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Evaluating your client's debt position.

This article looks at one aspect of personal financial planning--the management of personal debt including the mortgage on a home. We first begin with general personal financial planning considerations by discussing client characteristics. We then turn our attention to how much debt the client can handle, whether debt is being managed properly, determining the cost of credit, whether a loan should be paid off early, what price to pay for a home, how much can one afford to spend for housing and refinancing of a home.

Client Characteristics

When doing personal financial planning for clients, you should take into account present income and desired future income, possible inheritances, net worth, age and health (e.g., younger clients are more concerned with reducing taxes, middle-age individuals look to retirement and estate planning), marital status (e.g., a married client will want life insurance to protect his or her family), liquidity needs, risk preferences (e.g., a risk-adverse client may favor investing in U.S. government securities), stability of employment, standard of living, insurance coverage, tax status, family composition (e.g., if there are small children, provision has to be made for education costs, a childless working couple can more afford to speculate, and a retired couple on a fixed income cannot take risks), personal obligations, retirement obligations and sufficiency of estate to satisfy beneficiaries.

The personal financial plan of a client will vary depending on individual circumstances through life, including age. For example, a client in his or her 30s is more concerned with budgeting and monitoring discretionary expenses, tax planning, contributions to a pension fund, saving for a child's education, appraising insurance requirements and modifying the will as the family status changes. Personal financial planning for a client in his or her 40s involves providing for a child's graduate education, increasing personal savings, contributing to a pension fund, considering the tax consequences of investments, investing for long-term appreciation, reappraising insurance needs as children get married and formulating estate planning, including gifts and trusts as needed. For a client in his or her 50s, consideration is given to increasing savings to 10% to 15% of gross income, retirement planning, conservative investing, hedging against inflation, engaging in tax saving strategies and adjusting the estate plan as necessary.

How Much Debt Can the Client Handle?

It is not easy to determine the maximum debt anyone can have. Rule of thumb: The client's monthly debt payments should be about 15% of his or her total monthly net income. The absolute maximum personal debt is 20%. Thus, if the take-home pay is $2,000 monthly, only $400 (20% x $2,000) should go toward paying off items bought on credit. The maximum limit includes payments due on credit cards and personal, college and car loans--but not mortgages, home equity loans or rent. Those obligations can account for as much as an additional 35% of the client's total monthly expenditures. The following steps can assist in determining the debt limit:

1. Calculate monthly consumer debt payments.

2. Determine monthly net income (after all taxes, Social Security and IRA contributions).

3. To calculate the most the client can afford each month, multiply the monthly income by 20%, 15% or 10% (the client's personal permissible debt ratio, if you will). Rule of thumb: If the client is single, middle-aged and nets $40,000 a year, he or she can perhaps afford 20% in debt. Reduce debt to 10% if the client's income is not stable (e.g., based on commissions rather than salary). If the client takes home $50,000, he or she can afford 20%. If the client has children, knock it back to 15%. If the client is retired on a fixed income, make it 10%.

4. To find whether payments are within the client's means, subtract (1) from (3). This figure is the safety margin. If (1) is larger than (3), however, the client should start taking steps suggested previously.

If the client is beyond his or her debt limit, he or she should seriously consider cutting down on existing debts and avoiding additional borrowing.

Is the Client Managing Debt Properly?

Here are some tips for managing debt properly:

* Avoid borrowing from the future to meet current living expenses. Is the client borrowing against future raises or bonuses to pay for daily spending? If the client is living beyond his or her means, danger lurks ahead.

* Avoid borrowing for depreciating assets. Rather, only borrow for appreciating assets.

* What is the interest rate on each type of debt? Keep track of who is charging a higher rate and move to the lower cost source. Warning: Do not collateralize a loan with savings because a net cost will arise in this case. Further, in the event of an emergency, the savings may not be withdrawn. Always try to buy something with cash rather than on credit.

* Avoid using a bank credit card because of the high finance charge (e.g., 18-20%). It is unwise to charge and incur an 18% financing cost while putting money in the bank and earning only 6%. The client should withdraw the savings and pay off the credit card balance. Otherwise, the client is losing 12% on his or her money.

* Avoid using borrowed funds to invest unless the interest rate is very low and there is a dependable investment return. Rule: Always pay off the high interest loans first.

* Establish a line of credit before it is necessary. There is usually no charge for a preapproved line until borrowing takes place. Tip: To reduce credit payments, the loan may be extended over a longer time period (e.g., financing the purchase of a car over four years rather than three years).

How to Determine the Cost of Credit

One way to determine the cost of credit is in terms of an annual percentage rate (APR). The APR is useful in comparing different credit plans on the same basis.

Banks often quote their interest rates in terms of dollars of interest per hundred dollars. Other lenders quote in terms of dollars per payment. This leads to confusion on the part of borrowers. Fortunately, APR can eliminate this confusion. The APR is the simple-interest rate established for the use of a given amount of money (principal) for a period of one year. The interest charge equals: Interest = Principal x Rate x Time. The APR, however, acts as a common denominator to all programs.

You will be able to convert the dollar cost of credit into a single rate, i.e., APR, using to following formula:

APR = 2MC/{P(N+1)}

where M = number of payments of one year, C = dollar cost of credit, P = original proceeds from credit, and N = total number of payments in the debt contract.

The Federal Truth in Lending Act requires lenders to reveal the APR for any loan. This information makes comparison of similar loans more straightforward. Other features that should be considered include the size and term of the loan, the size of the down payment, and any prepayment penalties.

Should the Client Pay Off a Loan Early?

Most lenders allow the client to pay off a loan before its scheduled maturity without prepayment penalty. In fact, they will refund the client's interest charges. The question then is: How early should the client pay off his or her loan? The client should know the interest savings prior to a prepayment decision, because he or she might be better off investing the funds elsewhere rather than prepaying the loan.

One might think there is an equal amount of interest savings each month. Unfortunately, lenders compute interest differently. They use the Rule of 78--sometimes called the Sum of the Digits--which results in the client paying more interest in the beginning of a loan when he or she has use of more of the money and less and less interest as the debt is reduced. Therefore, it is important to know how much interest the client can save by prepaying after a certain month and how much one still owes on the loan.

Example: The client borrows $3,180 ($3,000 principal and $180 interest) for 12 months, so his or her equal monthly payment is $265 ($3,180/12). You want to know how much interest can be saved by prepaying after six payments. You might guess $90 ($180 x 6/12), reasoning that interest is charged uniformly each month. Good guess, but wrong. Here is how the Rule of 78 works.

First, add up all the digits for the number of payments scheduled to be made, in this case the sum of the digits 1 through 12. (1 + 2 + 3...+ 12 = 78). Generally, you can find the sum of the digits (SD) using the following formula:

SD = n(n+1)/2 = 12 (12+1)/2 = (12) (13)/2 = 156/2 = 78

where n = the number of months. The sum of the digits for a four-year (48-month) loan is 1,176 |(48) (48+1)/2 = (48) (49)/2 = 1,176)~.

In the first month, before making any payments, you have the use of the entire amount borrowed. You thus pay 12/78ths (or 15.39%) of the total interest in the first payment. In the second month, you pay 11/78ths (14.10%); in the third, 10/78ths (12.82%); and so on down to the last payment, 1/78ths (1.28%). Thus, the first month's total payment of $265 contains $27.69 (15.39% x $180) in interest and $237.31 ($265 - $27.69) in principal. The 12th and last payment of $265 contains $2.30 (1.28% x $180) in interest and $262.70 in principal.

In order to find out how much interest is saved by prepaying after the sixth payment, one merely adds up the digits for the remaining six payments. Thus, using the above formula, 6 (6+1)/2 = 21. This means that 21/78ths of the interest, or $48.46 (21/78 x $180), will be saved.

To calculate the amount of principal still owed, subtract the total amount of interest already paid, $131.54 ($180 - $48.46), from the total amount of payments made, $1,590 (6 x $265), giving $1,458.46. Then subtract this from the original $3,000 principal, giving $1,541.54 still owed.

Does it pay to pay off after the sixth payment? It depends on how much return the client can get from investing elsewhere. In this example, the client needed $1,541.54 to pay off the loan to save $48.46 in interest.

For loans of longer maturities, the same rules apply, though the actual sum of the digits will be different. Thus, for a 48-month loan, one would pay in the first month 48/1,176ths of the total interest, in the second month 47/1,176ths and so on.

What Price Should the Client Pay for a Home?

To determine the maximum price the client should pay for property, two methods can be used.

Have the real estate agent run "comparative sales" analysis on a computer. The computer should be able to give a recent history of sales in the neighborhood. The price that a subject property can bring must be adjusted upward or downward to reflect the difference between the subject property and comparables. Since this particular approach is based on selling prices not asking prices, it can give one a good idea about the market.

A professional real estate appraiser may be hired for a fee. Appraisal is not a science but a complex and subjective procedure requiring good information about specific properties, their selling prices and applicable terms of financing. The use of an expert may well be worth the cost.

How Much To Spend For Housing?

An accurate way to determine what kind of house the client can afford is to make two basic calculations: How much can the client pay each month for the long-term expenses of owning a home (e.g., mortgage payments, maintenance and operating expenses, insurance and property taxes)? And how much cash does the client have to spend for the initial costs of the purchase (e.g., the down payment, points and closing costs)?

Many lenders use various rules of thumb to determine a borrower's housing affordability. They include:

35% Rule: A borrower can afford no more than 35% of monthly take-home pay.

Example: The client's annual income is $33,000 per year and take-home pay is $2,095 per month. At 35%, the client can afford a monthly payment of $733. Using this amount, the mortgage rate (variable or fixed), the mortgage term and a mortgage payment schedule, the lender can determine how much the client can qualify for. For example, say, an interest rate of 13% and a 30-year term, one could borrow $66,300. Assume that the budget has already provided for property taxes, insurance and maintenance expenses and $20,000 is available for a down payment (after point charges and closing costs). The client could buy a house that costs about $86,300 ($20,000 + the $66,300 mortgage).

Multiple of Gross Earnings Rule: The price should not exceed roughly 2 to 2 1/2 times the family's gross annual income.
Table 1

Savings From Refinancing

Present Current Monthly Monthly Annual
Mortgage Monthly Payment Savings Savings
Rate Payment at 10% at 10% at 10%

12.0 $771 $658 $113 $1,356
12.5 800 658 142 1,704
13.0 830 658 172 2,064
13.5 859 658 201 2,412
14.0 889 658 231 2,772
15.0 948 658 290 3,480


Percent of Monthly Gross Income Rule: The monthly mortgage payment, property taxes and insurance should not exceed 25-28% of the family's monthly gross income, or about 35% for a Federal Housing Administration (FHA) or Veterans Administration (VA) mortgage.

Does It Pay to Refinance?

Whether refinancing is worthwhile depends on the costs of refinancing and the time required to recoup those costs through lower mortgage payments. The costs of refinancing are the closing costs, which can vary widely.

Closing costs include title search, insurance (such as hazard, title and private mortgage insurance), lender's review fees, buyer's loan points, reappraisal fees, credit report, escrow fees, lawyer fees, document preparation fees, judgment reports, notary fees and recording fees. To get a rough estimate of the closing costs, take the costs of refinancing (3-6% of the outstanding principal) and multiply it by the amount of the loan.

Rule of thumb: To refinance successfully, the client should plan on staying in the house for at least three years and should be able to reduce the rate paid on the mortgage by at least two percentage points.

* If the current mortgage is fixed-rate, the client might look for another fixed-rate home loan at least two to three percentage points below the mortgage currently held.

* If the current mortgage is adjustable-rate, consider what the expected rate on the adjustable rate mortgage (ARM) will be several years hence. If the current rates on fixed mortgages are substantially below the expected rate ARMs, it might pay to refinance.

The major factor to consider when refinancing is the amount of time it will take to recoup the costs of refinancing. Example: Assume the clients wants to refinance a $75,000 loan. A 14% mortgage involves closing fees of $3,750 and the new interest rate is 10%. At the new rate of 10%, the monthly payment on a 30-year fixed loan would be $658. That is a savings of $231 from the monthly payment of $889 required on a 14% loan. Dividing the total refinancing cost of $3,750 by $231 gives a recovery period of about 16 months. Table 1 illustrates the monthly and yearly savings from refinancing to a 10% 30-year fixed-rate mortgage for $75,000.

Conclusion

People have different attitudes toward credit. Some people think credit is "good," others say credit is "bad." But one thing is clear: Too much credit is bad. Too much debt may lead to personal disaster and bankruptcy. The client has to manage credit wisely and judiciously. The proper amount of credit varies with the client's needs.

If the client knows how to manage and control debt, he or she can in effect increase return through the use of leverage. Balance the advantages and disadvantages of credit in deciding whether or not to use it. The client should keep a credit record. In case credit problems arise, try to work it out with the lender first.

Joel G. Siegel, PhD, CPA, is professor of accounting at Queens College and a self-employed practitioner. He was previously employed by Coopers and Lybrand and Arthur Andersen. He has authored over 40 books and 200 articles.

Frank Grippo, MBA, CPA, is professor of accounting at William Paterson College and a self-employed practitioner.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Siegel, Joel G.; Grippo, Frank
Publication:The National Public Accountant
Date:Sep 1, 1993
Words:2803
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