Chapter 10 - Other Financial Products

Question 1

Overdrafts

Answer 1

Expensive way of borrowing
Restrict their use to temporary

Question 2

Credit cards

Answer 2

Wide variety of retail goods such as food electric goods, petrol and cinema tickets can be paid for using credit card. The retailer is paid by the credit card company for the goods sold. The credit card company charges the retailer a % fee but this enables the store to sell goods and services to customers

Interest is charged on the balance owed by the owner

High interest rates

Question 3

Loans can be divided into 2 groups

Answer 3

Secured loans
Unsecured loans

Question 4

Unsecured loan

Answer 4

Typically used to purchase consumer goods. The lender will check the creditworthiness of the borrower, accessing weather they can afford to repay.

Unsecured loan is not linked to the item that is purchased with the loan so if the borrower defaults it can be difficult for the lender to enforce repayment. The usual mechanism for the unsecured lender to enforce repayment is to start legal proceedings to get the money back.

Question 5

Secured loans

Answer 5

If secured loans are not repaid the lender can repossess the specific property which was the security for the loan
Eg a mortgage

Question 6

Commercial loans

Answer 6

Businesses will also need to borrow money from time to time, either through an overdraft or by longer term borrowing

A commercial loan is typically used to fund major capital expenditure

As with other loans the lender will access the ability of the company to repay the loan and whether it requires any security

Question 7

Interest rates

Answer 7

Cost of borrowing can vary depending on the form of borrowing, how long money is required for and amount borrowed

Mortgages are much cheaper than credit cards

Loan companies quote flat rates rather than the effective annual rate (rate which includes the interest already accrued on the amount)

Question 8

How to work out the effective annual rate

Answer 8

Take quoted rate eg 12%, divide by frequency (quarterly yearly etc) and express as a decimal so if it’s 12% quarterly it’s 0.03.

Example

1+0.03 = 1.03

1.03^4 = 1.1255
Then - 1 x10= 12.55%

Question 9

Annual percentage rate

Answer 9

To make comparisons easier, lenders must quote the true cost of borrowing = the effective annual rate plus any fees required

Question 10

Mortgages

Answer 10

Tend to be taken out over a long term with most at one time running for 20 or 25 years. Due to rising prices, more than 40% have over 25 years.

Question 11

Mortgage applicants are accessed in terms of

Answer 11

Income and security of employment (amount borrowed is 4.5x income)
Existing outgoings
Future problems
the size of the loan in relation to value of property

Question 12

Mortgage interest rates

Answer 12

Variable
Fixed
Capped
Tracker

Question 13

Repayment mortgages - advantage

Answer 13

As long as borrower meets the repayments each month, they are guaranteed to pay off the loan

Question 14

Risks of repayment mortgages (borrower’s perspective)

Answer 14

Cost of servicing the loan could increase, when interest is charged at the lenders standard rate of interest
Mortgage repayments can rise significantly at the end of a fixed rate deal when they revert to the standard variable rate
Borrower runs the risk of having the property repossessed if they fail to meet the repayments

Question 15

Interest only mortgages

Answer 15

Requires borrowers to make interest payments to the lender throughout the period of the loan

Borrowers aim is for the investment to grow through regular contributions and investment returns so that at the end of the mortgage the accumulated investment is sufficient to pay back capital borrowed.

Question 16

Main risk of interest only mortgage (borrowers perspective)

Answer 16

Borrowers with interest only mortgages still face the risks that repayment mortgage borrowers face
Additional risk that the investment might not grow sufficiently to pay the amount owing on the mortgage.

Question 17

Offset mortgages

Answer 17

For calculation and charging of interest, any mortgage is offset against, any savings you may hold.

Eg mortgage of £100k with £10k savings. You only pay interest on £90k

Question 18

Benefits of offset mortgages

Answer 18

A higher rate tax payer will not incur tax on any savings interest earned bcos it’s been offset by the mortgage borrowing
As interest is being paid on a lower mortgage, it provides some flexibility to manage finances, pay off mortgage a little quicker and have more control

Question 19

Whole of life assurance - what are the 3 types

Answer 19

Non profit - for guaranteed sum only

With profits - which pays a guaranteed amount plus any profits made during period between policy being taken out and death

Unit linked policies - in which the return will be directly related to the investment performance of the units in the insurance company fund

Question 20

Term assurance

Answer 20

Type of policy that pays out a lump sum in the event of death occurring within a specified period.

Variety of uses such as ensuring there are funds available to repay a mortgage in case someone dies or providing a lump sum that can be used to generate income for a surviving partner or to provide funds to pay an tax that might become payable on death.