B.10 Financing Strategies and Debt Management Flashcards
A personal finance measure that compares an individual’s monthly debt payments to their gross monthly income.
Debt-to-Income Ratio (DTI)
Lenders use DTI to assess a borrower’s ability to manage monthly payments and repay debts.
The ratio of monthly consumer debt payments to monthly net (after-tax) income.
Consumer Debt Ratio
Should not exceed 20% of net monthly income.
The ratio of monthly housing costs (including principal, interest, taxes, and insurance) to monthly gross income.
Housing Cost Ratio
Housing costs should not exceed 28% of gross monthly income.
The ratio of total monthly debt payments to monthly gross income.
Total Debt Ratio
Total debt payments should not exceed 36% of gross monthly income.
A liquidity ratio that measures a person’s ability to pay short-term obligations, calculated as current assets divided by current liabilities.
Current Ratio
A ratio greater than 1 indicates more assets than liabilities.
The ratio of net investment assets to net worth, indicating the proportion of net worth invested.
Net Investment Assets to Net Worth Ratio
Individuals should aim for at least 50%, increasing as retirement approaches.
Cash or cash equivalents set aside to cover unexpected expenses or financial emergencies.
Emergency Fund
Typically 3-6 months’ worth of living expenses.
A loan repaid over time with a set number of scheduled payments, including interest.
Installment Loan
Auto loans, personal loans.
Short-term financing repaid in one lump sum, often used between two transactions.
Single Payment (Bridge) Loan
A loan to cover a down payment while awaiting the sale of another property.
A debt reduction strategy where the smallest debts are paid off first, regardless of interest rate, to build motivation.
Debt Snowball Method
Provides quick wins to encourage continued debt repayment.
A debt repayment strategy focusing on paying off debts with the highest interest rates first to minimize total interest paid.
Debt Avalanche Method
Can save more money over time compared to the snowball method.
A type of credit score created by the Fair Isaac Corporation, ranging from 300 to 850, used by lenders to assess credit risk.
FICO Credit Score
Payment history, amounts owed, length of credit history, new credit, and credit mix.
A mortgage with low initial payments that increase over time, designed for borrowers with rising income expectations.
Graduated Payment Mortgage (GPM)
Payments may become unaffordable if income does not increase as anticipated.
The mix of debt and equity financing used by a company to fund its operations and growth.
Capital Structure
Optimize the balance to minimize the cost of capital and maximize firm value.
The use of borrowed funds to increase the potential return on investment.
Leverage
Increases potential losses if investments do not perform as expected.
The proportion of debt and equity that minimizes a firm’s cost of capital and maximizes its value.
Optimal Capital Structure
Balances the tax benefits of debt with the financial risks of excessive borrowing.
A theory suggesting that firms balance the tax benefits of debt financing with the costs of potential financial distress to determine their optimal capital structure.
Trade-Off Theory
There is an optimal level of debt where the marginal benefit equals the marginal cost.
A theory stating that firms prefer to finance new projects using internal funds first, then debt, and issue equity as a last resort.
Pecking Order Theory
Minimizes the costs associated with asymmetric information between managers and investors.
Replacing an existing debt obligation with a new one under different terms, often to reduce interest rates or extend the repayment period.
Debt Refinancing
Can lower monthly payments and total interest paid.
The order of repayment in the event of a company’s liquidation, with senior debt being paid before subordinated debt and equity.
Seniority in Capital Structure
Affects the risk and return profile of different securities
The process of gradually repaying a debt over time in equal payments, with each payment covering both principal and interest.
Amortization
Fixed mortgage payments are typically amortized over 15-30 years.
A large, lump-sum payment due at the end of a loan term, following smaller periodic payments during the term.
Balloon Payment
Borrowers may struggle to make the final large payment without refinancing or selling assets.
A type of credit that allows the borrower to use or withdraw funds up to a pre-approved limit repeatedly as long as they make minimum payments.
Revolving Credit
Credit cards and home equity lines of credit (HELOCs).
Debt backed by collateral, which the lender can seize if the borrower defaults.
Secured Debt
Mortgages (secured by real estate) and auto loans (secured by vehicles).
Debt not backed by collateral, relying solely on the borrower’s creditworthiness.
Unsecured Debt
Credit card debt and personal loans.
Combining multiple debts into a single loan or payment, often at a lower interest rate
Debt Consolidation
Simplifies repayment and may reduce total interest costs.
When loan payments are insufficient to cover interest costs, causing the unpaid interest to be added to the loan principal.
Negative Amortization
Borrowers owe more over time, increasing overall debt.
The percentage of available credit a borrower is using, calculated as total credit balances divided by total credit limits.
Credit Utilization Ratio
Should be kept below 30% to maintain a good credit score.
Loans offered to borrowers with poor creditworthiness, typically at higher interest rates to offset the increased risk.
Subprime Lending
Often criticized for contributing to financial instability.
The legal process by which a lender repossesses a property when the borrower fails to make mortgage payments.
Foreclosure
The property is usually sold to recover the outstanding loan balance.
A temporary postponement of loan payments, often granted for student loans during financial hardship.
Deferment
Interest may continue to accrue on certain loan types.
A temporary reduction or suspension of loan payments granted by the lender due to financial hardship.
Forbearance
Forbearance often accrues interest regardless of loan type.
A legal process in which individuals or businesses unable to repay debts can seek relief through court-approved debt restructuring or discharge.
Bankruptcy
Chapter 7 (liquidation) and Chapter 13 (repayment plan).
A short-term, high-interest loan typically due on the borrower’s next payday.
Payday Loan
Can lead to a cycle of debt due to high fees and interest rates.
The ratio of a loan amount to the appraised value of the collateral, used to assess risk.
Loan-to-Value Ratio (LTV)
Lower LTV ratios are less risky for lenders.
The cancellation or reduction of a borrower’s obligation to repay a debt.
Debt Forgiveness
Certain student loans may be forgiven under qualifying programs.
A refinancing option that allows borrowers to take out a new mortgage for more than they owe, receiving the difference in cash.
Cash-Out Refinance
Often used for home improvements or debt consolidation.
A revolving line of credit secured by the borrower’s home equity.
HELOC (Home Equity Line of Credit)
Borrowers can draw funds as needed within a set term.
The process of negotiating new terms with creditors to improve a borrower’s ability to repay debts.
Debt Restructuring
May involve lower interest rates, extended repayment periods, or debt forgiveness
Failure to meet the legal obligations of a loan, such as missing payments.
Default
Can lead to penalties, higher interest rates, or legal action.
