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- Chapter 7
Debt
1
- Chapter Goals
Develop debt strategies.
Understand the many facets of debt.
Calculate and comprehend the rates charged on
loans.
Identify the factors that enter into selecting credit.
Evaluate a fixed versus a variable rate mortgage.
Specify the advantages and disadvantages of a
credit card loan.
Interpret debt financial ratios.
2
- Risk and Leverage
The higher the debt, the higher the household’s risk.
People who have too much debt are said to be
overleveraged.
Operating risk arises from uncertainties in
connection with household activities.
Financial risk comes from the amount of debt
outstanding relative to your assets.
3
- Risk and Leverage, cont.
Operating leverage is the degree to which you have
fixed costs in your budget that come from household
operating functions.
The greater the percentage of your non-discretionary
costs, the greater your operating leverage.
When you have high fixed costs, a modest increase
or decrease in your income can have a material
impact on your free cash flow.
4
- Risk and Leverage, cont.
Financial leverage arises from the amount of debt
outstanding and its contribution to household fixed
costs.
The greater the amount of your interest expense and
debt repayment commitments, the greater your
financial leverage.
When you have high fixed financial costs, a change
in your income can have substantial effects on your
free cash flow.
5
- Financial Leverage and Returns
Financial leverage can increase potential rewards for
the household.
Many first time homebuyers undertake significant
financial leverage by making an expensive purchase
of a dwelling.
Should the home subsequently rise sharply in price,
that financial leverage can enable the member-
owners to make a high return on their household
investment.
Undertaking additional debt has two effects: It not
only raises risk; it also increases potential returns.
6
- Financial Leverage and Returns,
cont.
The amount of money a household borrows depends
on:
– The cost of borrowing in relation to the returns
received.
– The owners’ risk profile.
The higher the tolerance for risk, the greater the
amount of debt it will be willing to borrow.
7
- Financial Leverage and Returns,
cont.
Debt borrowed for items that increase household
cash flows may be less risky.
These cash flows provide resources to support future
household operations. unless it led to significantly
higher cash flows.
When expectations of materially higher future
income are not realistic, substantial borrowing over a
period of time to maintain or increase the
household's current life style is generally not
considered desirable.
Therefore, an ongoing pattern of borrowing for such
things as a vacation or fashion-right clothing may
best be put off until it can be financed internally.
8
- Determining Simple Interest Rates
Interest rate: The cost for money borrowed.
To calculate the real interest rate, you need to know
the time period for the loan and the actual amount of
money that is made available.
Consider the following case:
– A $5,000 loan.
– A $600 yearly cost to borrow.
– A one year investment.
9
- Determining Simple Interest Rates,
cont.
If the interest is paid at the end of the period, then:
Interest Paid $600
Interest Rate 12%
Cash Made Available $5,000
If the interest is paid at the beginning of the period,
then:
Interest Paid $600
Interest Rate 13.6%
Cash Made Available $5,000 $600
10
- Determining Simple Interest Rates,
cont.
Under an installment loan, repayments may be
made in equal sums throughout the year.
Assuming a one-year loan retired in 12 equal
monthly installments of interest and principal of
$466.67, the cash available would decline by that
amount per month.
$5,000 $600
Monthly Installment $466.67
12
The interest cost can be approximated as follows:
IP $600
Interest Rate 24%
(CABP CAEP ) / 2 ($5,000 0) / 2
11
- Determining Simple Interest Rates,
cont.
The actual cost can be calculated in the following
manner:
Inputs 12 5,000 -466.67
N I/Y PV PMT FV
Solution 1.7882
Press i = 1.7882% (Monthly interest)
Annual interest = 1.7882 × 12 months = 21.5%
The actual annual rate is 21.5%.
12
- Determining Simple Interest Rates,
cont.
The annual percentage (APR) rate must be given to
borrowers under a federal law that requires lenders
provide an effective interest rate on consumer loans
and the total amount of finance charges.
The APR includes all defined costs such as closing
fees, points, and appraisal fees on mortgage loans
on a time-weighted basis.
It serves as a useful method for comparing costs on
loan alternatives.
13
- Sources of Debt
The broader availability of credit cards and home
equity loans has resulted in greater credit availability
to a wider cross-section of households.
Two sources of debt are as follows:
Closed-end retail credit is generally limited to a
specific loan with a specific repayment schedule.
– Example: an auto loan.
Open-end credit provides a loan limit, which can be
utilized for multiple purchases over a period of time.
– Example: credit card loan.
14
- Interest Rates Charged by Lenders
In theory, lenders should present an array of interest
rates with the rate offered appropriate to the risk of
non-payment that the individual household presents.
Instead there often appears to be one interest rate
offered per lender.
Loan applicants are placed into two risk classes, with
one rejected and the other accepted.
There is some indication that for certain types of
loans, the interest rate charged may not be highly
sensitive to changes in market rates.
15
- Types of Borrowers
Unrationed borrowers have sufficient internal cash
flow and assets to be able to select the loan maturity
offering the most attractive rates.
When rates change, their decisions on amount, type,
and repayment period for credit may change.
Rationed borrowers are short of internal cash flow
and would like to borrow more credit at comparable
interest rates than is available.
These borrowers may have to take any payment
terms offered.
16
- Credit Standards
A number of items are used to assess whether credit
should be extended to a household; these include:
– The amount of income earned,
– The amount of debt outstanding,
– The history of timely repayments of debt owed,
and
– Whether the loan is secured.
17
- Outcome
The outcome is that households often have a variety
of borrowing alternatives at various interest rates.
The ultimate selection is generally to take the lowest
cost alternative.
For example, a home equity loan may be used to
finance the purchase of a car instead of an auto
loan.
As the amount of debt increases, the household will
qualify for fewer loan alternatives and the cost of
credit will increase.
At some point, the cost of credit discourages further
borrowing, or it can reach the government-
sanctioned limit of a 24 percent annual rate.
18
- Long-Term vs. Short-Term Debt
Short-term debt is money owed that is payable in a
relatively brief period.
For accounting purposes it is debt due within the
current year, while in investment usage it is debt
payable within three years.
Examples of short-term debt are general credit card
debt and credit extended by particular stores.
19
- Long-Term vs. Short-Term Debt,
cont.
Long-term debt involves financial obligations whose
terms call for final payment to be made many years
from now.
While for accounting purposes it is any debt not due
in the current year, it can be thought of as debt
payable in four years or longer.
Examples are home mortgages, bank debt, and
other loans such as those from friends and family
members.
20
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