PFM Chapter-5 (Global)

Chapter 5: Debt and Financing Alternatives You will learn the various types of credit, loan products, their implications and your client’s behaviour towards loans. You will also know about what are the various alternatives available Debt is a way of raising money by corporates, individuals, investors and governments and is not integrally bad. In fact, if debt borrowed in limit and used properly, can help individuals, organizations, investors, governments and others accomplish their various objectives. Even countries use sovereign debt – bonds and T-Bills to keep the government running. Companies raise money either by issue of shares or issue of bonds. Individuals also would find benefit by use of debt. Unfortunately, the misuse of debt – by individuals or other entities – can be financially devastating. Excessive deployment of various forms of debt financing has created significant problems in many places. Interestingly, several first-world economies depend on active use of consumer credit to support overall economic activity. For example, consumer spending is one of the biggest drivers of the U.S. economy. This is not bad in itself, but the fact that a large percentage of the spending comes through use of credit cards and loans has created problems. Individuals may also choose to use debt wisely by borrowing it only if required or to purchase an asset like residential house. Two friends having same level of income may have different well-being if one family is using debt judiciously than other. Credit Use and Potential Problems When purchases are made on credit, the buyer incurs a debt by borrowing the amount of product. Credit is a financial tool, and is available easy, it should be used correctly. An individual may have many reasons to use debt for buying or financing some purchases. Usually, an individual uses credit because money is not available to buy something. It may me to buy consumer products, some emergency spending (personal loan). Using a credit card is convenient. You get monthly statement and you can tally your purchases and pay on due date. You get few days’ time between purchase and due date of payment. Some expenses like booking cab, airline, train tickets etc. becomes easy with the use of credit cards as transactions are done online. If the price of an item is increasing rapidly, purchasing the item now using debt may be financially prudent. As part of a cost-benefit analysis, it is important to add the interest cost when evaluating a potential purchase. When you take credit, you will have to pay interest on that. Interest is the cost of credit. At times, interest rates can be very high and sometimes it may be low. Interest rates move in a cycle of every 3-4 years. If you take credit at high interest rate, any potential benefit from making a good purchase is negated by it. EMIs on Debt decrease cash flow and reduce funds that could otherwise be available for other purposes. For this reason, debt is best used if possible to purchase assets that build equity, such as real estate. Excess use of consumer debt should generally be avoided, because it is not often used to build equity or any long lasting financial value. Where individuals decide to take loan to replace a household item that has broken down like washing machine, refrigerator, Air Conditioner etc. , the key thing is that EMI/ debt repayments should be paid comfortably without any undue hardship to the individual. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 1

Use of debt sometimes is done to meet some emergency when emergency funds are not adequate. Maintaining a reasonable cash reserve is a better practice. Problems Associated with Credit Managing debt is an important part of financial advice, and helping clients avoid excessive debt is a valuable service the financial professional brings to the financial relationship. Educating clients about using debt wisely to advance along the path toward their financial goals is beneficial. Helping clients strike a healthy balance between wisely using debt and avoiding excessive debt is one way a financial professional can provide meaningful value to clients. But it is very important for the clients to have right attitude towards debt. Financial planners have to make understand their clients that many important financial goals like higher education expenses, home purchases, and vehicle purchases mostly require the use of debt. While it is nearly impossible in today’s economic scenario to achieve important financial goals without the use of debt, it is important for clients to avoid taking too much debt. Too much debt will create a pressure on cash flows of the clients. During the interaction with client, a financial professional should learn what the understanding of clients towards debt is and can also help those with more debt than they wish to have, made them understand that they did not get into this situation overnight and neither is it likely they will get out of debt quickly. Hence the need for clients to understand debt management. Many clients will be ok with debt while they are earning handsome income as they know they have means of paying EMIs with the money they earn. As people approach retirement, their attitude toward debt often changes. At this point their primary concern becomes being able to live a comfortable retirement. Before a person retires, he should have paid all this outstanding loans. In fact when you approach bank for any type of loan, they ask retirement age and debt is sanctioned for remaining number of years. Having no debt going into this phase of their lives will increase the likelihood that they can achieve that goal. We all know that using credit has disadvantages as well as advantages. Spending too much is perhaps the biggest disadvantage. It is highly possible for a person to become over-leveraged. That is, they owe more than they have the ability to repay. At an extreme, if a person accumulates too much debt, all future income during the repayment period may be committed to repaying that debt. Keeping an exact record of expenditures is a very good idea. This is especially true when credit is involved. Without controls, credit use can cause lot of damage to financial situation. Before taking credit, a person has to understand his financial situation, interest on debt and return on his existing investments. If a person is able to generate a higher return on his investment than the cost of servicing debt, he can go ahead with debt. Need to consider affordability of paying EMIs out of his monthly income. Qualifying for Credit Most lenders consider the following areas when evaluating a potential borrower:  Credit Record: A credit record shows how well a person has paid his existing debt repayments. Was there any delay in payment of EMIs, if yes, was it genuine reason or carelessness that person forgot to transfer money to the respective account. Personal experience with a lender can also be a consideration. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 2

 Net Worth: The lender will always look for a positive net worth of the person about to take loan. Bank would like to be confident about net worth of the client.  Regular Income: Before sanctioning loan, bank will verify monthly income of client from either his salary slip (working clients) and bank statement or Income Tax returns and bank statements in case of self-employed/business. Bank would like to check availability of surplus to enable client to meet his debt servicing commitment.  Collateral: Bank will identify assets that can be used to secure the debt. When necessary, a lender will check to see what assets are available to be sold in the event of a loan default.  Economic Conditions: Lenders have become very conscious they follow a tight money policy. This means they are requiring individuals to satisfy more rigorous qualification requirements. It also may mean that credit, if extended, will be more expensive. Many lenders look at your credit score before initiating the process of loan sanction. A credit score is a measure of an individual’s ability to pay back the borrowed amount. It is the numerical representation of their creditworthiness. A credit score is a 3 digit number that falls in the range of 300-900, 900 being the highest. You should always work towards reaching a credit score that is close to 900. A higher credit score offers you several benefits and helps you at the time of getting a loan or a credit card. Having a low credit score suggests you have not been a responsible borrower and have been slacking off repaying the borrowed sum. Credit scores are calculated by the credit bureaus in the country after taking into consideration several factors like the length of your credit history, repayment records, and credit inquiries. Mortgages and Other Instalment Loans: Home loans generally come with fixed tenure repayment periods (e.g., 20, 25, 30 years in some cases). Car loans are for a period 5 years to 8 years. And consumer loan can be for a period of 5 years. The term of the loan depends on the purpose of the loan finance. For example, it is appropriate to purchase a home over a 30-year period, but it would be more appropriate to reduce the loan to 0 over a much shorter period for the purchase of a motor vehicle or home appliance. As a rule, the loan term should not exceed the expected useful life of the asset being purchased (e.g. 2 – 5 years). A loan should almost always be short term except home loan. A home loan is the most widely used type of long-term instalment loan. With a mortgage, the borrower (mortgagor) gives the lender (mortgagee) a lien on property as security for the repayment of the mortgage. A lien is the legal right to repossess the property (i.e., collateral) in the event the borrower defaults on the loan. When the mortgagor repays the loan, the mortgagee removes the lien. People most often mortgage real estate, but other property such as motor vehicles can also be mortgaged. Often the cost of borrowing (the interest rate) is reduced if an asset is offered as security for the loan as the lender has more certainty of being repaid if an asset is at risk in the event of non-payment of the loan. Interest rates on any loan may either be fixed or variable. The interest rate on a fixed-rate loan does not change either throughout the life of the loan or for a specified period during the loan. Normally, payments on a fixed rate loan do not change but payments could be subject to change if the interest rate is variable to ensure the loan is repaid within the original term. By making regular payments on the mortgage, the borrower is said to be “amortizing” the mortgage. When an EMI on home loan is paid, each includes principal and interest. Interest component is highest in first EMI and principal component is lowest in first EMI. An amortization schedule shows how much interest and principal the mortgagor repays with each monthly payment. The amount of each payment (interest and CFP Level 1 - Module 1 - Personal Financial Management - Global Page 3

principal) typically varies over time, with more interest paid earlier in the loan and more principal paid as the loan matures. The amortization schedule will also show how long it will take to repay, or retire, the mortgage and the total cost of borrowing over the term of the loan. A shorter repayment period would result in the borrower paying less overall interest on the loan. As a result, if the person can afford the higher payments, shorter terms generally is the better option. In addition to a fixed rate loan, borrowers may make available variable rate loans. With a variable rate loan, the interest rate and the monthly payments can periodically be changed by the lender depending on their cost of funds. The loan documents identify the terms under which interest charges can be modified. Usually, there is an initial pause on any rate change. Then, after a predetermined period, rates can float along with a benchmark, such as the Mumbai Interbank Offer Rate (MIBOR) or Marginal cost of Fund based lending rates (MCLR). Two additional types of mortgages include: 1. Interest only (eventually, the principal amount must be repaid, but for a time, the borrower only repays interest) 2. Graduated payment (here, not even all the interest is paid, with unpaid amounts being added to the mortgage principal) Neither of these options is wise over an extended period. Some would question whether their use, especially the graduated payment option, is ever appropriate. Eventually, principal must be repaid, and when unpaid interest is added to the principal monthly, the loan doesn’t decrease, it increases until additional payments can be made. Cost of an Instalment loan over time: Mortgages and other instalment loans are amortized by making a series of payments (EMIs) to reduce the amount borrowed to zero. To calculate EMI or amortization payments requires knowing the principal amount, applied interest rate and the amount of time used to retire the debt. You will be required to know how to amortize a sum (PMT) by using CASIO- FC 200 V. Solution with the help of FC 200V PV = Amount of loan I = Rate/12 (monthly payment on reducing balance method) N = No of years*12 FV =0 P/Y =12 C/Y =12 Solve PMT (EMI) Let us understand this with the help of an example: Mr Mehta takes home loan of Rs.70,00,000 for a period of 25 years @ 7.5% p.a. Compute the amount of EMI. Solution with the help of FC 200 CFP Level 1 - Module 1 - Personal Financial Management - Global Page 4

Set: End -70,00,000 PV 7.5% I 25*12 N FV 0 P/Y 12, C/Y 12 Solve PMT= 51729.38 Solution with the help of Excel: How to use Amortization schedule We will understand this with the help of example. Mr Basu has recently purchased a house partly with loan amount and partly his own money. Home loan has been taken from a public sector bank at an interest rate of 8% p.a. An amount of Rs.75,00,000 has been taken for a period of 20 years. You are required to calculate the following: 1. Amount of Equated Monthly Instalment (EMI) 2. How much principal will be paid in first month? 3. How much interest will be paid in first instalment? 4. How much principal will be paid in 12 months? 5. How much interest will be paid in 24 months? 6. How much principal will be outstanding after 5 years? 7. How much total interest has been paid in 20 years? CFP Level 1 - Module 1 - Personal Financial Management - Global Page 5

Let us start with first computing an amount of EMI: With the help of FC 200V 1. -7500000 PV a. 8 I% b. 20*12 N c. P/Y 12, C/Y=12 Solve PMT = 62733 2. From here itself select AMRT (Amortization) in FC 200V PM1 = 1 PM2 =1 PRN Solve = 12733.00 It means in the first month, Rs.12733 has been paid as principal. In the same way we can calculate for any month. Remember, this is principal paid in one particular month. 3. In this question, we wish to compute interest paid in the first month. PM1 =1 PM2 =1 INT Solve =50000 If I add principal paid and interest paid in first instalment. It is equal to Rs.50,000+12733= 62733 (EMI) 4. In this question, we need to find principal paid in 12 months: PM1=1 PM2=2 ∑PRN=158524.97 In 12 months an amount of Rs.158524.97 has been paid. If we need to compute how much interest has been paid in 12 months, PM1=1, PM2=12 ∑INT Solve= 594271.08 If we want to cross check, 12 EMIs= 62733*12=752796, Total principal +Total Interest= 158524.97+594271.03= 752796 5. How much interest has been paid in 24 months: PM1 =1 PM2 =24 ∑INT Solve = 1175384.68 6. How much is outstanding principal at the end of 5 years: PM1 =1 PM2 =60 Balance Solve = -6564418.80 Over a period of 5 years, less than Rs.10, 00,000 has been paid off as principal because in the initial years, interest outgo is more and in the later period, principal payment is more. 7. How much total interest has been paid in 20 years? PM1 =1 PM2 =240 ∑INT Solve = 7555921 CFP Level 1 - Module 1 - Personal Financial Management - Global Page 6

This can also be done with the help of Excel also. Amortization Schedule Months Outstanding at Interest rate EMI Interest paid Principal paid Outstanding at the beg end 1 0.08 62733.005 50000 12733.005 2 7500000 0.08 62733.005 49915 12817.892 7487266.995 3 7487266.995 0.08 62733.005 49830 12903.344 7474449.103 4 7474449.103 0.08 62733.005 49744 12989.367 7461545.759 5 7461545.759 0.08 62733.005 49657 13075.962 7448556.392 6 7448556.392 0.08 62733.005 49570 13163.135 7435480.430 7 7435480.43 0.08 62733.005 49482 13250.890 7422317.295 8 7422317.295 0.08 62733.005 49394 13339.229 7409066.405 9 7409066.405 0.08 62733.005 49305 13428.157 7395727.176 10 7395727.176 0.08 62733.005 49215 13517.678 7382299.019 11 7382299.019 0.08 62733.005 49125 13607.796 7368781.340 12 7368781.34 0.08 62733.005 49034 13698.515 7355173.544 13 7355173.544 0.08 62733.005 48943 13789.838 7341475.030 14 7341475.03 0.08 62733.005 48851 13881.770 7327685.192 15 7327685.192 0.08 62733.005 48759 13974.316 7313803.421 16 7313803.421 0.08 62733.005 48666 14067.478 7299829.106 17 7299829.106 0.08 62733.005 48572 14161.261 7285761.628 18 7285761.628 0.08 62733.005 48477 14255.669 7271600.367 19 7271600.367 0.08 62733.005 48382 14350.707 7257344.698 20 7257344.698 0.08 62733.005 48287 14446.378 7242993.991 21 7242993.991 0.08 62733.005 48190 14542.688 7228547.613 22 7228547.613 0.08 62733.005 48093 14639.639 7214004.925 23 7214004.925 0.08 62733.005 47996 14737.236 7199365.286 24 7199365.286 0.08 62733.005 47898 14835.485 7184628.050 25 7184628.05 0.08 62733.005 47799 14934.388 7169792.565 26 7169792.565 0.08 62733.005 47699 15033.950 7154858.177 27 7154858.177 0.08 62733.005 47599 15134.177 7139824.227 28 7139824.227 0.08 62733.005 47498 15235.071 7124690.050 29 7124690.05 0.08 62733.005 47396 15336.638 7109454.979 30 7109454.979 0.08 62733.005 47294 15438.883 7094118.340 31 7094118.34 0.08 62733.005 47191 15541.809 7078679.457 32 7078679.457 0.08 62733.005 47088 15645.421 7063137.649 33 7063137.649 0.08 62733.005 46983 15749.723 7047492.228 34 7047492.228 0.08 62733.005 46878 15854.722 7031742.505 35 7031742.505 0.08 62733.005 46773 15960.420 7015887.783 36 7015887.783 0.08 62733.005 46666 16066.823 6999927.363 37 6999927.363 0.08 62733.005 46559 16173.935 6983860.541 38 6983860.541 0.08 62733.005 46451 16281.761 6967686.606 39 6967686.606 0.08 62733.005 46343 16390.306 6951404.845 6951404.845 6935014.539 CFP Level 1 - Module 1 - Personal Financial Management - Global Page 7

40 6935014.539 0.08 62733.005 46233 16499.575 6918514.964 41 6918514.964 0.08 62733.005 46123 16609.572 6901905.392 42 6901905.392 0.08 62733.005 46013 16720.302 6885185.090 43 6885185.09 0.08 62733.005 45901 16831.771 6868353.319 44 6868353.319 0.08 62733.005 45789 16943.983 6851409.336 45 6851409.336 0.08 62733.005 45676 17056.943 6834352.393 46 6834352.393 0.08 62733.005 45562 17170.656 6817181.737 47 6817181.737 0.08 62733.005 45448 17285.127 6799896.611 48 6799896.611 0.08 62733.005 45333 17400.361 6782496.250 49 6782496.25 0.08 62733.005 45217 17516.363 6764979.886 50 6764979.886 0.08 62733.005 45100 17633.139 6747346.747 51 6747346.747 0.08 62733.005 44982 17750.693 6729596.054 52 6729596.054 0.08 62733.005 44864 17869.031 6711727.023 53 6711727.023 0.08 62733.005 44745 17988.158 6693738.864 54 6693738.864 0.08 62733.005 44625 18108.079 6675630.785 55 6675630.785 0.08 62733.005 44504 18228.800 6657401.985 56 6657401.985 0.08 62733.005 44383 18350.325 6639051.660 57 6639051.66 0.08 62733.005 44260 18472.661 6620579.000 58 6620579 0.08 62733.005 44137 18595.812 6601983.188 59 6601983.188 0.08 62733.005 44013 18719.784 6583263.404 60 6583263.404 0.08 62733.005 43888 18844.582 6564418.822 935581 Let us also do the same question by reducing the tenure to 15 years and its impact on interest payment. Set End (FC 200V) -7500000 PV 15*12 N 8I P/Y =12, C/Y =12 Solve PMT = 71673.90 Let us see how much the difference in interest outgo is in 15 years and then compare with interest outgo in 20 years. Go to AMRT PM1 =1 PM2 =180 (15*12) ∑INT Solve = 5401303 In 20 years repayment schedule, total interest paid is Rs.7555921, Difference of Rs.21, 54, 618 Revolving Credit In this world of digitalisation, everyone needs to have easy availability of facilities to do shopping, to transfer money, to buy airline or train tickets. Therefore use of credit card has become very common and everyone starts using credit card as soon as he/she starts working. Some people prefer to carry cash in their wallets and pay for goods or services; they think it helps them limit their expenses as they will spend on the basis of cash in their wallet. Credit cards have become very convenient when it comes to online shopping, booking tickets. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 8

Some guidelines for credit card use can provide a reasonable balance between no use and abuse. First, no one needs many credit cards. For most of people, one or two cards are sufficient. The problem with holding too many cards is keeping track of the cards and the charges on them. Also, some cards, especially those that offer points or travel miles, may incur an annual fee. Multiple cards mean multiple annual fees, which can start adding up (clients should always try to find cards with low or no annual fees). When deciding which credit cards to get, cost of credit (i.e., interest rate) is a key selection factor. Even a small interest-rate increase can make a significant difference in total interest cost. It is common to find rates as high as 15 per cent or greater assessed against credit card balances. Obviously, one wants to get the lowest interest rate possible. Often, financial professionals guide their clients to pay off all balances each month. If this is not possible, clients should pay off the balance as quickly as possible. These costs are common, and help explain why a financial professional’s first task is often to help a client pay down debt as fast as is reasonably possible. For those who can only make minimum payments on outstanding balances, it becomes difficult to become debt free. Use credit card only up to the amount one can afford to pay next month. It should be used as a temporary debt to be paid off by due date. Leasing Versus Buying Lease offers cost and convenience to the person. The decision to lease can be complex, and should be carefully evaluated. More and more products now offer a lease option. A client may consider leasing a car, home, furniture, computer, and even clothes and jewellery. Sometimes the choice to lease is clear. At other times, there is no easy answer. Generally, the financial professional can best help a client by educating him or her about the options and the pros and cons of each. Who are the parties to a lease? The person or business that owns the asset and leases it to another is called the lessor. The person who leases or rents the asset is called the lessee. One major point to remember is that a lease does not always provide ownership of the asset (depending on the type of lease being entered into). At the end of the lease period, use of the asset can be returned to the lessor by the lessee unless it has been fully paid for (including interest) over the term of the lease. The former is referred to as an “operating” lease and the latter is referred to as a “finance” lease. The difference between a finance lease and a loan to purchase the asset is that the lessor retains the ownership of the asset until the lease expires when ownership transfers to the lessee whereas with a loan the borrower gains ownership of the asset from the outset. The lease payment is based on the amortized cost of the initial price of the asset minus the residual value expected at the end of the lease. In a simplified example, a person leases a Rs.360, 000 car for four years. At the end of four years, the expected residual value of the car will be Rs.160, 000. The lease payment is based on paying for the Rs.200, 000 of value used plus interest. Types of Leases The two basic types of lease are open-end and closed-end. At the end of a closed-end lease, the lessor simply takes back the leased property. Except for unusual damage (beyond normal wear and tear) to the property, there are not usually any additional charges. For this reason, a closed-end lease sometimes is referred to as a fixed-cost lease (although it is not technically true that the full cost will be fixed, given the possibility of excess wear and tear). This type of lease is often used by businesses to acquire equipment rather than for consumer use. However, consumers sometimes use such leases with cars or other equipment. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 9

At the end of an open-end lease (sometimes called a finance or equity lease), the lessee may be required to pay the difference between the leased property’s value and the amount for which it is sold by the lessor. Lease agreements may make maintenance and upkeep the responsibility of either the lessor or lessee. It is important for the individual to carefully review all components of the lease agreement to ensure the terms are acceptable. Deciding Whether to Lease or Buy an Asset Obsolescence is the consideration that often applies to leasing or renting smaller items. Computers, children’s skis, formal wear, and some jewellery have a limited useful life for a specific user. Most personal computers today are obsolete almost by the time they are placed on store shelves. An individual who, for whatever reason, needs to have the latest and greatest computer equipment probably should lease rather than buy. Children can outgrow ski boots and skis in one season. If there are no siblings to whom the skis might be passed down, renting them for a season would be far less expensive than buying them new every year. Unless an individual has many formal functions to attend, purchasing formal wear may not make sense. Additionally, most people do not want to wear the same formal attire to many functions. A short-term rental of two or three days may be adequate. There is no simple answer to the question of whether to buy or lease. Regarding home ownership, the rule used to be that a home would always appreciate. This is no longer necessarily the case. There are communities where home values have decreased rather than increased. Generally, this is a temporary trend, but if a person must sell at the wrong time, he or she may suffer a substantial loss. A renter who does not live in a place with rent control (which is not widely available in many territories) will usually have rent increases that reflect inflation. A homeowner will generally have level payments for principal and interest, with taxes and insurance increasing over time. Generally, the long-term cost of purchasing is more stable and level than the long-term cost of renting. Here are some guidelines to consider when trying deciding which option makes the most sense. Consider leasing/renting if the person  Wants a new car every few years Page 10  Does not like to borrow money  Does not have the required funds for a down payment  Will only drive a car a relatively few miles each year  Sees a lower monthly payment as a priority over ownership  Has a temporary need for housing (e.g., perhaps for a short-term job assignment)  Expects housing needs to change significantly in the near future  Does not want to take on the responsibility for on-going upkeep and maintenance  Uses the item for business and wants to avoid obsolescence Consider buying if the person  Plans to keep a car for many years  Regularly drives many miles each year  Wants to ultimately stop making payments and own the asset (e.g., car or house)  Intends to live in the same house for an extended period  Intends to make improvements on the house (e.g., add a room)  Wants to experience the pride of ownership CFP Level 1 - Module 1 - Personal Financial Management - Global

Additionally, there may be differences in taxation between leasing and owning. Sometimes insurance companies apply different criteria to requirements relative to leased or owned assets. After reviewing the leasing vs buying decision, it should be clear that a simple “one size fits all” solution doesn’t really exist. In fact, a solution that worked in one situation for an individual may not work in a different situation or environment. This is why it’s best to consider options and discuss alternatives when providing guidance to a client. Regardless of how an individual earns and spends income, there is a need to track inflows and outflows. The usual tool to do the tracking is known as a budget. One of the categories to which a person should allocate funds is addressing possible emergency situations. A well-structured budget will be rendered invalid if there is a big enough emergency that requires substantial funding that is not readily available. The tool to address this need is called an emergency fund. We will look at budgets and emergency funds in the next chapter. A key role for a financial professional can be to help a client through situations of financial hardship. This could include an investigation of strategies to help a client under stress to meet loan payment commitments including repayment holidays, converting a loan to interest only, extending the term of a loan and the importance of maintaining communication with the lender during the period of hardship. The financial professional can also help the client to understand the implications of such strategies on the client’s goals and objectives, and help the client to understand various options, including the option to voluntarily liquidate the asset in order to repay the debt. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 11