FP511 Module 3

Question 1

Statement of Financial Position / Net Worth statement / personal balance sheet

Answer 1

a profile of what is owned (assets), what is owed (liabilities), and your client’s net worth on a specific date.

assets = liabilities + net worth or
net worth = assets − liabilities

Question 2

3 categories of assets (listed in liquidity order)

Answer 2

1. cash and cash equivalents (money market funds, short term CDs 90 days or less)
2. Invested assets (stocks, bonds, etc.)
3. personal use assets (residence, automobiles, furnishings, jewelry, etc)

Question 3

fair market value

Answer 3

the price at which a willing and knowledgeable buyer would purchase an asset from a willing and knowledgeable seller.

This is the price used on personal balance sheets

Question 4

current (short-term) liabilities

Answer 4

those due within one year from the statement date, such as a promissory note.

Question 5

Long-term liabilities

Answer 5

those due more than one year from the statement date

Question 6

net worth

Answer 6

difference between assets and liabilities. It fluctuates from statement to statement, depending on the financial transactions that take place between the dates of statement preparation

Question 7

Footnotes

Answer 7

an integral part of all personal financial statements and should be taken into consideration when the financial planner evaluates the client’s situation. Footnotes clarify items in the statement or indicate values or circumstances not disclosed in the body of the statement.

Question 8

cash flow statement

Answer 8

reveals the client’s cash receipts and disbursements over a specific period of time—monthly, quarterly, and often over one year

Contrary to the statement of financial position which is a snapshot of a given point in time

Question 9

inflows

Answer 9

Part of a cash flow statement. Inflows include gross salaries and wages, interest and dividend income, rental income, tax refunds, and other amounts received by the client.

Question 10

outflows

Answer 10

Part of a cash flow statement. Outflows should be divided into savings and investments, fixed outflows, and variable outflows.

Question 11

fixed outflows

Answer 11

part of a cash flow statement.

predictable and recurring expenses like note payments, mortgage payments, insurance premiums

Question 12

variable outflows

Answer 12

part of a cash flow statement.

Variable outflows are those over which the client can exercise some degree of control, such as expenditures for food, transportation, clothes, and entertainment.

Note: credit card purchases do not impact outflows until the credit card is paid off. Until then, its a liability

Question 13

pro forma cash flow statement

Answer 13

As a projection of cash flows, the pro forma cash flow statement is a planning tool that projects the anticipated inflows and outflows for a future period.

Question 14

Consumer debt ratio

Answer 14

This is the ratio of monthly consumer debt payments to monthly net income. Net income is defined as gross income less taxes.

consumer debt refers to debt other than mortgage indebtedness and most often includes debt incurred to service automobile purchases and credit card purchases.

A generally accepted rule in personal financial planning is that monthly consumer debt payments should not exceed 20% of net monthly income.
- Known as the nonmortgage debt-to-income ratio

Consumer debt ratio = monthly consumer debt payments / monthly net income

Question 15

nonmortgage debt-to-income ratio

Answer 15

A generally accepted benchmark in personal financial planning is that monthly consumer debt payments should not exceed 20% of net monthly income.

Consumer debt ratio = monthly consumer debt payments / monthly net income

Question 16

hosing cost ratio (total debt ratio)

Answer 16

This is the ratio of housing costs to monthly net income.

Housing costs include rent or an individual’s monthly mortgage payment (principal and interest payments on the mortgage, property taxes, homeowners insurance premium [PITI]), as well as association fees) should not exceed 28% of gross monthly income.

This is also known as the front-end ratio.

Housing cost ratio = monthly housing costs / monthly gross income

Question 17

front-end ratio

Answer 17

housing cost ratio of 28%

Housing costs include rent or an individual’s monthly mortgage payment (principal and interest payments on the mortgage, property taxes, homeowners insurance premium [PITI]), as well as association fees) should not exceed 28% of gross monthly income.

This is also known as the front-end ratio.

Question 18

total debt ratio (back-end ratio)

Answer 18

Total debt (recurring debt including monthly housing costs, consumer debt payments, monthly alimony, child support, and maintenance payments)—should not exceed 36% of gross monthly income.

This is also known as the back-end ratio.

Total debt ratio - total monthly debt / monthly gross income

Question 19

Current ratio

Answer 19

calculated by dividing the amount of a client’s current assets by his current (short-term) liabilities. This ratio represents the ability of an individual to service short-term liabilities in case of a financial emergency.

no accepted standard for the ratio

A higher current ratio is preferable and a ratio greater than 1.0 (> 1.0) indicates that the client can pay off existing short-term liabilities with readily available liquid assets/cash

Question 20

net-investment-assets-to-net-worth ratio

Answer 20

This ratio compares the value of investment assets (excluding equity in a home) with net worth.

An individual should have a ratio of at least 50%, and the percentage should get higher as retirement approaches. Younger individuals will most likely have a ratio of 20% or less because they have not had the time to build an investment portfolio.

Question 21

emergency fund

Answer 21

cash or cash equivalents set aside to offset the expenses of unexpected events, such as a job loss, a medical crisis, or major home repairs

Question 22

saving

Answer 22

he process of putting cash aside in safe, liquid accounts, such as the emergency fund discussed in the previous section.

Question 23

Investing

Answer 23

involves your clients using their money, or capital, to purchase an asset that offers the probability of generating an acceptable rate of return over time, providing potential for earnings while assuming more volatility.

Question 24

secured loan

Answer 24

a loan for which the creditor maintains a security interest in property, such as personal property, which serves as collateral for the debt. If the debtor falls behind on secured debt payments, the lender can repossess the property that secures the debt.

Question 25

unsecured (signature) loan

Answer 25

a loan for which the client merely promises to repay the debt in exchange for the borrowed funds. In the event of default, lenders can take legal action, but most often will attempt to settle the debt for less than the amount owed.

Question 26

fixed-rate loan

Answer 26

a loan with an interest rate that remains constant until paid in full. Although initial interest rates are higher than those of variable (adjustable) rate loans (see next), fixed-rate loans offer more security because the underlying interest rates will not increase considerably during the term of the loan.

Question 27

variable (adjustable) rate loan

Answer 27

the interest rate adjusts at various intervals throughout loan term; thus, they are riskier. The initial interest rate on these types of loans is typically lower than those of fixed-rate loans.

Question 28

short-term loan

Answer 28

loan that is due within one year

Question 29

long-term loan

Answer 29

a loan due more than one year from a specified date

Question 30

installment loan

Answer 30

a loan for which the client borrows a single amount of money and repays the balance with interest at stated intervals. Most loans are installment loans.

Question 31

single payment (bridge) loan

Answer 31

a loan that provides short-term, temporary financing that is repaid with interest in one lump sum at the end of the term. These types of loans are often used to provide funds for a time period between two transactions (e.g., the purchase of one house and the subsequent sale of another).

Question 32

snowball debt management technique

Answer 32

smaller balances are paid off first so clients feel encouraged by their success and motivated to continue the process.

Question 33

avalanche debt management technique

Answer 33

Another debt reduction option prioritizes high-interest debt to save money, but it may take longer to get the first debt eliminated.

When the highest-interest debt is eliminated, your client focuses on eliminating the debt with the next-highest interest rate, and so on, until all of his debt is paid off

Question 34

5 credit score categories

Answer 34

1. Payment history (35%)
2. Amounts owed (30%)
3. Length of credit history (15%)
4. New credit (10%)
5. Credit mix (10%)

Question 35

Closed-end-lease (fixed cost lease)

Answer 35

the lessee agrees to pay a stated monthly fee for the use of the asset for a specified time period

Question 36

Open-end lease (finance lease or equity lease)

Answer 36

Generally has a lower monthly payment than a closed-end lease but, at the end of the lease, the lessee may owe the lessor additional money if the asset rents or sells for an amount that is less than the value projected at the time the lease was initiated.

Question 37

loan-to-value ratio (LTV)

Answer 37

Part of a mortgage loan.

the percentage of the value of the collateral real estate that is loaned to the borrower. The lower the LTV, the higher the borrower’s equity in the property.

Question 38

Prime loans

Answer 38

In the United States, mortgages made to borrowers with good credit are referred to as prime loans.

Question 39

subprime loans

Answer 39

Mortgages to borrowers of lower credit quality, or that have a lower-priority claim to the collateral in event of default, are considered subprime loans.

Question 40

Federal Housing Administration (FHA) mortgage loans

Answer 40

These mortgages appeal to buyers who may not meet the financial underwriting requirements for a conventional home loan (i.e., a 15-or 30-year fixed mortgage or adjustable-rate mortgage).

A key feature of the FHA mortgage is a very low initial down payment and, sometimes, a lower interest rate because of the federal government’s guarantee of repayment.

Question 41

Veterans Administration (VA) loans

Answer 41

feature the same federal guarantee of repayment as that for Federal Housing Administration (FHA) mortgages, but VA mortgages are for service members and veterans of the U.S. armed services, their spouses, and other eligible beneficiaries.

Question 42

Conventional mortgage loans

Answer 42

those made by commercial lenders in the private sector.

Also known as conforming loans because they conform to Fannie Mae & Freddie Mac dollar limit requirements

Loans above that amount are known as jumbo loans or nonconforming loans. Nonconforming loans may also be called subprime loans and have higher down payment and/or higher interest rate requirements.

Question 43

Fixed-rate mortgages

Answer 43

have a level interest rate for the term of the loan and a fixed payment amortization schedule

Question 44

adjustable-rate mortgages (ARMs)

Answer 44

the interest rate and payment may change every month, quarter, year, three years, or five years. Interest rate changes are usually tied to a specific index such as the one-year London Interbank Offered Rate (LIBOR).

Question 45

interest-only mortgage

Answer 45

the homeowner tries to keep the mortgage payment at a minimum while hoping that the fair market value of the home will increase so that the principal amount will be paid off by the sale proceeds.

Question 46

balloon mortgage

Answer 46

a mortgage in which the borrower makes fixed payments, which are based upon the established interest rate for a long-term mortgage. However, payments are made only for a short duration—frequently five or seven years—and then the borrower is required to pay off the remainder of the mortgage in a lump sum.

Question 47

graduated payment mortgage

Answer 47

payable over a long time period, such as 30 years, and has a fixed interest rate.

The payments are lower for the first few years of mortgage repayment (although they sometimes increase annually), then they adjust to a higher fixed payment that continues for the remainder of the loan.

Question 48

Reverse mortgages

Answer 48

special type of home loan that allows senior citizens with limited income to stay in their homes. Here, the payment stream is reversed; that is, the lender pays the homeowner a stream of income secured by a considerable amount of equity in the home.

Question 49

home equity loan

Answer 49

Home equity loans and lines of credit are essentially second mortgages that use the current equity in the homeowner’s primary residence to provide money for home improvements and other purposes.

home equity loan receives a lump sum in the amount of the loan. With this type of loan, borrowers repay the loan with equal monthly payments over a fixed term.

Question 50

home equity line of credit (HELOC)

Answer 50

provides a set amount of credit from which funds may be drawn as needed. Because a HELOC is a line of credit, borrowers make payments only on the amount they actually borrow, not the full amount available.

Question 51

Federal Deposit Insurance Corporation (FDIC)

Answer 51

All individuals are entitled to FDIC insurance for a deposit at a U.S. financial institution

Only cash and cash equivalent deposits

Securities, mutual funds and other investments and money market funds are denied coverage.

Amount per depositor is $250,000

Deposits maintained in different categories of ownership are separately insured (single ownership, joint ownership, retirement account, revocable trust ownership)

Question 52

credit unions

Answer 52

sponsor a number of financial products. Members of such institutions are provided with a convenient place to save and borrow, although membership may be restricted on the basis of employer or other association affiliation.

Question 53

investment bank

Answer 53

a securities broker-dealer that underwrites new issues. An investment bank’s functions may include the following:

1. Advising corporations on effective strategies to raise long-term capital
2. Raising capital for issuers by distributing new securities
3. Buying securities from issuers and reselling them to the public
4. Distributing large blocks of stock to the public and institutions
5. Helping issuers comply with securities laws

Question 54

brokerage company

Answer 54

an intermediary that facilitates transactions involving sales of investments or real estate. Brokers are agents that arrange trades for clients and charge commissions.

Question 55

insurance company

Answer 55

primarily engaged in the business of furnishing insurance protection to businesses and consumers.

Question 56

mutual fund company

Answer 56

pools money from shareholders and invests the funds in various types of securities (e.g., stocks, bonds, and money market instruments) according to the funds’ prospectus.

Question 57

savings and loan association (S&L) AKA a thrift institution

Answer 57

The main purpose of a savings and loan association (S&L), also called a thrift institution, is to accept savings and provide home loans. S&Ls are not permitted to provide demand deposits (e.g., checking accounts); however, they can offer interest-bearing NOW (negotiable order of withdrawal) accounts, which are similar to demand deposit accounts.

Question 58

trust company

Answer 58

Typically owned by one of three entities (i.e., an independent partnership, a bank, or a law firm), each of which specializes in managing estates and serving as the trustee for various types of trusts.