Transcript for: Debt Management and Financing Options
So before I go any further with material
here, I've got a disclaimer that I wanna make sure you all know about. First of all, I am not a
financial advisor, okay? I've not been certified as one. I've not been chartered as one. I'm not
a financial advisor. I'm probably older than at least 90% of you, so I may be willing to assume
more risk or less risk than you would because of my age, because of what I'm doing in life. I
also want to emphasize that as of right now this moment, I own a 1998 car with 78,000 miles on it,
and I don't have a car payment. So I think you can get a sense that my take on risk and how I invest
might be different than yours. And so we're going to take a look at debt management right now.
And commercial loans that businesses take out, credit card debt, these are probably some of the
most significant financial transactions as we look at the world of, you know, transactions that
involve interest. So after completing this module, you should be able to explain some common loan
terms, be able to describe the structure of amortized installment loans in the sense
of breaking down principal and interest. You should be able to talk to or contrast loan
financing for a car versus lease financing. And you should also be able to explain how credit card
processing works. So when we talk about amortized installment loans, these are like car loans,
mortgage loans, or home loans you may call them, maybe a loan for some appliances that you might
have bought. Actually, the majority of loans are installment loans other than some very, very
short-term loans that businesses may take out. And so in a conventional amortized loan, the interest
that is owed in a particular period is based on the remaining balance on the loan at the beginning
of the period. And so let's step through that a little bit. We're going to take a look at a loan
of $1,000 that is going to be repaid in four years at an interest rate of 10% per year. And so we can
figure out that those four payments are going to be $315.47, okay? And so if we look at time zero
right now, we are taking out our loan. We have a loan balance of $1,000, right? And over the course
of a year, we're going to, at the end of that year, owe 10% interest. And our first payment
that we make of $315, right, will go towards, $100 towards interest, okay? The remaining amount,
$215.47 is going to go towards the principal, okay, which is gonna leave us with a balance on
our loan of $784. So when we're talking about an amortized installment loan, what we're talking
about is how in the payment that you're making, kind of the mix or the ratio, the proportion of
what's going towards interest and what's going towards principal changes. And some of you may
have mortgages, right? And you would have gotten a statement from your lender that shows for each
payment you make, how much goes towards principal, how much goes towards interest. So that's at the
end of the first year. And we have an outstanding balance of $784. And so then, the next payment
that we make, right, we're going to make a 10% interest payment on that, which is going to be
$78.45. That leaves, then, $237 of our payment that'll go to reduce the principal, giving
us a balance on our loan of 547. And so yeah, you can guess, then, our next payment at 10%
interest rate, right? $54.75 will go towards interest. And then the remaining will go towards
reducing the balance on the loan. And then that last year when we make our final payment of $315,
$28 and change will be the last interest payment, and then the loan balance is driven to zero with
that last payment, okay? So this is what we call an amortized loan, and it's this idea that we are
paying interest on the outstanding balance of our loan with every payment that we make. And as you
can see, over the course of this loan, you know, at the very beginning was the largest amount of
interest that was being paid, and then towards the end, it's a smaller amount of interest,
right? So this is an amortized installment loan, okay? Some additional loan lingo. When we talk
about annual percentage, right, you all remember now that that is a nominal rate, not an effective
interest rate, one reason we bring this into play is that with a loan, there are going to be
some other things that come into play, not just interest. There're gonna be some other costs
that include fees. And so the annual percentage rate that you're quoted for a loan is going to
account for both interest as well as fees. Fees, okay. So the lender is going to charge you money
for lending you money, right? So you might pay a fee that's called an application fee, so filling
out the application for the loan, they process it, right? There might be a fee. If you're approved
and they decide to originate the loan, you may pay a loan origination fee. You may be having to pay
some mortgage insurance. You may have to pay some closing costs. This can be quite a lengthy list,
but fees go on and on. By the way, you need to be told what these are, okay? So make sure you check
that out. And then finance charges would include things that are related to the cost of borrowing
itself, like interest and fees, maybe any credit-related insurance premiums that you might
have, any service charges for servicing the loan, et cetera. The periodic interest rate is our rate
that we're actually paying on what we're borrowed, right, and doesn't include the fees. But when we
talk about an annual percentage rate, it's gonna be what a loan actually costs, which is going to
be this interest rate plus these fees that we pay, okay? The term of a loan is the length of a loan.
So if you've looked at home loans, you might see that some of 'em might be 15-year loans or 30-year
loans. If you've financed a car recently, you might see 36-month or 48-month loans, right? And
so if you have a shorter-term loan, you're gonna pay less interest overall. And so the cheapest
loan isn't necessarily gonna be the one with the lowest interest rate or the one with the smallest
payments, right? May not be the cheapest loan, and we're going to take a look at how to figure
some of that out. What you need to understand is what is the total cost of borrowing? What is the
interest rate you're paying? What are the fees? You know, what is the term or length of time that
the loan is for, okay? So let's take a look at an example. If you haven't already had to do this,
probably will be maybe one of the first loans that you look for. Or maybe not even a loan; it's
just that decision about how to finance a car, right? And what we often have are the choice
between paying cash, right, you've got that money saved up, right, taking out a loan for the
car, or perhaps leasing the car. So when you enter into an installment sales contract to buy a car,
your down payment and your monthly payments go towards purchasing that car. When you've paid off
the financing, when you've made your last payment at month 48 or month 72 or whatever it is, when
you've paid off the financing, you own your car, okay? When you lease a vehicle, you may make
payments for 36 months or whatever the term of your lease. However, when you have finished
the term of your lease, you don't own your car, right? The leaser does. So whoever it was
that you leased the vehicle from, it's theirs, you return the vehicle to them. So this is kind
of a big difference between a loan and a lease. And so I realize that for folks, there can be some
non-economic choices that go into deciding do you wanna do a loan or do you wanna do a lease, right?
We're gonna look at the financial decision. There are people who maybe can write off their car for
business expense, right? And so it doesn't really matter how much it costs them. Maybe they do a
lot of driving, and so they're gonna get a new car every year. Or maybe you just want a new car
every year because you want a new car every year, right? So there could be a lot of reasons to do
a loan versus a lease. And even if we look at, as we will here in a minute, you know, which makes
better sense financially, you know, part of the other bottom line might be, you know, what do you
actually have that you can afford out of pocket, right? And so there are some different things
that come into play, not just what is, you know, the better deal, right? So we're gonna actually
take a look at an example here. We're gonna take a look at a 2017 Chevrolet Cruze Sedan, front
wheel drive, I don't know what the LT stands for. Automatic transmission, okay? We're going to
assume that you are driving 15,000 miles or less per year. We're going to look at some different
financing options that include paying cash, taking out a loan, or leasing a vehicle. And
what we're going to assume is that the tax, the title, the license, all the dealer fees, et
cetera, are the same for all of the financing options. And so one of the things that we learn
is that if things like these fees are the same across all of the options, then we can kind of
exclude them from the numerical calculations, right? We're also going to assume that your
insurance, any maintenance expenses that you might incur, and any other expenses like
maybe how often you take it to the car wash, right, are going to be the same for all financing
options. So we're not going to delve into getting what those numbers are. We're also going to assume
that the car experiences average depreciation over four years, maybe about 50%. I don't know, my 1998
car that I still have right now, I gotta tell you, it's cream puff. I certainly don't think
that it should have average depreciation on it. And I'm going to introduce this
idea of what our personal savings rate is, and that's going to be 3% per year, or a quarter
percent per month. As we get into this, you know, the dealer's obviously going to have an interest
rate that they're going to use to figure out how much your payment is going to be every month,
right? And what we're gonna be doing is we're gonna be kind of balancing that against, okay, am
I gonna be making a $300 car payment every month, or lease payment, or should I take this $300 and
should I be investing it in something else? But that's why we need to talk about this idea of a
personal savings rate of 3% per year. And this is a pretty conservative number. You know, you don't
wanna make it 10% or something. Well, maybe you would, but making it a conservative number, it's
something that might be easily achievable with the funds, okay? And so a couple more assumptions. For
the situation where we're gonna pay cash, we're going to assume that we'll get a 9.5% discount
off of the manufacturer's suggested retail price, which is gonna be about 2,100 bucks. For the loan,
we're going to assume that we can put down a 10% down payment, 2,232. By the way, you can play with
all these variables. These are just the ones that I've picked for this example. For the lease, we're
going to assume that we can put down a 10% down payment. The first payment is also gonna be due
at signing. We don't need to put down a security deposit. And then we're also going to assume that
we are going to turn in the vehicle at the end of the lease, and when we do that, there's going to
be a disposition fee of $395. Yeah, okay. By the way, the other option is instead of turning it
in, you might keep it for yourself. Maybe it's one that you really like. My neighbors did that
a few years ago. And then obviously, you've gotta pay some amount of money for it, but the option
that we're gonna pick is that we turn in the vehicle at the end of the lease with a disposition
fee of 395 bucks. So, the question's going to be, which financing option is a better choice from
an economics viewpoint? Should we pay cash, should we take out a loan, or should we lease the
vehicle? And so here are some numbers. As I said, we're looking at a Chevy Cruze, 2017 sedan, front
wheel drive, automatic. Assume that you would be able to sell the car for $11,163 after 48 months.
We'll see why this is important in a moment. Find the most economical financing options. So if I'm
looking at paying cash, manufacturer's suggested retail price is 22,325. Actually, it's the same
regardless, right, of which option. Since I'm paying cash, I'm gonna get a discount of 2,100
bucks. So my price is gonna be $20,000, $20,204. So the cash due at signing is $20,204. That's
my paying cash option. If I finance the loan, the manufacturer's suggested retail price of
22,325, I need to put down a 10% down payment. My annual percentage rate of 1.9% from the dealer
financing will give me a monthly payment of $484. I will pay that for 48 months. Cash due at
signing is going to be just my down payment, 2,232, and then you'll get a lease. Back when I
bought my first car, you get this little booklet, and you've got all your little tickets in it,
and you tear it off and you send it in, but I'm sure it all happens electronically these days.
Haven't done that in a while. If we're looking at the lease option, the vehicle price is still the
same. We're saying a 10% down payment. Right now, the dealer is offering a monthly lease payment of
23,239 for 48 months. Cash due at signing is gonna be the down payment plus the first month, and then
we have to remember this 395 disposition fee. So with these cash flows for these three alternative
financing options, which one's gonna be the most economical for us to look at? So we've got the
cash flows. I've also told you what my personal interest rate is. And so the way that we would
approach this problem would be to look at the cash flows, apply my personal interest rate, and
then that's going to tell me which is the best option for me in the sense of, you know, which is
the lowest cost, right? And like I said, this is just purely economics. And so I have the numbers
noted down here, and hopefully you've had a chance to note them too, otherwise you'll be keeping up
with me as I keep track of this. So let's take a look at the first option of paying cash and figure
out what the present value of the cash option is. So if you recall, I'm going to pay cash, right,
to get this thing, so that would be the present value of my purchase. If I pay cash, I also have
this asset at the end of the year, not the end of the year, but the end of 48 months, right? And
so I believe I made the assumption here, right, of depreciation over four years of approximately
50%, and that's what led me to my value. I don't think I actually calculated it here, but
we will in a moment. So the present value of what this car could be sold for in 48 months.
And so the present value of the purchase, well, that's kind of a no-brainer, 20,204. And then with
my depreciation on here, I've got 50%, basically. It was the rate that I was using, right? And we
would do that off of the manufacturer's suggested retail of 22,325. And then a PF factor at my
personal rate, well, I mean, I can do 3% for four years. We can do it in terms of months. And if we
go ahead and do it in terms of months, that's how we're doing it for all the others, but it doesn't
really matter at this point. So 3% divided by 12 over 48 months, right? And the number that
I come up with here as far as the value, the present value of paying cash for this vehicle
is, let's see, 20,204 minus 9,902, or $10,302. So that's the present value of the pay cash option.
Let's take a look at financing the loan. So the present value of the loan. So let's see, I have
some money that's due at signing, right? So the present value of the money due at signing plus,
oh yeah, those payments I'm gonna have to make, right? The present value of the payments, all
right? And when I've financed this for 48 months, it's still mine. I could sell it. It has some
value to it, so let's go ahead and sell this. So the month that was due at signing was my 10% down
payment, which was 2,232. The present value of my payments, so my monthly payment for financing was
484 times a PA at 3% divided by 12 for 48 months, right? And then I still have my sale here, and I'm
just gonna copy it on down. It's the same number, 9,902, right? So 2,232 plus, I don't know
if you've figured this one out, the present value of $484 at a pretty small interest rate
here, was at a quarter percent, 48. I ended up with 21,866 minus 9,902, or a value right now for
financing at 14,196. If I was to stop right here, the economical choice would be to pay cash. If you
have $20,000 sitting around, you can deal with it, right? But that would be the economic decision,
okay? And by the way, between the two of these, both paying cash and financing the loan, you know,
the value of the car at the end in 48 months is still the same, so we could have actually not
included that and just compared the purchase now with the signing and the down payments, right?
So let's take a look at leasing the vehicle, right? And what's the present value of the lease?
Okay, so I have got, when I signed for this thing, right, I'm gonna have to give him some money. It
was the down payment plus the first month, right? And then I'm going to have some payments. In this
case, though, I'm only gonna have 47 payments, right, because I've got one that's due at
signing. And let's see, it won't be mine, so I can't account for the value in this vehicle
of selling it. But not only that, I have a fee that I have to pay when I turn it in 48 months
from now. Remember that disposition fee? So at signing, it's going to be, let's see, it was the
down payment, 2,232, plus the first lease payment, which is $239, right? Plus 239 multiplied by a PA
factor for 47 months. And then plus, oh, this is just totally rude, isn't it, $395 times the PF,
3%, divided by 12, and that's 48 months from now, okay? So I end up with 2,471 plus 10,586. And the
present value of that $395 is about $350, or a total of 13,407. Hmm, what do you think? Maybe?
So obviously, if you have economic decision, obviously you've got the cash, pay the cash
now, otherwise, between financing and leasing, this looks like leasing might come out on top just
a little bit. And I just wanna caution that right now, this interest rate that I'm using here is
a pretty darn low interest rate. First of all, just where we are kind of in the cycle of interest
rates, it's near a historic low. And then right now, a lot of offers have, you know, they're kind
of really low so that dealers can sell a lot of cars and get the volume up. And so this isn't
always gonna happen. I would not say walking away. Typically, that leasing is gonna be a better
option than loan, okay? And this is the economic decision. So we've got three alternatives here.
We're gonna pick one of 'em, right? And maybe we can get the down payment, or the purchase price,
rather, from Mom and Dad or Grandpa. So anyway, we've got the solution here for you. So,
that was car loans. Home mortgage loans, also sometimes referred to as home loans, have a
few more terms that get thrown at us. Might be a fixed rate loan so that the rate stays the same
for the entire length of the loan. We might have an adjustable-rate mortgage. We looked at one of
these where it's a flat rate for the first five years, and then it can increase. It depends on
what kind of specific loan you get, but a typical one might be able to increase once a year subject
to a maximum cap. So it's an adjustable-rate mortgage. Here in the United States, I don't
ever think the rates went down on adjustable-rate mortgages. Down payments also get to be very
important when you're talking about home loans. It might be somewhere between 5% and 20%. 20% is kind
of a magic number because it gets you outta some additional fees or some additional expenses that
we'll get to in a moment. When you buy a house, there're gonna be some closing costs associated
with it. Typically, 3 to 7% of the total loan amount. Yeah. So this is stuff that the lender's
going to charge you for doing the loan. Points are a fee that you can pay that essentially, you pay
a chunk of money up front right now, and what you can do is kind of buy yourself down to a lower
interest rate. Why would you wanna buy yourself down to a lower interest rate? So that you have
a smaller monthly payment. You'll hear people who are doing mortgage loans talk about this a lot.
You kind of need to decide for yourself whether it makes sense or not, kind of doing the whole time
value of money thing, right? It may make sense to you that you have a little bit of chunk of money
right now that it may make sense to buy your loan if you know that you're going to have, buy down
your loan rate, rather, if you know that you're going to have a smaller payment for the, you know,
foreseeable future. That might help you with your monthly budgeting expenses, right? So points may
be something that come into play. You might also hear this term, PITI. I call it PITI. I don't know
if anybody else calls it PITI, PITI, principal, interest, taxes, and insurance. And this is what
you're going to have to pay in a payment every month. This is our property taxes that we're
talking about, and insurance, and specifically homeowner's insurance, okay? There's another type
of insurance that you may have to worry about, which would be private mortgage insurance. So
for example, if you put down less than 20% as a down payment, you might be considered, mm, a
little bit of a, I don't wanna say a flight risk, but the idea is here you might not have enough
skin in the game. Let's see if I can come up with any more cute little sayings. But, you know, 20%'s
kind of the threshold. Like, if you put down more than 20%, lender's gonna feel pretty confident
that you're gonna wanna stay there, you're not gonna wanna lose your investment, et cetera. Less
than 20%, little bit riskier. So private mortgage insurance is something that you might have to buy
if you don't put down a large enough down payment. So don't be surprised by that. I have an example
here of a typical quote that you might find on a bank website right now. This is based on a
certain loan in a certain zip code. This was just the default zip code. That's not my zip code. And
we have a couple of different common home loans, 30-year fixed rate, 15-year fixed rate, 5/1
adjustable-rate mortgage. And you can see the rate, okay? You can see the APR, and you now know
what goes into an APR. You could see points, what it would take to buy down, and you could see an
estimate of your monthly payment. And so there's a lot of assumptions and a lot of disclaimers
that go into this, right? And at this point in time right now, depending on what happens
with interest rates overall, they could go up, they could go down, right? But this would be very
typical of what you might be looking at, the kind of language that you might be looking at, okay? So
by now, you should be able to explain some common loan terms. You should also be able to describe
the structure of an amortized installment loan, this idea of principal and interest and how
in your payment each month, kind of the mix of that is changing. I showed you how to take
a look at a car loan versus lease financing, so you should be able to do that and come to a
conclusion for yourself. There's also a video that I need you to watch that is going to talk about
how credit card processing works. And once you've watched that, you should be able to explain
it to somebody else. So thank you very much.