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Certified Financial Planner CFP®Terms > B.10 Financing Strategies and Debt Management > Flashcards

B.10 Financing Strategies and Debt Management Flashcards

1
Q

A personal finance measure that compares an individual’s monthly debt payments to their gross monthly income.

A

Debt-to-Income Ratio (DTI)

Lenders use DTI to assess a borrower’s ability to manage monthly payments and repay debts.

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2
Q

The ratio of monthly consumer debt payments to monthly net (after-tax) income.

A

Consumer Debt Ratio

Should not exceed 20% of net monthly income.

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3
Q

The ratio of monthly housing costs (including principal, interest, taxes, and insurance) to monthly gross income.

A

Housing Cost Ratio

Housing costs should not exceed 28% of gross monthly income.

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4
Q

The ratio of total monthly debt payments to monthly gross income.

A

Total Debt Ratio

Total debt payments should not exceed 36% of gross monthly income.

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5
Q

A liquidity ratio that measures a person’s ability to pay short-term obligations, calculated as current assets divided by current liabilities.

A

Current Ratio

A ratio greater than 1 indicates more assets than liabilities.

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6
Q

The ratio of net investment assets to net worth, indicating the proportion of net worth invested.

A

Net Investment Assets to Net Worth Ratio

Individuals should aim for at least 50%, increasing as retirement approaches.

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7
Q

Cash or cash equivalents set aside to cover unexpected expenses or financial emergencies.

A

Emergency Fund

Typically 3-6 months’ worth of living expenses.

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8
Q

A loan repaid over time with a set number of scheduled payments, including interest.

A

Installment Loan

Auto loans, personal loans.

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9
Q

Short-term financing repaid in one lump sum, often used between two transactions.

A

Single Payment (Bridge) Loan

A loan to cover a down payment while awaiting the sale of another property.

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10
Q

A debt reduction strategy where the smallest debts are paid off first, regardless of interest rate, to build motivation.

A

Debt Snowball Method

Provides quick wins to encourage continued debt repayment.

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11
Q

A debt repayment strategy focusing on paying off debts with the highest interest rates first to minimize total interest paid.

A

Debt Avalanche Method

Can save more money over time compared to the snowball method.

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12
Q

A type of credit score created by the Fair Isaac Corporation, ranging from 300 to 850, used by lenders to assess credit risk.

A

FICO Credit Score

Payment history, amounts owed, length of credit history, new credit, and credit mix.

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13
Q

A mortgage with low initial payments that increase over time, designed for borrowers with rising income expectations.

A

Graduated Payment Mortgage (GPM)

Payments may become unaffordable if income does not increase as anticipated.

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14
Q

The mix of debt and equity financing used by a company to fund its operations and growth.

A

Capital Structure

Optimize the balance to minimize the cost of capital and maximize firm value.

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15
Q

The use of borrowed funds to increase the potential return on investment.

A

Leverage

Increases potential losses if investments do not perform as expected.

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16
Q

The proportion of debt and equity that minimizes a firm’s cost of capital and maximizes its value.

A

Optimal Capital Structure

Balances the tax benefits of debt with the financial risks of excessive borrowing.

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17
Q

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.

A

Trade-Off Theory

There is an optimal level of debt where the marginal benefit equals the marginal cost.

18
Q

A theory stating that firms prefer to finance new projects using internal funds first, then debt, and issue equity as a last resort.

A

Pecking Order Theory

Minimizes the costs associated with asymmetric information between managers and investors.

19
Q

Replacing an existing debt obligation with a new one under different terms, often to reduce interest rates or extend the repayment period.

A

Debt Refinancing

Can lower monthly payments and total interest paid.

20
Q

The order of repayment in the event of a company’s liquidation, with senior debt being paid before subordinated debt and equity.

A

Seniority in Capital Structure

Affects the risk and return profile of different securities

21
Q

The process of gradually repaying a debt over time in equal payments, with each payment covering both principal and interest.

A

Amortization

Fixed mortgage payments are typically amortized over 15-30 years.

22
Q

A large, lump-sum payment due at the end of a loan term, following smaller periodic payments during the term.

A

Balloon Payment

Borrowers may struggle to make the final large payment without refinancing or selling assets.

23
Q

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.

A

Revolving Credit

Credit cards and home equity lines of credit (HELOCs).

24
Q

Debt backed by collateral, which the lender can seize if the borrower defaults.

A

Secured Debt

Mortgages (secured by real estate) and auto loans (secured by vehicles).

25
Q

Debt not backed by collateral, relying solely on the borrower’s creditworthiness.

A

Unsecured Debt

Credit card debt and personal loans.

26
Q

Combining multiple debts into a single loan or payment, often at a lower interest rate

A

Debt Consolidation

Simplifies repayment and may reduce total interest costs.

27
Q

When loan payments are insufficient to cover interest costs, causing the unpaid interest to be added to the loan principal.

A

Negative Amortization

Borrowers owe more over time, increasing overall debt.

28
Q

The percentage of available credit a borrower is using, calculated as total credit balances divided by total credit limits.

A

Credit Utilization Ratio

Should be kept below 30% to maintain a good credit score.

29
Q

Loans offered to borrowers with poor creditworthiness, typically at higher interest rates to offset the increased risk.

A

Subprime Lending

Often criticized for contributing to financial instability.

30
Q

The legal process by which a lender repossesses a property when the borrower fails to make mortgage payments.

A

Foreclosure

The property is usually sold to recover the outstanding loan balance.

31
Q

A temporary postponement of loan payments, often granted for student loans during financial hardship.

A

Deferment

Interest may continue to accrue on certain loan types.

32
Q

A temporary reduction or suspension of loan payments granted by the lender due to financial hardship.

A

Forbearance

Forbearance often accrues interest regardless of loan type.

33
Q

A legal process in which individuals or businesses unable to repay debts can seek relief through court-approved debt restructuring or discharge.

A

Bankruptcy

Chapter 7 (liquidation) and Chapter 13 (repayment plan).

34
Q

A short-term, high-interest loan typically due on the borrower’s next payday.

A

Payday Loan

Can lead to a cycle of debt due to high fees and interest rates.

35
Q

The ratio of a loan amount to the appraised value of the collateral, used to assess risk.

A

Loan-to-Value Ratio (LTV)

Lower LTV ratios are less risky for lenders.

36
Q

The cancellation or reduction of a borrower’s obligation to repay a debt.

A

Debt Forgiveness

Certain student loans may be forgiven under qualifying programs.

37
Q

A refinancing option that allows borrowers to take out a new mortgage for more than they owe, receiving the difference in cash.

A

Cash-Out Refinance

Often used for home improvements or debt consolidation.

38
Q

A revolving line of credit secured by the borrower’s home equity.

A

HELOC (Home Equity Line of Credit)

Borrowers can draw funds as needed within a set term.

39
Q

The process of negotiating new terms with creditors to improve a borrower’s ability to repay debts.

A

Debt Restructuring

May involve lower interest rates, extended repayment periods, or debt forgiveness

40
Q

Failure to meet the legal obligations of a loan, such as missing payments.

A

Default

Can lead to penalties, higher interest rates, or legal action.

Certified Financial Planner CFP®Terms (15 decks)

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