CH-6-8 Using Credit – PFIN Personal Finance : Book Guide

This Document Contains Chapters 6 to 8 Chapter 6 Using Credit Chapter Outline Learning Goals The Basic Concepts of Credit Why We Use Credit Improper Uses of Credit Impact of the Credit Crisis on Borrowers Establishing Credit First Steps in Establishing Credit Build a Strong Credit History How Much Credit Can You Handle? Credit Cards and Other Types of Open Account Credit Bank Credit Cards Line of Credit Cash Advances Interest Charges Then There Are Those Other Fees Special Types of Bank Credit Cards Reward Cards Affinity Cards Secured Credit Cards Student Credit Cards Retail Charge Cards Debit Cards Revolving Credit Lines Overdraft Protection Unsecured Personal Lines Home Equity Credit Lines Obtaining and Managing Open Forms of Credit Opening an Account The Credit Application The Credit Investigation The Credit Bureau The Credit Decision Computing Finance Charges Managing Your Credit Cards The Statement Payments Using Credit Wisely Shop Around for the Best Deal Avoiding Credit Problems Credit Card Fraud Bankruptcy: Paying the Price for Credit Abuse Wage Earner Plan Straight Bankruptcy Major Topics Managing credit is an important part of personal financial planning. Consumer credit can be used in one form or another to purchase just about every type of good or service imaginable. It is a convenient way to make transactions, but when consumer credit is misused it can lead to real problems. It is important for you to understand where consumer credit fits into your financial plans so that it is used wisely. This chapter covers the following major topics: Consumer credit enables the user to pay for relatively expensive purchases, to deal with financial emergencies, and to enjoy the convenience of using credit. Disadvantages to using consumer credit generally arise from abuse of credit—people borrow more than they can handle—and this can eventually lead to bankruptcy. Open account credit is the most popular form of consumer credit. It is provided by banks, stores, and other merchants and includes bank credit cards, retail charge cards, travel and entertainment cards, and personal revolving credit lines, which include overdraft protection and home equity loans. Formal application for open account credit involves a credit investigation; a credit report will probably be obtained from one of the major credit bureaus. Finance charges are typically based on a variation of the average daily balance method. Using open account credit wisely involves choosing the right card or line of credit, avoiding credit problems and fraud, and not abusing credit. Key Concepts Open account credit is a very important concept in the understanding of your personal financial plan. Improper use of this type of credit can lead to disaster, but wise use of open account credit can help you implement your overall plan. To understand the application of open account credit, you should understand some of the key terminology, including the following terms: Debt safety ratio Credit history Credit limit Bank credit cards Retail charge cards Cash advance Debit cards Revolving line of credit Overdraft protection Home equity credit lines Credit bureau Credit scoring Finance charges Credit card fraud Personal bankruptcy Credit counseling Open account credit Line of credit Base rate Grace period Reward (co-branded) credit card Affinity cards Secured (collateralized) credit cards Student credit card Unsecured personal credit line Credit investigation Annual percentage rate (APR) Average daily balance (ADB) method Minimum monthly payment Wage Earner Plan Straight bankruptcy Financial Planning Exercises The following are solutions to some of the problems at the end of the PFIN 4 textbook chapter. 1. Evelyn is wise to begin establishing a good credit history early. She should start by opening bank accounts (checking and savings) and applying for a few credit cards. She should use these cards sparingly and pay bills promptly. Having a student loan helps establish her credit history, as by making payments on time, she demonstrates her ability to meet her loan obligations. If Jake makes payments of $410 and his take-home pay is $1,685, his debt safety ratio is $410/$1,685 = 0.24 or 24%, which is slightly above the maximum suggested limit of 20%; as such, he should be cautious about incurring any more debt before he pays off his current obligations. If his take-home pay were $850 and his payments were $150 per month, his debt safety ratio would be $150/$850 = 0.176 or approximately 18%, which is within the recommended guidelines. However, 18% is close to the maximum suggested limit of 20%, so Jake would do well to try to reduce his debt load. Natalie’s consumer debt safety ratio is calculated as follows: Use worksheet 6.1. Type of Loan Mo. Payment Auto loan $380 Dept. store charge card 60 Bank credit card 85 Personal line of credit 120 Total Monthly Payments $645 Debt Safety Ratio = Total Monthly Consumer Credit Payments Monthly Take-Home Pay = $645 $3,320 = 19.4% If Natalie wants her debt safety ratio to be only 12.5% of her current take-home pay, she must reduce her total monthly payments to $415 ($3,320 x .125). If she wants her current consumer debt load to equal 12.5% of take-home pay, then she would have to increase her take-home pay to $5,160 ($645 = 0.125 x Take-home pay or Take-home pay = $645 ÷ 0.125) If Scott plans to pay his balance in full each month, the interest rate on his credit card would not matter. Virtually, all cards do not charge a fee if the cardholder’s balance is paid in full each billing cycle, provided no late fees or over-the-limit fees apply. Therefore, he would go with the card which does not have an annual fee. However, if he knows he will carry a significant balance from one billing cycle to the next, he may well be better off with the card that charges an annual fee and a lower interest rate. The higher his balance, the more attractive such a card would become. Scott should also consider the method the lender uses to calculate the balances on which they apply finance charges. The most common method (used by an estimated 95 percent of bank card issuers) is the ADB, including new purchases. Card issuers can also use an ADB method that excludes new purchases. Balance calculations under each of these methods affect the finance charger that he will have to pay. If Chase and Olivia have a home appraised at $180,000 and a mortgage balance of only $90,000, they have equity in the home of $90,000 ($180,000 – $90,000). If an S&L will lend money on the home at a loan-to-value ratio of 75%, the S&L would be willing to lend up to $135,000, or .75 x $180,000. Subtracting the first mortgage of $90,000, the Ellisons could qualify for a home equity loan of $45,000. According to the latest provisions of the tax code, all of the interest paid on their home equity loan would be fully deductible (for federal tax purposes). It makes no difference what the house originally cost; the only thing that matters is that the amount of indebtedness on the house not exceed its fair market value (which is virtually impossible given a loan-to-value ratio of 75%). Other than that, a homeowner is allowed to fully deduct the interest charges on home equity loans of up to $100,000; since the Ellisons’ home equity line is within this limit (theirs is a $45,000 line), the interest on it is fully deductible. Note: under current tax laws, the total amount of itemized deductions as reported on Schedule A may be reduced for taxpayers with adjusted gross incomes greater than a certain level. Also, if taxpayers do not itemize deductions and take the standard deduction instead, the tax deductibility feature of a home equity loan would not make a difference in the amount of taxes owed. Lilly has a fairly large balance of $14,500 on her credit cards. If her current cards charge her 12% per year, she would be paying $1,740/year or $145/month ($14,500 x .12/12) in interest on this amount. Therefore, if she feels she would not be able to pay off this balance fairly rapidly, she might indeed wish to transfer her balance to a 0% interest rate card for 9 months. If such a card charges a 2% transfer fee, she would pay $290 to transfer her $14,500 balance. She would have paid that amount in interest in 2 months anyway by leaving her balance with her old cards. Most cards have a maximum amount charged to transfer a balance, such as $65 or $75. However, since Lilly has multiple cards, she might be charged that maximum several times. She should call the customer service number on the new credit card offer, explain her situation, and ask them to calculate what her fees would be to transfer the balance. She should also inquire what the regular rate will be on the new card, because she will have to pay that on her unpaid balance once the special offer time period is over. She should also be aware that if she pays late on such an offer, many times the rate will automatically go up to the card’s regular rate and even higher if she has several late pays. Amy should immediately notify the credit card issuer of any charges on her statement which are not hers. The customer service representative of the issuing card can give her more information concerning the purchases so that she can determine if she indeed made them and forgot or if they are fraudulent. Her liability would be limited to $50 on any charges she did not make. 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. 6-1. People typically borrow money to pay for items or services that cost more than the consumer can afford to pay out of current income. By spreading payments over time, expensive items become more affordable, and as a result, consumers can obtain the immediate use of an asset without having to fully pay for it for many years. Other reasons for borrowing include: Financial emergencies—when unexpected expenses arise; Convenience—it can be easier to pay with a credit card than by writing a check; Investment purposes—when investors partially finance the purchase of securities with borrowed funds. The biggest danger in borrowing is overspending. Credit is so easily available it is not all that difficult to spend beyond your means. This, of course, can lead to serious financial strain (as it becomes harder and harder to repay the growing debt load) and ultimately bankruptcy. Usually, such problems are brought on by improperly using credit; i.e., by using credit to: (1) meet basic living expenses; (2) make impulse purchases (especially the expensive ones); (3) purchase a lot of nondurable (short-lived) goods and services; and (4) use one form of credit to make payments on other debt. As the economy slowed and unemployment increased during the wake of the financial crisis of 2008-2009, overly indebted households had problems making their mortgage payments. As a result, they drastically cut spending on housing and consumer durables and also many sold their houses to reduce debt. This reduced the overall GDP and exacerbated the downward spiral in home prices. As consumers adapted to the financial crisis, their total indebtedness relative to disposable income fell between 2008 and 2011. About two-thirds of the reduction is due to home and consumer loan defaults. Ongoing foreclosures will likely reduce debt even further. Despite the fact that interest rates fell to record lows, the decline in housing prices made it harder for households to refinance mortgages. In addition, the consumer demand for cash and safe government securities increased, while banks became more reluctant to make riskier loans. Much of the extra public borrowing required to help stimulate the economy was financed by the increased saver demand for safe assets and as a result, the government bond yields dropped as government indebtedness rose. Installment and revolving credit by lenders was reduced to diminish exposure to credit risk. Deleveraging was caused by both tightening credit conditions and voluntary household credit decisions. While debt continues to fall, reduced home equity will likely constrain consumer spending and dampen GDP growth. The crisis has changed the borrowing and spending environment for consumers who now look for greater value and more transparency in financial transactions. As a general guideline, your monthly debt repayment burden should not exceed 20% of your monthly take-home pay. To measure how you are doing, the consumer credit industry employs the debt safety ratio, this is computed as: Debt Safety Ratio = Total monthly consumer credit payments Monthly take-home pay To establish a good credit rating: Use credit only when you an afford it and only when the repayment schedule fits comfortably into the family budget—in short, do not over-extend yourself. Fulfill all the terms of the credit. Be consistent in making payments on time. Consult creditors immediately if you cannot meet payments as agreed. Be truthful when applying for credit—if you are not, you may have some explaining to do to reconcile what you say with what your credit record has to say about you. A woman should always use her own name in filing a credit application, and she should maintain her own credit file, separate from her husband’s. 6-6. Open account credit is credit extended to a consumer in advance of any transactions. Credit is extended as long as the consumer does not exceed the established credit limit and payments are made in accordance with the terms specified. Financial institutions and retail stores are the main providers of open account credit, which can be in the form of bank credit cards, retail charge cards, 30-day charge accounts, travel and entertainment cards, and revolving lines of credit. Typically, a store or bank agrees to allow the consumer to buy or borrow up to a specified limit on open account. A line of credit is the maximum amount that the holder of a credit card can owe at any time. The amount of the line is set by the issuer based upon an investigation of the applicant’s credit and financial status and upon the applicant’s request. Lines of credit offered by issuers of bank cards can reach $25,000 or more, but for the most part, they range from $2,000 to $5,000. A line of credit is a customary part of bank credit cards and many types of retail charge cards (e.g., cards issued by major department stores); however, some charge cards (like gasoline credit cards) do not come with lines of credit, nor do travel and entertainment cards—whatever has been charged on these cards has to be paid in full in the next billing cycle. You can use your credit card to obtain a cash advance in exactly the same way you do to purchase any other service or piece of merchandise. You present your card at the teller window of any participating bank (or other financial institution), and along with proper identification, can obtain a cash advance of just about any amount you want, so long as you do not exceed your credit limit—though some banks may have limits as to how much they will advance to non-customers. Alternatively, you can use your card at any participating ATM to obtain cash advances, though the amount of such advances is usually limited to some nominal amount (of, say, $200 or $300). There is usually a fee for a cash advance, regardless of how it is obtained. However, ATMs may charge an additional fee for using the service of the machine. You receive an advance on an overdraft line if you write a check that overdraws your checking account. Then the overdraft protection line will automatically advance the funds necessary to put the account back into the black. While a separate line of credit might be set up at the bank to handle the overdraft protection, it is becoming increasingly common today to simply link the bank’s credit card to your checking account (then, if your checking account becomes overdrawn, the bank simply taps your credit card line and transfers the necessary funds to your checking account). 6-7. Reward cards combine traditional bank or T&E card features with a special incentive, such as frequent flier miles or rebates on cars or other merchandise based on purchases up to a limit. Unless you charge a lot and pay balances in full, however, these cards may not make sense, as they often carry higher interest rates. 6-8. Most issuers now use a variable rate tied to the prime rate—prime plus a certain amount with stated minimum and maximum rates. Generally, interest starts accruing immediately on cash advances and many times at a higher rate than that charged on purchases. If you pay your balance in full every month, most purchases will not be charged interest whereas cash advances will. Additionally, a cash advance usually incurs a fee, so effectively the cost of a cash advance can be significantly higher than that of a purchase. 6-9. Many bank credit card issuers impose fees besides the finance charge. These include: Annual fees for the “privilege” of being able to use certain credit cards. These fees usually range between $25 and $40. Transaction fees for cash advances. These are normally about $5 per cash advance or 3% of the amount obtained, whichever is higher. Balance transfers are a type of cash advance and may also incur fees. Late-payment fees and over-the-limit charges are also added by some cards. Inactivity fees are now being assessed by some cards on customers who do not use their cards within a given period. Foreign transaction fees may be assessed when you use your card in a foreign country. In addition to fees, many cards reserve the right to increase the interest rates they charge you if you are late on your payments or do not pay the minimum amounts. The true or effective cost of borrowing must reflect all costs involved and not just the interest charges. So obviously, all of these fees add to the effective cost of borrowing. A debit card provides direct access to your checking account and works just like writing a check. When you use the debit card, the amount of the purchase is deducted directly from your checking account. It is similar to a credit card in that it looks like a credit card and is presented in the store just like a credit card. It differs from a credit card in that it does not provide credit or deferred payment. Revolving lines of credit are a form of open account credit that are offered by banks and some other financial institutions. The borrower accesses the funds by writing checks rather than using a credit card. A home equity credit line is a personal line of credit that is secured with a second mortgage on the borrower’s home. This means that a family can borrow against the equity in their home. The typical home equity credit line has a minimum of $10,000 in available credit and an advance period of 5 to 20 years during which the homeowner then taps into the credit by writing a check or using a special credit card. At the end of the advance period, borrowing must stop and the credit must be repaid over a period of 10 to 20 years. Credit scoring is where values will be assigned to such factors as age, annual income, marital status, length of employment, whether the applicant owns or rents a home, etc. These variables lead to an overall “credit score;” if the score equals or exceeds a predetermined minimum, the applicant will be given credit; if not, the credit will be refused (though borderline cases may be granted credit on a limited basis). In essence, credit scoring is a highly mechanical process whereby the credit decision itself is based largely on the credit score obtained. A credit bureau is a type of reporting agency that gathers and sells information about individual borrowers. Lenders who do not know you personally use credit bureaus as a cost-effective way to verify your employment and credit history. There are three sources of credit bureau information: creditors who subscribe to the bureau, other creditors who supply information at your request, and publicly recorded court documents. The information gathered usually includes: Your name, social security number, age, number of dependents, and current and previous addresses; Your employment history; Your credit history, including loans, credit cards, payment records, and account balances; Public court records; Names of financial institutions that have recently requested your credit information. By law, if the information in your credit bureau report is incorrect, it must be deleted and lenders receiving the report within the last six months must be notified of the correction. You should notify the credit bureau in writing of the error, including proof to verify your claim; then request a copy of the report to make sure the correction was made. If there is a dispute that cannot easily be settled, you are entitled to add to your file a short statement giving your side of the story. Your explanation must be included with future lender reports. Most bank and retail charge card issuers use one of four variations of the average daily balance (ADB) method, which applies the interest rate to the average daily balance of the account over the billing period. The most common method (used by an estimated 95 percent of bank card issuers) is the average daily balance including new purchases. The monthly statement shows all transactions, payments, account balances, finance charges, credit available, and the required minimum payment. Merchandise and cash advance transactions are often separated on these statements, as different interest rates may be used to calculate the interest on them, and the interest usually starts to accrue immediately on cash advances. When choosing a credit card, you should compare annual fees, rates of interest, grace periods, how balances are calculated, and additional fees. You should also look at your spending patterns. If you pay off balances each month, look for no annual fees and a long grace period—even if that means choosing a card with a high rate of interest (which does not affect you since you do not carry balances anyway). However, if you normally carry a high credit balance, then look for cards that charge a low rate of interest on unpaid balances, even if that means you have to pay an annual fee on the card, and avoid twocycle balance calculations. For rebate cards, calculate the annual cost with and without the incentive, based on your own spending habits, to see whether the incentive is worth having or not. Steps to avoid credit problems include exercising discipline when using credit, limiting the number of credit card accounts you have, and reducing the number of cards you carry. Many problems can be resolved simply by calling the credit card company and speaking with their representative. If you do run into problems paying off credit card balances, first stop using your credit cards until you pay off the balances, pay off the highest interest cards first. It may make sense to transfer balances from higher-interest cards to a lowerinterest card or to consolidate the loans and use a home equity line to repay the balances. However, using home equity can be risky—if you don’t change bad credit habits, you could lose your home. The biggest source of credit card fraud is stolen account numbers—usually obtained by dishonest employees or thieves going through an establishment’s trash. Some things that you can do to reduce your chances of being a victim of credit card fraud are: Never give your credit card account number over the phone to people who call you. When paying for something by check, never put your credit card account number on the check, and do not let the store clerk do it either. Never put your phone number or address on credit/charge slips. When using your card to make a purchase, always keep your eye on your card. Draw a line through any blank spaces on a credit card slip so the totals cannot be altered. Destroy all carbon copies and old credit card slips. If your card is lost or stolen, report it to the card issuer immediately. Use only secure sites when using your card for Internet purchases. 6-20. A Wage Earner Plan (as defined in Chapter 13 of the U.S. Bankruptcy Code) is a plan for scheduled debt repayment over future years. It may be a viable alternative to straight bankruptcy when a person has a steady source of income and has a reasonable chance to repay his or her debt in three to five years. In this instance, the debtor retains the use of, and keeps title to, all of his or her assets. Straight bankruptcy (Chapter 7 of Bankruptcy Code), in contrast, is a legal procedure that results in “wiping the slate clean and starting anew.” The debtor is released of the majority, but not all, of his or her indebtedness and also relinquishes possession of or equity interest in the majority, but again not necessarily all, of his or her assets. This procedure is usually viewed as more severe than a wage earner plan. 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. Students will calculate their own debt safety ratios using the following equation: Debt Safety Ratio = Total monthly consumer credit payments Monthly take-home pay Then they should comment on their personal credit situation based on the ratio (low = 10%, manageable = 15%, and maximum = 20%) and describe any corrective actions they must take. The main features and implications of the Credit Card Act of 2009: In the past, credit card companies could change interest rates and other aspects of the agreement with no notice. They could even change terms retroactively such that they applied two months before you were notified. The new law requires credit card companies to give 45 days’ notice before changing your agreement. Similarly, credit card companies previously could raise your interest rate if your credit report deteriorated or if you were late on even just one payment. The new law allows credit card companies to apply a new interest rate only to new balances after you are 60 days delinquent paying on your account. Just as importantly, your old balance can only be charged your old interest rate. Assuming that the latest balance on Debora’s overdraft account is $862, and with a minimum monthly payment of 5% of the latest balance, her payment on the overdraft account would be: $862 x 5% = $862 x .05 = $43.10 or $45, when rounded to the nearest five dollar figure. If Gabriel has a balance of $380 on her retail credit card, the calculation of the monthly interest on her account would be: $380 x (21%  12) = $380 x 0.0175 = $6.65 This calculation assumes that the balance was computed by the average daily balance method. The calculation of Joel’s interest is as follows: Number of Days Balance (1) x (2) = (1) (2) (3) Previous balance 4 $386 $ 1,544 Purchases and payments: June 4–11 balance ($386 + $137) 8 523 4,184 June 12–19 balance ($78 + $523) 8 601 4,808 June 20 balance ($98 + $601) 1 699 699 June 21–25 balance ($699 – $35) 5 664 3,320 June 26–30 balance ($75 + $664) 4 739 2,956 30 days $17,511 Average daily balance = $17,511 = $583.70 30 Finance charge = $583.70 x (0.15  12) = $583.70 x .0125 = $7.30 Credit cards provide a line of credit and can be used worldwide as well as on the Internet to make purchases or pay for services. Credit cards also allow the holder to obtain cash advances, either from a financial institution or at an ATM machine. Other features offered by credit cards may include a buyer protection plan on merchandise purchased with the card, travel accident insurance, auto rental insurance coverage or other added attractions, such as a rebates or frequent flyer miles. Even though most credit cards carry a fairly high interest rate, cardholders who pay their balance in full each month usually pay no interest or finance charges. So in essence, such card users are the beneficiaries of a short, free loan each month. The main drawback to credit cards is the tendency of some cardholders to overspend, go into debt and incur high interest charges. Debit cards do not provide credit, but rather are like writing a check. Purchases on debit cards come directly from one’s checking account and therefore incur no finance charges. People who have difficulty managing credit many times prefer a debit card because they are not as tempted to overspend. However, some merchants charge a fee to debit card users, and some issuers charge transaction fees. Debit cardholders can have overdraft problems when they fail to record transactions in their checkbooks William would be a convenience user of either type card. He is a disciplined spender and probably would not be tempted to overspend. He likely will not need credit for emergency purposes, either, as he has a sizeable emergency fund of $8,500 built up. William might want to consider a credit card with a rebate or frequent flyer miles. With his disciplined approach to spending, he could charge purchases, pay them in full each month, and rack up points or miles. Also, when a credit card is stolen, the most the cardholder can be out is $50. When a debit card is stolen, the cardholder can possibly lose a lot more, plus the money has been removed from his or her account and the burden falls to the cardholder to get the money restored to his or her account. In the meantime, before the money is restored the debit cardholder is denied use of his or her funds. On the other hand, if fraudulent charges appear on one’s charge card statement, the credit cardholder contests the charges and doesn’t pay the bill. 7. The five Cs of credit are character, capacity, collateral, capital, and condition. Refer to the “Financial Road Sign.” Harvey certainly seems to be a person of great character. He was active in clubs and community service while in college, serving frequently in a leadership role. His capacity to service a loan would depend on his other sources of income. We are not told if he has another job lined up or not. If he has other income, that would greatly increase his capacity to repay the loan, particularly since he has no other debts to service. However, if he does not have other income, the $10,000 expected cash flow from his investment is certainly not enough for him to live off of plus pay on his loan. Harvey might consider offering his car as collateral for this loan, since he owns it free and clear. Backing a loan with collateral would likely allow him to obtain a much lower interest rate on the loan, since the bank would have an asset to seize in the event he did not repay his loan as promised. The lower the interest rate, the less it would cost Harvey to service his loan, which in turn would also increase his capacity to repay the loan. Harvey has a fair amount of capital for a young person who has just completed college. He owns his car, which is valued at $10,000, plus he has $6,000 in savings. This should be a positive for him. However, the current condition of the economy will probably work against Harvey. Even though an economic recovery is predicted soon, it may not be soon enough for Harvey’s business to generate the cash flow he anticipates. A high percentage of new businesses fail in the first year, and a slow economy usually increases the likelihood of failure. 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. 6.1 The Morales Family Seeks Some Credit Card Information Conrad and Ingrid should expect to provide information with respect to family, housing, employment and income, assets and liabilities, existing charge accounts and credit references. They should provide this information as honestly, accurately, and thoroughly as possible, because it will be verified in the process of the credit investigation. The bank will analyze and verify the accuracy of the data in the credit application. It will likely get a credit report from a credit bureau in order to check on past payment habits. Further investigation by the bank may involve contacting references listed on the credit application. Generally, only in the case where a credit report cannot be obtained or when the credit report is marginal will the bank check credit references. The bank may use subjective techniques to evaluate and assess the applicant’s credit worthiness, or they may use some type of credit scoring scheme. In the credit scoring approach, the bank assigns values to certain factors and then calculates a credit score. This score can then be compared to predetermined values in order to decide whether or not to extend the requested credit. Regardless of what techniques are used, the bank will ultimately make a decision to accept, reject, or issue some type of restricted credit. Applicants are notified of the decision, and those who are granted credit are sent a personalized credit card along with materials describing the credit terms and procedures to be used. The Morales family should understand that a credit card is a powerful tool that can provide them with many of the things they want. At the same time, if it is not used properly, they can get into a lot of financial trouble. They should make sure that the goods and services they charge on their cards fit into their needs as expressed in their financial plans. If they use the credit card for everyday needs, then they should pay off the entire balance each month. This means that they are living within their budget and are just using the credit card for convenience. If they make a substantial purchase with the card, they should know beforehand how the purchase fits into their financial plans and how the payments are to be met. Any use of the card as a way of buying permanent goods or expensive services must not damage their long-term financial goals. Additionally, proper use of a credit card can build a strong credit record. The lenders will report the Morales family payment history and outstanding balances to the credit bureau. Any problems will show up quickly, but good use of the credit will also be reported, thus building their credit history. Sound use includes one-time payments, staying within credit limits, and making their payments on time. 6.2 Nancy Starts Over After Bankruptcy Obviously, the first thing Nancy has to do is pay back the $24,000 in bankruptcy debt— and the sooner that can be done, the better! She has to show that she now has the discipline to pay off the debt that she owes. She also has to be careful about taking on any new debt—though that probably will not be much of a problem, since she is likely to find new debt very hard to come by. Finally, if she has any monthly bills (like phone bills, etc.), she should make sure she always pays them on time. She might look into the possibility of obtaining a charge card from one or two major department stores in her area. While Nancy has to be careful about taking on new debt, she might be able to get approval for a charge card with a low credit limit—say, $250– $300. Then she has to make sure that she uses it judiciously and that she promptly pays the account balance in full each month. For at least a year or so, probably the only way she will be able to obtain a bank credit card is to sign up for a secured credit card. Nancy can do that by using part of her savings to purchase a CD, which will then act as collateral for the credit card. Again, she will have to take care to use the card sparingly and make payments on time, preferably in full, every month. For the first year or two, Nancy should monitor her credit report every six months, then after that, every year or so for the next five to seven years. If she finds any discrepancies in the report, she should contact the credit bureau immediately (in writing). If she is making progress in her fight to get out of debt, that should be reflected in her credit report; if it is not, she should let the credit bureau know. Nancy needs to know that it is possible to start over again. In addition, she should take the time to reflect on the past and determine what went wrong—knowing that, she can take steps to make sure it does not happen again. She should not overspend, not take on more debt than she can afford, and not let the debt build up. She should make sure that the repayment of the debt fits into her monthly budget and that she stays current on all her bills and credit lines. Chapter 7 Using Consumer Loans Chapter Outline Learning Goals Basic Features of Consumer Loans Using Consumer Loans Different Types of Loans Student Loans Obtaining a Student Loan Are Student Loans “Too Big to Fail”? Strategies for Reducing Student Loan Costs Single-Payment or Installment Loans Fixed- or Variable-Rate Loans C. Where Can You Get Consumer Loans? Commercial Banks Consumer Finance Companies Credit Unions Savings and Loan Associations Sales Finance Companies Life Insurance Companies Managing Your Credit A. Shopping for Loans Finance Charges Loan Maturity Total Cost of the Transaction Collateral Other Loan Considerations B. Keeping Track of Your Consumer Debt Single-Payment Loans A. Important Loan Features Loan Collateral Loan Maturity Loan Repayment B. Finance Charges and the Annual Percentage Rate Simple Interest Method Discount Method Installment Loans A Real Consumer Credit Workhorse Finance Charges, Monthly Payments, and the APR Using Simple Interest Add-on Method Prepayment Penalties C. Buy on Time or Pay Cash? Major Topics Although saving is an important way to reach a financial goal, borrowing by using a consumer loan may also help you attain your personal financial goals. Consumer loans are an important part of achieving financial goals, particularly when the amount borrowed and the debt repayment requirements are well within the budget. There are a variety of consumer loans available for a variety of purposes. The major topics covered in this chapter include: One of the most legitimate reasons for going into debt is to pay for a college education. There are several federally sponsored, subsidized student loan programs available: Stafford Loans, Perkins Loans, and Parent Loans (PLUS). Installment loans are frequently preferred to single-payment loans because of the ease of repayment over time. Consumer loans can be obtained from commercial banks, consumer finance companies, credit unions, savings and loan associations, sales finance companies, life insurance companies, and friends or relatives. When shopping for a loan, the borrower should be aware of finance charges and other terms of the loan, as well as the total cost of the debt. Single-payment loans usually mature in one year or less, and interest can be calculated using the simple method or the discount method. Installment loans can have maturities of up to seven to ten years, and interest can be calculated using the simple method or the add-on method. Consumer loans may have various provisions, including collateral requirements, variable or fixed interest rates, recourse clauses, and other clauses that protect the position of the lender. Comparisons among various loans should include calculation of the annual interest rate charged on the loan. Key Concepts This chapter introduces a number of key phrases and concepts associated with consumer loans. It continues to stress the relationship of consumer actions, such as borrowing to fulfill a personal financial goal, and the requirements of good financial planning so that the burden of borrowing fits into the budget. The following phrases represent the key concepts stressed in this chapter: Student loans Single-payment and installment loans Fixed- or variable-rate loans Consumer finance and sales finance companies Cash value of life insurance policies Loan provisions to protect the lender Finance charges and total cost of the loan Annual percentage rate calculation Simple interest method and discount method for single-payment loans Simple interest method and add-on method for installment loans Rule of 78s (sum-of-the-digits method) Consumer loans Collateral and collateral note Interim financing Captive finance company Loan application Lien Chattel mortgage Prepayment penalty Loan rollover Loan disclosure statement Financial Planning Exercises The following are solutions to some of the problems found at the end of the PFIN 4 textbook chapter. Although Marissa could borrow money for college through normal channels through a regular consumer loan from the bank, better avenues exist such as several federal and state subsidized educational loans Federally sponsored programs include: Stafford Loans (Direct and Federal Family Loans--FFELs). Perkins Loans Parents Loans (PLUS) Stafford and Perkins Loans have the best terms and are the foundation of the government’s student loan programs. In contrast, PLUS loans are supplementary loans for undergraduate students who demonstrate a need for funding but do not qualify for Stafford or Perkins Loans. The best place to look for funding is on the Internet through such sites as FASTWEB, which can provide loan and scholarship information as well as form type application letters. Exhibit 7.1 could understand help interest rates, borrowing limits and terms. To minimize her borrowing costs and maximize her flexibility, Marissa should borrow as little as possible to cover college costs. One way to meet this goal is to quantify borrowing based on future expected salary and then figure out what amount of monthly payment will be affordable. This analysis should also look for the lowest interest rate. Before making the final decision, she should explore all possible grants and scholarships and apply for Federal aid. At graduation, there are also money saving forgiveness and deferment programs to explore, as well as options to consolidate federal student loans and participate in an income-based repayment program. The Specialty Autos deal total cost: $3,000.00 down + (48 × $333.67) = $3,000 + $16,016.16 = $19,016.16 The Exotic Cars deal total cost: $3,500.00 down + (60 × $265.02) = $3,500 + $15,901.20 = $19,401.20 Based on total cost, the Specialty loan is better. The monthly payment offered by Exotic is lower, but the longer time period makes the total cost paid higher with them, and they require a higher down payment. As computed on Worksheet 7.1, Liam’s debt safety ratio for his consumer debt is 30.2%, considerably higher than the suggested maximum of 20%. He has overextended himself, particularly since he also has his mortgage payments, and chances are that he will have difficulty continuing to meet these payments and the single-payment loan when it comes due. 5. [We will assume that the loan amount requested is $1,000 and compute the interest rate using both methods.] Using the simple interest method, the finance charges on a 6.5 %, 18-month singlepayment loan would be: Finance charge = Principal × 6.5% × 1.5 years = $1,000 × 0.065 × 1.5 = $97.50 Using the discount method, the finance charge is the same dollar amount as that obtained with the simple interest method. However, the finance charges are subtracted first from the amount requested, and then the borrower receives what’s left, or the proceeds. Using the same setup as in the example above: Amount requested – interest = loan proceeds received $1,000 – $97.50 = $902.50 The real difference between these two loans is shown when you compute the APR: Average annual finance charge Average loan balance outstanding APR for the simple interest method is calculated by dividing the finance charge by the life of the loan and then dividing this annual charge by the loan balance ($1,000 in our example). APR = ($97.50/1.5) = $65 = 6.5% $1000 $1,000 The APR for the discount method is found in a similar manner: APR = ($97.50/1.5) = $65 = 7.2% $1,000 – $112.50 $902.50 Using the financial calculator, set on End Mode and 12 payments/year: 3,000 +/- PV 24 N 6 I/YR PMT $132.96 Using the financial calculator, set on End Mode and 12 payments/year: 5,000 + PV 36 N $166.10 - PMT I/YR 12.0119 [(1 + .010010)^12] – 1 = 1.1270 – 1 = 12.70% APR 10. [IMPORTANT NOTE TO INSTRUCTORS: Please provide students with the monthly payment at 4% of $132.84 for $4,500 for 36 months or $29.52 per $1,000 at 4% for 36 months in order to complete Worksheet 7.2.] Using Worksheet 7.2 on whether to borrow or pay cash, we see that line 12 is negative. Therefore, Emma will earn more in interest earnings after-taxes over the loan term than she will pay in interest. Therefore, she should finance the home entertainment center. 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. 7-1. The five major reasons to use consumer loans are: To buy a new car. Auto loans account for nearly 35% of all consumer loans. As a rule, 80 to 90% of the cost of a new vehicle will be financed with credit; the buyer must come up with the rest through a down payment. The auto is the collateral for the loan, and it can be repossessed in the event that the buyer fails to make payments. These loans generally mature in 36 to 60 months. To purchase other costly durable goods. These loans are used to purchase such things as furniture, appliances, recreational vehicles, even mobile homes. The item purchased serves as collateral, and some down payment is almost always required. The loans can mature in as short a time as 9 to 12 months for less costly items all the way to 10 to 15 years or longer for purchases such as a mobile home. To pay for an education. Many students, or their parents, have taken out loans to pay for high-cost college education. These loans often carry low interest rates, and loan repayment often does not start until the student is out of school. As a personal loan. This type of credit is used to make expenditures for nondurables, such as an expensive vacation, or to cover temporary cash shortfalls. Many personal loans are made on an unsecured basis. As a consolidation loan. These loans are used to straighten out an unhealthy credit situation. For various reasons, consumers sometimes use their available credit to such an extent that they are no longer able to service the debt promptly and in a timely manner. When this happens, they can often consolidate the loans to systematically bring the credit under control. In effect, they borrow money from one source to pay off the other forms of borrowing. The usual effect of such a move is to reduce the total payment, but payments may have to be made for a longer time period. 7-2. The federal government makes available several different types of subsidized educational loan programs: Stafford Loans Perkins Loans Parent Loans (PLUS) The Stafford and Perkins loans form the foundation of the government's student loan programs, and PLUS loans are supplemental programs for students who either need the funds but do not qualify for Stafford/Perkins loans, or who do qualify for Stafford/Perkins loans but need additional funds. Generally speaking, the loans carry very low, government-subsidized interest rates, and with Stafford and Perkins loans, repayment does not begin until the student is out of school. As long as the student is making satisfactory progress academically and can show a need financially, the loans are fairly easy to obtain and do not involve a lot of "red tape." There are limits on the amount that can be borrowed each year, though there is no limit on the number of loans you can take out. In contrast to regular consumer loans, the subsidized student loan programs are very lenient; they may not even involve credit checks, and they are less costly and have more accommodating loan repayment provisions. Repayment with some loans does not even begin until after graduation, and then the student can take as long as 10–20 years to pay off the loans. Also, interest on student loans is tax deductible. This question deals with the students' views of these loans; this could provide some lively discussion of what they think of these loans, what they see as the positive and negative aspects of the programs, etc. Borrowing as little as possible is an upfront strategy on student loans. A student should consider how much to borrow in light of his/her expected future salary. In addition, explore all possible grants and scholarships, as well as apply to federal student aid. Upon graduation, explore the Public Service Loan Forgiveness and Loan Repayment Assistance programs. There may also be an option to consolidate federal student loans and to participate in an income-based repayment program. a. The interest rate as well as monthly payment on fixed-rate loans remains the same over the life of the loan. With variable rate loans, the interest rate changes monthly, quarterly, or semiannually every 6 to 12 months in line with market conditions. b. Single-payment loans are made for a specified period of time at the end of which full payment is due. They are available primarily from commercial banks, consumer finance companies, life insurance companies, sales finance companies, pawnshops, and friends and relatives. Installment loans are made generally for six months or more and are repaid in a series of fixed scheduled payments. They are primarily available from commercial banks, consumer finance companies, credit unions, savings and loan associations, and sales finance companies. 7-6. a. Consumer finance companies—A consumer finance company, often called a small loan company, provides secured and unsecured or signature loans to qualified individuals. They acquire their funds from stockholders or borrow funds from various sources. They loan these funds to borrowers at generally high annual interest rates. The amount they loan and the rate charged are normally dependent on state laws. Loans are usually for a short period of time to high-risk borrowers. b. Sales finance companies—A sales finance company provides installment financing for a retailer's customers who may purchase such items as automobiles, furniture, or appliances. The retailer originally lends its money to the customer to promote the sale and initially holds the loan contract. The retailer may not want to tie up its money for very long with installment loans, so the retailer then sells the customers' contracts to a finance company. The customer will then be notified to make his or her payment directly to the finance company. Interest rates will usually be higher than those offered by banking institutions and will vary depending on the maturity date of the loan and the amount of the purchase. Captive finance companies—Captive finance companies, such as General Motors Acceptance Corporation (GMAC) and General Electric Credit Corporation (GECC), are the largest sales finance companies and are owned by large corporations. These institutions usually purchase the installment loan contracts made by their product dealers. 7-7. a. Credit unions offer loans to people and their immediate families who belong to the credit union and who are members of a particular working environment or organization. No nonmembers are allowed to save, loan, or participate in the activities of the lending organization. Interest rates are low relative to other institutions. The loans may be secured or unsecured. An added feature is that loan payments may be deducted from payroll checks. This type of borrowing is one of the most favorable for non-housing consumer loans. b. Savings and loan associations deal primarily in home mortgages, but they also make consumer loans to qualified borrowers. S&Ls are regulated with regard to how much they can put into consumer loans; as a rule, their loans tend to go for consumer durables or for home improvements. The interest rates charged typically depend on a number of factors and are usually slightly above commercial bank rates. 7-8. Basically, before taking out a consumer loan you should ask yourself: 1) Does making this acquisition fit into your financial plans? and 2) Does the required debt service on the loan fit into your monthly cash budget? If the expenditure in question will seriously jeopardize your financial plans and/or the repayment of the loan is likely to place an undue strain on your cash flow, you should reconsider the purchase. 7-9. When shopping for a consumer loan, you should pay particular attention to the following loan features: Finance charges (APR)—how much are you going to have to pay? Loan maturity—does the term of the loan (and, therefore, the size of the payment) fit your needs and your budget? Collateral—is there going to be any, and if so, what? Other considerations—what is the total cost of the transaction, including all finance charges, when are the payments due, how is interest figured (simple vs. add-on), and what kind of an interest refund will you receive if you prepay your loan? To determine the total cost of the transaction, multiply the monthly loan payments by the number of payments to be made. Then add the down payment and any other fees and charges to determine the total. 7-10. A lien gives the lender the power to liquidate loan collateral to satisfy its claim in the event of default. It is part of a secured loan. 7-11. A loan rollover is requested when the borrower is unable to repay the loan when it matures. It involves taking out another loan to repay the original loan in full. 7-12. Under the simple interest method, interest is charged on the actual loan balance outstanding. The discount method first computes interest and then subtracts it from the principal. The borrower gets the difference, not the full amount of the loan. While the amount of interest paid is the same, the APR is higher with the discount method, because you receive less in loan proceeds for the same amount of interest. The simple interest method is better for the borrower. 7-13. An installment loan can be used for many types of purchases and can range from a few hundred dollars to thousands of dollars. These loans are usually calculated at a fixed interest rate, and set payments are made at given intervals, such as monthly or yearly. These loans typically have maturities of 6 months to 15 years. Most are secured, either by the item purchased, a financial asset, or your home. 7-14. A home equity loan lets a homeowner use his or her home as collateral to borrow a given amount of money for a set period of time at either a fixed or variable rate of interest. Except for the collateral (home-equity loans take a second mortgage on the borrower's home), there is really no difference between a home equity loan and a regular installment loan. They both involve a fixed amount of money that is paid back in monthly installments over time. Advantages of a home-equity loan: They can be used to obtain large sums of money; they have long repayment periods (of as long as 15 years), which keeps payments low; they generally carry lower interest rates than other forms of consumer loans; and (their biggest advantage) the interest on the loans is still tax-deductible for those who itemize their deductions (some limits apply). Disadvantages: The availability of these loans may encourage people to take out big loans that can far outlive the assets acquired with the loans; there are costs involved in setting up these loans; and, of course, you stand to lose your home if you cannot repay the loan. 7-15. Purchasing credit life and disability insurance may be a condition of receiving an installment loan. This assures the lender that in the event of death or disability of the borrower, the loan will still be repaid. Credit life insurance provides for repayment of the entire outstanding loan balance at the death of the borrower. Credit disability insurance assures the lender the scheduled installment payments will continue in the event the borrower becomes disabled and unable to meet the scheduled installment payments. The seller's or lender's ability to dictate the terms of these insurance requirements is restricted by law in many states. From the borrower's perspective, such insurance is not a very good deal—it is very costly and really does little more than provide lenders with a very lucrative source of income. Purchasing term life insurance instead is usually more cost effective. 7-16. The simple interest method on installment loans refers to the fact that interest is charged only on the actual installment loan balance outstanding each period and not on the entire original balance. Each time a payment is made, the principal is reduced somewhat, and the interest for the next period is calculated on the remaining installment loan balance. You are better off, as a borrower, with simple interest versus add-on interest. 7-17. If the consumer has adequate liquid reserves and if those reserves are held in an interest-earning account, then if it costs more to borrow the money than can be earned in interest in the savings account, one should not borrow but draw down from savings. In contrast, borrowing becomes the better course of action if the borrowing cost is less than the rate earned on savings, or if the borrower does not have any liquid reserves to draw on. 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. On a single-payment loan, the finance charge using the simple interest method or Fs = Principal × Rate × Time. So Kevin will owe the original principal plus interest at the end of the time period or $8,000 + ($8,000 × 0.06 × 5) = $8,000 + $2,400 = $10,400. If Kevin must pay the interest annually on this loan, then he would owe $480 each year ($8,000 × .06 × 1). At the end of year 5, he would owe the interest for that year plus the principal, or $8,000 + $480 = $8,480. First State Bank will lend Kristin the $4,000 for 12 months through a single-payment loan at 8% discount. The APR on this loan is calculated as follows: APR = $4,000 × .08 × 1 = $ 320 = 8.7% $4,000 – $320 $3,680 Home Savings and Loan will make the $4,000 single-payment, 12-month loan at 10% simple interest. The APR on this loan is: APR = $4,000 × .10 ×1 = $ 400 = 10% $4,000 $4,000 Kristin should borrow the money from First State Bank because they will charge her an annual percentage rate (APR) of 8.7%, while Home Savings and Loan will charge her an APR of 10%. a. Using the financial calculator, set on End Mode and 12 payments/year: 20,000 +/- PV 60 N 4.0 I/YR PMT $368.33 b Outstanding Monthly Interest Charges Principal Loan Balance Payment [(1) × .0033] [(2) – (3)] Month (1) (2) (3) (4) 1 $20,000.00 $368.33 $66.67 $301.66 2 $19,698.34 $368.33 $65.66 $302.67 3 $19,395.67 $368.33 $64.65 $303.68 4 $19,091.99 $368.33 $63.64 $304.69 $18,787.30 $368.33 $62.62 $305.71 $18,481.59 $368.33 $61.61 $306.73 $18,174.86 $368.33 $60.58 $307.75 $17,867.11 $368.33 $59.56 $308.77 $17,558.34 $368.33 $58.53 $309.80 $17,248.54 $368.33 $57.50 $310.84 $16,937.70 $368.33 $56.46 $311.87 $16,625.83 $368.33 $55.42 $312.91 Total Interest Paid in First Year: $732.90 ($368.33 × 60) = $22,099.80 − $20,000 = $2,099.80 [(1 + .04/12)^12] − 1 = (1.0033)^12 − 1 = 1.0403 − 1 = 4.03% To solve for the APR, divide the purchase price of $2,000 by $1,000 to get 2. Then divide the payments given by 2 and look up that amount in the columns under the given time periods. Clearly, Dealer A is offering the better deal. Dealer A: Divide the quoted monthly payment of $119.20 by 2 to get $59.60. Look under the 18 month column to find that the APR is 9%. Dealer B: Divide the quoted monthly payment of $69.34 by 2 to get $34.67. Look under the 36 month column to find that the APR is 15%. You can also use the financial calculator to find the APR as shown below. Set your calculator on End Mode and 12 payments/year. You must put in either the PV or PMT as a negative in order to solve the problem. Dealer A Dealer B 2000 +/- PV 2000 +/- PV 119.2 PMT 69.34 PMT 18 N 36 N I 9% I 15% a. Patricia Fox plans to borrow $5,000 to be paid back in 36 monthly payments. At an annual add-on interest rate of 7 1/2%, the total finance (interest) charges are: Finance Charge using Add-On Method = Principal × Rate × Time F = $5,000 × 0.075 × 3 = $1,125 The monthly payment on the loan is: $5,000 + $1,125 = $170.14 36 Use the financial calculator to find the annual percentage rate (APR) of interest on this loan. Set your calculator on End Mode and 12 payments/year. 5,000 +/- PV 36 N 170.14 PMT I/YR 13.69% Note that the reason the financial calculator can be used to solve for the APR is because the time value of money formulas programmed into the calculator are based on the simple interest method. For installment loans, simple interest is calculated on the outstanding loan balance for each time period. Since the definition of APR is based on simple interest as well, when you solve for I% on the financial calculator, you have also calculated the APR, assuming that the interest is the only finance charge involved. a. The furniture store will lend Charles the $6,400 for 48 months at 6.5% add-on. Monthly payments using this method are calculated as follows: Finance charges = P × R × T = $6,400 × 0.065 × 4 = $1,664 Payment = $6,400 + $1,664 = $8,064 = $168 48 48 The credit union will lend Charles the $6,400 for 24 months at 6% simple interest. Monthly payments using this method are calculated with the financial calculator as follows. Set your calculator on End Mode and 12 payments/year. 6,400 +/- PV 24 N 6 I/YR PMT $283.65 b. The APR for the loan from the furniture store can be calculated with the financial calculator, because the time value of money equations programmed into the financial calculator use the simple interest method, which yields the APR. Set your calculator on End Mode and 12 payments/year. 6,400 +/- PV 48 N 168 PMT I/YR 11.83% The APR for the loan from the credit union is the stated rate of 6%, because APR is calculated using the simple interest method. To prove this point, we can create a Monthly Payment Analysis Table for the first year's payments to derive the numbers necessary to calculate the APR. Outstanding Monthly Interest Charges Principal Loan Balance Payment [(1) × .005] [(2) – (3)] Month (1) (2) (3) (4) $6,400.00 $283.65 $32.00 $251.65 $6,148.35 $283.65 $30.74 $252.91 $5,895.44 $283.65 $29.48 $254.17 $5,641.27 $283.65 $28.21 $255.44 $5,385.83 $283.65 $26.93 $256.72 $5,129.08 $283.65 $25.65 $258.00 $4,871.08 $283.65 $24.36 $259.29 $4,611.79 $283.65 $23.06 $260.59 $4,351.20 $283.65 $21.76 $261.89 $4,089.31 $283.65 $20.45 $263.20 $3,826.10 $283.65 $19.13 $264.52 $3,561.58 $283.65 $265.84 Total Interest Paid in First Year: To calculate the APR, take the interest paid in year 1 and divide by the average outstanding loan balance: $299.58 = 6.18% ($6,400 + $3,295.74)  2 A loan over the same time period with a lower APR will save the consumer more in interest charges. In the loan examples given in this problem, the furniture store offered a higher stated rate (6.5% vs. 6%) and lower monthly payments ($168 vs. $283.65). The APR on the furniture store's offer was higher (11.83% vs. 6.18%) as was the total cost of the interest over the life of the loan ($1,664 vs. $407.65). It stands to reason that because the credit union's loan was over a shorter time period, the interest charges would be less. While it is difficult to evaluate loans over different time periods, here both the interest rate and time period for the credit union are less resulting in less interest paid. However, sometimes consumers may be forced to go with the loan which offers the lowest monthly payments, whether it's the most cost effective or not, because of budget constraints. Then consumers need to ask themselves if they really need to make the purchase now or if they would be better off waiting. [Note: To find the total cost of interest over the life of a loan, multiply the monthly payments by the number of months on the loan and then subtract the principal amount.] 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. 7.1 Financing Anita’s Education With the North Carolina State Bank discount interest loan: Anita would receive initial proceeds of $26,400 calculated as follows: Principal Amount $30,000 Less: Interest for two years ($30,000 × .06 × 2 years) 3,600 Initial Loan Proceeds $26,400 At maturity, Anita would be required to repay the $30,000 principal. a. The finance charges on the North Carolina State Bank loan would be $3,600 as shown above in the interest calculation. b. The APR on the North Carolina State Bank loan can be calculated using the equation: APR = Average Annual Finance Charge Average Loan Balance Outstanding The average annual finance charge is $1,800 ($3,600/2). The average loan balance is the initial loan proceeds, $26,400. Substituting into the equation, the APR is: APR = $1,800 = 6.8% $26,400 a. The finance charge on the simple interest loan from the National Bank of Chapel Hill is $25,000 × .07 × 2 years = $3,500. b. The APR on this loan is found by substituting the appropriate values into the APR equation: APR = $3,500/2 = 7% $25,000 This result is not surprising, since the APR and the stated rate of interest on a simple interest loan are always equal. The loan payment due at the end of two years is $30,000 ($25,000 principal + $3,500 interest). The discount loan from North Carolina State Bank (line a in the table below) is preferred since it has a lower APR and she will spend a little less in finance charges while receiving a bit more in proceeds. The following table illustrates the features of each loan: Method Stated Rate Finance Charge Amount Received Amount Repaid APR a. Discount loan 6% $3,600 $26,400 $30,000 6.8% b. Simple interest loan 7% $3,500 $25,000 $30,000 7% Since Anita plans to spend the $25,000 over the following two years, she should either (1) try to arrange a line of credit in which she can draw the money as needed, with the interest being charged only as the funds are disbursed, or (2) immediately invest the funds in a highly liquid savings instrument, such as a savings account or money market mutual fund. Each of these alternatives should allow Anita to reduce the total finance charges, either (1) by only paying interest on needed funds or (2) by earning a return on the unneeded portion of the loan until the funds are needed. These two approaches should help Anita avoid paying interest on currently unneeded funds while assuring her that her $25,000 college education expense will be met. 7.2 Michael Gets His Outback The First National Bank of Charlottesville will lend Michael the $8,900 for 36 months at 6% simple interest. Monthly payments using this method are calculated with the financial calculator as follows. Set your calculator on End Mode and 12 payments/year. 8900 +/- PV 36 N 6 I/YR PMT $270.76 a. The total finance charges on this installment loan can be found by subtracting the loan principal from the total payments of $9,747.36 (36 months × $270.76/month): Total finance charges = ($9.747.36 – $8,900) = $847.36 b. Since interest on this simple interest installment loan is charged only on the outstanding loan balance, the APR equals the stated interest rate of 6%. The first step in determining the monthly payment required on the add-on interest loan from the Charlottesville Teacher's Credit Union is to calculate the total finance charges. Finance Charges = P × R × T Finance Charges = $8,900 × .045 × 3 = $1,201.50 The monthly payment can then be found by adding the principal to the finance charges and dividing by the number of monthly payments: Monthly payments = $8,900 + $1,201.50 = $10,101.50 = $280.60 36 months 36 a. The finance charges on the Charlottesville Teachers' Credit Union loan are $1,201.50 per question 3 above. b. To find the APR, use the financial calculator. Set on End Mode and 12 payments/year: 8,900+/- PV 36 N 280.60 PMT I/YR 8.41% The following table summarizes the key characteristics of the two loans. Comparing the monthly payment, total finance charges, and APR on the two loans, it's clear that while the two loans are about equal, the one from the credit union (line b) has a slight edge over the one from the bank (line a), which has a slightly higher monthly payment, total finance charge, and APR. Such being the case, Michael should then compare the institutions on other features that are important to him, such as convenience, helpfulness, or possibly one might lower the interest rate if he allows the institution to take automatic payments from his account. Method Stated Rate Finance Charge Monthly Pmt. Amount Recv. Amount Repaid APR a. Simple interest loan 6% $847.36 $270.76 $8,900 $9.747.36 6% b. Add-on loan 4.5% $1,201.50 $280.60 $8,900 $10,101.50 8.41% Chapter 8 Insuring Your Life Chapter Outline Learning Goals Basic Insurance Concepts The Concept of Risk Risk Avoidance Loss Prevention and Control Risk Assumption Insurance Underwriting Basics Why Buy Life Insurance? Benefits of Life Insurance Do You Need Life Insurance? How Much Life Insurance is Right for You? Step 1: Assess Your Family's Total Economic Needs Step 2: Determine What Financial Resources Will Be Available After Death Step 3: Subtract Resources from Needs to Calculate How Much Life Insurance You Require Needs Analysis in Action: The Meese Family Financial Resources Needed After Death (Step 1) Financial Resources Available After Death (Step 2) Additional Life Insurance Needed (Step 3) Life Insurance Underwriting Considerations What Kind of Policy is Right for You? Term Life Insurance Types of Term Insurance Straight Term Decreasing Term Advantages and Disadvantages of Term Life Who Should Buy Term Insurance? Whole Life Insurance Types of Whole Life Policies Continuous Premium Limited Payment Single Premium Advantages and Disadvantages of Whole Life Who Should Buy Whole Life Insurance? Universal Life Insurance Advantages and Disadvantages of Universal Life Who Should Buy Universal Life Insurance? Other Types of Life Insurance Variable Life Insurance Group Life Insurance Other Special-Purpose Life Policies Buying Life Insurance Compare Costs and Features Select an Insurance Company Choose an Agent Key Features of Life Insurance Policies Life Insurance Contract Features Beneficiary Clause Settlement Options Policy Loans Premium Payments Grace Period Nonforfeiture Options Policy Reinstatement Change of Policy Other Policy Features Understanding Life Insurance Policy Illustrations Major Topics A key ingredient of every successful personal financial plan is adequate life insurance coverage. The overriding purpose of life insurance is to protect the family from financial loss in the event of the untimely death of an income earner. Additionally, some types of life insurance also possess attractive investment characteristics which can further enhance a financial plan if they are chosen correctly. In essence, life insurance is an umbrella for a personal financial plan. The major topics covered in this chapter include: Adequate life insurance acts as protection for the financial goals you have already achieved, and it can also help to attain unfulfilled financial goals. Insurance is based on the idea of recognizing and sharing risk, which includes ways of decreasing risk through loss prevention and control and risk avoidance. The amount of life insurance coverage needed can be determined by assessing your family's needs, subtracting from that amount the resources that will be available after death, and funding the difference. There are three basic types of life insurance policies, which differ from each other by the amount of insurance coverage versus savings element per dollar of premium: term, whole life, and universal. Policy provisions in life insurance policies are very flexible and provide many options to the policyholder and policy beneficiaries. The best coverage for your purposes means that you consider buying the proper amount and right type of insurance as well as the lowest cost for your needs. Key Concepts The key concepts associated with life insurance represent the language of the industry and are used to signify the importance that life insurance represents to the financial security of the insured and his or her beneficiaries. The following phrases represent the key concepts stressed in this chapter. Insurance planning Concept of risk Risk avoidance, risk assumption, and loss prevention and control Underwriting The multiple-of-earnings method and the needs analysis method Term insurance: straight and decreasing; renewability and convertibility Whole life insurance: continuous premium, limited payment, and single premium Cash value Universal life Variable life insurance, joint life and survivorship insurance, credit life insurance, group life insurance, and other types of life insurance Contract features of policies Beneficiary clause Settlement options Policy loans Premium payments and grace periods Nonforfeiture right Policy Reinstatement Change of Policy Living Benefits Insurance company ratings Choosing a company and choosing an agent Social Security survivor’s benefits Mortgage life insurance Industrial life insurance (home service life insurance) Multiple indemnity clause Disability clause Guaranteed purchase option Participating policy Financial Planning Exercises The following are solutions to some of the problems at the end of the PFIN 4 textbook chapter. 3. The premium calculations demonstrate that, in general, rates for men are higher than for women of the same age, that premiums increase with age, and that term insurance is far less expensive than whole life. However, remember that whole life insurance builds up cash value, so that if the insured canceled the policy, he or she would receive the cash value back (subject to any taxes and possibly a penalty if withdrawn before age 59 1/2). With term life insurance, there is no cash value build up and the premiums are simply gone. We cannot adequately compare the true costs of these policies without having the schedule for the whole life policies' cash value build up over the specified time periods. [Note: Exhibit 8.2, Annual Renewable Term (ART) Life Premiums, is condensed and only shows years 1 and 5; in reality, the premium will increase each year. One approach to estimate the five- or ten-year cost is to develop an annual average based on the first and last years of the coverage period in question, the method used here. The instructor may prefer to skip ART and have students compare only level premium term and whole life.] Premium Comparisons for 5-Year Period, Age 25, $100,000 coverage: ART premium calculations: Year 1 + Year 5 = Average annual premium 2 Male: $95 + $97 = $96 Female: $49 + $63 = $56 2 2 Multiply annual premiums by 5 to get total premiums paid over a 5-year period. Annual Renewable Term: Level-Premium Term: Whole Life: Premium s: Annual 5-Yr. Total Annual 5-Yr. Total Annual 5-Yr. Total Male $96 $480 $106 $530 $603 $3,015 Female $56 $280 $102 $510 $525 $2,625 Premium Comparisons for 10-Year Period, Age 40, $100,000 coverage: ART premium calculations: Year 1 + Year 10 = Average annual premium 2 Male: $145 + $237 = $191 Female: $117 + $194 = $155.50 2 2 Multiply annual premiums by 10 to get total premiums paid over a 10-year period. Annual Renewable Term: Level-Premium Term: Whole Life: Premium s: Annual 10-Yr. Total Annual 10-Yr. Total Annual 10-Yr. Total Male $191 $1,910 $122 $1,220 $1,078 $10,780 Female $155.50 $1,555 $115 $1,150 $931 $9,310 6. When you look at an insurance illustration, focus first on the basic assumptions and double check all information. Ask the insurance agent to provide an inforce reprojection that shows any changes in credits or charges that the insurance company has declared for the next policy year. These changes will affect your premiums or benefits. Watch for any unexpected premium changes or increases. Check for the following parts of the illustration to make sure that all changes are present and that you understand their contents: Policy, description, terms and features; Underwriting discussion; Column definitions and key terms; • Disclaimer; and Signature page. 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. 8-1. Basically, insurance is needed to protect you from losing assets you have already acquired and to shield you from an interruption in your expected earnings. Insurance lends a degree of certainty to your financial plans. Life insurance is meant to replace income that you would have earned had premature death not occurred. Enough life insurance means that family financial plans can be achieved, even though family income might be interrupted. 8-2. a. Risk avoidance involves avoiding the act that creates the risk. It is an attractive way to deal with risk when the estimated cost of avoidance is less than the estimated cost of exposure, although it is not always possible to avoid some risks. Loss prevention is an activity (such as obeying the traffic laws) that reduces the probability that a loss will occur. Loss control is an activity (such as wearing safety belts in a car) that lessens the severity of an injury or loss once an accident occurs. Risk assumption involves bearing or accepting risk. It can be an effective way to handle many types of potentially small exposures to loss for which the protection of insurance would be too expensive. With an insurance policy, the policyholder is transferring the risk of loss to the insurance company. You pay an insurance premium in return for a promise from the insurance company that they will reimburse you if you suffer a loss covered by the insurance policy. These concepts are interrelated in that they are all ways of handling the risk of economic loss. Using each method effectively and in connection with one another will help you protect yourself in the most cost effective manner. Underwriting is the process by which insurance companies evaluate applications to decide which exposures to loss they can insure and the appropriate rates to charge. Underwriting helps the company guard against adverse selection and establish rates commensurate with the chance of loss. Factors a life insurance underwriter considers include age, sex, occupation, health history and prior problems, driving record and credit rating. In addition to financial protection for one's family, the benefits of purchasing life insurance include the following: Protection from Creditors—The purchase of life insurance can be structured in such a way that when death benefits are paid, the cash proceeds do not become part of the estate and, therefore, are protected from creditors. Even if creditors are successful in securing judgments against persons while still alive who have substantial accumulations of life insurance cash values, they most often cannot levy any claim on those cash values. Tax Benefits— Upon the death of the insured, the proceeds of a life insurance policy pass to the beneficiaries free of any state or federal income tax but may have certain death taxes levied, depending on who owned the policy at the time of death. In policies which build cash value, the cash accumulation grows tax free unless it is withdrawn from the policy. If cash values are withdrawn from a policy, income taxes are payable on the amount by which the cash value exceeds the total premiums paid. Vehicle for Savings—Life insurance can be an attractive medium for savings for some people, particularly those seeking safety of principal. Because life insurance companies have a fairly low failure rate, whole and universal life insurance policies are considered very low risk savings media. As investment vehicles, these policies tend to stack up fairly well when their returns are compared to savings accounts, money fund yields, and returns on T-bills—especially when you factor in the tax shelter provided by the life insurance products. Reasons people need life insurance are: to provide for those who depend on the insured's income, to eliminate debts, to pay for final expenses, and/or to leave someone a gift. Unless a single college student has one or more of these needs, he or she does not need life insurance. Those college students with student loans, auto loans, or other types of debt would want life insurance to eliminate those debts. Important events such as marriage, birth of children, divorce, etc., call for careful consideration as to life insurance needs. Of particular importance is the birth of a child, which instantly creates a long-term need for a large amount of life insurance. The two basic methods for determining a person's life insurance requirements are the multiple earnings approach and the needs analysis approach. The multiple earnings approach is a simple technique in which the amount of insurance to purchase is found by multiplying gross annual earnings by some arbitrarily selected number. Most frequently multiples of five, or in some cases, ten, are used. The needs analysis approach considers the financial resources available in addition to life insurance and the specific financial obligations that a person may have. It involves three steps: Estimating total economic resources needed; Determining all financial resources that would be available after death; and Subtracting the amount of resources available from the amount needed to determine the amount of life insurance required to provide for an individual's financial program. The most common economic needs that must be satisfied after the death of a family breadwinner are: funds to pay off debts in order to leave his or her family relatively debtfree; income to sustain the family until the children are self-sufficient; income to sustain in full or part the surviving spouse; and income to fund any special financial requirements, such as college education for children and/or surviving spouse. Using the needs approach, each of these financial needs should be estimated and viewed in light of available resources to determine life insurance requirements. Factors a life insurance underwriter considers include age, sex, occupation, health history and prior problems, driving record and credit rating. The company is trying to determine the likelihood of their having to pay a claim if they issue you a policy. Under the provisions of term life insurance, the insurance company agrees to pay a stipulated sum if the insured dies during the policy period. Common periods of coverage are five years, ten years, even thirty years with premiums payable annually or semiannually or quarterly. Term insurance offers the most economical way to purchase life insurance on a temporary basis for protection against financial loss resulting from death, especially in the early years of family formation. Common types of term life insurance include: Straight Term—the most frequently purchased, it is a term policy written for a given number of years. The face value of the policy remains constant while the cost of the insurance increases along with one’s risk of mortality. With annual renewable term policies, the annual premiums increase each year reflecting one’s increased likelihood of dying each year. With level-premium term policies, the premiums remain constant for a specified period of years. The cost of insurance still increases each year, but with levelpremium policies, the costs for the given period are averaged so that for the first few years of the policy, the insured is overpaying for the cost of insurance, and for the last few years, he or she is underpaying. Decreasing Term—a term policy that maintains a level premium throughout all periods of coverage, while the face amount decreases. As the insured gets older, the cost of insurance goes up reflecting the greater chance of death occurring. If the premium remains constant but the cost is increasing, then the amount of coverage has to decrease. This type policy is often used to provide for mortgage or other debt repayment in the event of death. The face amount decreases along with the amount of outstanding debt. In addition, term insurance is often written with renewability and convertibility provisions. The first provision basically allows the insured to renew his or her policy for another term without providing proof of insurability; in contrast, the second provision allows the insured to convert his or her policy to whole life without providing proof of insurability. The primary advantage of term life insurance is that it offers an economical way to purchase a large amount of protection against financial loss resulting from death, especially during the childbearing years. The guaranteed renewable and convertible options allow the insured to continue coverage throughout his or her life. The most commonly cited disadvantage of term insurance is that the rates increase as the insured ages. People frequently discontinue coverage for this reason. Whole life insurance is designed to offer financial protection for the entire (whole) life of an individual, and the premiums are calculated assuming lifetime protection for the insured. (Term life insurance premiums are calculated based on the probability of death during the given time of the term only.) In addition to death protection, whole life insurance has a savings element called cash value. The life insurance company sets aside assets to be used to pay the claims expected to result from the policies they issue. If policyholders decide to cancel their contracts prior to the death of the insured, that portion of the assets set aside to provide payment for the death claim which did not take place is available to them for use in their retirement years, for example. Whole life policies, therefore, either pay accumulated cash values to the policyholder if canceled or pay their face value to the beneficiaries at the death of the insured. State laws require that permanent whole, universal, or variable life policies contain a nonforfeiture provision. With the paid-up insurance provision, the policy holder receives a policy exactly like the terminated policy, but with a lower face value. In other words, the cash value buys a new single premium policy and allows the policy holder to still have some coverage. This also makes reinstatement of the original policy possible if the policy holder pays all back premiums plus interest and can meet any insurability requirements. The three major types of whole life policies, based on premium frequency, are: Continuous premium whole life policies, which require a level premium payment each year until the insured dies. Limited payment whole life policies, which offer coverage for the entire life of the insured but schedule the payments to end after a limited period. The period may be a stated number of years, such as 20-year life, or until a specified age, such as paid-up at age 45. Single premium whole life policies, which are purchased on a "cash basis." One premium payment upon inception of the contract buys life insurance coverage for the insured for the remainder of his or her life. One advantage of whole life is that the premium payments contribute toward building an estate, regardless of whether the insured lives or dies. It also permits individuals who need insurance for an entire lifetime to budget their premium payments over a relatively long period, thus eliminating the problems of affordability and uninsurability often encountered in later years with term insurance. Disadvantages most often cited are that more death protection for the same amount of money can be purchased with term insurance and higher yields can be obtained on other investments. Universal life insurance is a blended product that combines the features of an investment that earns current money market interest rates with a term life insurance policy. It offers policyholders a product that blends the favorable features of a whole life policy with the higher yields that money market and bond funds pay. Universal life insurance is a type of whole life insurance because the policy provides both death protection and a savings element. However, unlike whole life, universal life separates the insurance protection portion from the savings portion and offers the insured greater flexibility in paying premiums and in changing the level of the benefit. You can increase or decrease both your premium payments and death benefits as long as there is currently enough to pay the cost for the death protection element. Variable life is like universal life in that a death benefit provision is combined with a savings/investment plan. The big difference is that the consumer can select and periodically change the type of investment vehicle—money market funds, bond funds, and even stock funds—used with his or her variable life policy. Another difference between variable life and whole or universal life is that the amount of death benefits provided will vary with the profits (or losses) generated in the investment account. As its name implies, variable universal life insurance is a variation of variable life that includes flexible premiums, like universal life policies, and a choice of investment vehicles, like variable life insurance. The administrative costs are typically higher, which may undermine some of the higher investment returns, and there are few guarantees concerning the rate of investment return or the level of benefit. Group life insurance is an arrangement under which one master policy is issued, and each eligible member of the group receives a certificate of insurance. It is nearly always term insurance, and the premium is based on the characteristics of the group as a whole rather than those related to any specific individual. Group insurance is commonly offered as a fringe benefit to employees. Because of its temporary nature and relatively low face amount (often equal to one year's salary or less), it should fulfill only low-priority insurance needs. However, the employee may be allowed to purchase additional insurance for himself as well as his dependents. This is a very attractive feature when employees intend to stay with the same employer for an extended period. For individuals and their dependents who may be virtually “uninsurable” because of health problems, etc., this may be about the only way they can obtain insurance. a. Credit life insurance assures the borrower's beneficiaries that, upon death of the borrower, the stated debt will be repaid. Most often this type of insurance is a term policy with a face value that decreases at the same rate as the balance on the loan and is one of the most expensive ways to buy life insurance. Contrary to popular belief, a lender cannot legally reject a loan if the potential borrower chooses not to buy credit life insurance from them. Mortgage life insurance is a form of credit life designed to pay off the mortgage balance upon the death of the borrower. This need can usually be met less expensively by shopping the open market for a suitable decreasing term policy. The high cost of mortgage life insurance is attributable to the fact that the lender selling such insurance receives a commission, and, therefore, is not sensitive to cost factors. Industrial or home service life insurance is whole life or endowment insurance issued in policies with small face values and is sold by agents who call on policyholders weekly or monthly to collect the premiums. The small size of its policies coupled with the high collection costs makes this insurance more expensive per dollar of coverage than whole life or endowment policies. It is rarely sold and accounts for less than 1% of the total amount of life insurance in force in the U.S. The first and most important step involved in shopping for and buying life insurance is developing an estimate of your future financial needs and then selecting the types of policies that will best satisfy those needs. Life insurance must be evaluated in conjunction with other financial goals. A person should also become familiar with the various provisions that life insurance contracts typically include. Next, a person should select companies and agents to contact based on their reputations (financial and otherwise), cost of their policies, and agents' experience, training, and personality. Once these decisions have been made, the individual(s) should discuss their needs with their agent and capitalize on his or her expertise. They should learn the details of the various policy alternatives and select the most cost-effective policy that best serves their coverage needs. A.M. Best, Moody's, Fitch, and Standard & Poor's all rate insurance companies according to their underlying financial strength. These firms look at the financial solvency of insurance companies and assess the ability of the insurer to pay future claims to their policyholders. They look at the insurance company's investment portfolio (especially its holding of high risk real estate and junk bonds), its debt structure and the adequacy of its capital to absorb financial shocks, and even its pricing practices and management strategies. From such in-depth analysis, the rating agencies then assign letter ratings that designate the financial integrity of the insurance company—the higher the rating, the more financially secure the company. Obviously, it is important to know how an insurance company is rated (financially) because you are depending on them to stand behind a very sizable financial obligation (a life insurance policy that could easily run into six figures) at some unknown time in the future. Because of this, you would probably want to stick with insurance companies that receive one of the top two or three grades from the rating agencies (A++ to A from Best; Aaa to Aa2 from Moody's; and AAA to AA from S&P); equally important, look for companies that receive one of these top grades from all of the major rating agencies. Important factors to consider in choosing an insurance agent include his or her level of competence, knowledge of the insurance industry and the various insurance products, willingness to listen to you and his or her attentiveness in determining the most appropriate insurance products to meet your needs. You also want an agent who is known to be dependable and capable of working with other professionals in carrying out your insurance planning needs. A beneficiary is the person or persons who receive the death benefits of the policy if the insured person dies. A contingent beneficiary is a person or persons to whom benefits of the policy would go in the event that the insured outlives the primary beneficiary or that they both died at the same time. It is essential to name a beneficiary. Otherwise, the policy proceeds would be payable to the estate of the deceased and might be subject to prolonged legal and other procedures associated with estate settlement. There are five basic settlement options available for payment of life insurance proceeds upon the death of the insured. Lump sum—The entire death benefit is paid to the beneficiary in a single amount. Interest Only—The policy proceeds are left on deposit with the insurance company for a given period of time. In exchange, the insurer guarantees to make interest payments to the beneficiary during the time it holds the funds. The beneficiary may or may not be permitted to withdraw the proceeds, depending on the agreement. Fixed period payments—The face amount of the policy, along with earned interest, is systematically liquidated over a fixed period of time. The amount of the periodic payment is determined by the face amount of the policy and length of time over which the funds are to be distributed. Fixed amount payments—The beneficiary chooses the amount of periodic benefit desired rather than the number of years over which income is to be received. The period over which the payments are received will, therefore, be determined by the amount of policy proceeds and the size of the periodic benefit specified by the beneficiary. Life Income—The insurer guarantees a certain payment amount to the beneficiary for the remainder of his or her life. The amount is dependent upon the face value of the policy, interest rate assumptions, and the life expectancy of the beneficiary. 8-22. With policies which build cash value, policyholders have a right to receive the cash value if they cancel their policies prior to death (i.e., they do not have to forfeit their cash value). Nonforfeiture options give policyholders choices concerning how they wish to receive these benefits in the event that they do cancel their policies. One option, of course, may be to receive cash. With the paid-up insurance option, the policy's cash value is applied to a new, single-premium policy with a lower face value. Under the extended term insurance option, the cash value is used to buy a term life policy of the same face value; the coverage period is based on the amount of term protection that can be purchased for the given amount of cash value for a person of the insured's age. 8-23. a. A multiple indemnity clause doubles or triples the face amount of a policy if the insured dies as a result of an accident. This benefit is usually offered to the policyholder at a small additional cost. A disability clause may contain either a waiver of premium benefit or a waiver of premium coupled with disability income. A waiver of premium benefit excuses the payment of premiums on the life insurance policy if the insured becomes totally and permanently disabled prior to age 60 (or sometimes age 65). Under the disability income portion, the insured is entitled to a monthly income equal to five or ten dollars per $1,000 of policy face value. Some policies will continue these payments over the life of the insured; others will terminate them at age 65. A suicide clause voids the contract if an insured commits suicide within two years (sometimes one) after its inception. In such cases, the company returns the premiums that have been paid. If the insured takes his or her life after this initial period has elapsed, the policy proceeds are paid without question. The most common exclusions are aviation (piloting a private plane or flying on a military plane) and war. Hazardous occupations or hobbies, such as skydiving, may also be specifically excluded. 8-24. With a participating life insurance policy, the policyholder is entitled to receive policy dividends that reflect the difference between the premiums that are charged and the amount of premium necessary to fund the actual mortality experience of the company. A company estimates its base premium schedule and then adds an adequate margin of safety. The premiums charged to the policyholder are based on these somewhat overcautious estimates. When the company experience is more favorable than that estimated, policyholders receive policy dividends. The policyholder may accept the dividend as a cash payment, leave it with the company to earn interest, use it to buy additional paid-up coverage, or apply it toward the next premium payment. 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. Students' answers will vary. Undergraduates will probably not need insurance unless they have dependents. Older students should justify their answers. 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. Ya Gao’s Insurance Decision: Whole Life, Variable Life, or Term Life? a. Whole life insurance provides protection over the whole life of the insured. In addition to death protection, whole life insurance has a savings element called cash value, which results from the manner in which premiums are paid. Variable life insurance allows the policyholder to decide how the money in the cash value component should be invested. Therefore, it offers the highest and most attractive level of investment return, but it also involves the most risk, because unlike whole or universal life, no minimum return is guaranteed. It also tends to have higher expenses and fees. Term insurance is a type of life insurance under which the company agrees to pay a stipulated amount if the insured dies within the policy period. It offers the most economical way to purchase life insurance on a temporary basis. This form of life insurance only offers protection against financial loss resulting from death. It has no savings function. The major advantages of whole life are: (1) building an estate as the cash value accumulates or as the face value is paid upon death; (2) the premium is constant over a lifetime, so if you need lifetime insurance the premiums are known; (3) it provides a regular forced savings feature that many people like; (4) the cash value can be borrowed against; and (5) the accumulated earnings are given favorable tax treatment. The most frequently cited disadvantages of whole life are that: (1) more death protection can be purchased with term insurance; (2) higher yields may be obtained from other investment vehicles; and (3) there may be consequences to borrowing against the cash value. The major advantages of variable life include: (1) the ability to spread your money over a variety of different investment accounts in one convenient, tax-favored package; (2) the ability to move funds from one account to another as market conditions dictate; and (3) the tax benefits, which include earnings free of current taxation, no tax consequences to switching between funds, and a tax-free death benefit. The major disadvantages are: (1) you can lose money on the investment portion, which could reduce (or possibly even wipe out all together) the built-up cash value and (2) the amount of insurance protection is not well defined because it depends, in large part, on the amount of profits or losses generated from your investments—in other words, you may end up with a lot less insurance coverage than you want. The major advantage of term insurance is that it offers an economical way to purchase a large amount of life insurance protection over a given, short period of time. The major disadvantage is that the cost of continued term coverage will increase through time due to the increased chance of death as one gets older. Therefore, people frequently discontinue needed coverage because of increasing cost. Whole life is superior to variable life because it emphasizes the insurance element of the policy and guarantees a minimum earnings level. Whole life is superior to term in that the premium is constant over a long period of time so that both the level of insurance and the amount of the premium are known. Variable life is superior to whole life because of the better investment earnings opportunities and is superior to term because of this savings element. Term is superior to both whole life and variable life because of its emphasis on the insurance element. The highest face value per dollar of premium is available with term. Ya should probably buy some form of term insurance. As a single parent with young children, she needs to get the most coverage possible per dollar expended. She also needs to supplement the insurance provided by her employer with other insurance that is not dependent on her job security. The $150,000, 25-year limited payment whole life policy might not be feasible due to its high premium cost per dollar. These high rates are due to the large savings component that results because the policy will be fully paid up after only 25 years. If whole life were chosen, continuous premium whole life would more affordable. Variable life insurance would not be appropriate at this time, as she needs to have a known amount of coverage in order to provide for her three children. Since Ms. Gao’s goal is to obtain as much coverage per dollar as possible, rather than building sizable savings, she should purchase term insurance. If she wants to continue the term coverage beyond its initial maturity, she may want to consider some type of renewability provision. A good choice might be to lock in the rate of a 20-year level term policy, and by that time hopefully the last child will be through college. A convertibility option may also be desirable so that as her needs change from pure insurance coverage to saving for retirement, she can shift from term insurance to some type of whole life insurance. Regardless of the options she selects, term insurance will probably best fulfill her insurance needs at this point in her life. 8.2 The Nisbits Want to Know: How Much is Enough? Using the earnings multiple calculation, the Nisbits’ insurance needs are: Ryan: $54,000 × 8.7 = $469,800 Alison: $64,000 × 7.4 = $473,600 Worksheet 8.1 for both Ryan and Alison are found on the following pages. Note that the first worksheet is for Ryan Nisbit; this was prepared to show the needs that will exist if Alison dies and Ryan is the surviving spouse. The second worksheet is for Alison Nisbit, and here it is assumed Alison is the surviving spouse. The worksheets show that Ryan needs another $460,000 in life insurance, while Alison should have another $330,000. Ryan’s life insurance needs are less because Ryan makes more money, and as the surviving spouse, she can provide a larger share of the family's income needs. The amount of insurance needed is different depending on the methods used in questions 1 and 2. The earnings multiple approach from question 1 is a general, average estimate of a family's needs; the worksheets in question 2 address the Nisbits’ specific situation. The needs approach gives a far more accurate picture of life insurance needs and also considers existing life insurance and other assets. Using the Needs Approach in number 2 above, we found that Ryan needs another $480,000 in life insurance and Alison needs another $310,000. However, the $100,000 amount they now have is a declining-term policy, which means every year the pay off amount decreases. This policy may not be very cost effective, and they may be better off replacing it, particularly since their insurance needs will increase each year because this policy will pay less and less. Therefore, they would probably do well to get an additional $600,000 of insurance for both of them, and after it is in place cancel the declining-term policy. [This problem is continued after the worksheets.] Case 8.2, Problem 2—Worksheet 8.1 Case 8.2, Problem 2—Worksheet 8.1 Annual renewable term is usually not as cost effective as a level term policy. If the Nisbits are considering a term policy, they would probably be better off with a 20-year level term policy rather than annual renewable term. (A 20-year time frame was chosen because that is about how long it will take for the youngest child to finish college.) If they would like a policy which builds cash value, whole life would probably be better for them than either variable or variable universal life. Because their children are young, they need to have a policy where they know what the pay off amount will be. Such is not the case with either of the variable policies. Universal life might be an attractive option to whole life. However, we will consider the options of 20-year level term and whole life insurance, as we do not have an example table of premiums for universal life insurance. The following chart compares the premiums on a 20-year level term policy with a whole life policy. The representative tables given in text Exhibits 8.3 and 8.5 were used. Actual costs will vary. Premium Comparisons for 20-Year Period, Age 35, $200,000 coverage: Multiply annual premiums given for $100,000 coverage by 2 to get annual premiums for $200,000. Then multiply annual premiums for $200,000 coverage by 20 to get total premiums paid over a 20-year period. Level-Premium Term: Whole Life: Premiums: Annual 20-Yr. Total Annual 20-Yr. Total Male $268 $5,360 $1,782 $35,640 Female $250 $5,000 $1,550 $31,000 Total for both $518 $10,360 $3,332 $66,640 The 20-year level term is obviously more affordable, costing only $518 per year vs. $3,332, a difference of nearly $3,000. Clearly, the Nisbits have to decide if they can even afford the whole life insurance. The difference in premiums paid over a 20 year period is even more dramatic, with the whole life costing over $100,000 more than the level term. However, the whole life would have built up a cash value of $36,750 × 2 = $73,500 for a $200,000 policy after 20 years for 2 people. So, the Nisbits would have to decide if they could better invest this money or if the whole life should be viewed as protection plus an investment. In the case of the term insurance premiums, the amounts paid would just be gone. If the Nisbits have the money to pay the premiums on the whole life policy, then they have to decide if they would be better off getting the level term policy and investing the difference. The whole life policy would allow their investment to grow tax free, which is a plus. However, if the Nisbits ever need to take a loan against their life insurance and don’t replace it in a given time period, they will have to pay taxes and possibly a penalty. One attractive choice would be to invest as much as is allowed of the difference in yearly premiums in Roth IRAs each year. Their money would grow tax free and offer the family more flexibility in using their money for their children’s education if necessary. The remainder of the annual difference would be invested in a taxable account. It is possible that the family's investments after 20 years would be more than what the cash value would be on whole life insurance. And, if they remove cash value from a whole life insurance policy, some amount would be lost to taxes. Plus, the Roth IRAs would provide tax-free income for their retirement. Solution Manual for PFIN Personal Finance Michael D. Joehnk, Randall S. Billingsley, Lawrence J. Gitman 9781305271432