Upload
katherine-sauer
View
222
Download
0
Embed Size (px)
Citation preview
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
1/39
Credit, Debt and Insurance
Dr. Katie Sauer
Metropolitan State College of Denver
Presented at
Junior Achievements Elementary School Personal Financial Literacy Workshop
in collaboration with
the Colorado Council for Economic Education
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
2/39
Session Overview
I. Credit and Debt
II. Insurance
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
3/39
I. Credit and Debt
Credit refers to the amount of money that a third party is willing to
advance to you (or on your behalf).
Once you have spent that money, it is debt that you owe to the third
party.
You can have credit without debt.You can have credit and debt.
Your debt results from you first having credit.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
4/39
Common examples of credit:
- car loan approval
- mortgage approval
- credit card
- overdraft line of credit on checking account
There are 2 types of credit accounts:
- fixed loans
- revolving credit
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
5/39
A. Creditworthiness
In order for you to borrow money for a purchase, someone
has to be willing to lend it to you.
Often times you ask complete strangers to lend you
thousands of dollars.
- car loan
- home loan- credit card
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
6/39
How do they know you will pay them back?
They dont. So, theyll check your financial history and
make a decision based on your past actions.
Whenever you apply for credit or a loan, you give the
lender permission to check your financial history.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
7/39
A Credit Reportis a record of your credit history.
- how much and type of debt you have
- if you have made payments on time
- if you have failed to pay back a loan
Credit reports are compiled by 3 agencies.
Equifax
Experian
TransUnion
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
8/39
All the items on your credit report are compiled into a credit score.
(aka FICO score)
Credit scores are used to predict the likelihood that a person will go90 days past due (or worse) in the next 24 months.
- higher score = less likely to go past due
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
9/39
Credit scores can range from 300 to 850.
- the higher the number, the better your credit score
In general:
750 and above means you have excellent credit and
will qualify for the best interest rates
700 749 means you have good credit and willlikely be approved for loans you apply for, but you
might not get the best interest rate possible
650 700 means you may or may not be approvedand you definitely will have a higher interest rate
649 and below means you are subprime and will
not be approved
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
10/39
Individuals are entitled to one free credit reportper year from each
of the three credit bureaus.
annualcreditreport.com
You are not entitled to receive a free credit score.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
11/39
What affects my credit score?
- paying bills on time (very important!!!!)
- available credit vs how much you owe
- length of time you have had credit
- recent applications for new credit
- number of credit accounts do you have- type of credit accounts do you have
Credit scores may notconsideryour race, color, religion, nationalorigin, sex or marital status.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
12/39
The reason that people apply for credit is so they can pay for
things now, even though they dont have the money.
B. Consumption smoothing is the term used to describe the
spending, saving and borrowing that people do in order to
maintain a more constant standard of living throughout their
lifetimes.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
13/39
In the working years people tend to put aside some money for thefuture.
In the retirement years people spend the money that they
previously saved.
Early on in adulthood, people may borrow against future earnings.
By the middle to end of the working years, people should have paid
back any debt before retirement.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
14/39
Examples of Borrowing to Smooth Consumption
Instead of saving up and paying for a house in cash, you take out a
loan and enjoy the benefits of living in the home while you pay
back the loan.
Instead of saving up and paying for a car in cash, you take out aloan and enjoy the benefits of driving the car while you pay back
the loan.
Instead of saving up and paying for college tuition in cash, you
take out a loan. This enables you to build human capital sooner
and then receive the benefit of a better job and better pay for the
rest of your working years while you pay back the loan.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
15/39
Instead of saving up for new clothes, you charge it on your creditcard. You enjoy the benefits and pay back the debt later.
Your cars engine suddenly needs repair. You dont have enough
money in the bank to cover the cost so you charge it on your credit
card. You get your car back in working order now and pay back the
debt later.
The holiday gift-giving season has arrived and you dont have cash
to cover all of the gifts you would like to buy for your family. Youcharge the gifts to your credit card and pay back the debt later.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
16/39
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
17/39
Sometimes borrowing in order to smooth consumption is
financially responsible, sometimes it is not.
Be sure that the benefits of borrowing truly outweigh the costs.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
18/39
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
19/39
D. Cost of Borrowing
When you borrow money to pay for something, you end up paying
back more than the purchase price.- pay interest
Most people know they have to pay interest on a loan. However,
they are often unaware just how much they are paying.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
20/39
Example: Suppose you take out a $100,000 mortgage at 5%
interest for 30 years.
- compound the interest annually (simplified)- $6000 in payments per year
Year Principal Interest Payment
1 100,000 + (0.05)(100,000) = 5,000 - 6,000
2 99,000 + (0.05)(99,000) = 4,950 - 6,0003 97,950 + (0.05)(97,950) = 4,897.5 - 6,000
4 96,847.5 + (0.05)(96,847.5) = 4,842.38 - 6,000
5 95,689.88 + (0.05)(95,689.88) = 4,784.49 - 6,000
6 94,474.37 + (0.05)(94,474.37) = 4,723.72 - 6,000
7 93,198.09 + (0.05)(93,198.09) = 4,659.9 - 6,000
8 91,857.99 + (0.05)(91,857.99) = 4,592.9 - 6,000
9 90,450.89 + (0.05)(90,450.89) = 4,522.54 - 6,000
10 88,973.43 + (0.05)(88,973.43) = 4,448.67 - 6,000
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
21/39
Total payments: 6,000 x 10 years = $60,000
How much of that $60,000 went to
principal?
$100,000 - $88,973.43 = $11,026.57
interest?$60,000 - $11,026.57 = $48,973.43
Still left to pay: $88,973.43 plus interest for 20 more years
In ten years, youve paid $60,000 on a $100,000 mortgage but still
have $88,973.43 left to pay (plus more interest).
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
22/39
The general loan payment formula is:
M = P [ i(1 + i)n ]
(1 + i)n - 1
M = monthly payment
P = principal amounti = interest rate divided by 12
n = total number of payments
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
23/39
Ex: Suppose you take out a 5-year car loan for $10,000 at 8%
interest. Calculate your monthly payment.
first calculate i: 0.08 / 12 = 0.0066667 = 0.0067
then calculate n: 5 x 12 = 60
M = 10,000 [ 0.0067(1.0067) ]
(1.0067) - 1
= $202.96
60
60
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
24/39
Over the life of the loan, what is the total amount you end up paying
back?monthly payment x number of payments
$202.96 x 60 = $12,177.60
How much did you pay in interest?
total amount paid loan amount
$12,177.60 - $10,000 = $2,177.60
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
25/39
Suppose you charge $4500 on your credit card and your interest
rate is 21% annually.
Calculate how much you would have to pay per month to pay offthis debt in 2 years.
i = 0.21 / 12 = 0.0175
n = 2 x 12 = 24
M = 4500[ 0.0175(1.0175) ]
(1.0175) - 1
= $231.24
What is the total amount you end up paying back?
$231.24 x 24 = $5,549.76
How much do you pay in interest?
$5,549.76 - $4,500 = $1,049.76
24
24
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
26/39
Suppose instead you want to pay it off in 1 year. Calculate your
monthly payment.
i = 0.21 / 12 = 0.0175
n = 1 x 12 = 12
M = 4500[ 0.0175(1.0175) ]
(1.0175) - 1= $419.08
What is the total amount you end up paying back?
$419.08 x 12 = $5,028.96
How much do you pay in interest?
$5,028.96 - $4,500 = $528.96
12
12
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
27/39
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
28/39
The Fed controls the discount rate, which is the interest rate that
the Fed charges to banks for loans
Board of Governors - meets every 6 weeks
This interest rate usually just acts as a signalfrom the Fed to
banks about what the Fed would like banks to do.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
29/39
A higher discount rate:
- means that it will be more costly for banks to borrow from
the Fed (should they need to)
- so banks take this as a signal to lend out less (be less risky)
- when banks lend out less, the quantity of money in the
economy falls
- economy slows down
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
30/39
Open MarketOperations are the purchase or sale of US
government bonds by the Fed.
Federal Open Market Committee meets every 6 weeks
The Fed uses Open Market Operations to targetthe FederalFunds Rate.
- cant control the Fed Funds Rate directly
The Federal Funds Rate is the rate that banks charge each otheron short term loans. (overnight)
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
31/39
When the Fed buys bonds:
- banks receive cash in exchange for the bonds they
were holding
- banks have more cash reserves on hand so they are
willing and able to lend it out to other banks
- this decreases the federal funds rate
- banks know it is cheap to borrow from a bank overnight
so they are willing to make more loans
- quantity of money in the economy rises
- economy speeds up
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
32/39
II. Insurance
Risk Aversion is a dislike of uncertainty.
One way to deal with risk is to buy insurance.
- a person facing a risk pays a fee to an insurance firm
- the firm agrees to take on all or a part of the risk
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
33/39
From the standpoint of the economy as a whole, the role of
insurance is to spread around the risk.- cant eliminate it completely
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
34/39
A. How insurance is priced:
Suppose that 1 in 5 drivers age 21 to 24 get in an accident eachyear. The average amount of damage is calculated to be $4500 per
incident.
If an insurance company insures 5 drivers age 21 to 24, it faces this
situation:20% chance of paying out $4500
80% chance of paying out $0
Expected payout per individual:
(0.20)(4500) + (0.80)(0) = $900
The company will need to charge $900 to each driver.
- actuarially fairpolicy
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
35/39
What if in one year 2 people have accidents. One costs $2000
and the other costs $7000.
The insurance company will have paid out $9000 but will have
only received 5 x $900 = $4500 in premiums.
Small groups of insured can have a lot of volatility!
In order to stay in business, insurance companies need to insure
many people.
- spread around the risk
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
36/39
In general, the lower the probability of an event, the less you
will pay in premiums.
In general, the larger the number of people in the risk pool, the
less you will pay in premiums.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
37/39
Insurance markets suffer from two problems not faced by other
markets:
- people likely to use the insurance are the ones whomost want to buy it (adverse selection )
- once a person has insurance, they may change their
behavior (moral hazard)
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
38/39
To deal with these problems, the insurance firm rarely agrees to
take on all of the risk.
They will only accept the financial responsibility after you haveaccepted some of it.
- deductibles
In general, the higher the deductible, the lower the premiums.
8/6/2019 PFL - Secondary Credit, Debt, and Insurance
39/39
Educationcents.org
B. Types of Insurance