CHAPTER 4 FUNDAMENTALS OF PERSONAL FINANCIAL PLANNING

LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

  Identify the assumptions in the personal financial planning (PFP) process.

  Analyze a personal statement of financial position (PSFP).

  Apply the financial ratios to an individual’s spending plan.

  Differentiate between the various types of mortgages and make recommendations based on the client’s facts and circumstances.

  Identify the various consumer protection laws.

Introduction

Personal financial planning is about more than simply adhering to the Statement of Standards in Personal Financial Planning Services (SSPFPS) No. 1 (the standard) and performing time value of money calculations. Those are certainly key elements of personal financial planning, but in this chapter we turn our attention to a bit more of the human touch in the process.

At its heart, personal financial planning is all about connecting with clients. You need an ability to understand their wants and needs, often better than they themselves do. When clients walk into your office, they need help. They don’t always know how to ask, or what kind of help they need, so it’s your role as a financial planner to listen, to understand, and to assess—and then to offer up solutions.

How do you do it? Arming yourself with a knowledge of the standard and various calculations is a good foundation. But there are other tools and processes that can further your abilities.

You have to start by acknowledging a number of assumptions involved in the PFP process—both those of your clients and those you have to make based on factors such as inflation, tax rate, and rate of return. From there you can move on to creating a statement of financial position and a spending plan. Doing so will require a strong understanding of financial strategies and various consumer protections.

Let’s explore these topics to see how they help you meet your clients’ needs.

Personal Financial Planning Assumptions

Understanding financial planning assumptions and how they interact is a core piece of personal financial planning. SSPFPS No. 1 makes several recommendations about how to approach these assumptions:

When analyzing information obtained while performing a PFP engagement, the member should:

a. evaluate the reasonableness of estimates and assumptions that are significant to the plan;

b. use assumptions that are appropriate and consistent with each other;

c. consider the interrelationship of various PFP activities (Ref: par. .03).¹

Let’s look at the types of assumptions addressed in the PFP process: client assumptions, inflation, rates of return, longevity, and tax rates.

•Client assumptions about goals need to be analyzed to understand whether the goals are reasonable, or unreasonable and unattainable.

•Inflation assumptions about the overall inflation rate are taken into consideration by determining which inflation indices to use. The historical time period to be used for the indices also needs to be considered. Two examples of indices computed by the Bureau of Labor Statistics are the consumer price index (CPI) and the CPI –U. The CPI is the broadest statistical measure of the change in the prices of a specific set of products for the U.S. population as a whole. The CPI-U measures the change in prices for urban consumers which represents 80 percent of the U.S. population. Generally, the inflation rate for the service sector of the economy exceeds both the CPI and the CPI-U. Individuals who are retired tend to be older and are more heavily dependent on the service sector of the economy. The personal financial planner should take the higher service sector inflation rate into account as they develop models for financial independence.

•Rate of return assumptions for the plan’s investment are made based on client input, as well as historic returns for a specific asset class or index. Additionally, the client’s individual responses to a risk assessment tool are taken into account in determining rate of return.

•Longevity assumptions are critical to the PFP process. Many of the planning assumptions can be reworked or tinkered with as situations change; however, living longer than expected obviously cannot be. If longevity assumptions are too short and the client lives longer than assumed, there will not be sufficient funds available to maintain the client’s standard of living.

•Tax rate assumptions are problematic for several reasons. First, consumers have been told their tax rates at retirement will be lower than those of their working years; in practice, the authors have found this statement to be false. Second, tax rates can have as much impact on a retirement portfolio as investment returns. Third, tax rates are jurisdictionally dependent and vary widely between states.

Aspects of financial planning assumptions will come up throughout this book.

SSPFPS No. 1 mandates that the planner discuss and document assumptions to the client file. This includes the assumptions used in the client’s plan, as well as the impact the assumptions have on the plan. Paragraph .35 of the standard says:

The member should communicate to the client the assumptions and estimates that are significant to the recommendations. This should be documented and include the following:

1. A summary of the client’s goals

2. Significant assumptions

3. Estimates

4. Recommendations

5. A description of limitations on the work performed

6. The recommendations in the engagement should contain qualifications to the recommendations if the effects of certain planning areas on the client’s overall financial picture were not considered

The following example shows the role an assumption can play in a client’s plan.

EXAMPLE

Personal Statement of Financial Position

Once you are comfortable with the assumptions at play in the personal financial planning process, you can create a personal statement of financial position (PSFP). The PSFP is also known as a balance sheet or a statement of financial position. It illustrates an individual’s assets, liabilities and net worth on a specific date. The PSFP is a snapshot of an individual’s financial condition at a given moment in time.

Assets appear first on the PSFP and are listed in order of liquidity, beginning with cash and cash equivalents. Listed next are investment assets. Investment assets are assets that can be liquidated quickly, if necessary, such as mutual funds or stock shares. The last category of assets are use assets. These are assets that would take time to liquidate, such as real estate, or ownership in a closely held business. Listed alongside each asset is the estimated value of that asset. The values of each asset are then added up for the total assets figure.

Liabilities appear second on the PSFP, with the individual liabilities appearing in the order in which they come due. Current liabilities are due within one year and are listed first. The next category of liabilities are noncurrent liabilities. Noncurrent liabilities have due dates of more than one year. As was the case with assets, listed alongside each liability is its estimated value. The value of each liability is totaled to determine total liabilities. Total liabilities are then subtracted from total assets to determine an individual’s net worth. See table 4-1 for examples of assets and liabilities that would be found on a PSFP.

TABLE 4-1	PERSONAL STATEMENT OF FINANCIAL POSITION ASSETS AND LIABILITIES

	CASH/CASH EQUIVALENTS	INVESTMENTS	USE ASSETS
Examples of Assets	Cash	Life insurance cash values	Residence
	Checking accounts	Qualified plans	Personal property
	Money market deposit account	Real estate (investment purpose)	Collectibles (personal use)
	Money market mutual fund	Collectibles (investment purpose)	Second home
	Savings accounts	Variable and fixed annuities	Automobiles
	CDs close to maturity	IRAs	Closely held business interest
	Laddered CDs	Mutual funds
		Individual securities
	CURRENT LIABILITIES	NONCURRENT LIABILITIES
Examples of Liabilities	Income tax payable	Automobile loan
	Credit card balance	Mortgage

The PSFP is an essential component of personal financial planning because it helps monitor a client’s progress. It informs the planner as to whether the client’s net worth is increasing, decreasing, or staying the same. It may be presumed that increasing is good, and decreasing or no change is bad; however, there are occasions when clients may need to go deep into their reserves in order to accomplish a specific financial goal. The result will be a temporary decrease in net worth, with an ultimate increase at a specific point in the future. The PSFP monitors the plan during the interim. Without a PSFP, it is difficult to help an individual achieve his or her financial goals and objectives.

Putting all of this together, exhibit 4-1 illustrates what a fictional client’s PSPF would look like.

EXHIBIT 4-1	STATEMENT OF FINANCIAL POSITION

Spending Plan

Our next discussion topic is the creation of a spending plan, also referred to as a budget or an income statement. Whereas a PSFP provides a picture of a client’s financial condition at a specific moment, a spending plan provides a picture, or at least an estimate, of the client’s cash flow within a given time frame, typically a calendar year. It estimates the amount of cash receipts to be received (income) and dispersed (expenses) within that time frame. An obstacle to the creation of a spending plan—a tool for financial self-evaluation—is the inherent dislike individuals have for maintaining detailed records of income and expense, but a personal financial plan cannot be created without a spending plan.

The spending plan will reveal whether the client’s spending is in alignment with established financial ratios and whether there is a deficit or surplus of income. It may be used as a tool to identify areas of opportunity to leverage current cash flow in order to attain financial objectives; to provide controls over household expenses; and to measure progress toward the achievement of specific goals, such as financial independence and education funding.

The following are the steps to creating a spending plan.

1. Project annual income and expenses

2. Categorize expenses: fixed, variable, discretionary, tax

3. Calculate expenses as a percentage of gross income

4. Analyze financial ratios

5. Assess methods to increase income or decrease expenses

6. Reconsider current allocation of resources

Let’s take a closer look at ‘categorizing expenses,’ the second step in creating a spending plan, as shown in table 4-2.

TABLE 4-2	CATEGORIZING EXPENSES

EXAMPLES OF FIXED EXPENSES	EXAMPLES OF VARIABLE EXPENSES	EXAMPLES OF DISCRETIONARY EXPENSES	EXAMPLES OF TAX EXPENSES
Automobile payments	Automobile maintenance	Clothing	FICA taxes
Credit cards (minimum payment due)	Charity	Entertainment	Income taxes (federal, local and state)
Housing (mortgage or rent payments)	Contingency (10 percent of gross income for the unanticipated and unexpected)	Gifts given	Self-employment taxes
Insurance premiums	Food	Vacation
Property tax	Home maintenance
	Utilities

What does it look like when you put these categories and their values together? Exhibit 4-2 provides an example of the spending plan as it comes together.

EXHIBIT 4-2	SPENDING PLAN

The third step of creating a spending plan involves calculating expenses as a percentage of gross income. Gross income is income before taxes and other payroll deductions. Table 4-3 presents a few examples of what constitutes gross income.

TABLE 4-3	GROSS INCOME

EXAMPLES OF GROSS INCOME
Employment (salary/wages)
Investment income received (capital gains, dividends, interest, rent received)
Employer contributions to benefit plans
Alimony
Child support
Gifts received

The next section delves into the fourth step in creating a spending plan, analyzing financial ratios.

Financial Ratios

Financial ratios are used by banks, credit ratings agencies, landlords, and other lenders to evaluate a prospective borrower’s suitability for a home mortgage or other type of credit. These ratios are used in creating a spending plan to explore the client’s credit options and how those options might fit into an overall personal financial plan. There are three primary financial ratios: debt-to-income ratio, PITI ratio, and savings ratio.

DEBT-TO-INCOME RATIO

The debt-to-income ratio, also known as the total debt ratio and back-end ratio, is the ratio of all monthly debt payments divided by gross monthly income (recall gross income as income before taxes and payroll deductions). Lenders use the debt-to-income ratio as a way to measure a borrower’s ability to manage payments and repay money borrowed.

EXAMPLE

PITI RATIO

The PITI ratio, or front-end ratio, is the ratio of specific monthly housing costs divided by gross monthly income. Specific housing costs for the PITI ratio are: Principal, Interest, Taxes (property) and Insurance. Lenders for home loans or owners of apartments consider an applicant’s PITI ratio in their decision-making process regarding the granting of credit for a mortgage or an apartment lease. If applicable, homeowners’ association (HOA) fees and private mortgage insurance (PMI) also are considered.

EXAMPLE

Lenders have different standards with regards to an acceptable PITI ratio, although the range is generally 28 percent to 35 percent of gross income. Obviously, the lower the percentage, the greater the likelihood of securing a mortgage with a favorable interest rate.

SAVINGS RATIO

Determining an ideal level of savings is complicated and is fact specific for each PFP client. The savings ratio will depend on employment stability, budget constraints, taxes, and so on. The savings ratio is the sum of gross income less cash outflows divided by gross income. Ideally, a family should save 10 percent of gross income as a bare minimum.

MINI CASE STUDY

Josh Armstrong, 38, is single and has never been married. He owns his own company and works as a computer programmer. His income from the business is $36,000 per year. He purchased his home 13 months ago, and the current fair market value for the residence is $90,000. He has the property insured for $75,000.

Josh’s mortgage payment (principal and interest) is $576. The current principal owed on the home is $69,187. The value of his tangible personal property, which includes home furnishings, is $27,000. He owns a pickup truck, his pride and joy, with a current appraised value—which he checks frequently—of $5,100. He has no debt on his pickup truck.

He banks at the local credit union and has a checking account balance of $2,700. His rainy day fund is $5,000, which is invested in a 36-month COD. The interest earnings are paid out in cash. Last year’s annual earnings from the credit union was $120. He is invested in an S&P 500 mutual fund with a current value of $26,000. Last year, he received annual distributions of $880 (dividends and capital gains). He also owns an intermediate-term bond with a current value of $5,000. His annual coupons are $237 in cash dividends this year.

Josh has a simplified employee pension for his business and the current value is $25,000. He has credit card debt of $250. He has a credit life insurance policy with a $72,000 death benefit. He has a homeowner’s insurance policy with an annual premium of $422. The insurance for the pickup truck is $620 per year.

Exhibit 4-3 shows Josh’s annual expenses:

EXHIBIT 4-3	ANNUAL EXPENSES

First, construct a statement of financial position for Josh. Use exhibit 4-4 as a starting point and fill in the blanks based on the information provided.

EXHIBIT 4-4	STARTING POINT—STATEMENT OF FINANCIAL POSITION

Now let’s construct a spending plan for Josh. Use exhibit 4-5 as a starting point, again filling in the blanks based on the information provided.

EXHIBIT 4-5	STARTING POINT—SPENDING PLAN

Emergency Fund

You should have noticed in the preceding mini case study that Josh Armstrong maintained a “rainy day fund.” You’ve likely heard the term before, but what does it mean? A rainy day fund is simply what financial planners call an emergency fund or emergency reserve. It can be used to meet unexpected expenses and is always a personal financial planning recommendation. The unanticipated and the unexpected emergency may include: disability, medical expenses, uninsured/underinsured property losses and unemployment. The recommended reserve for an emergency fund is usually expressed in terms of monthly fixed and variable expenses. The presumption is that in the event of unemployment, income taxes are no longer paid and discretionary spending is eliminated.

The determination of the number of months of fixed and variable expenses that an individual should have on hand is more of an art than a science, and a variety of factors affect the planning recommendation. Typically a sum equal to three to six months of fixed and variable expenses is recommended for the emergency reserve account. Three months is recommended if the PFP client is married and both spouses work for separate employers; or for the single client who has a second source of significant income (alimony, child support, employment, investments). Six months is recommended if the client is single with only one employer, or married and only one spouse is employed outside the home.

The emergency fund should not be invested and should be held in cash or cash equivalents, such as certificates of deposit with maturities of less than 90 days, money market demand accounts, and savings accounts.

Financing Strategies

It doesn’t matter how big a client’s bank account is or how much of an emergency fund is maintained—chances are your clients will have debt. Debt is ubiquitous. Appliances and automobiles are purchased on credit, as are homes. Businesses and governments are run on credit. Most consumers have some type of debt. Yet credit has a bad reputation. Why is this the case?

Debt is not bad, per se; it is the abuse or misuse of debt that has created the stigma associated it. The strategic use of debt can be a useful tool in financial planning. For example, let’s say your client wants to buy a car. Should he pay for it in cash or buy it on credit? If the assumed rate of return used in the personal financial plan is 7 percent and the client has access to credit in the form of a car loan at 3 percent, than a prudent personal financial planning recommendation would be to use the car loan and invest his cash instead. The client is then able to realize a 4 percent profit on the spread.

Debt may be either long term (mortgage) or short term (credit cards and automobile loans). Consumer debt is typically considered short-term debt; all other debt is categorized as long-term debt. Debt may also be secured or unsecured. Unsecured debt (credit card) tends to have a higher interest rate associated with it because there is greater risk to the lender. Secured debt, also called collateralized debt, carries a lower interest rate because the borrower has pledged an asset, such as an automobile or a residence, to repay the loan in the event of a default.

We used automobiles and residences as examples of pledged assets, mainly because they are two of the most common types of pledged assets. Transportation and housing are such basic needs that they come up again and again in financial planning, so they deserve some extra attention here, particularly in terms of the decision to buy or lease/rent.

AUTOMOBILE: PURCHASE OR LEASE

We used the example of purchasing a car in the preceding introduction to debt. Purchasing, of course, is not the only option. The decision to purchase or lease an automobile is fact specific in each PFP engagement. Automobile ownership may or may not be the most cost-effective solution. In addition to quantitative factors (can the automobile be purchased financially), there are qualitative factors as well. Qualitative factors may include whether the individual is mechanically inclined, whether public transportation is more practical and how many miles are anticipated to be driven each year.

If the decision is made to lease an automobile, there are two types of leases to consider: closed end and open end. In a closed-end lease, the vehicle is returned at the end of the lease and the lessee’s obligation to the lessor ends. Another name for a closed-end lease is a walk-away lease. The open-end lease involves an additional step for the lessee. At the end of the lease period, if the vehicle is worth less than had been originally estimated (residual value), the lessee pays the difference between the now current market value and the residual value. An open-end lease is typically a commercial lease.

Generally speaking, automobile ownership has higher upfront costs, but at some point in time (36, 48, 60 months) the vehicle is owned and the costs decrease. Leasing a vehicle has lower initial costs; however, the costs are ongoing because of the lack of ownership. At the end of a lease, a new lease will need to be started, and so on. Additionally, a leased automobile will only add debt to a personal statement of financial position, whereas a vehicle that is purchased will add an asset to a PSFP, albeit subject to depreciation.

HOME: PURCHASE OR RENT

Unlike an automobile, homes tend to be an appreciating asset—their value increases over time rather than decreasing. Also, the federal government subsidizes home ownership through income tax incentives. It would appear that the financial cards are stacked in favor of home ownership. However, a word to the wise: Unless your client is able to buy a home with cash (a rarity), he or she will need a mortgage, and “mortgage” is a French word meaning “death pledge,” or payable until death.

The alternative to a mortgage is either renting or attaining a long-term lease. Home ownership is not appropriate in several instances. First, when your client plans to stay in a location less than five years, purchasing is not a financially prudent decision. Even in an up-market, there is not a sufficient amount of time to overcome closing costs (the costs of securing a loan and making the home purchase) and interest charges on the mortgage. The second instance when it is not prudent to purchase is when an individual’s financial reserves are limited. Home ownership brings with it unexpected and unanticipated events: water heaters and air conditioners breaking down, storm damage, and general upkeep, to name a few. Merely being able to afford the mortgage payment is not enough reason to purchase a home. The potential home buyer must not only be able to make the mortgage payments, but must be able to maintain the home, as well. These annual costs are usually quantified as 2 percent to 3 percent of the home’s value. There’s also the time commitment of maintenance to consider. A third instance in which home ownership is inadvisable—and which is critical to lenders—concerns employment history. A potential home buyer who has been with an employer for less than two years presents an economic risk to the lender.

There are, of course, a number of advantages to buying a home versus renting. For example, home owners can deduct mortgage interest payments on their income taxes. In most circumstances, the higher the marginal tax bracket for an individual, the greater the tax advantage in owning a home.

Mortgage Financing

If a purchase is the correct decision for your client, you then need to help determine exactly what type of mortgage works best. There are two types of interest structures associated with a home mortgage: fixed or adjustable.

Fixed interest rates are locked and remain the same for the term of the repayment period. The principal (the main sum of money borrowed) and the interest payments do not change during the term of the mortgage. These types of mortgages are typically 15 or 30 years in length. Fixed interest rates tend to be higher than adjustable-rate mortgages because the interest rate risk (the risk that interest rates will rise or fall during the life of the loan) is borne by the lender. The idea behind interest rate risk is that there is a risk of losing money as interest rates change. For example, if a buyer gets a fixed-rate mortgage at 4.5 percent interest, that buyer would effectively be losing money if interest rates then dropped to 3.5 percent. Conversely, the lender would be losing money if interest rates rose to 5.5 percent.

An adjustable-rate mortgage (ARM), also known as variable-rate mortgage or floating-rate mortgage, allows for adjustments of the loan interest rate at pre-specified regular intervals.

Adjustable interest rates fluctuate with interest rates in the overall economy. As interest rates vary, the adjustable interest rate and principal payments change. However, there are no limits as to how frequently the rates may change or how high they may become. Adjustable-rate mortgages generally carry a lower initial interest rate than fixed mortgages because the interest rate risk is borne by the borrower. The following are components of an adjustable-rate mortgage:

•Initial rate is the initial interest rate charged on an ARM for a specified period of time, which may be anywhere from three months to 10 years. The shorter the initial rate period, the lower the initial rate is because more of the interest rate risk is shifted to the borrower.

•Interest rate index is an index used to calculate the interest rate for an ARM, independent of the lender. As the index rises or falls, the interest rate for the ARM also rises and falls. Some common indexes include the interest rates for the 6- or 12-month U.S. Treasury securities or the prime rate.

•Margin is the number of percentage points added to an interest rate index to determine the current ARM rate. This is calculated as follows:

ARM rate = index rate + margin

For example, if the index rate is 5 percent and the margin is 2 percent, then the ARM rate is 7 percent.

•Adjustment interval determines how often the ARM rate will be reset. A one-year adjustment interval is most common.

•Rate cap is the limit on how much an ARM rate can change.

PAYMENT CAPS AND INTEREST RATES

•Negative amortization is a potential situation in which monthly payments are not enough to cover interest due on the loan. Unpaid interest is then added to the loan balance. This causes the borrower’s principal balance to increase each month rather than decrease.

Payments

Mortgage payments might seem very straightforward: you take out a mortgage and, each month, you pay back a fixed amount, with the payment comprised of a mix of interest payments and repayment of the principal. But it’s not that easy. Mortgage payments also factor in property taxes and home insurance (in most cases, for simplicity’s sake the mortgage lender actually pays your property taxes and the cost of your home owner’s insurance; you then have to reimburse the mortgage lender as part of your monthly payment). And then there are special payment circumstances as well. The following are two of the more common ones:

•Bi-weekly payments. Some home buyers might opt for bi-weekly payments, which are due every two weeks in an amount equal to one-half the scheduled monthly mortgage payment. The purpose of establishing biweekly payments is to pay the mortgage off sooner and to reduce the total amount of interest paid.

•A balloon payment. Some mortgages include balloon payments, which are so named because after a specified period, the payment required by the borrower balloons up quite notably. Loans with balloon payments generally work like a fixed long-term mortgage, at a given interest rate. However, after a five-year period, for example, the unpaid balance must be either paid off in its entirety (quite a bit of payment ballooning) or refinanced at the then-current interest rates. A balloon rate payment typically has a lower interest rate than a traditional mortgage payment because the borrower is assuming more risk.

Government Assistance

Because home ownership is often seen as beneficial, the federal government offers some incentives and assistance to home buyers.

•Federal Housing Administration. The federal government does not originate mortgage loans; however, it may guarantee mortgage loans through insurance issued by the Federal Housing Administration (FHA). This insurance reduces the risk to the lender because the FHA will repay the loan should the borrower default. This guarantee enables lenders to offer mortgages to low- and middle-income individuals, who lack the necessary down payment or are not able to meet other requirements (financial ratios and credit history) necessary to obtain conventional mortgage financing.

•Veterans Administration. The Veterans Administration (VA) home loan program is a similar program to the FHA, except it is available only to service members, veterans, and eligible surviving spouses. The requirements for veterans, especially the amount of the initial down payment, are less stringent than conventional mortgage financing. The VA home loans are provided by private lenders, such as banks and mortgage companies. The VA guarantees a portion of the loan, enabling the lender to provide service members, veterans, and eligible surviving spouses with more favorable terms.

•Tax Incentives. In Exclusion of Gain from Sale of Principal Residence, Internal Revenue Code (IRC) Section 121, the Internal Revenue Code encourages home ownership by providing certain income tax benefits when the home is sold. If the taxpayer qualifies, the first $250,000 of gain (or $500,000 if married filing jointly) is excluded from income in the year of sale. In order to qualify for the exclusion, the taxpayer must have used the property as the main home during at least two of the previous five years before the date of sale. Exceptions to the two-out-of-five rule are available based on facts and circumstances.

Credit Lines

Taking out a mortgage when buying a home represents the largest single debt most people will ever incur. But buying a home can sometimes involve even more debt than just the mortgage. Some home buyers opt to take out additional loans or lines of credit on their homes.

•Home Equity Loans. A home equity loan, also known as an equity loan or second mortgage, is a consumer loan secured by a second mortgage, allowing home owners to borrow against their equity in their home. The loan is based on the difference between the homeowner’s equity and the home’s current fair market value. There is a limit on the deductibility of a home equity loan: $50,000 for a loan not associated with purchase, construction or improvement of the home ($100,000 for married filing joint). Interest on loan amounts above the limit are treated as nondeductible personal interest.

•Home Equity Lines of Credit. A home equity line of credit (HELOC) is a line of credit extended to a homeowner in exchange for collateral—their home. Once a maximum credit facility is established, the homeowner may draw on the line of credit at his or her discretion. Interest is charged at a predetermined variable rate, usually based on the prevailing prime rate. Once there is a draw on the HELOC, the homeowner can choose any repayment schedule, as long as minimum interest payments are made monthly. The term of a HELOC can last anywhere from one to 20 years, at the end of which all balances must be paid in full. The limit on the deductibility of a HELOC is $50,000 for a draw not associated with purchase, construction or improvement of the home ($100,000 for married filing joint). Interest on draws above this limit are treated as nondeductible personal interest.

Bankruptcy

Taking on debt to purchase an automobile or home can often seem like a huge benefit. You get the asset you want without having to pay for it outright, and as long as you make your payments in full and on time, there really is no problem. But there is a downside to debt: What if you can’t make your payments? In some cases, that simply means forfeiting the asset you obtained through borrowing. When debts pile up, though, bankruptcy becomes an option.

Bankruptcy is the state of insolvency, or the inability to pay off debts. Filing for bankruptcy should not be taken lightly, and should only be considered as a last resort to obtain relief from overwhelming debt. Both individuals and businesses may seek relief from their debts by filing for bankruptcy. Personal bankruptcy does not erase the following types of debts: alimony, unpaid income taxes, child support and student loan debt. The two most common types of personal bankruptcy are Chapter 7 and Chapter 13.

Chapter 7 is known as a straight bankruptcy and involves liquidating all the debtor’s property that is not exempt. Exempt property includes an automobile, work-related tools and basic household furnishings. Chapter 7 results in a complete discharge of debts. A person can file for Chapter 7 only once every eight years. The Bankruptcy Abuse Prevention and Consumer Protection Act made it more difficult for individuals to file for Chapter 7 bankruptcy.

A Chapter 13 bankruptcy is referred to as a wage earner’s plan. It enables individuals with regular income to develop a plan to repay all or part of their debts. Chapter 13 allows individuals to keep property that they might otherwise loose. Debtors in Chapter 13 are subject to mandatory education in personal finance management.

Consumer Protection Issues

By their very nature, financial transactions—and thus much of personal financial planning—involve some degree of risk. Sadly, those risks include theft and fraud. There have been a number of laws passed to help protect consumers from these risks. Understanding these laws can help you advise your clients when creating a personal financial plan, as well as in the event of unfortunate, unforeseen circumstances.

THE FAIR CREDIT REPORTING ACT AND IDENTITY THEFT

The Federal Trade Commission defines identity theft as the unauthorized use of an individual’s name, Social Security number, date of birth or other identifying information with the intent to commit fraud. Identity fraud is a widespread and growing concern, unfortunately, with new cases appearing daily. The Fair Credit Reporting Act (FCRA) provides that victims of identity theft have a number of rights to help them recover. Some of the rights under FCRA are:

•Fraud alerts—Consumers who suspect they have been a victim of identity theft have the right to ask potential creditors and credit reporting agencies to place a “fraud alert” in their file. A call to one credit reporting agency will lead to a fraud alert with all three major agencies. An initial fraud alert stays in place for at least 90 days. An extended alert remains in place for seven years.

•Free copies of credit files—An initial fraud alert entitles a consumer to all information on file with each of the three credit reporting agencies. An extended alert allows two free file disclosures in a 12-month period after placing the alert.

•Information block—Individuals have the right to block information from their credit reports that results from identity theft.

ELECTRONIC FUND TRANSFER ACT

The Electronic Fund Transfer Act (EFTA) provides consumers with protection for all transactions using a debit card or other electronic means to debit or credit an account. It limits the consumer’s liability for unauthorized electronic fund transfers. The limit is dependent on how quickly the consumer reports the loss of an ATM or debit card. If loss of the card is reported before the card is used without permission, the consumer is not responsible for any unauthorized withdrawals. If the loss is reported within two business days, the consumer’s liability limited is limited to $50. A loss reported after two business days, but within 60 days of account statement mailing, is limited to $500. A loss which is reported 60 days or later after a mailing of an account statement is unlimited.

FAIR CREDIT REPORTING LAWS

In 1968, the Truth in Lending Act was enacted. This law requires lenders to disclose to borrowers the true cost of a loan and make the interest rate and terms of the loan easy to understand. The consumer must be provided with the total finance charge and annual percentage rate on the loan.

In 1971, the Fair Credit Reporting Act gave consumers the right to see their credit reports and challenge incorrect information. The FCRA requires that consumers be provided with the name of any credit agency supplying a credit report that leads to the denial of credit. It allows consumers to sue creditors if reporting errors are not corrected and requires employers to obtain an employee’s or prospective employee’s permission to view a credit report.

In 1974, the Equal Credit Opportunity Act legislated that credit discrimination on the basis of gender, marital status, race, national origin, religion, age or receipt of public assistance was no longer legal.

Also in 1974, the Fair Credit Billing Act established procedures for resolving billing errors on credit card accounts and limited a consumer’s liability for fraudulent credit card charges to $50.

In 1977, the Fair Debt Collection Practices Act prohibited unfair, abusive, and deceptive practices by debt collectors and established procedures for debt collection.

The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999 directly affects the financial services industry. It contains measures to protect the personal financial information held by financial institutions and requires institutions to provide consumers with privacy notices that explain the institutions’ information-sharing practices.

Lastly, in 2003, the Fair and Accurate Credit Transactions Act (FACT Act) amended the Fair Credit Reporting Act by requiring the three major credit reporting agencies to provide consumers with a free copy of their credit report every 12 months.

Chapter Review

The foundation of a personal financial plan is the client’s Personal Statement of Financial Position (PSFP), the client’s Spending Plan, and the unique client specific assumptions, such as inflation and interest rates. In addition to the creation of the PSFP and the Spending Plan, the personal financial planner will need to provide an objective and reasoned analysis of the statements based on established financial ratios and unique client assumptions. The analysis will allow the client to make effective financial decisions regarding cash flow, debt and savings; such as, renting or owning a home or increasing savings to either a retirement account or an emergency reserve fund.

CASE STUDY REVISITED

In order to help the Earls achieve a more favorable interest rate on their home mortgage, what advice would you provide to them as their PFP specialist?

1. Have the Earls obtain their credit reports and review them to see if there is any incorrect information contained in them.

2. Create a spending plan and perform a financial ratio analysis.

3. Review the various types of mortgages available and discuss their applicability to the Earls’ specific facts and circumstances.

4. Create a personal statement of financial position in order to assess their current net worth and to begin the process of tracking their progress over time.

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1. In the personal statement of financial position, which value is used for the client’s residence?

A. Client’s basis in the home.

B. Insured replacement value.

C. Personal financial planning client’s estimate of current value.

D. Property tax value.

2. Susan and Tom have annual fixed and variable expenses of $100,000. They each earn $80,000 for a combined earned income of $160,000. Susan has a small trust fund which provides minimal income. How much should Susan and Tom maintain in their emergency fund?

A. $25,000.

B. $50,000.

C. $80,000.

D. $100,000.

3. Which of the following investment vehicles are most appropriate for an emergency fund for a family with discretionary income of $12,000 a year?

I. Balanced index ETF.

II. CD ladder with maturities every 90 days.

III. Home equity line of credit.

IV. Money market mutual funds.

A. I, II.

B. II, IV.

C. III, IV.

D. I, II, III.

4. What is the primary advantage of buying an automobile versus leasing?

A. Income tax deduction.

B. Insurance costs.

C. Ownership.

D. Size of down payment.

5. Claudia and Albert increased their net worth from $250,000 to $270,000 during the current year. Their combined income was $60,000 and the only changes to their assets was an increase in their investments of $12,000, and an additional contribution of $2,000 to Albert’s IRA. How much did Claudia and Albert reduce their home loan during the year?

A. $4,000.

B. $6,000.

C. $8,000.

D. $20,000.

6. Elizabeth and Rick would like to purchase a new home. Their mortgage broker has pre-qualified them for two mortgages: a 30-year fixed at 4 percent or a 5-year ARM at 3 percent. Which of the following factors should be considered in deciding between the two mortgages?

I. Gross income.

II. Estimated length of ownership.

III. Real estate tax liability.

IV. Cash currently available.

A. I, II.

B. II.

C. I, III.

D. III, IV.

7. Mary Ann bought a new home for $100,000. Her mortgage is $65,000 and she has a 30-year ARM. The lender used the one-year Treasury index (4 percent) and a 2 percent margin. The ARM has an interest rate cap of 2 percent. If the one-year Treasury index rate goes up 3 percent, how much can the ARM increase?

A. 2 percent.

B. 6 percent.

C. 7 percent.

D. 9 percent.

8. The ________________ gives consumers the right to see their credit reports and challenge incorrect information.

A. Electronic Fund Transfer Act.

B. Fair Credit Reporting Act.

C. Gramm-Leach-Bliley Act.

D. Truth in Lending Act

9. An ARM payment is an example of

A. Fixed expense.

B. Front-end ratio.

C. PITI ratio.

D. Variable expense.

10. Alice was out of town on spring break. Upon her return, she discovered that sometime over the past seven days she had lost her debit card. She did not know what to do, and waited until she received her bank statement. Her bank statement arrived within the month and she realized her debit card had been fraudulently used. She contacted the bank. What will be the limit of her losses?

A. − 0 −.

B. $50.

C. $500.

D. Unlimited.

INTERNET RESEARCH ASSIGNMENTS

1. What tools and resources are available for students from the Consumer Financial Protection Bureau for financing college education?

2. What tools and resources are available for home buyers from the Federal Housing Administration (FHA)?

3. Visit AnnualCreditReport.com and obtain your free credit report.

4. Visit Consumer.gov. What tools and resources are available to consumers?

5. Visit the Federal Trade Commission’s website and download the Mortgage Shopping Worksheet.

Note