homes, to large, high-rise apartment complexes containing several hundred units. Renting does come with restrictions, however. You may not be allowed to have a pet or make changes to the unit's appearance.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 188-190*

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