Lecture 3-Debt,Savings and budgeting

Question 1

What is debt?

Answer 1

-a liability and refers to the amounts or stocks of money owed at a particular point in time

Question 2

What is personal debt?

Answer 2

• Personal debt has become part of everyday life in the UK.

- Anyone who has a mortgage, credit card or loan contributes to the ‘personal debt

Question 3

Debt in the UK in 2016 and projected in 2020

Answer 3

-Debt in the UK was estimated to total more than £1.46 trillion in January 2016. It is predicted to increase by 55% to £2.639 trillion by 2020.

Question 4

Debt and the financial crisis 2007

Answer 4

Global crisis began in 2007 (credit crunch)

• Banks found it difficult to raise funds from the financial markets to support their lending business
• Concerns about solvency of banks
• Lehman Brothers collapsed in 2008 resulting in many governments bailing out banks
• In UK Government bailed out Halifax Bank of Scotland (HBOS)

Question 5

The impact the credit crunch had on banks

Answer 5

• Banks decided to cut down the amount of lending resulting in personal and business customers finding it difficult to obtain loans
• Slowed down the amount of personal debt between 2007-2009
• Loss in economic confidence impacts on individuals undertaking new/additional debt

Question 6

Poor households and debt

Answer 6

-Formal financial institutions may not lend money to the people with poor or no collateral, poor credit history or unstable source of income.

-Thus people from poor or low income households remain unable to access mainstream credit.
These households turn to payday or mail order loans for financing their needs.

-These loans are high cost short term debts and borrowers often find it difficult to pay back.

Question 7

What are the 2 categories of debt?

Answer 7

• Good debts

- Bad debts

Question 8

What are good debts?

Answer 8

• you borrow money for buying/investing in an asset that will either generate a source of income for you or will appreciate in value over time, thus increasing your wealth in long run
• Home improvement loans allow for an increase in value of house after sale making it more desirable
• Student loans as they allow for education which allows access to opportunities.

Question 9

Problem with Investing in just property

Answer 9

-Change in neighbourhood or subsidence can lead to decrease in prices

Question 10

What are bad debts?

Answer 10

-Money borrowed for financing spending or to acquire disposable items or durable goods that lose value over time. These will include loans for financing holiday, or to buy clothing, furniture, presents, entertainment etc.

Question 11

The negative impact of bad debts

Answer 11

-Bad debt not only has financial but also emotional consequences. Research shows that more than eight out of ten people with debt problems say that their financial difficulties are affecting their personal relationships, suffering a nervous breakdown, loss of hair and other health problems.

Those facing debt problems are twice as likely to think about suicide, and often feel humiliated, disconnected and entrapped.

These combined with the process of debt collection (persistent phone calls and threatening letters) make them feel depressed and suicidal.

Question 12

What factors have led to increased consumer debt?

Answer 12

• Over-confidence bias

- Lack of self-control

Question 13

How has over-confidence bias led to increased consumer debt?

Answer 13

People take out more debt because they feel more confident about the future and therefore are more willing to spend. There are reasons for this consumer confidence: improving employment rates, prices at petrol pumps and supermarket checkouts have ben low, interest rates, and low cost of debt.

However, over-confidence makes people underestimate their risks. By taking more risk they make themselves vulnerable to debt-problems

Question 14

Lack of self-control as a reason for increased consumer debt?

Answer 14

• Many people lack self control when it comes to spending money. And consumers spend more today at the expense of saving for tomorrow. UK society is consumer society and people believe in ‘buy now and pay later’.
• This culture is incompatible with wealth accumulation. People who have good self-control can regulate their emotions and feel more confident and self-assured. They can overcome negative outcomes.

Question 15

What are the 2 main types of debt?

Answer 15

• Unsecured debt

- Secured debt

Question 16

What are unsecured debts?

Answer 16

-is a debt not secured against any asset. It includes overdrafts, credit cards, charge cards, and personal loans and is more expensive compared to secured debt. Lender compensates for a higher risk by charging a higher rate of interest.

Question 17

What are secured debts?

Answer 17

is a debt secured against an asset. It is a cheaper form of lending because the lender has more security. If the borrower does not pay the loan back, the lender can repossess the collateral and sell it to get the money back. A mortgage loan is an example of a secured debt.

Question 18

The different ways that lenders calculate interest

Answer 18

Lenders have different ways in calculating interest
Daily, monthly, annually

The average balance of the principle sum during year
Average of the balance at the start and at end of year

The compound Interest
Interest payments accumulate and added to the original amount

Question 19

What is the annual percentage rate?

Answer 19

is the true rate of interest calculated on a yearly basis including all fees and costs. It is in effect the real cost of credit. It is a summary figure for comparing debt costs incorporating interest and other charges (lower APR lower costs for borrower)

Question 20

Credit referencing and scoring

Answer 20

Holding a good credit record is essential because it means you will be able to access prime lending rates and pay a lower interest rate.
A credit record is a history of a borrower’s past borrowing and repayments including information about late payments and bankruptcy.

Credit record is checked when a borrower opens a bank account, applies for a credit card, loan or a mortgage.

Most lenders give information to three main credit reference agencies in the UK: Experian, Equifax and Call Credit. These agencies keep a record of borrower’s credit history.

Question 21

4 sources where credit reference agencies keep record of information

Answer 21

Publically available: electoral roll

Closed user group: lenders who choose to share information about what credit has been taken out and how good the borrower is at repayment

Court data on court judgements; i.e. bankruptcies and so on

Search information: every time a consumer applies for credit, a search record for credit history is created. This is called ‘footprint’ A lot of footprints in a short space of time may suggest that either a person is borrowing too much or is a victim of fraud.

Question 22

Credit score ratings

Answer 22

• 961-999 excellent=Should get the best credit cards, loans and mortgages
• 881-906 Good=Get most credit cards, loans and mortgages, but the best may reject
• 721-880 fair=You might get ok interest rates but your credit limits limited
• 561-720 Poor=You might get accepted for credit cards, loans and mortgages but they may be at a higher interest rate
• 0-560 very poor=Most likely be rejected for most credit cards, loans and mortgages that are available.

Question 23

How are credit scores used for mortgages, credit cards etc.

Answer 23

When a borrower applies for loan, many lenders will use credit scoring for determining consumer’s profile.

Lenders use credit scoring system for this purpose.

Credit reference agencies also provide indicative scores for the borrowers based on their record held by the agency.

Question 24

Why is it important to be on the electoral roll?

Answer 24

-it allows any interested party to confirm that you are who you say you are and that the details you have provided are accurate.

Question 25

Easy to do factors that affect credit scoring

Answer 25

• Being on the electoral roll
• Not too many credit account
• Total credit balance=Do not let it go too high
• Highest card limit, the higher the better.

Question 26

Easy to avoid factors that affect credit score

Answer 26

• Late payment even by a few days can decrease your score
• Applying for credit=every application you make can decrease your score
• Maxed-out cards spending up to your credit limits decreases your score

Question 27

Harder to fix factors that affect your credit score

Answer 27

• Defaulted accounts
• Count court judgements
• Individual voluntary arrangements (IVAs)=Agree to pay amount over a set time which is agreed by creditors. Insolvency
• Bankruptcies and insolvencies

Question 28

Why do people borrow money?

Answer 28

To be able to drive
To pay for education
To buy a house
Home improvements
For their children
For Christmas
Widen monthly budget
To save face from family and friends

Question 29

What does budgeting involve

Answer 29

• This involves making a cash flow statement to see where your money is coming from and where do you spend it.
• The cash flow statement lists all your incomes and expenditures and will help you determine whether you are living within your means or are over spending.

Question 30

3 steps of budgeting

Answer 30

• Check your income
• Control your expenses
• Increase income

Question 31

Check your income as a component of budgeting

Answer 31

• The first step is to calculate your net income, that is, income after all taxes and deductions.
• All additional income, e.g. rental income, interest/dividend income, benefits etc should be included

Question 32

Control expenses a component of budgeting

Answer 32

-List all expenses and decide what you need and what you want

Fixed expenses: occur every month and the amount usually does not vary and include rent/mortgage, car payments and childcare.

Variable Expenses: also occur monthly but the amount may vary month to month. These include food expenses, utilities, petrol, household expenses and credit card payments.

Periodic expenses: can be seen as those which occur on a regular basis but not monthly basis. These should include car insurance, medical expenses, home or car maintenance and memberships.

Discretionary expenses: are seen as luxuries that can be sacrificed. These include vacations, gifts, subscriptions, entertainment, eating out and treats.

Question 33

Difference between a cash flow statement and a budget

Answer 33

• A cash flow statement gives an indication of any surplus or deficit in income.
• A Budget is a plan to decrease deficit or increase surplus. Expenses can be reduced by moving to a less costly accommodation, reducing food expenditure, reducing expenses on entertainment etc

Question 34

Jars system as a way of budgeting

Answer 34

• Six actual physical jars are bought and are labelled as necessities, financial freedom account, long term savings and spending, Give (charity), education and play.
• The largest amount is allocated to necessaries (50%) while the rest of the jars receive 10% each. Individual puts their salary in these jars in the beginning of the month.

Question 35

Increasing income in budgeting

Answer 35

Besides reducing expenses, various ways could be found to increase income.

Renting our driving space: monetise personally owned assets by for example renting a car, and renting out driving space. There are a number of companies that offer such services, all searchable online.

Rent a furnished room: in your home to a lodger and receive rental income tax free (up to a limit). Alternatively make bookings from Airbnb. Etc.

Get a part-time job: to supplement income
Work overtime on your current job

Create a part-time business: for example online freelance work etc.

Increase marketability by becoming better educated:
Graduates during their working lives earn approximately 20% more than non-graduates on average. If they have a masters, a PhD and/or further professional qualifications these all increase their market value to an employer.

Making oneself indispensable in a job: by always doing more than is expected eventually such people will be paid more for doing less.

Question 36

What is a saving?

Answer 36

• Is the flow of money in a particular time

- An excess of income over spending

Question 37

What are savings?

Answer 37

The current value of the total accumulated sum of previous saving

A proportion of money not spent on consumption

Accumulation of a stock of money

Question 38

9 reasons why saving is important

Answer 38

Uncertainty: To build an emergency fund

Anticipated changes in income/expenditure: For example, to finance growing children’s education.

Time preference: To enjoy interest and appreciation in value of savings

Improved living standards: To enjoy a better standard of living in later life

Independence: Savings prevent depending on others in future.

Investment: To make investments, e.g., starting a new business

Create Estate: To leave inheritance for children.

Preference for Frugality: Some people are miser.

To finance a later expense: For example, buying a house, car etc.

Question 39

6 factors affecting savings

Answer 39

• Demography
• The welfare state
• Retirement behaviour
• Constraints on borrowing
• Income uncertainty
• Changes in wealth

Question 40

Demography as a factor affecting savings

Answer 40

The age structure of the population (proportion of working and non-working population) will influence saving rate. It is expected that people save more when they are working and less when they do not work. In countries with a higher working population, a higher rate of savings is expected

Question 41

The welfare state as a factor affecting savings

Answer 41

-: If the welfare system is generous and looks after people when they are old, sick and unemployed, then saving will be lower as people feel less need to save as they have a buffer. In countries where there is no provision of health care or income, people will face much uncertainty and will save more.

Question 42

Retirement behaviour as a factor affecting savings

Answer 42

-Savings will be influenced when people retire and whether they expect to work beyond retirement age

Question 43

Constraints on borrowing as a factor affecting savings

Answer 43

-Savings will be affected by the ease of borrowing. In countries where it is difficult to borrow money, savings rates are expected to be high, and saving will be lower where access to credit is easy.

Question 44

Income uncertainty as a factor affecting wealth

Answer 44

-When people face income uncertainty they will save more to protect themselves against the unexpected and so saving will increase.

Question 45

How changes in wealth affect savings?

Answer 45

-changes in consumers’ wealth also affect the rate of savings. When people’s wealth increases as a result of gains on property and investments, they will feel richer and more confident so they will save less. Conversely, they will save more if they feel less wealthy

Question 46

Compounding as a way of saving?

Answer 46

• When we invest money we receive interest on the original amount that we invest (principal amount).
• If we choose the keep money in savings account then the money would earn interest along with the interest paid on the principal
• It is important concept to understand because it shows the importance of investing money early and power of reinvesting the interest received.