This Document Contains Chapters 4 to 5 Chapter 4 Managing Your Cash and Savings Chapter Outline Learning Goals I. The Role of Cash Management in Personal Financial Planning A. The Problem with Low Interest Rates II. Today's Financial Services Marketplace A. Types of Financial Institutions 1. Depository Financial Institutions 2. Nondepository Financial Institutions B. How Safe Is Your Money? 1. Deposit Insurance III. A Full Menu of Cash Management Products A. Checking and Savings Accounts 1. Checking Accounts 2. Savings Accounts 3. Interest-Paying Checking Accounts a. NOW Accounts b. Money Market Deposit Accounts c. Money Market Mutual Funds 4. Asset Management Accounts B. Electronic Banking Services 1. Electronic Funds Transfer Systems a. Debit Cards and Automated Teller Machines b. Preauthorized Deposits and Payments c. Bank-by-Phone Accounts 2. Online Banking and Bill Payment Services C. Regulation of EFTS Services D. Other Bank Services IV. Maintaining a Checking Account A. Opening and Using Your Checking Account 1. The Cost of a Checking Account 2. Individual or Joint Account? 3. General Checking Account Procedures 4. Overdrafts 5. Stopping Payment B. Monthly Statements 1. Account Reconciliation C. Special Types of Checks 1. Cashier’s Check 2. Traveler’s Check 3. Certified Check V. Establishing a Savings Program A. Starting Your Savings Program B. Earning Interest on Your Money 1. The Effects of Compounding 2. Compound Interest Generates Future Value C. A Variety of Ways to Save 1. Certificates of Deposit 2. U.S. Treasury Bills 3. . Series EE Bonds 4. I Savings Bonds Major Topics This chapter is concerned with cash management, which involves making sure that adequate funds are available for meeting both planned and unplanned expenditures and that spending patterns are in line with budgetary guidelines. Cash management is an important aspect of personal financial planning; it ensures that adequate funds are available for paying bills and that an effective savings program is established and implemented. This process begins with an understanding of the financial marketplace, which includes a tremendous variety of institutions providing numerous account and transaction services. Financial institutions provide checking facilities that allow transactions to be made safely and efficiently. They also make available numerous savings vehicles that can be used to earn a return on temporarily idle funds. In addition, a variety of other ways to save are also available from the government and brokerage firms. The major topics covered in this chapter include: 1. The importance of cash management in personal financial planning. 2. A discussion of the financial marketplace and how financial deregulation has greatly increased the number of financial services and financial service providers. 3. The role of traditional financial institutions—"banks"—in providing individuals with the financial services they need. 4. Federal deposit insurance programs. 5. The growing menu of financial products available to the individual. 6. Other important money management services, especially electronic funds transfer services. 7. How to save by purchasing short-term securities. 8. Understanding checking account procedures and how to reconcile accounts. 9. Procedures involved in establishing a savings program and factors that determine how much interest you earn on deposits. Key Concepts Managing savings and liquid assets requires an understanding of the numerous opportunities available in the financial marketplace as a result of deregulation. Today, many new providers offer various types of savings accounts and vehicles. It is also necessary for those using these services to understand procedures relating to interest calculations, differences in account features, and procedures for opening, utilizing, and managing accounts—especially checking accounts. The following phrases represent the key concepts/terms stressed in this chapter: 1. Traditional banks: commercial banks and thrift institutions 2. Deposit insurance 3. Checking and savings products 4. Interest-paying checking accounts 5. Electronic banking 6. Electronic funds transfer (ETF) 7. Account balance determination 8. The variety of savings instruments 9. Checking account procedures 10. Checking account reconciliation 11. Special types of checks – Cashier’s check, Traveler’s check, and Certified check 12. Compound interest and simple interest 13. Depository financial institutions 14. Demand deposit 15. Time deposits 16. Money market mutual funds (MMMF) 17. Negotiable order of withdrawal accounts (NOW) 18. Asset management accounts (AMA) 19. Debit cards 20. Automated teller machines (ATMs) 21. Nominal (stated) interest and effective interest rate 22. Certificates of deposit (CDs) 23. U.S. Treasury bills (T-bills) 24. Series EE bonds 25. I Savings Bonds Financial Planning Exercises The following are solutions to some of the exercises at the end of the PFIN 4 textbook chapter. 1. While it is true that low interest rates will result in reduced income to retirees, the search for higher current returns has led many individuals to make investments of questionable risk. You probably would be best to urge your parents to be very skeptical of “sure-fire” claims for higher returns. If something sounds too good to be true, then it probably isn’t. Talk to your parents about considering investments in higher-quality corporate bonds for the short term of the low interest rates. Returns for these bonds typically go up as interest rates go down and alternatively go down as interest rates go up. Conversely, more moderate strategies for your parents would be to invest in stocks that typically pay high dividends and/or buy preferred stock. Temper your advice to your parents by letting them know that stocks are generally riskier than bonds, so the higher risk is an important consideration. 2. If your ATM card was stolen and $950 was withdrawn from your checking account, you would be liable for: a. $50 if you notified the bank the next day; b. $500 if you notified the bank six days later; and c. $950 (or all the money in your account, whichever is greater) if you waited 65 days to notify the bank. Some states provide even greater protection for debit card users, as do various banking institutions. 3. Student answers will vary but should discuss the following aspects of bank and account choice: • Individual or joint accounts and why selected • Convenience factors that are important (e.g., what hours, locations are required) • Desired services, where available, and fees charged for them • Type of account charge (monthly fees or minimum balance) and why selected 5. a. Per-month cost = $4 + 23($.20) = $ 8.60 Annual cost = 12 × $8.60 = ($103.20) b. Interest earned/month = .025/12 × $815 = $1.70 Add: total annual interest (for months where balance exceeds $750) = 8 × $1.70 = $13.60 Less: monthly fee for months when balance is below $750 = 4 × $8 = ($32.00) Net cost of account ($18.40) 7. Use the formula FV = PV × (1 + i)n as the tables in the appendix do not have 4%. FV = 6,000 × (1+.04) 5 = 6,000 × 1.2167 = $7,300.20 Using the financial calculator, set on END MODE and 1 P/YR: 6,000 +/- PV 4 I/YR 5 N FV $7,299.92 Since you initially deposit $6,000 and end up with $7,299.92 in five years, the amount of interest earned is the difference, or $1,299.92. Calculate the future value of a series of yearly $6,000 payments compounding at 4% per year using the financial calculator, set on END MODE and 1 P/YR: 6,000 +/- PMT 4 I/YR 5 N FV $32,497.94 9. Short-term investment vehicles include savings accounts, money market deposit accounts, money market mutual funds, NOW accounts, CDs, U.S. Treasury bills, Series EE bonds, I Savings bonds, and asset management accounts. T-bills are almost as liquid as cash because they can be sold at any time However, Series EE savings bonds earn interest at a fixed rate for 30 years. Their long life lets investors use them for truly long-term goals like education and retirement. The higher the rate of interest being paid, the shorter the time it takes for the bond to accrue from its discounted purchase price to its maturity value. Bonds can be redeemed any time after the first 12 months, although redeeming EE bonds in less than 5 years results in a penalty of the last 3 months of interest earned. The interest rate is set every 6 months in May and November and changes with prevailing Treasury security market yields. EE bonds increase in value every month and the stipulated interest rate is compounded semiannually. I Savings bonds should be considered if there is concern about an increase in inflation because they are inflation-adjusted. The earnings rate cannot go below zero and that the value of I bonds cannot drop below their redemption value. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 4-1. Cash management is an activity that involves the day-to-day administration of cash and near-cash liquid resources by an individual or family. The major functions of cash management are (1) making sure that adequate funds are available to meet both planned and unplanned expenditures and (2) establishing an ongoing savings program that cushions against financial emergencies and accumulates funds to meet financial goals. 4-2. Liquid assets are held for two broad reasons: (1) to meet known, near-term spending needs and (2) to meet unplanned future needs. Per Exhibit 4, 1, the popular types of liquid assets include: Cash: pocket money—the coin and currency in one's possession. Checking Account: a substitute for cash offered by commercial banks and other financial institutions, such as savings and loans and credit unions. Savings Account: a standard savings account pays a relatively low rate of interest and does not permit withdrawal of funds by check. Money Market Deposit Account (MMDA): primarily a savings vehicle that pays market rates of interest, offers limited check-writing privileges, and requires a fairly large (typically $1,000 or more) minimum deposit. These are offered by banking institutions and are federally insured. Money Market Mutual Fund (MMMF): a savings vehicle that is actually a mutual fund and, like money market deposit accounts, offers check-writing privileges. These are offered by investment companies and are not federally insured. Certificate of Deposit (CD): a savings instrument in exchange of funds left on deposit in a financial institution for a stipulated period of time. Penalty is imposed for early withdrawal of the funds. Usually pays an attractive interest rate, which can vary depending on the size and maturity of the CD. CDs do not have any check-writing privileges. U.S. Treasury Bill (T-bill): short-term, highly marketable securities issued in various maturities of 52 weeks or less by the U.S. Treasury. Typically offer competitive shortterm interest rates. U.S. Savings Bond (EE): a popular savings vehicle issued by the U.S. Treasury. They are sold in denominations as low as $25 and are purchased for half their face value. 4-3. Extremely low interest rates favor borrowers and dampen the incentives to save. Many argue that low interest rates have helped protect banks or lenders from absorbing the consequences of their actions and redistribute wealth away from prudent savers. Inflation adjusted real interest rate has been negative, which means that savers are not keeping up with inflation and will either have to tap into their principal or cut their spending. This is bad for retirees and the overall economy. Lower interest rates encourage the substitution of debt for equity in capital structures and as a result increase financial risk. Lower rates discourage savings and the reduction of debt in the economy. Regarding savings for retirement, for every 1 percent decline in interest rates, pension fund liabilities increase $180 billion. 4-4. a. Commercial banks are the largest of the four traditional banking institutions. They provide a full array of financial services including checking accounts, a variety of savings vehicles, credit cards, several kinds of loans, trust services, and numerous other services like safe deposit boxes, traveler's checks, and check-cashing privileges. They are often referred to as full-service banks. b. Savings and loan associations (S&Ls) are financial institutions that channel people's savings deposits into mortgage loans for purchasing and improving homes. Since deregulation, S&Ls have expanded their product offerings so that today they offer many of the same checking, savings, and lending services as commercial banks. In fact, on the surface it is hard to distinguish them from commercial banks. One major difference is that S&Ls do not offer regular checking accounts (regular checking accounts do not pay interest). They instead provide NOW accounts and money market deposit accounts. Another major difference between commercial banks and S&Ls is that some S&Ls are formed as mutual associations in which the depositors actually own the institution and the returns they receive are technically called dividends, not interest. However, these dividends are treated as interest for all practical purposes. There are also stockholder owned S&Ls where the depositors receive interest on their deposits instead of dividends. c. Savings banks are a special type of savings institution, similar to S&Ls and found primarily in New England. They offer MMDAs and NOW accounts and pay interest on deposits at a rate comparable to S&Ls. Most savings banks are mutual associations (owned by their depositors); the interest they pay is called dividends. As with mutual S&Ls, dividends are paid out at a fixed rate and any surplus profits are retained in the savings bank to provide greater protection for depositors. d. Credit unions are a special type of mutual association that provides financial services to specific groups of people with a common tie, such as their occupation, religion or fraternal order. They are owned, and in some cases operated, by their members. After qualifying for membership, a person joins the credit union by making a minimum deposit, which must be left on deposit in order to remain a member and borrow from the association. Credit unions pay interest on savings. These dividends are treated as interest like the dividend payments of other mutual associations. Frequently, however, the depositor does not know the dividend rate prior to distribution, because many credit unions pay out all or most of their profits. Members not only receive a favorable return on their deposits, they may also be able to borrow at rates lower than those offered by banks and other financial institutions. e. Stock brokerage firms may offer a variety of services in addition to buying and selling securities on behalf of their customers. Most provide money market mutual funds and wrap accounts; some offer credit card services as well. f. Mutual funds, or investment companies, often provide in their offerings one or more money market funds. Typically, these money market funds yield a higher rate of return than banking institutions offer and also allow check-writing privileges. 4-5. The FDIC provides deposit insurance on accounts up to $250,000 for commercial banks and thrift institutions. This type of insurance is not available on money market mutual funds, which are offered by investment companies, but it is offered by credit unions, which are insured by the National Credit Union Administration (NCUA). The National Credit Union Share Insurance Fund (NCUSIF) is the federal fund used by the NCUA to insure accounts at credit unions for up to $250,000 per depositor. 4-6. An individual could have six or seven checking and savings accounts at the same bank and still be fully protected under federal deposit insurance as long as the total balance in all the accounts does not exceed $250,000. A married couple could obtain $1,500,000 in deposit insurance coverage without going to several banks by setting up individual accounts in the name of each spouse ($500,000 total coverage), a joint account in both names ($250,000 per account owner, or $500,000 total), and separate trust or IRA accounts in the name of each spouse (an additional $250,000 coverage per spouse). Deposits maintained in different categories of legal ownership are separately insured. So, you can have more than $250,000 insurance coverage in a single institution by opening accounts in different depositor names. The most common categories of ownership are single (or individual) ownership, joint ownership, and testamentary accounts. Separate insurance is also available for funds held for retirement purposes, e.g., Individual Retirement Accounts, Keoghs, and pension or profit-sharing plans. Find out more at www.fdic.gov. 4-7. A checking account is a demand deposit whereby withdrawal of funds from this account must be permitted as long as there are sufficient funds in the account. Funds may be accessed by writing checks against the account, by using a debit card or by personally going to the institution. Checking accounts typically pay no or very low interest and are used for paying bills and making purchases. A savings account is a time deposit. Funds are expected to remain on deposit for a longer period of time than demand deposits and are used for accumulating money for future expenditures or for meeting unexpected financial needs. Usually, checks are not written against savings accounts, and the interest offered is higher than that offered on checking accounts. 4-8. a. Demand deposit refers to an account held at a financial institution from which funds can be withdrawn (in check or cash) upon demand by the account holder. As long as sufficient funds are in the account, the bank must immediately pay the amount indicated when presented with a valid check or when accessed with a debit card or when the account holder appears in person. This means that money in checking accounts is liquid and can be easily used to pay bills and make purchases. b. Time deposits are expected to remain untapped for a longer period of time than demand deposits. While financial institutions generally retain the right to require a savings account holder to wait a certain number of days before receiving payment on a withdrawal, most are willing to pay withdrawals immediately. Typically, a savings account pays interest at a fixed rate, and money is held in this type of account in order to accumulate funds for known future expenditures or to meet unexpected financial needs. c. Interest-paying checking accounts are distinguished from regular checking accounts which are not required to pay interest. As a result of the changes in the laws governing financial institutions in the late 1970s and early 1980s, depositors now have the opportunity to choose among a wide variety of accounts to meet their checking and cash balance needs. Each of these accounts has its own specific characteristics. Interest-paying checking accounts include money market mutual funds (MMMFs) which are offered through investment (mutual fund) companies and are not FDIC insured, money market deposit accounts (MMDAs), and NOW accounts. MMDAs and NOW accounts are available at virtually every deposit-taking financial institution in the U.S. and are federally insured (provided the institution offers FDIC or NCUA insurance, and virtually all do). 4-9. a. NOW accounts (or negotiable order of withdrawal accounts) have been popular since the removal, beginning in 1986, of all interest rate restrictions. The account itself pays interest and offers unlimited checkwriting privileges so that investors can view the account as both a savings account and a convenience checking account. While no legal minimum account balance exists, many institutions impose at least a $500 minimum. Many banks also charge fees on the use of these accounts, such that in some cases the fees may negate the amount of interest earned. b. Money market deposit accounts (MMDAs) are vehicles offered by banks, S&Ls, and other depository institutions to compete with money market mutual funds. Unlike MMMFs, MMDAs are federally insured. Depositors have access to their funds through check-writing privileges or through automated teller machines. However, most require minimum balances, and there is usually a limit on the total number of transfers permitted during a month, with additional transfers subject to a penalty charge. This limits the flexibility of the accounts, but most people look upon them as savings accounts rather than as convenience accounts, so this is normally not a serious obstacle. c. Money market mutual funds (MMMFs) are offered by investment companies and pool the funds of many small investors to purchase high-yielding, short-term marketable securities offered by the U. S. Treasury, major corporations, large commercial banks, and various government organizations. The main advantage of these types of accounts to the small investor is that you can indirectly own these types of marketable securities by making fairly small minimum deposits, often $500, owning such securities directly may require a higher minimum investment. The interest rate earned on a MMMF depends on the returns earned on its investments, which fluctuate with overall credit conditions. Investors typically have instant access to their funds through check-writing privileges, although the checks often must be written for at least a stipulated minimum amount. In the banking system, checks written on MMMFs are treated just like those written on any other demand deposit account, and although they are considered very safe, these funds are not federally insured. 4-10. Asset management accounts (AMAs) are comprehensive deposit accounts that combine checking, investing, and borrowing activities. They are offered primarily by brokerage houses and mutual funds. Their distinguishing feature is that they automatically "sweep" excess balances into relatively high-yielding short-term investments, such as a money market mutual fund. They are not for everyone, since their stipulated minimum balance requirements typically may be $5,000 or higher. While not FDIC insured, these deposits are protected by the Securities Investor Protection Corporation (SIPC) and the firm's private insurance. 4-11. a. Debit cards are specially coded plastic cards that permit cash withdrawals at ATM machines or allow a transfer of funds from your checking account to the recipient's account. ATM cards are one form of debit card, and Visa and MasterCard also issue debit cards. They provide a convenient form of payment and are accepted at many retail and service establishments. But remember to record all debit card purchases in your checkbook ledger to avoid overdrawing your account. b. An automated teller machine (ATM) is a remote computer terminal at which bank customers can make deposits, withdrawals, and other types of basic transactions. The ATM can operate 24 hours a day, seven days a week. Banks and other depository institutions locate them in places convenient to shopping, offices, and travel facilities. c. Another form of EFTS service is the pre-authorized deposit, an automatic deposit made directly into your checking account on a regular basis. Some examples are paychecks, social security payments, and pension checks. Similarly, preauthorized payments allow a customer to authorize the bank to automatically make monthly payments for mortgages and other loans, utilities, or mutual fund purchases. d. Bank-by-phone accounts allow customers to make many types of banking transactions using their telephones. They can either talk to a customer service representative or use a touch-tone phone to verify balances, find out whether a check has cleared, transfer funds, and, at some banks, pay bills. e. Online banking and bill payment services enable one to handle nearly all account transactions from a personal computer at any time of the day or night and on any day of the week. Basically, with an online banking setup the customer instructs the bank to pay various bills by electronically transferring funds to designated payees. One can also call up a current "statement" on the computer screen at any time to check on the status of transactions, including checks written the traditional way. However, these systems do not permit one to make deposits or cash withdrawals through the home computer. This can only be accomplished by going to the bank or an ATM. The cost of electronic home banking systems is small once the person has the computer. The cost of a full-service teller transaction is about $1, an ATM transaction is less than 30 cents, and an Internet transaction is less than 1 cent. 4-12. The federal Electronic Fund Transfer Act outlines the rights and responsibilities of EFTS users. While it does not allow you to stop payment in the case of defective or problem purchases, it does require that banks investigate billing errors upon notification in writing within 60 days from the date the error appears on the billing statement or ATM or similar terminal receipt. The bank must respond within ten days of such notification. Failure to notify the bank within 60 days ends the bank's obligation to investigate the problem. You must also notify the bank promptly if your EFTS card is lost, stolen, or you suspect unauthorized use. The amount you could lose depends on the speed with which you notify the bank; it is limited to $50 if you notify the bank within two days, up to $500 if you notify the bank after two days but within 60 days, and up to all the money in your account if you fail to inform the bank within 60 days. Some states and institutions offer greater protection than this for their customers. Another provision of the law prohibits banks from requiring you to use EFTS for loan payments, although they can offer the incentive of a lower rate. You must also have the right to choose the bank where you will receive salary or government benefit payments via EFTS. In addition to federal and state consumer legislation, you can protect yourself by safeguarding your personal identification number (PIN). 4-13. When opening a checking account, you'll want to consider convenience (location of branches and ATMs, hours), services offered, and fees and charges for both deposit accounts and other services. These must be reviewed in conjunction with your personal needs. Individual accounts may be easier for some couples to maintain, as each person is responsible for his or her own account. Joint accounts may result in lower service charges and also have rights of survivorship if one account holder dies (if specified when the account is opened). Each couple should determine which account arrangement works best given their money styles and level of account balances. For example, if one partner regularly forgets to record checks written on a joint account, the other partner is likely to become annoyed and may bounce checks unexpectedly. 4-14. It is possible to bounce a check due to insufficient funds when the checkbook ledger shows a balance available to cover it if certain deposits added to the checkbook ledger have not yet been credited to the account by the bank. This situation could also arise when certain service fees are deducted from the account by the bank, but the account holder has not yet been notified and therefore has not yet deducted them from his or her checkbook ledger. When a check bounces, the bank stamps the overdrawn check with the words “insufficient balance (or funds)” and returns it to the party to whom it was written. The account holder is notified of this action, and a penalty fee of $20 to $25 or more is deducted from his or her checking account. In addition, the depositor of a “bad check” may be charged as much as $15 to $20 by its bank, which explains why merchants typically charge customers who give them bad checks $15 to $25 or more and refuse to accept future checks from them. To prevent bounced checks, you can arrange for overdraft protection through an overdraft line of credit or automatic transfer program. Here the bank will go ahead and pay a check that overdraws the account, but be aware that bank charges and policies vary widely on the cost and terms of such protection. The bank may even extend such protection without prior arrangement, but in such a case it will notify the account holder of the overdraft and charge a penalty for the inconvenience. 4-15. Payment on a check is stopped by notifying the bank. Normally, the account holder fills out a form with the check number and date, amount, and the name of the payee. Some banks accept stop-payment orders over the telephone or online and may ask for a written follow-up. Banks charge a fee ranging from $20 to $35 to stop payment on a check. If checks or checkbook are lost or stolen, there’s no need to stop payment on them because the holder has no personal liability on that. Several reasons to issue a stop payment order include: • A good or service paid for by check is found to be faulty. • A check is issued as part of a contract that is not carried out. 4-16. Your monthly bank statement contains an itemized listing of all transactions (checks written, deposits made, electronic funds transfer transactions such as ATM withdrawals and deposits and automatic payments) within your checking account. It also includes notice of any service charges levied or interest earned in the account. Many banks also include canceled checks and deposit slips with the bank statement. The monthly bank statement can be used to verify the accuracy of the account records and to reconcile differences between the statement balance and the balance shown in the checkbook ledger. The monthly statement is also an important source of information needed for tax purposes. The basic steps in the account reconciliation process are: 1. Upon receipt of the bank statement, arrange all canceled checks in descending numerical order based on their sequence numbers or issuance dates. 2. Compare each check amount, from the check itself or the statement, with the corresponding entry in the checkbook ledger to make sure that no recording errors exist. Place a checkmark in the ledger alongside each entry compared. Also check off any other withdrawals, such as from ATMs or automatic payments, and make sure to add any checks written or deposits made which are shown on the bank statement but you forgot to record in your checkbook. 3. List all checks and other deductions (ATM withdrawals, automatic payments) still outstanding (deducted in the checkbook but not returned with the statement.) 4. Repeat the process for deposits. All automatic deposits and deposits made at ATMs should be included. Determine the total amount of deposits made but not shown on the bank statement (deposits in transit). 5. Subtract the total amount of checks outstanding (from step 3) from the bank statement balance, and add the amount of outstanding deposits (from step 4) to this balance. The resulting amount is the adjusted bank balance. 6. Deduct the amount of any service charges levied by the bank and add any interest earned to the checkbook ledger balance. The resulting amount is the new checkbook balance. This amount should equal the adjusted bank balance (from step 5). If not, check all of the addition and subtraction in the checkbook ledger, because there probably is a math error. 4-17. a. A cashier's check is drawn on the bank, rather than a personal or corporate account, so that the bank is actually paying the recipient. There is a service fee in addition to the face amount. b. Traveler's checks provide a safe, convenient way to carry money while traveling because they are insured against loss. They are purchased from financial institutions in certain denominations for the face value plus a fee. c. A certified check is a personal check guaranteed by the bank as to availability of funds. The bank charges minimal or no charge for this guarantee. 4-18. The amount of liquid reserves you have on hand will depend on your personal circumstances (for example, if you have a salary continuance plan at work) but should keep at least six months of after-tax income. From 10 to 25% of your investment portfolio should be in liquid assets. This provides additional funding for unexpected needs, planned near-term expenditures, and investment opportunities. The actual amount will fluctuate based on interest rate levels. 4-19. The nominal rate of interest is the stated rate of interest, so in this instance the S&L’s nominal interest rate is 4.5%. The effective rate of interest is the interest rate actually earned over the period of time that the funds are on deposit. It is found by dividing the dollar amount of interest earned over the course of one year by the amount of money on deposit. We can determine the effective rate when the S&L has a stated rate of 4.5% by calculating how much interest is actually paid during the year. The easiest way is with a financial calculator because the S&L compounds daily in this example. We will arbitrarily choose to calculate the interest on a $1,000 account. (The percentage rate will be the same no matter what dollar amount we choose to begin with.) Set the calculator on End Mode and 1 Payment/Year. 1,000 +/- PV 4.5 365 I 1 × 365 N FV $1,046.03 During the year, this account earned $46.03 in interest, so we take the interest earned and divide it by the beginning principal to determine the effective interest rate. $46.03 = 4.6% effective rate of return $1,000 4-20. The amount of interest earned depends on several factors, including frequency of compounding, how the bank calculates the balances on which interest is paid, and the interest rate itself. Look for daily or continuous compounding and a balance calculation using the "day of deposit to day of withdrawal" method. This is the most accurate balance determination and gives depositors the highest interest earnings for a given period. It is also considered the fairest procedure since depositors earn interest on all funds on deposit during the period. This method is sometimes called daily interest, but it should not be confused with the daily compounding of interest, which is an entirely different concept. 4-21. a. Certificates of deposit (CDs) are savings instruments that require funds to remain on deposit for a specified period of time and can range from seven days to a year or more. Although it is possible to withdraw funds prior to maturity, an interest penalty usually makes withdrawal somewhat costly. While the bank or other depository institution can impose any penalty it wants, most result in a severely reduced rate of interest—typically a rate no greater than that paid on its most basic regular savings account. CDs are attractive for the high competitive yields they offer, the ease with which they can be purchased, and the protection offered by federal deposit insurance. In addition to purchasing CDs directly from the issuer, "brokered CDs" can be purchased from stockbrokers. b. U.S. Treasury bills (T-bills) are obligations of the U.S. Treasury issued as part of the on-going process of funding the national debt. T-bills are sold on a discount basis now in minimum denominations as low as $1,000 and are issued with 3-month (13week), 6-month (26-week), and one-year maturities. They carry the full faith and credit of the U.S. government and pay an attractive and safe yield that is free from state and local income taxes. They are almost as liquid as cash, because they can be sold at any time in a very active secondary market without any interest penalty. If they should be sold before maturity, however, one can lose money if interest rates have risen. In addition, broker's fees have to be paid in order to sell T-bills prior to maturity. c. Series EE bonds are the well-known savings bonds that have been around for decades. They are often purchased through payroll deduction plans or at banks or other depository institutions. Though issued by the U.S. Treasury, they are very different from U.S. Treasury bills. The fixed interest rate is set every six months in May and November, and change with prevailing Treasury security market yields. They increase in value every month, and the fixed interest rate is compounded semiannually. The interest is exempt from state and local taxes and, for federal tax purposes, it does not have to be reported until the bonds are cashed. In addition, when the bond proceeds are used to pay educational expenses, such as college, the tax on bond earnings may be partially or completely avoided if the taxpayer’s income falls below a certain level at the time of redemption (other restrictions apply). d. I Savings Bonds are similar to Series EE bonds in numerous ways. Both are issued by the U.S. Treasury and are accrual-type securities. I bonds are available in denominations between $25 and $10,000. Interest compounds semiannually for 30 years on both securities. Like Series EE bonds, I savings bonds’ interest remains exempt from state and local income taxes but does face state and local estate, inheritance, gift, and other excises taxes. Interest earnings are subject to federal income tax but may be excluded when used to finance education with some limitations. There are some significant differences between the two savings vehicles. Whereas Series EE bonds are sold at a discount, I bonds are sold at face value. I savings bonds differ from Series EE bonds in that their annual interest rate combines a fixed rate that remains the same for the life of the bond with a semi-annual inflation rate that changes with the Consumer Price Index for all Urban Consumers (CPI-U). In contrast, the rate on Series EE bonds is based on the 6-month averages of 5-year Treasury security market yields. Thus, the key difference between Series EE bonds and I bonds is that I bond returns are adjusted for inflation. Note in particular that the earnings rate cannot go below zero and that the value of I bonds cannot drop below their redemption value. Like Series EE bonds, I bonds can be bought on the Web or via phone. I bonds offer the opportunity to “inflation-protect” your savings somewhat. I bonds cannot be bought or sold in the secondary market; transactions are only with the U.S. Treasury. Solutions to Online Bonus Personal Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. Individual student answers will vary depending upon student preferences. Commercial banks offer checking and savings accounts and a full range of financial products and services. They can offer non-interest-paying checking accounts (demand deposits). They are the most popular of the depository financial institutions. Most are traditional brick-and-mortar banks, but some Internet banks—online commercial banks—are growing in popularity because of their convenience, lower service fees, and higher interest paid on account balances. Savings and loans (S&Ls) channel the savings of depositors primarily into mortgage loans for purchasing and improving homes. Also offers many of the same checking, saving, and lending products as commercial banks. Often pays slightly higher interest on savings than do commercial banks. Savings banks are similar to S&Ls, but are located primarily in the New England states. Most are mutual associations, which means their depositors are their owners and thus receive a portion of the profits in the form of interest on their savings. Credit unions are nonprofit, member-owned financial cooperatives that provide a full range of financial products and services to its members, who must belong to a common occupation, religious or fraternal order, or residential area. Generally, these are smaller institutions when compared with commercial banks and S&Ls. Offer interest-paying checking accounts—called share draft accounts—and a variety of saving and lending programs. Because they are run to benefit their members, they pay higher interest on savings and charge lower rates on loans than do other depository financial institutions. 2. Use Worksheet 4.1 for Felipe Aguilar. 3. a. Since Carl and Elaine have annual after-tax income of $82,000, their monthly income is $6,833.33 (i.e., $82,000/12). Based on holding at least six month's after-tax income as liquid reserves, Carl and Elaine should hold at least $41,000 (i.e. 6 × $6,833.33). b. The general rule is that 10% to 25% of one's investment portfolio should be held in savings and short-term investment vehicles. For the Blankenships, this would amount to between $15,000 and $37,500 (i.e., .10 × $150,000 and .25 × $150,000). c. In total, their short-term liquid asset position should be the sum of their liquid reserves (calculated in (a) above) and their short-term investments (calculated in (b) above). This amount totals between $56,000 (i.e., $41,000 + $15,000) and $78,500 (i.e., $41,000 + $37,500). However, the longer their investment time frame the less short-term investments are needed in their investment portfolio, particularly with adequate liquid reserves as described in part a. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 4.1 Judith Bao’s Savings and Banking Plans 1. Annual net cost of the different checking account plans: Regular checking, per-item plan: Monthly cost = $3 service fee + (18 checks @ $.35) = $ 9.30 Annual cost = $9.30 × 3 = ($27.90) Regular checking, flat fee plan: Annual cost = $7 per month × 3 months = ($21.00) Interest checking—monthly charge of $7 if balance is below $1,500; 3% interest, compounded daily (a stated rate of 3% compounded daily is effectively ~3.05%). Annual interest earned = $795 avg. balance × .0305 = $24.25 Less annual cost = $7 per month × 12 months = ($84.00) Net annual cost = ($59.75) Based on Judith’s current banking habits, the flat fee plan is the least expensive. 2. If Judith maintains the $1,500 minimum balance in an interest checking account, she will earn $45.75 ($1,500 × .0305 = $45.75). She would also save $21 in annual costs as calculated above, so she would be $66.75 better off each year. However, she would have to come up with another $705 in addition to the $795 she currently averages in her account. This money would probably have to be pulled from her money market deposit account, which is probably earning about the same amount as the interest checking account. So Judith would really be at about the same position on the interest earned off the additional $705. However, she would be able to avoid the $21 annual costs as well as earn $24.25 on the $795 (see above), leaving her $45.25 better off per year. 3. Judith should start a regular savings plan using direct deposit so that she makes monthly deposits and builds up a reserve account to about 3 months of her pay, or $9,750. Reviewing her budget—or making one if she doesn't have one—will reveal ways to find greater savings. Once her reserve account is funded, she should invest any excess in higher yielding securities. She should also periodically compare the rates of CDs vs. her checking account and money market deposit account to figure out her best choices. However, CDs do not offer her the flexibility that the other types of accounts do. 4.2 Reconciling the Lamars’ Checking Account 1. The bank reconciliation using Worksheet 4.1 appears on the following page. 2. The Lamars need to make two adjustments in their checkbook ledger. • Add in the $9.25 deposit made on September 25. Apparently they failed to write this deposit amount into their records at the time the deposit was made. • Subtract the $3.00 bank service charge from their checkbook ledger balance to accurately reflect this charge made against their account by the bank for a service. With these two adjustments, the Lamars’ checkbook ledger balance will be: Current balance $476.74 + September 25 deposit 9.25 – Bank service charge (3.00) Adjusted balance $482.99 This adjusted balance now agrees with the values shown on lines A and B of the checking account reconciliation worksheet. Since the Lamars just opened this account, balancing the account was fairly simple— there were no checks from prior periods outstanding, and the beginning balance of the account was zero. The checking account reconciliation form streamlines this process. 3. With a NOW account, the Lamars could have reduced their effective bank charges by the amount of interest earned during the period, which would have been noted on the monthly NOW account statement and entered on line 6 of the checking account reconciliation form. The effect of the interest earnings would have been an increase in both bank and checkbook balances. Case 4.2, Question 1—Worksheet 4.1 Chapter 5 Making Automobile and Housing Decisions Chapter Outline Learning Goals I. Buying an Automobile A. Choosing a Car B. Affordability 1. Operating Costs 2. Gas, Diesel, or Hybrid? 3. New, Used, or "Nearly New"? 4. Size, Body Style, and Features 5. Other Considerations C. The Purchase Transaction 1. Negotiating Price 2. Closing the Deal II. Leasing a Car A. The Leasing Process B. The Lease versus Purchase Analysis C. When the Lease Ends III. Meeting Housing Needs: Buy or Rent? A. Housing Prices and the Recent Financial Crisis B. What Type of Housing Meets Your Needs? 1. Gauging the General Attractiveness of Renting vs. Buying a Home 2. Analyzing the Rent-or-Buy Decision IV. How Much Housing Can You Afford? A. Benefits of Owning a Home B. The Cost of Homeownership 1. The Down Payment 2. Points and Closing Costs 3. Mortgage Payments a. Affordability Ratios 4. Property Taxes and Insurance 5. Maintenance and Operating Expenses C. Performing a Home Affordability Analysis V. The Home-Buying Process A. Shop the Market First 1. Real Estate Short Sales B. Using an Agent C. Prequalifying and Applying for a Mortgage D. The Real Estate Sales Contract E. Closing the Deal VI. Financing the Transaction A. Sources of Mortgage Loans B. Types of Mortgage Loans 1. Fixed-Rate Mortgages 2. Adjustable-Rate Mortgages (ARMs) a. Features of ARMs b. Beware of Negative Amortization 3. Fixed or Adjustable Rate? 4. Other Mortgage Payment Options 5. Conventional, Insured, and Guaranteed Loans C. Refinancing Your Mortgage Major Topics Buying a car is probably the first major purchase most people make. And because people tend to purchase another car every two to five years, it is quite possible that during the course of a lifetime, they will spend more money on cars than on homes. Both car ownership and home ownership are important financial goals for most American families, with the home usually representing the largest single purchase a person or family will make at one time. Housing is a necessity for everyone, and ownership can provide peace and security to a family. The best home is one that fits the needs of the family and is affordable (falls within their budget). Whether buying a car, a home or other major purchase, care should be taken to first research the purchase thoroughly, select the item that best suits one's needs, buy the item after negotiating the best price and arranging favorable financing, and then maintaining and repairing the item as needed. The major topics covered in this chapter include: 1. Purchase considerations and procedures involved in buying an automobile. 2. Evaluating the lease versus purchase decision for automobiles. 3. Description of the alternative forms of housing ranging from single-family home ownership to rental apartments and houses. 4. Procedures for renting a home, including contractual considerations and procedures for making the rent-or-buy decision. 5. Motives for home ownership, including its role as a tax shelter and potential hedge against inflation. 6. The costs of owning a home, including the initial purchase price, closing costs, financing costs, and maintenance. 7. The role of real estate agents in the home search, negotiation, and purchase process. 8. Mortgage loans and other documents and procedures, including disclosure statements, title checks, and closing statements involved in closing a home purchase transaction. 9. Financing the home purchase under the best and most appropriate terms. 10. Deciding when to refinance your mortgage. Key Concepts Purchasing big ticket items, such as an automobile or a home, requires much care and planning. Numerous nonfinancial and financial considerations are involved in the decision whether to buy or lease appropriate and affordable transportation and housing, consistent with your personal financial goals. Additionally, home ownership can represent an appreciating asset that may also provide tax benefits while meeting a family's needs for shelter and security. The following phrases represent the key concepts and terms stressed in this chapter. 1. Automobile purchase or lease transactions 2. Alternative forms of housing 3. Home ownership motives 4. The costs of owning a home 5. Mortgage costs 6. Rental housing procedures and justification 7. Shopping for and negotiating a home purchase 8. Sources and types of mortgage loans 9. Adjustable-rate mortgages (ARMs), Adjustment period, Index Rate, Margin, Interest Rate Cap, and Payment Cap 10. Types of loan programs 11. Mortgage refinancing 12. Closing the home purchase deal 13. Depreciation 14. Sales contract 15. Lease 16. Closed-end lease 17. Open-end (finance) lease 18. Residual value 19. Capitalized cost 20. Money factor 21. Purchase option 22. Condominium (condo) 23. Cooperative apartment (co-op) 24. Down payment 25. Loan-to-value ratio 26. Private mortgage insurance 27. Mortgage points 28. Closing costs 29. PITI 30. Property taxes 31. Homeowner’s insurance 32. Real Estate Short Sale 33. Foreclosure 34. Multiple Listing Service (MLS) 35. Prequalification 36. Earnest money deposit 37. Contingency clause 38. Real Estate Settlement Procedures Act (RESPA) 39. Mortgage Loan 40. Mortgage Banker 41. Mortgage Broker 42. Fixed-rate Mortgages 43. Negative amortization 44. Convertible ARMs and two-step ARMs 45. Interest-only Mortgages 46. Graduated Payment Mortgages 47. Growing-Equity Mortgages 48. Biweekly Mortgages 49. Buydowns 50. Conventional Mortgage 51. FHA Mortgage Insurance 52. VA Loan Guarantee Financial Planning Exercises The following are solutions to exercises at the end of the PFIN 4 textbook chapter. 1. Olivia should follow the following steps before making a major purchase, such as a car: a. Research the purchase thoroughly. Car manufacturers and dealers provide information in printed literature obtained from dealers' showrooms or from the manufacturers' or dealers' Web sites. Consumer sources of information include magazines and guides such as Car and Driver, Kiplinger's, and Motor Trend. Internet sources, such as Edmunds.com, provide pricing and model information on new and used vehicles, as well as links to other useful sites. If Olivia currently owns a vehicle, she also needs to research its value so she can decide whether to sell it on her own or trade it in. b. Select the car best suited to your needs. Olivia needs a car primarily to commute to work, so she should focus on vehicles which are fairly economical to operate and maintain, which can be handled well in traffic and that are suited for her driving conditions. She also should select a vehicle which will hold its value fairly well and which will be reliable. c. Arrange favorable financing. Olivia should pull up Web sites such as bankrate.com to find institutions offering the best auto loan rates. She should also research the loan rates and terms available from local lenders as well as the leasing options available from car dealers and manufacturers. Using the various rates and terms, she should then calculate how much she can afford, given her $450 per month budget allotment and $2,000 savings. She also should complete a lease vs. buy analysis to determine the best option for her. If she feels she should buy a car, then she should approach the most favorable lenders and get preapproval for a loan. If she feels she should lease a car, she should seek the most favorable terms. d. Negotiate the best price. Armed with her knowledge of the market and her needs, Olivia should then visit various dealers, test drive the vehicles which interest her, and negotiate prices. If she is considering buying a used car, whether from a dealer or an individual, she should arrange for a mechanic to inspect the car for problems. If she is considering trading in a car on the purchase, she should first negotiate the best deal on the new vehicle before mentioning that she has a possible trade-in. e. Understand the terms of the sale. Before she signs any contracts, Olivia should thoroughly understand the terms of the sale. She should compare the written contract with the quoted terms to make sure she is getting exactly what was promised. She should also not allow the seller to hurry her or pressure her in completing the sale. At all times, she needs to remember that she is the one in charge of the sale and there are thousands of other suitable cars available if this deal isn't to her liking. 2. [IMPORTANT NOTE TO INSTRUCTOR: Please have students use Worksheet 5.1 to complete this exercise. For the purchase interest rate, please instruct them to use Interest rate earned on savings of 4% (Item 6). 3. Rent ratio is the ratio of the average house prices to the average annual rent in the area you are considering to live. Rent ratios between 31 to 35 indicate that it is more attractive to rent than to buy a house. Rent ratios between 6 and 10 indicate that it is more attractive to buy than to rent. And a moderate rent ratio between 16 to 20 suggests that renting is expensive and that it may still be better to buy. Therefore, if the jobs that Max is offered are equally attractive, it will likely be more attractive to move to Miami with respect to this ratio. He will likely get better value for his housing dollar in buying a home in Florida. However, the ratio of 20 in L.A. indicates that it would still be better to buy, if Max instead decides to move to California. 4. If the Revell family income is $3,500 per month: Maximum monthly payment they could afford: $1,050 ($3,500 x .30). Maximum total monthly installment loan payments: $1,330 ($3,500 x .38). If they are already paying $750 monthly on installment loans, the maximum mortgage payment they could make would be $580 ($1,330 – $750). 7. Answers using text Exhibit 5.5 are listed first followed by answers obtained using the financial calculator set on End Mode and 12 payments/year: a. For a $90,000/6.5%/30 year loan $90,000 = 9.0 9.0 x $63.21 = $568.89 payment $10,000 90,000 +/- PV 6.5 I/YR 30 x 12 N PMT $568.86 b. For a $125,000/5.5%/20 year loan $125,000 = 12.5 12.5 x $68.79 = $859.88 payment $10,000 125,000 +/- PV 5.5 I/YR 20 x 12 N PMT $859.86 c. For an $97,500/5%/15 year loan $97,500 = 9.75 9.75 x $79.08 = $771.03 payment $10,000 97,500 +/- PV 5.0 I/YR 15 x 12 N PMT $771.02 10. The Mortgage Refinancing Analysis for Emily Sun using Worksheet 5.4 appears below: MORTGAGE REFINANCING ANALYSIS Name: Emily Sun Date: Ite Description Amount m Current monthly payment (Terms: $162,000; 8%; $ 1 25 yrs.) 1,250.00 New monthly payment (Terms: $152,401; 6%; 21 2 1,065.00 yrs.) 3 Monthly savings, pretax (Item 1 – Item 2) 185.00 4 Tax on monthly savings [Item 3 x tax rate (15%)] 27.75 5 Monthly savings, after-tax (Item 3 – Item 4) 157.25 6 Costs to refinance: a. Prepayment penalty b. Total closing costs (after-tax) c. Total refinancing costs (Item 6a + Item 6b) $ 0 1,500 $ 1,500.00 7 Months to break even (Item 6c Item 5) 9.54 months Given that Emily plans to remain in the condo for another 48 months and she will break even on the refinancing in about 10 months, she should go ahead and refinance the mortgage under the specified terms. 11. Pros: The higher your extra payment, the sooner you pay off your mortgage. This would provide extra future flexiblity to meet needs like funding a child’s college education or retirement. Extra payments can also dramatically reduce the total interest paid on a mortgage. Cons: You will have less short-term flexibility because the extra payments obviously absorb resources. And the lower amount of interest will reduce the tax shelter benefits associated with the mortgage deduction. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 5-1. a. Affordability is the starting point for a car purchase. Once you know how much you can afford to buy, operate, and maintain, you can look for models suitable for your needs and budget. b. Operating costs include loan payments, insurance, license fees, repairs, gas, oil, tires, and other maintenance. Some cars are more expensive to operate than others. It is important to consider operating expenses as well as the cost of the car when evaluating affordability. c. Gas, Diesel, or Hybrid? It is important to consider the differences between the costs and performance of differently fueled vehicles and decide which type you want before shopping for a specific new or used car. Generally, diesels are a bit noisier, have less acceleration and more power, and have longer engine lives than traditional gas-powered cars. Hybrids are very economical and less polluting than gas- and diesel-powered vehicles. They do have some disadvantages: high cost of battery replacement, more sluggish acceleration, generally higher repair costs, and the typically higher initial purchase price. d. New, Used, or “Nearly New”? Of these three choices, the new car is the most expensive but typically has the best warranty. Used cars cost less, but it can be difficult to accurately assess the mechanical condition of the car. Warranty coverage, if available, covers a shorter time period and may be limited. However, you may be able to afford a better used car than if you bought a new car. The “nearly-new” car is a low-mileage used car, such as a car which has come off rental or a dealer "executive" car, which can offer good value. These cars usually have warranties similar to new cars and cost 25 to 40% less than comparable new cars. e. The choice of size, body style, and features affects the purchase price and operating costs. By selecting the desired options before shopping, you can avoid pressure from the salesperson to buy a car loaded with options you don't want. f. By comparing the reliability records of the cars that interest you, using such publications as Consumer Reports, you can select the car with the lowest need for repairs and hopefully reduce your maintenance costs. Manufacturers who offer longer warranty coverage can also save you money. 5-2. The first step in purchasing a new car is to do research on the types of cars available, their features, price, reliability, and other key factors. Educating yourself in these areas will help to determine which car is best suited for your needs and budget. After narrowing the field, you can visit the dealers who sell the cars of interest to you. Test drive them and then select two or three that best meet your needs. Complete the comparison shopping process before making any offers. Next, negotiate price. To do so wisely, find out the dealer's cost for the car and the options you want; the sticker price is not very meaningful. Sources of dealer's cost figures include Consumer Reports magazine and individual cost reports ordered from Consumer Reports and Kelley Blue Book. Edmund’s is now available on-line at www.edmunds.com. Knowing the dealer's cost enables you to negotiate the lowest possible markup. Also, take into consideration any rebates that are offered, deducting the amount from the dealer's cost. Doing your homework before starting price negotiations helps to avoid high-pressure sales tactics that may encourage you to take a deal too soon and should also result in a lower price. Until you negotiate a firm price, be sure not to discuss how you plan to finance the purchase or whether you are trading in your old car. These issues can affect price negotiations. The closing process involves signing a sales contract specifying the offering price and other terms of the sale. Once you and the dealer have accepted and signed the contract, it becomes binding. Some dealers require a deposit at this time. The final step is to arrange financing, pay for the car, and accept delivery. 5-3. Advantages to leasing include the ability to afford a better car for the same payment, no or low down payment, and the ability to turn the car in at the end of the lease period. On the other hand, because you only pay for the use of the car during the lease period, you have no ownership. Terminating the lease early may be difficult and costly. Also, finding out the actual cost factors used to calculate the lease payments can be hard, and there will likely be a penalty if you drive the car more miles than the lease allows. 5-4. Student answers as to leasing or purchasing a car will, of course, vary. 5-5. In addition to single-family homes, other types of housing available in this country include condominiums, cooperative apartments, and rental apartments and houses. Single-family homes, condominiums, and cooperatives offer pride of ownership and the opportunity to benefit from price appreciation. The owner of a condominium receives title to an individual unit and a joint ownership of any common areas and facilities, such as lobbies, swimming pools, lakes, and tennis courts. Since buyers own their units, they arrange their own mortgages, pay their own taxes, and pay for maintenance and building services. They are usually assessed, on a monthly basis, an amount deemed sufficient to cover their proportionate share of the cost of maintaining common facilities. The owners also elect a board of directors to supervise their building and grounds. A cooperative apartment, or co-op, is an apartment in a building in which each tenant owns a share of the corporation that owns the building. Residents lease their units from the corporation and are assessed monthly fees in proportion to their ownership shares, which are based on the amount of space they occupy. These assessments cover the cost of service, maintenance, taxes, and the mortgage on the entire building. The assessment can change depending on the actual costs of operating the building and the actions of the board of directors, which determine the corporation's policies. Rental units may be houses or apartments that are owned by someone else and leased for a set time period. The landlord is responsible for the upkeep, and the renter does not build up equity in the property. 5-6. Student answers will vary. There are advantages and disadvantages to both renting and buying. Commonly cited advantages of renting include: (1) a down payment and closing costs are not required, (2) greater mobility because moving in and out of rental units is less complicated and less costly than selling and purchasing homes, (3) some units or complexes have security systems provided, (4) the appeal of community living, and (5) access to certain amenities such as swimming pools and tennis courts may be provided. The disadvantages of renting are primarily financial. Renters neither receive any equity (ownership) interest in the property nor do they receive any tax-deductible benefits from rent payments. In addition, rental units may not be quiet, neighbors may be unfriendly, repairs may not be made promptly, and landlords can be uncooperative. A homeowner has an advantage over a renter with respect to taxes because the homeowner who itemizes deductions for federal income tax purposes can include mortgage interest and property taxes as itemized deductions. Renters do not receive these deductions; generally, no portion of rent is deductible for federal tax purposes. 5-7. A written lease agreement provides better protection than an oral agreement for both the lessor and lessee. It spells out the conditions applicable to both parties and thereby avoids misunderstanding. Lease agreements typically include the monthly payment amount, date due, penalties for late payment, lease term, deposit requirements, distribution of expenses, and restrictions on occupancy. 5-8. People own a home for various reasons, including using it as a tax shelter because both the interest paid on the mortgage and property taxes paid are tax deductible for taxpayers who itemize deductions. In addition, a home can be viewed as an inflation hedge because its value will likely increase with inflation, which typically causes the prices of real assets to increase. The most important reason for preferring to own rather than rent a home is probably the basic security and peace of mind derived from living in one's own home— pride of ownership, a feeling of permanence, and a sense of stability. The least important motive for owning a home is its ability to act as a hedge against inflation; because inflation cycles are unpredictable as are local real estate values, so too are the inflationhedging benefits of home ownership. 5-9. The loan-to-value ratio specifies the maximum percentage of the value of a property that the lender is willing to loan. The loan-to-value ratio determines the amount of down payment that will be required. For example, if the loan-to-value ratio is 80%, the down payment must be at least 20% of the purchase price. 5-10. Mortgage points are a one-time, up-front fee charged by lenders at the time they grant a mortgage loan. In appearance, they are like interest in that they are a charge for borrowing money. One point is 1% of the loan amount, so if a lender wanted to charge 2.5 points on an $250,000 mortgage, the buyer would have to pay $6,250 ($250,000 x .025) in points. The points are charged in addition to the down payment and other closing costs and are paid at the time of closing the mortgage loan transaction. Paying points is sometimes referred to as “buying down the interest rate.” Lenders are willing to lower the interest rate if borrowers are willing to pay the up-front points necessary to compensate the lender for what he’s giving up in the future stream of mortgage payments. 5-11. 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. Closing costs, including points, can total an amount equal to 50% or more of the down payment. When the down payment is only 10%, closing costs can run as high as 70% or more of the down payment. 5-12. The most common guidelines used to determine the amount of monthly mortgage payments one can afford are the affordability ratios that stipulate: • Monthly mortgage payments should not exceed 25 to 30% of the borrower's monthly gross (before tax) income; and • The borrower's total monthly installment loan payments (mortgage and other consumer loan payments) should not exceed 33 to 38% of monthly gross income. 5-13. The prospective home buyer should carefully investigate property taxes, insurance, maintenance, and operating costs when shopping for a home because these expenses are unavoidable and significantly impact the overall cost of the home. If a person cannot afford these substantial costs in addition to meeting the monthly mortgage payments, then the home would be unaffordable even if the prospective buyer could make the required down payment and closing costs. 5-14. There are many possible answers to this question, some of which follow: • Shop carefully and take time to familiarize yourself with the various residential areas you are considering. • Know why you want a home and what your needs are in terms of lifestyle, physical space, type of neighborhood, features and style of house, etc. • Know in advance what you can afford, and prequalify for a mortgage. • Set priorities, but also be prepared to make compromises; it is unlikely that you will be able to get everything you want. • Negotiate the price, but don't get into a bidding war that could drive the price up. • Read all documents carefully to make sure you understand them. • Have the property inspected before finalizing the sale. 5-15. With their knowledge of the real estate market, real estate agents can expedite the search for housing by matching the individual with appropriate properties. An agent can also help in negotiations with the seller, assist in obtaining satisfactory financing, and help in preparing a real estate sales contract. MLS refers to the Multiple Listing Service, a compilation of properties for sale by members of the MLS in a particular area. Such shared listings provide greater market access for both buyers and sellers. Real estate agents earn a commission on completed sale transactions. The seller typically pays the commission from the sale proceeds. 5-16. A real estate short sale is the sale of property in which the proceeds are less than the balance owed on a loan secured by the property sold. This procedure is an effort by the mortgage lender to come to terms with a homeowner who is about to default or is defaulting on their loan. The benefit of a short sale for the borrower is to prevent a home going into foreclosure and this will appear on the borrower’s credit history. However, a short sale may also have a negative effect on a borrower’s credit score. In the case of a foreclosure, the lender then repossesses the home in order to recover the loan on the property. Mortgage holders only agree to short sales if they believe the proceeds generated will benefit them by bringing smaller losses than foreclosing on the property. For both the lender and the borrower, the benefit of the short sale is that it is usually faster and cheaper than foreclosure. Most short sales satisfy the debt owed by the borrower, but this is not always the case. 5-17. Starting your search for mortgage financing early in the home-buying process helps in many ways. By identifying potential lenders and prequalifying for a mortgage, you know before you start to look at houses how much you can afford, all the costs involved, and whether you can, in fact, obtain financing. You'll have time to correct any problems that may prevent you from getting a mortgage. Also, by focusing on homes that fall within your price range, you can streamline your search and eliminate frustration. Having your financing pre-arranged also saves time once you find a house to buy. 5-18. State laws generally specify that in order to be enforceable in court, real estate buy-sell agreements must be in writing and contain certain information, including (1) names of buyer(s) and seller(s), (2) a description of the property sufficient to provide positive identification, (3) specific price and other terms, and (4) usually the signatures of the buyer(s) and seller(s). An earnest money deposit is money the buyer is asked to pledge at the time she or he makes an offer in order to show good faith. This money is later applied to the closing costs. If, after the sales contract is signed, the buyer withdraws from the transaction without a valid reason, he or she stands to forfeit the earnest money deposit. Contingency clauses make a real estate sales contract conditional upon satisfaction of specified factors, such as obtaining financing or a satisfactory inspection. They protect the buyer. 5-19. The closing process begins once a suitable property is found, a written offer for the property is presented and the price is negotiated and accepted, terms are agreed upon, and both buyer and seller have signed the sales contract. Once the buyer makes the required earnest money deposit, certain legal procedures are followed to close the transaction and ensure the rights of both the buyer and the seller in the transaction. These include review of the RESPA statement of closing costs; hiring a title company to verify that the title to the property is free of all liens and encumbrances except those specified in the sales contract, and paying all required fees, taxes, points, etc. In some states this will be handled by lawyers acting for each party or it may be handled by an escrow company that is a third party working for both the buyer and seller to ensure that all the terms of the contract are correct. This process can take anywhere from a few weeks to several months to complete, depending on the nature of the property, the contract terms, and applicable state laws. 5-20. The sources of home mortgages today include commercial banks, thrift institutions, mortgage brokers and online lenders. Mortgage brokers take loan applications and then find lenders willing to grant the mortgage loans under the desired terms. Credit unions also make some mortgage loans. So do mortgage bankers, who frequently use their own money to initially fund mortgages that they later resell. 5-21. The fixed-rate mortgage is the traditional form of a mortgage and is characterized by the fact that both the rate of interest and the monthly payment are fixed over the full term of the loan. Adjustable-rate mortgages (ARMs) provide that the rate of interest, and therefore the monthly payment, is adjusted up and down in line with movements in interest rates. The rate of interest on the mortgage is linked to a specific interest rate index and adjusted at specific intervals (usually once a year) in accordance with changes in the index. The adjustable-rate mortgage usually has the lowest initial rate of interest. The fixed-rate mortgage has a higher rate of interest because the lender assumes all of the interest rate risk; under ARMs this risk is instead borne by the borrower. Negative amortization of a mortgage loan results in an increasing principal balance because monthly loan payments are lower than the amount of monthly interest being charged. The difference between the loan payment and interest incurred is then added back to the principal, thereby increasing the size of the loan. This occurs either when the initial mortgage payment is intentionally set below the interest charge or when the ARM has interest rates that adjust monthly but the actual monthly payment can only be adjusted annually. Fixed-rate mortgages are usually desirable because the payment amount is known in advance. Their major disadvantage can be their higher cost, although if a fixed rate is obtained during a period of low rates, the homeowner will benefit if rates rise considerably in later years. They are best for those who plan to stay in their homes for five or more years. ARMs generally cost less over the life of the mortgage than fixed-rate loans, although this is hard to predict given the variable nature of the rate. The lower rate makes it possible to afford a larger mortgage. It is important to have an ARM with a cap to protect against rising rates. However, rates can still rise several points in a year, and homeowners should be careful not to overextend themselves and then not be able to make the higher payments on the mortgage when rates rise. Also, as described above, some ARMs can have negative amortization. ARMs are best for those who can live with some uncertainty, are willing to monitor rates so that they can refinance at a fixed rate if necessary, and who plan to stay in their home a short time. 5-22. A conventional mortgage is a mortgage offered by a lender who assumes all the risk of loss. To protect themselves on this type of mortgage, lenders usually require either a 20% down payment or stipulate that the borrower must obtain private mortgage insurance. Insured mortgages, such as those backed by the FHA mortgage insurance program, usually feature lower required down payments, below-market interest rates, few if any points, and relaxed income/debt ratio qualifications. In exchange for a mortgage insurance premium of 2.25% of the loan amount—which is paid by the borrower at closing or included in the mortgage—plus another .5% annual renewal fee, the FHA agrees to reimburse the lender in the event the buyer defaults. Guaranteed loans, such as VA loans provided by the U.S. Veterans Administration, are insured loans but do not require the lender or the borrower to pay a premium for the guaranteed payment. Veterans are eligible for this type loan only one time, and essentially are able to make the purchase without a down payment. Closing costs and a 2.15% funding fee are usually required, however, but the rates on VA loans are usually about 0.5% below the rate of conventional fixed-rate loans. Solutions to Online Bonus Personal Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. Appraised value of the house = $105,000 80% of the value = 0.80 x $105,000 = $84,000 Required down payment at $100,000 selling price = ($100,000 – $84,000) = $16,000 2. Using the generalization that with a 10% down payment, one could expect to spend an amount equal to 70% of the down payment for other closing costs, we can estimate that total closing costs would be around $59,400. Down payment = .10 x $220,000 = $22,000 Other closing costs = .70 x 22,000 = $15,400 Estimate of total closing costs = $59,400 This estimate would more than likely already include some amount of points paid on the home mortgage. Exhibit 5.4 shows an example of a typical breakdown of closing costs and includes an allowance for 3 points paid on a $198,000 mortgage ($220,000 purchase price less 10% down payment). To illustrate how points are calculated, one point equals one percent of the loan amount. Three points on a $220,000 home with 10% down would equal $22,000 Loan amount = Purchase price – Down payment = $220,000 – $22,000 =$198,000 Total points = 0.03 x $198,000 = $5,940 Total closing costs would include the down payment, any points paid on the mortgage, and other closing costs. Homebuyers should carefully shop for a loan, because even among lenders offering the same rate on the mortgage, it is possible to save several thousand dollars in closing costs. 3. Over the life of the mortgage the principal portion increases and the interest portion decreases as a percentage of the overall mortgage payment. This is because interest is calculated relative to the remaining outstanding principal, which declines with each payment. This implies that the tax benefit of a mortgage is higher in the earlier than in the later stages of a mortgage. 4. The Home Affordability Analysis (Worksheet 5.3) for Jennie and Caleb McDonald follows. The maximum priced home they can afford is $120,600. Problem 4—Worksheet 5.3 5. From text Exhibit 5.6, using a principal-amount factor of 15 ($150,000/$10,000): a. For a 15-year, 6% fixed rate loan 15 x $84.39 = $1,265.85 monthly payment Using the financial calculator set on End Mode and 12 payments/year: 150,000 +/- PV 6 I/YR 15 x 12 N PMT $1,265.79 b. For a 30-year adjustable-rate mortgage at 2.5 points above the index rate of 4.5%, the first-year monthly payment would be based on 30 years at 7% (i.e., 2.5% + 4.5%) 15 x $66.53 = $997.95 monthly payment Using the financial calculator set on End Mode and 12 payments/year: 150,000 +/- PV 7 I/YR 30 x 12 N PMT $997.95 6. Pros: The higher your extra payment, the sooner you pay off your mortgage. This would provide extra future flexiblity to meet needs like funding a child’s college education or retirement. Extra payments can also dramatically reduce the total interest paid on a mortgage. Cons: You will have less short-term flexibility because the extra payments obviously absorb resources. And the lower amount of interest will reduce the tax shelter benefits associated with the mortgage deduction. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 5.1 The Harrisons’ New Car Decision: Lease versus Purchase 1. The Harrisons appear to have made a common mistake by focusing on the advertised payment figure for the lease. They should first do market research using consumer and automobile magazines, dealer information, and information off the Internet to decide what type of car best suits their needs in terms of style, price range, options, reliability, and operating costs. Rather than jumping to a conclusion based on the monthly lease payment, they should comparison shop and choose from several possibilities. 2. The Harrisons need to consider many factors before visiting the dealer. As mentioned in question 1, they should visit several dealers and find out the cost of the cars they have chosen, without discussing whether they wish to lease or finance the purchase. Then they can accurately calculate the total cost of each option. They should also talk to an independent leasing dealer to determine the cost of leasing any of the models they like. Other important considerations are discussed in question 3 (b). The advantages of leasing include no down payment (or a small one) and a lower monthly payment than required to finance the car. This may make it possible to lease a nicer car than you could buy. On the other hand, the lease payments only cover a portion of the car's cost, so you don't own the car at the end of the lease period. Leases are costly to break if your needs change, and extra costs for wear and tear, excess mileage, or an unguaranteed residual may increase the costs at the end of the lease term. 3. a. The Harrisons’ lease versus purchase analysis is on the following page. Leasing the car results in cost savings of approximately $927. b. Other considerations include how long the Harrisons plan to keep the car, the mileage allowance, definition of wear and tear, and end-of-lease fees. c. The Harrisons should lease the car based on the cost analysis. However, if they feel they would like to keep the car longer than 4 years, they might consider buying. If they are uncertain about any of the lease terms, such as keeping the car for the full term, they should buy. They should shop around to find a loan with a lower interest rate, which would make purchasing more attractive and see whether they can earn more than 3% after tax on the down payment. Case 5.1, Problem 3a—Worksheet 5.1 5.2 Evaluating a Mortgage Loan for the Meyers 1. If the Meyers purchase the $215,000 home: Down payment = $215,000 x .20 = $ 43,000 Mortgage = $215,000 – 43,000 = $172,000 Other costs: Points = .02 x $172,000 = $ 3,440 Other closing costs = .05 x $215,000 = 10,750 Total closing costs $14,190 Plus: Down payment 43,000 Cash to close $57,190 The Meyers have saved $44,000—enough for the down payment and $1,000 of the closing costs, but they would be short $13,190 of the total closing cost requirement. In addition, they would be unable to meet many other costs associated with buying and moving into a new home. This financing strategy is clearly unaffordable for the Meyers. 2. With a $25,000 down payment and $190,000 mortgage, closing costs would be: Points = .03 x $190,000 = $ 5,700 Other closing costs = .05 x $215,000 = 10,750 Total closing costs $ 16,450 Plus: Down payment 25,000 Cash to close $ 41,450 The total cash needed to close the transaction is less than the $44,000 the Meyers have available, making this option feasible for them. Using text Exhibit 5.6, their monthly mortgage payment at 6%, 30 years is: $59.96 x $190,000/$10,000 = $1,139.24 Using the financial calculator (set on End Mode and 12 payments/year): 190,000 +/- PV 30 x 12 N 6 I/YR PMT $1,139.15 No information has been provided about any other installment debt, so the affordability ratio would consider only their monthly mortgage payment relative to their $5,167 monthly income ($62,000/12). Affordability ratio = $1,139 = 22% $5,167 This is well within the required 28% guideline, so the lender should be willing to make the loan. 3. Loan-to-value ratio = $190,000 = 88% $215,000 Total monthly mortgage payment (PITI): Mortgage payment $1,139.15 Insurance ($800/12) 66.67 Taxes ($2,500/12) 208.33 Total payment–PITI $1,414.15 The affordability ratio using the total payment is well below the usual total monthly payment affordability guideline of 33 to 38%. Affordability ratio = $1,414.15 = 27% $5,167 4. It appears that given the Meyers’ available savings and level of income, they can afford this home. They should go ahead with the purchase. However, they should budget carefully to allow for the additional expenses associated with moving and with repairing and maintaining a home. 5.3 Sophia’s Rent-or-Buy Decision 1. The solution to the rent-or-buy analysis using Worksheet 5.2 follows. Excluding the effect of appreciation in the value of the condo, Sophia should buy because her annual ownership cost would be $10,075 (see line B.11), while the annual rental cost would be $14,998. 2. Including the expected rate of appreciation for the condo further lowers its annual cost. With 3.5% appreciation, the annual cost of the condo declines by $6,125 (.035 x $175,000) in the first year. This lowers the annual ownership cost to $3,950 (see final line). Sophia should definitely buy the condo, since its annual cost with appreciation is far below that of renting. 3. The qualitative factors Sophia should consider include the pride of home ownership and security—benefits that renting does not offer. Purchasing also builds value and savings, while renting does not. On the other hand, home ownership is costly in several nonmonetary ways: the owner is totally responsible for its upkeep and repairs. A renter can merely dispatch the landlord to make and pay for work that needs to be done. But, is the landlord good about fixing things? That is another problem. How long does she plan to live there? What is the resale market for condos? What are her future plans and will the condo be suitable for her on down the road? 4. In light of the above analysis, Sophia should definitely buy the condo, assuming she qualifies for the loan. The annual after-tax cost of $3,950 including an adjustment for appreciation is about a fourth of the $14,998 annual cost of renting. The condo offers her appreciation potential, and her mortgage payments will be fixed (except for insurance and taxes). While certain operating costs may be greater in the condo than in the apartment, other benefits of ownership far outweigh this factor. Case 5.3—Worksheet 5.2 Note: Assume Sophia’s security deposit is equal to one month's rent of $1,200. Note: Find monthly mortgage payments from Exhibit 5.6. An easy way to approximate the portion of the annual loan payment that goes to interest (line B.8) is to multiply the interest rate by the size of the loan. To find the principal reduction in the loan balance (line B.7), simply subtract the amount that goes to interest from total annual mortgage payments. *Tax-shelter items, provided Sophia itemizes deductions. Solution Manual for PFIN Personal Finance Michael D. Joehnk, Randall S. Billingsley, Lawrence J. Gitman 9781305271432
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