Credit, Debt, and Insurance

Dr. Katie Sauer

Metropolitan State University of Denver ( ksauer5@msudenver.edu)

Presented at Junior Achievement’s Elementary School Personal Financial Literacy Workshop

in collaboration with the Colorado Council for Economic Education

Session Overview

I. Credit and DebtII. Insurance

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.

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

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

How do they know you will pay them back?They don’t. So, they’ll 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.

A Credit Report is 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. EquifaxExperianTransUnion

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 go 90 days past due (or worse) in the next 24 months.

- higher score = less likely to go past due

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 andwill qualify for the best interest rates

700 – 749 means you have good credit and will likely be approved for loans you apply for, but youmight 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 willnot be approved

Individuals are entitled to one free credit report per year from each of the three credit bureaus.

annualcreditreport.com

You are not entitled to receive a free credit score.

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 not consider your race, color, religion, national origin, sex or marital status.

The reason that people apply for credit is so they can pay for things now, even though they don’t 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.

In the “working years” people tend to put aside some money for the future.

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.

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 a loan 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.

Instead of saving up for new clothes, you charge it on your credit card. You enjoy the benefits and pay back the debt later.

Your car’s engine suddenly needs repair. You don’t 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 don’t have cash to cover all of the gifts you would like to buy for your family. You charge the gifts to your credit card and pay back the debt later.

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

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.

C. Benefits of Borrowing to Pay for Purchases- allows people to buy things that would otherwise take manyyears to save up for (house, car)

- allows people to attend college and improve their futureearnings

- allows people to pay for things in an emergency

- allows people to have the things they want, immediately

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.

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 InterestPayment 1 100,000 + (0.05)(100,000) = 5,000 - 6,000 2 99,000 + (0.05)(99,000) = 4,950 - 6,000 3 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

Total payments: 6,000 x 10 years = $60,000

How much of that $60,000 went toprincipal?

$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, you’ve paid $60,000 on a $100,000 mortgage but still have $88,973.43 left to pay (plus more interest).

The general loan payment formula is:

M = P [ i(1 + i)n ] (1 + i)n - 1

M = monthly paymentP = principal amounti = interest rate divided by 12n = total number of payments

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 = 0.0067then calculate n: 5 x 12 = 60

M = 10,000 [ 0.0067(1.0067) ] (1.0067) - 1

= $202.96

60

60

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

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 off this debt in 2 years.

i = 0.21 / 12 = 0.0175n = 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

Suppose instead you want to pay it off in 1 year. Calculate your monthly payment.

i = 0.21 / 12 = 0.0175n = 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

E. The Fed, interest rates, and you

The Fed directly sets the discount rate.The Fed indirectly controls the federal funds rate.

Banks charge each other the federal funds rate and areinfluenced by the discount rate.

Banks charge their best customers the “prime rate”, whichis based on the discount rate and federal funds rate.

The interest rate on consumer loans is often “prime + X”.- credit card- mortgage

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 signal from the Fed to banks about what the Fed would like banks to do.

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 theeconomy falls

- economy slows down

Open Market Operations 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 target the Federal Funds Rate.

- can’t control the Fed Funds Rate directly

The Federal Funds Rate is the rate that banks charge each other on short term loans. (overnight)

When the Fed buys bonds:- banks receive cash in exchange for the bonds theywere 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 overnightso they are willing to make more loans

- quantity of money in the economy rises

- economy speeds up

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

From the standpoint of the economy as a whole, the role of insurance is to spread around the risk.

- can’t eliminate it completely

A. How insurance is priced:

Suppose that 1 in 5 drivers age 21 to 24 get in an accident each year. 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 $450080% 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 fair policy

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

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.

Insurance markets suffer from two problems not faced by other markets:

- people likely to use the insurance are the ones who most want to buy it (adverse selection )

- once a person has insurance, they may change their behavior (moral hazard)

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 have accepted some of it.

- deductibles

In general, the higher the deductible, the lower the premiums.

Educationcents.org

B. Types of Insurance