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					            CHAPTER 13


Personal Credit, Debt and Lending
                                Introduction


In recent decades personal debt has grown significantly in Australia
Debt is used for different types of expenditure, and different consumer credit
products have been developed to meet these different needs
Financial planners need to be familiar with the maths, particularly related to
simple and compound interest and mortgage repayments
There are traps to be aware of when using consumer credit
Interest rates and inflation and tax all impact on saving and borrowing
Borrower’s creditworthiness is rated and bankruptcy can result from poor
decisions regarding debt
The careful use of debt can enhance investment returns
                   Debt Tolerance

Most people nowadays have a number of credit
products: credit cards, personal loans and/or a home
mortgage.
While credit and the ability to borrow may be positives
that facilitate our modern lifestyle, the ability to
borrow can also cause extreme distress when it gets
out of hand.
It is very easy for people to get into debt over their
heads, or at least to use it inappropriately.
             Growth of Debt
• In recent decades the use of debt/credit and the
  lack of savings has reached worrying levels.
• In the 1980s average household debt was 50% of
  income; in 2008, household debt had grown to
  1.6 times income.
• ABS statistics indicate that 86% of all household
  debt is related to the purchase of property.
• There is some evidence that the growth in
  lending has slowed since the GFC.
• For most people, the home and superannuation
  together account for between 75% and 90% of
  their total wealth
                       Growth of Debt
Credit is easily obtained

     – A typical recent advertisement offered 12 to 24 months interest-
       free finance, with no or minimal deposit for the purchase of
       furniture.

     – Interest applies after the interest -free period. There is no
       mention of the rate of interest. The store wants the business, the
       finance provider assumes that enough of the people taking up the
       offer will be unable or simply will not pay the full price of the
       furniture by the expiry date, and will finance customers then.
                    Growth of Debt
Easy credit carries economic as well as personal risks

   Before the GFC, the Australian Prudential Regulation Authority (APRA)
   warned banks against cutting staff and systems and sacrificing risk
   management for short-term profitability, warning that the growth rate
   in home lending was unsustainable.

   It said banks should be preparing for an economic downturn and
   falling property prices, which will increase the default rates of
   mortgages.

   They seem to have been proven to be right, and banks have tightened
   lending criteria, but many still feel the property correction in Australia
   is yet to come.
        Reasons for Borrowing


The main purposes of borrowing are to:
• fund lifestyle eg holiday
• purchase depreciating assets
  eg a car
• acquire a home
• invest eg investment property or shares
                                Types of Credit
    Various credit products have developed to meet these borrowing needs
•   Fund lifestyle
      – Credit cards
      – Re-draw or lines of credit
      – Reverse mortgage
•   Purchase depreciating assets
      – Personal loans
      – Leasing finance
•   Acquire a home
      – Home mortgage loans
      – Bridging loans
•   Invest
      – Margin loans
            Secured or Unsecured

• Secured loans mean that the lender retains title
  or takes a mortgage against the borrower’s assets
  (property or other assets)
   –   Principal and Interest Mortgages
   –   Lines of Credit
   –   Balloon Payments Loans
   –   Fixed/Variable Rate Loans
   –   Reverse Mortgages
• In unsecured lending, the lender relies on the
  agreement of the borrower to repay the loan
   – Credit cards
        Good Use of Credit Cards

• Credit cards are a convenient way of
  managing our finances
• They mean being able to do things and
  purchase things immediately, without having
  to carry the necessary cash around with us
• It can even be cheaper to use a credit card for
  purchases if the balance is paid in full each
  month
• Sometimes having a credit card is a necessity
                      Credit Traps

• It is said that wise borrowers use low-cost debt to
  purchase appreciating assets, while foolish
  borrowers use high-cost debt to purchase
  depreciating assets or consumer items.
• Credit can be used wisely. However, many people
  find it difficult to resist extending their credit card
  use to the point of straining the family budget.
                   Credit Traps

• A sure sign that credit card debt is out of
  control is when people withdraw money from
  one credit card to pay the bill on another
  credit card!
• People who want to have a credit card for
  convenience or because their lifestyle requires
  one should shop around for the best interest
  rate and credit free periods.
           Questions to Ask to Avoid
                 Credit Traps
• What type of ‘deal’ is being offered? Does it suit
  your personal spending/earning patterns?
• Can the minimum payments be comfortably paid?
  You need to do a monthly cash flow analysis to
  determine this.
• Does the purchase have a clear benefit? Do you
  really need the item?
• Can you wait and save?
• Might another type of finance be cheaper?
          Questions to Ask to Avoid
                Credit Traps
• Will the minimum payment cover the
  interest accrued and pay off some of the
  principal?

  Unfortunately, you will not appreciate this
  until you have made several payments.
  But some lenders make the minimum
  payment low, so that it just covers the
  interest payments. That means the debt
  goes down very slowly.
     Questions to Ask to Avoid Credit Traps

• Is the interest rate competitive?
  Shopping around does take time, but it is worth it.
  Even though lenders are required to state true
  interest rates (including fees), the combination of
  different rates and fees, with different interest-
  free periods, can be quite confusing.
• Is the interest rate higher because reward points
  are being offered?
  Where this is the case, really consider the value of
  the reward points to you. They rarely deliver more
  than 1% of the value of purchases and few people
  do the sums.
          Questions to Ask to Avoid
                Credit Traps

• Initial low interest rate offers for limited
  periods. Check what the expected interest
  rate is after the honeymoon period — is it
  competitive? What shock will it cause your
  finances once the honeymoon period is over?
  Can you make the extra payments now and
  lower the principal?
• Always read the fine print and understand the
  terms and conditions. They may vary
  between credit card providers.
    Credit Ratings and Assessments


All lenders have credit assessment
  processes. How thorough the process is
  usually depends on:
• the amount of money being borrowed
• what the money is to be used for
• who the borrower is
• the time period of the loan.
       Credit Ratings and Assessments
Some of the factors that lenders will look at
  are:
• Perceived character of the borrower
• Level of income
• Job tenure of the borrower
• Level of assets available as security or as an
  indication of wealth accumulation
• Credit history or rating from external
  sources and from the current lender
• Amount and term of the requested credit
       Regulation of Lending Industry

The regulation of the banking/lending industry aims to
  provide consumer protection for both depositors and
  borrowers.

The focus has been on a Consumer Credit Code, which,
  while state based, has consolidated the previous state
  Credits Acts.

The main features of the Codes are better disclosure
  before the loan/credit has been advanced and
  assistance for reasonable cause.
                  Bankruptcy

Bankruptcy occurs when an individual’s (family’s or
business’s) liabilities exceed their assets and their income can
no longer sustain payments of their debts.
A bankrupt’s assets are sold and any remaining debts are
excused.
Nevertheless bankruptcy is not an easy way out of debt.
Once a person is declared bankrupt, that information is
publicly available. Future requests for borrowing may be
denied, even where the bankrupt has repaid the debt.
Bankrupts may also have difficulty in obtaining work, rental
accommodation and such things as telephone and electricity
connections.
        Alternatives to Bankruptcy


• Informal arrangements: This is where the
  debtor seeks to work with the lender(s) and
  agrees a schedule of repayments.
• Declaration of Intent to Present a Debtor’s
  Petition, form ISTA — gains a 7-day period to
  halt action by the creditors to recover debts.
  Limited relief and can lead to a forced
  declaration of bankruptcy.
      Alternatives to Bankruptcy

• Part IX debt agreements are only
  available to individuals who have
  unsecured debt of under $60,000. This
  is a voluntary written agreement to clear
  the debt under a negotiated settlement.
• Part X arrangement is where a trustee is
  appointed and assists the debtor to
  reach an arrangement with creditors.
         Deterrents to Savings


• Taxation
• Interest Rates
• Inflation
                      Taxation
•   The rules of taxation do not favour people
    who are savers
•   All interest income is fully assessable for
    taxation purposes without any deductions or
    rebates
•   Potential savers who are high marginal tax
    ratepayers will see close to one-half of their
    interest earnings paid in taxes
•   Sometimes the after-tax interest is barely
    enough to compensate for the erosion of
    purchasing power caused by inflation
              Taxation

While there is tax relief for investors in
growth assets (discount capital gains
tax and franking credits for example),
many people may find holding a high
proportion of their investments in
growth assets too risky
                Interest Rates
• Low interest rates are good for borrowers, but
  not for people depositing money in a bank or
  investing in fixed interest investments
• Interest rates are the cost of money
• Lenders want to be paid for the lack of access to
  their funds and for any risk that they might not
  be paid the interest or repaid the borrowed
  amount
• Reduction in interest rates can be particularly
  detrimental to retirees who are living off their
  fixed interest payments
                    Inflation
• Inflation is the change in the buying power of
  money over time.
• We have all had the experience of going into a
  shop to buy something and finding that the price
  had gone up. There was no change in the product;
  we were just charged more for the same thing. If it
  is just a temporary price rise, because of a
  shortage due to a drought for instance, then the
  price may fall back to its previous price.
• However, it often occurs that the price never fully
  adjusts.
Types of Loan Based Savings and Investments



•   Bank accounts
•   Cash management trusts
•   Unsecured or floating debentures
•   Fixed interest securities
                Gearing To Invest

• Debt can also be used to purchase
  appreciating investment assets, whether they
  are property or shares. When money is
  borrowed for investment purposes it is called
  gearing or leveraging.
• There are three levels of gearing: positive,
  neutral and negative.
             Gearing To Invest

• Negative gearing occurs when interest payments
  are higher than be level of income earned from
  the portfolio, resulting in a cash deficit. The
  investor’s intention is that capital growth will
  more than compensate for this loss and will also
  be more favourably taxed.
• Neutral gearing is where the interest payments
  are at approximately the same level as income
  earned from the portfolio.
• Positive gearing is the least risky position, and as
  would be expected, provides the lowest
  potential total return.
           Advantages of Gearing


•   Additional capital available for investing
•   A larger portfolio can be constructed
•   Allows greater diversification
•   Tax benefits
 Issues to Consider Before Borrowing

Borrowing to invest is only rational if the money is
invested in growth assets.
An investor holding fixed interest or cash and
borrowing at the same time will always be better off
from both risk and return points of view by reducing
the cash and fixed interest and repaying the loan.
The reason is that rates paid to lenders are invariably
lower than rates charged to borrowers because of the
charges and margins made by intermediaries such as
banks. Borrowing and lending at the same time is
therefore rarely a good idea.
   Issues to Consider Before Borrowing

• Additional costs will be generated, including
  brokerage, lender fees and charges and the
  requirement to have full personal insurance in
  place can add to costs.
• Investors within a margin-lending package will
  need to have access to additional security (cash or
  additional shares) to cover a situation where they
  do not have enough equity in their gearing
  package.
• Whether home equity or margin-lending, the
  portfolio will have to be carefully managed to
  ensure it performs as well as it can.
            Questions to Ask Before
            Recommending Gearing
                 Investments

• Can the client afford to take up the
  borrowing, meet the interest payments,
  reinvest the distributions and still have
  more than enough money to meet
  normal living expenses?
• Does the client have a sufficiently long
  investment horizon?
               Questions to Ask Before
               Recommending Gearing
                     Investments
• Does the client (and their partner) have job
  stability?
• Is the interest rate and the investment markets in
  a phase that is conducive to gearing? Increasing
  interest rates and falling markets do not provide a
  good basis for entering a gearing package.
• Does the client have cash or fixed interest
  investments? If so, these should be transferred to
  growth assets before gearing is considered. If
  such a transfer results in an asset allocation
  outside the client’s risk tolerance, then so will
  gearing, but with lower expected returns.
Questions to Ask Before Recommending Gearing
                  Investments
 • Does the client have a sufficiently high risk-
   tolerance to invest in growth assets?
 • Sensitivity testing indicates that under
   various scenarios, there is a high probability
   that the gearing package will provide a
   positive long-term investment result.
 • The client has full personal insurance cover.
 • Where the client has a partner, is that partner
   comfortable with gearing?
                                    Summary

•   In recent decades personal debt has grown significantly in Australia.
•   Debt is used for different types of expenditure, and different consumer credit
    products have been developed to meet these different needs.
•   Financial planners need to be familiar with the maths, particularly related to
    simple and compound interest and mortgage repayments.
•   There are traps to be aware of when using consumer credit.
•   Interest rates and inflation and tax all impact on saving and borrowing.
•   Borrower’s creditworthiness is rated and bankruptcy can result from poor
    decisions regarding debt.
•   The careful use of debt can enhance investment returns.

				
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