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FP511 General Financial Planning Principles, Professional Conduct, and Regulation > Module 3 > Flashcards

Flashcards in Module 3 Deck (29)
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1

Assets may be separated into the three major categories:

(1) cash and cash equivalents (or current assets), these are low-risk assets that may be readily converted to cash. Typically, the cash and cash equivalents category will include assets such as checking accounts, savings accounts, and money market funds and accounts. This category could also include short-term certificates of deposit (CDs) with a maturity date of 90 days or less.

(2) invested assets, included in this category are stocks, bonds, mutual funds, gems, gold and other precious metals, collectibles, investment real estate, fine art, ownership interests in closely held businesses, vested pension benefits, and similar assets. Longer-term CDs would also be considered invested assets.

(3) personal use assets, includes the client’s residence, automobiles, boats, recreational real estate, and personal effects such as furnishings, clothes, jewelry, and similar assets.

2

Define "pro forma cash flow statement"

a planning tool that projects the anticipated inflows and outflows for a future period. It can be prepared on a monthly, quarterly, or yearly basis. The statement projections are based on established patterns of inflows and outflows, on the client’s goals for the designated period, and on the effects of either implementing or not implementing the recommended financial plan.

3

How do you calculate consumer debt ratio and what is the acceptable limit?

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

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

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

*Net income is defined as gross income less taxes

4

How do you calculate housing cost ratio and what is the acceptable limit?

housing cost ratio = monthly housing costs / monthly gross 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.

*Gross income is income before tax

5

How do you calculate total debt ratio and what is the acceptable limit?

total debt ratio = total monthly debt / monthly gross income

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.

* In computing the total debt (back-end) ratio, it is important to use the minimum required debt payment versus the amount your client may actually be paying
*Gross income is income before tax

6

An important liquidity ratio is the current ratio. What is it and how do you calculate it?

This ratio is 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.

Unlike the other ratios, which use independent rules of thumb to help estimate a client’s current financial stability, there is no accepted standard for the current ratio. However, a higher current ratio is preferable, and a ratio of greater than 1.0 indicates that the client can pay off existing, short-term liabilities with readily available, liquid assets such as cash.

7

Another important ratio is the net-investment-assets-to-net-worth ratio. What does the mean and how do you calculate it?

This ratio compares the value of investment assets (excluding equity in a home) with net worth. In some cases, it is useful to show how well a client is advancing toward his capital accumulation goals.

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.

A client with a statement of financial position showing that this ratio is only 18% indicates that he is not progressing well in his capital accumulation goal.

8

What's the difference between non-discretionary and discretionary expenses?

Non-discretionary - Recurring or nonrecurring expense that is needed to maintain lifestyle. Examples: mortgage payments, utilities, taxes.

Discretionary - Recurring or nonrecurring expense for a nonessential item or one more expensive than necessary. Examples: vacations, club dues, entertainment, and gifts

9

Emergency Funds: When should 3 months of expenses be set aside vs. 6 months?

Three months of expenses should be set aside if your client is:
-a single wage earner and has a second source of sizable income (e.g., as a beneficiary of a trust fund, as the recipient of rental income, or as an heir who wisely invested the inherited money)
-married and both spouses are gainfully employed; or „ --married and only one spouse is gainfully employed, but a second source of considerable income is available.

Six months of expenses should be set aside if your client is:
-a single wage earner
-married and only one spouse is gainfully employed

10

Your client’s emergency fund should be kept in liquid assets. These are assets that may be quickly accessed by the client without the risk of a significant loss to principal. They typically include:

-checking accounts
-savings accounts
-money market deposit accounts
-money market mutual fund accounts
-time deposits (e.g., CDs) that are close to maturity (less than one year)

11

Your client’s emergency fund should be kept in liquid assets. These are assets that may be quickly accessed by the client without the risk of a significant loss to principal. They typically include:

-checking accounts
-savings accounts
-money market deposit accounts
-money market mutual fund accounts
-time deposits (e.g., CDs) that are close to maturity (less than one year)

12

Debt Management: What is the snowball technique?

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

13

Debt Management: What is the avalanche technique?

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. This works well for clients who feel successful when saving interest costs. However, if your client would feel more accomplished by completely paying off a debt sooner, this technique may be not be for him, especially if the debt with the highest interest rate has one of the larger balances.

14

Name the 5 categories that are weighed when determining the FICO score? Name them in order starting with the ones weighted the highest.

1.) Payment History (35%)
2.) Amounts Owed (30%)
3.) Length of Credit History (15%)
4.) New Credit (10%)
5.) Credit Mix (10%)

15

STUDY NOTE:

Regarding buying or leasing a home, the economics depend primarily on the following factors: „

Buying
■ Intends to live in an area for many years
■ Can benefit from the income tax advantages of ownership
■ Wants to improve the appearance or structure of the residence

Leasing
■ Does not have the funds for a down payment
■ Has a temporary housing need (e.g., moving to a new city for a job change and does not know the duration of the job)
■ Expects housing needs to change substantially in the foreseeable future and does not now own a home
■ Is looking for a job or changing careers, which would likely require a move within a few years

16

STUDY NOTE:

Regarding buying or leasing a vehicle, the economics depend primarily on the following factors: „

Buying
■ Keeps an auto for many years
■ Drives well over 15,000 miles per year
■ Wants to discontinue payments eventually

Leasing
■ Wants to have a new auto every two to four years
■ Does not have the funds for the 20% or more down payment
■ Will not drive the auto more than 12,000–15,000 miles per year
■ Uses the auto for business
■ Needs a lower monthly auto payment and is willing to give up ownership for the lower payment

17

Describe Federal Housing Administration (FHA) mortgage loans.

The federal government guarantees Federal Housing Administration (FHA) mortgage loans through various FHA programs. 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.

18

What is mortgage insurance?

a policy that protects lenders against losses that result from defaults on home mortgages. FHA requirements include mortgage insurance primarily for borrowers making a down payment of less than 20%.

19

Describe Veterans Administration (VA) loans

Veterans Administration (VA) loans feature the same federal guarantee of repayment as that for FHA mortgages, but VA mortgages are for service members and veterans of the U.S. armed services, their spouses, and other eligible beneficiaries. An even more favorable attribute of the VA mortgage is that, in certain cases, no initial down payment is required; in other words, the entire purchase price can be borrowed. In addition, no mortgage insurance is required.

20

Describe the following:

-Conventional Mortgage / conforming loans
- Jumbo loans / nonconforming loans

Conventional mortgage loans are those made by commercial lenders in the private sector. These may also be called conforming loans, because they conform to Fannie Mae and Freddie Mac dollar limit requirements. For example, in 2019, a single-family home might have a conforming loan limit of $484,350 (amounts are higher in Alaska, Hawaii, and other areas).

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. Loans for those with damaged credit may also be considered nonconforming.

21

What is an interest only mortgage?

With an interest-only mortgage, 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. If the value of the home declines from its original purchase price, homeowners may find themselves in a cash-deficit position at the time of the subsequent resale. Therefore, by their very nature, interest-only mortgages should be executed only by relatively risk-aggressive homeowners.

22

What is a balloon mortgage?

A balloon mortgage is 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. The payments with some loans may be limited to interest only.

A balloon mortgage works well for clients purchasing homes during high interest rate periods who want to refinance when rates drop. It also works well for those with enough invested assets to finance the house without borrowing, or those who have access to family loans when the period ends and rates have not dropped.

23

What is a graduated payment mortgage?

A graduated payment mortgage is 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.

This type of mortgage may be appropriate for people who anticipate increases in income with some certainty, enabling them to afford a higher payment in the future than they can currently afford. However, clients should use caution when considering a graduated payment mortgage because of several disadvantages, including:
„
-higher payments during the second period of the loan than if the loan had been a standard fixed rate,
„-higher interest costs, and „
-negative equity accumulation in the early years of the loan because the payments during that period typically are not sufficient to pay the interest due (often called negative, or reverse, amortization, because the amount of the loan is increasing).

24

Describe a reverse mortgage.

Reverse mortgages are a 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. The lender makes payments to the homeowner on the basis of the fair market value of the home and the age of the borrower at the time the loan is made. Loans are available to borrowers who are age 62 or older with a residence that is largely free from indebtedness (with the required percentage owned based on the homeowner’s age). The homeowner retains title to the home but incurs an increasing amount of debt with each payment from the lender. Once the homeowner no longer occupies the property (e.g., at death or going into a nursing home), the debt must be repaid to the lender, usually by selling the home. However, one important consideration of lowered risk with a reverse mortgage is that it is a non-recourse loan, meaning that the homeowner, or the homeowner’s heir(s), will never have to pay back more than the value of the home; the amount in the end is never negative.

25

Which of the following statements regarding home equity lines of credit (HELOCs) is CORRECT?
I. Borrowers repay the loan with equal monthly payments over a fixed term.
II. Clients are given a set amount of credit from which they can draw from as funds are needed.
III. Borrowers make payments only on the amount they actually borrow, not the full amount available.
IV. HELOCs use the current equity in the homeowner’s primary residence to provide money for home improvements and other

II, III, & IV

The answer is II, III, and IV. With a home equity loan, not a HELOC, borrowers repay the loan with equal monthly payments over a fixed term. Clients who secure home equity loans receive a lump sum in the
amount of the loan. A HELOC gives clients a specified amount of credit from which they can draw from as funds are needed.

26

Which of the following actions would be appropriate for a homeowner who has a goal to retire debt and reduce the amount of total interest due over the life of his mortgage loan?
I. Replace a 30-year fixed-rate loan with a 15-year fixed-rate loan.
II. Replace a 15-year fixed-rate loan with a 30-year fixed-rate loan.
III. Replace a fixed-rate loan with a lower interest fixed-rate loan of the same term.

I & III

The answer is I and III. Replacing a 15-year fixed-rate loan with a 30-year fixed-rate loan will lower the homeowner’s monthly payment but will significantly add to the total amount of interest due over the life of the loan. In addition, this option will double the period over which the repayment of principal will occur.

27

Which of the following actions would be appropriate for a homeowner who has a goal to retire debt and reduce the amount of total interest due over the life of his mortgage loan?
I. Replace a 30-year fixed-rate loan with a 15-year fixed-rate loan.
II. Replace a 15-year fixed-rate loan with a 30-year fixed-rate loan.
III. Replace a fixed-rate loan with a lower interest fixed-rate loan of the same term.

I & III

The answer is I and III. Replacing a 15-year fixed-rate loan with a 30-year fixed-rate loan will lower the homeowner’s monthly payment but will significantly add to the total amount of interest due over the life of the loan. In addition, this option will double the period over which the repayment of principal will occur.

28

Which of the following are tax implications of owning a personal residence?

I. The points paid are tax deductible for the buyer.
II. Mortgage interest is generally tax deductible for the buyer.
III. Capital gains may be nontaxable within specific limits.
IV. Homeowners may depreciate their personal residence.

I, II, III

The answer is I, II, and III. Although I, II, and III are tax implications of home ownership, exceptions and restrictions apply to these benefits. A taxpayer of any age can exclude $250,000 of gain ($500,000 for joint filers) from the sale of a home owned and used by the taxpayer as a principal residence for at least two of the five years immediately preceding the sale. Generally, an individual cannot claim depreciation on a personal residence.

29

William is in the market for a new automobile. He is weighing the choice between leasing and buying. Which of the following are reasons he should consider leasing rather than buying?

I. Drives fewer than 15,000 miles per year
II. Uses the car mostly for business purposes
III. Keeps a car for five years or longer

I & II