financial services
WEN.XU
lecture__notes.pptxLecture 2
Personal Debt and Mortgage Products
By
Dr Jacinta Nwachukwu
Principal Lecturer in Finance
School of Economics and Finance
1
Something to think about
Supposed you have just inherited £250,000 from your grandfather. You are now considering investing the entire £250,000 in a bank deposit for 10 years. You expect to earn an average interest rate of 5 percent per annum over the investment period.
(i) What is the end balance at the end of the investment period?
(ii) How long will it take for your investment to double in value?
(iii)What is the annual average interest rate if your deposit actually grew to £310,000 at the end of the 10 years planned investment period?
2
Something to Think About
(1)The amount of personal debt owed by UK citizens exceeded the staggering figures of £1.46 trillion in 2010. This total has increased threefold from the level in 1995.
Should the UK government be worried about the growth in total personal debt
(a) Yes
(b) No
(c) Undecided
(Q2). Examples of personal debt include:
(a) Mortgages
(b) Personal loans
(c) Outstanding amounts of hire purchase agreement
(d) Credit card debts
(e) Bank overdrafts
(f) All of the above
3
Something to Think About
Q3: The value of assets minus the value of all liabilities is equal to:
(a) Net wealth
(b) Net worth
(c) Both of the above
(d) None of the above
(d) I don’t know
(Q4) An arrangement to receive cash, goods and services now and pay for them in the future is known as:
(a) Borrowing
(b) Credit
(c) Debt
(d) I don’t know
(Q5) Unsecured debt is not supported by the assets that may have been bought with the borrowed money. Nevertheless the assets could be “repossessed” and sold by the lender if repayments are not made by the borrower
(a) True
(b) False
(c) I don’t know
4
Something to Think About
(Q6) Examples of unsecured debt include:
(a) Money owed on credit cards
(b) Retail finance
(c) Overdrafts
(d) Mail order catalogues
(e) Store cards
(f) All of the above
(Q7) One of the important consequences of rising UK house prices is a process known as “equity withdrawal”.
Should the UK government be concerned about “equity withdrawal”
(a) Yes
(b) No
(c) Undecided
(Q8) To be sure, there is no universally agreed definition of “over indebtedness”.
So, in your opinion, when would you say that an individual is facing a debt problem
5
Lecture Outline
1. Debt definitional concepts
2. The debt products
3. The UK Lending Industry
4. The cost of debt
5. Types of interest rates
6. Mortgage repayment schedule
6
1. Debt Concepts
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1. Debt Definitional Concepts
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Debt is the stock of money that is owed by people at a particular point in time
Borrowing is the process by which debt is taken out
Credit is defined as an arrangement to receive cash, goods and services now and to pay for them in the future
Secured debt
Unsecured debt
Senior versus subordinated debt
2. The Debt Products
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2. The Debt Products
10
Overdrafts are approved by the lender up to a limit
Credit cards including store cards
Personal loans
Hire purchase (HP)
Mortgages
Alternative credit
3. The UK lending industry
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3. The UK Lending Industry
12
Banks
Building societies
Finance companies
Direct lenders
Credit unions
The student loans company (SLC)
The alternative credit market
Budgeting loans
4. Cost of debt
Principal sum
Simple interest rate
Other charges associated with taking out or repaying debt
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Principal sum
This is the amount originally lent. For example, if £100,000 is borrowed for twenty-five years to buy a house, then the full £100000 will have to be repaid at the end of term. This can be repaid in two main ways:
(1) In one lump sum at the end of the loan term
This is often referred to as an “interest only loan” as the only payments made are interest.
The borrower could raise the money needed to repay the loan at the end of term through:
(i) Deposits in savings accounts such as ISA and investment products like unit trusts
(ii) Proceeds of an endowment scheme which is designed to build up a lump sum to repay the mortgage when it falls due
(2) In stages over the life of the loan.
This is an example of a ” repayment loan”. A typical example is a reducing balance loan where a fixed amount of payment is made each month throughout the mortgage term
The fixed mortgage repayment comprised:
(i) Interest payments which tend to decline over the term of the mortgage
(ii) Principal sum which tends to accelerate towards the loan term
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The Simple Interest Rate
This is the interest rate that has to be paid on the amount originally borrowed.
It represents the actual price of the loan expressed as the percentage per year of the original amount borrowed.
From the lenders viewpoint, interest charges cover:
(1) The cost of financing
(2) Risk of non-repayment of money lent. So, higher risk borrowers may be charged more interest than those deemed to be of lower risk
(3) Profit in compensation for the money they have given up
(4) Expected inflation rate
Other extra costs of borrowing may include:
(i) Arrangement fees paid to the lender
(ii) Intermediary fees paid when a borrower deals with a broker
(iii) Early repayment fees which may be paid if a loan is repaid early
(iv)Tied insurance such as payment protection insurance (PPI) which may be required to protect the lender against non-repayment of loans
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5. Types of interest rates on Loans
A variable rate
A fixed rate
A capped rate
A Collared rate
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Types of Interest Rates on Loans
1. A variable rate can move up and down during the life of the loan. These are normally linked to official Bank of England rates (known as trackers).
2. A fixed rate is determined at the start of the loan and remains unchanged throughout the term of the loan.
3. A capped interest rate is where the rate cannot rise above a defined maximum (or cap), but below this cap, it can move in line with movements of official interest rates.
4. A collared interest rate is where the rate can move in tandem with official interest rates, but cannot either go above a defined maximum (the cap) or below a defined minimum (the floor).
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6. Mortgage repayment
The main types of mortgage
Mortgage repayment schedule
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The various types of mortgage
1. Variable rate mortgage moves in tandem with official interest rates.
2. Fixed interest rate mortgages are unchanged for a given period of time, say five, ten or twenty years.
3. Capped interest rate mortgages are variable, but cannot exceed a set maximum level.
4. Off-set mortgage sets off cash surplus in the borrower’s current or savings accounts against mortgage debt before monthly mortgage interest repayment is calculated
5. Equity release mortgages are taken out on a property that is previously 100 percent owned in order to release wealth locked up in the house
6. Share ownership mortgage is part-owned by the property owner and another party, often a housing association
19
Repayment mortgage schedule
Assume a £60,000 repayment mortgage payable over ten years at 8 percent annual percentage rate (APR) with interest calculated annually.
You are required to calculate:
The fixed annual payment each year
The interest rate paid each year
The principal amount paid each year
The total amount of money paid over a ten year period
20
Mortgage repayment schedule
Repayment mortgages pay off the principal sum in stages throughout the life of the loan.
T= 0
PV= £60K
T= 1
T= 2
T= 3
T= 10
PMT= ?
PMT= ?
PMT= ?
PMT= ?
How much is this fixed payment (PMT) taking account of the time value of money?
21
Something to think about
Assume that Mr Smith has an unsecured car loan with a fixed annual repayment of £3227, payable at the end of each year. The annual percentage rate (APR) on the loan is 3 percent
(i) What is the present value of £3227 payable at the end of year 5
(ii) What is the value of Mr Smith’s original loan assuming that he plans to repay his debt at the end of the following year?
Year 3
Year 4
Year 5
PV?
T=0
PMT=£3227
PMT=£3227
PMT=£3227
PMT=£3227
PMT=£3227
T=1
T=2
T=3
T=4
T=5
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Something to Think About
| APR = 3% PMT = £3227 | ||||||||
| 1 | 2 | 3 | 4 | 5 | ||||
| PVIF (from table 2) | ||||||||
| PVIFA (from table 4) | ||||||||
| PV of repayment amount (£) | ||||||||
| Original loan amount (£) |
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Mortgage repayment schedule
Repayment mortgages pay off the principal sum in stages throughout the life of the loan.
T= 0
PV= £60K
T= 1
T= 2
T= 3
T= 10
PMT= ?
PMT= ?
PMT= ?
PMT= ?
How much is this fixed payment (PMT) taking account of the time value of money?
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Table 1: Mortgage Repayment Schedule
| Year | Beginning principal amount (£) | Fixed annual payment (£) | Annual interest expense (£) | Principal amount repaid (£) | Principal amount remaining (£) |
| Col. 1 | Col. 2 | Col. 3 | Col.4 = (Col 2* quoted interest rate) | Col. 5 =(Col.3 – Col. 4) | Col.6 = (Col 2 – Col.5) |
| 0 | 60,000 | 8,941.77 | |||
| 1 | 60,000 | 8,941.77 | 4,800.00 | 4,141.77 | 55,858 |
| 2 | 55,858 | 8,941.77 | 4,468.66 | 4,473.11 | 51,385 |
| 3 | 51,385 | 8,941.77 | 4,110.81 | 4,830.96 | 46,554 |
| 4 | 46,554 | 8,941.77 | 3,724.33 | 5,217.44 | 41,337 |
| 5 | 41,337 | 8,941.77 | 3,306.94 | 5,634.83 | 35,702 |
| 6 | 35,702 | 8,941.77 | 2,856.15 | 6,085.62 | 29,616 |
| 7 | 29,616 | 8,941.77 | 2,369.30 | 6,572.47 | 23,044 |
| 8 | 23,044 | 8,941.77 | 1,843.50 | 7,098.26 | 15,946 |
| 9 | 15,946 | 8,941.77 | 1,275.64 | 7,666.13 | 8,279 |
| 10 | 8,279 | 8,941.77 | 662.35 | 8,279.42 | 0 |
| Sum | 89,417.69 | 29,417.69 | 60,000 |
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End of lecture
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UK Debt Time bomb
https://www.youtube.com/watch?v=eHmgQ4HtbmI
https:// www.youtube.com/watch?v=yOX6RFBdfxk
https://www.youtube.com/watch?v=d1bvv3pTJCo
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News headlines about UK personal indebtedness
http://themoneycharity.org.uk/money-statistics/
https://www.gov.uk/options-for-paying-off-your-debts/overview
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The UK lending landscape
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The Plague of the Black debt
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Take Home Assignment 1
Assume that you have taken up a repayment mortgage of £400,000 over ten years at 5% APR.
Assume that you have three different ways to repay the loan:
(1) You can pay off the principal and all the interest at one time at the maturity date of the loan (Discount loan)
(2) You can make monthly interest payments as you go and then pay the principal and final interest payment at the maturity date (interest-only loan)
(3) You can pay both principal and interest as you go by making equal payments each period. (i.e., Amortized loan)
Questions:
(i) Provide the information for the different types of loans in the Tables below
(ii) Why is the interest paid on each loan method so different?
(iii) So which payment method would you choose?
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Mortgage Repayment Schedule Table
| Year | Beginning principal amount (£) | Fixed annual payment (£) | Annual interest expense (£) | Principal amount paid (£) | Principal amount remaining (£) |
| Col.1 | Col. 2 | Col. 3 | Col.4 (Col 2* quoted interest rate) | Col. 5 =(Col.3 – Col. 4) | Col.6 = (Col 2 – Col.5) |
| 0 | 25,000 | ||||
| 1 | |||||
| 2 | |||||
| 3 | |||||
| 4 | |||||
| 5 | |||||
| 6 | |||||
| Sum |
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Take home assignment 1: payment plans and total interest on a loan
| Repayment Plan | Annual Payments (£) | Total Interest (£) | Principal Repayment (£) | Total repayment (£) |
| Discount loan | ||||
| Interest only-loan | ||||
| Amortized-loan |
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Take Home Assignment contd.
2. Most lenders “credit score” loan applicants before releasing money. People with poor “credit standing” will have limited access to cheaper forms of debt
What factors are frequently considered by your bank in analysing the credit score of their borrowers?
3. Rank the following debt products in an ascending order of Annual Percentage Rate from the lenders viewpoint
(i) Arranged overdraft, (ii) Personal loan, (iii) store card, (iv) credit cards, (v) Hire purchase, (vi) Mortgage and (vii) loan from a payday loan company
4. Data shows that rates on personal loans are the lowest of unsecured debt products.
Why might some one choose any product other than personal loans
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Take Home Assignment contd.
5. Some analysts believe that one of the consequences of the recent decision by UK residents to leave the EU (i.e., Brexit) is an increase in the proportion of households that report their debt as being a burden
What are the key reasons for this expected positive link between debt problems and Brexit?
6. A recent development in the UK has been the sharp increase in the number of women experiencing debt problems
What are the reasons for the growing number women having debt problems
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Take home assignment 7
Events of the past 30 years since the liberalisation of the UK financial sector have underlined the dangers for unsuspecting customers
On top of these dangers, financial firms’ keenness to attract new customers led to instances of mis-selling in which thousands of people lost money through products they bought because of high pressure selling, incomplete or misleading information
Some of the most famous cases of financial mis-selling in the UK are:
1. Payment protection insurance (PPI)
2. Endowment mortgages
3. Extended warranties
4. Personal pensions
You are required to:
Describe the major characteristics of these financial products with particular emphasis on how an investor might use them to reduce the risk associated with their investment options
Explain why each of these products ran into difficulties
Identify the specific policy reforms which have been implemented by the UK authorities to protect consumers from instances of mis-selling of such financial products in the future.
PPI
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Further reading
1. Personal Finance, by George Callaghan, Ian Fribbance and Martin Higginson, Palgrave Macmillan, 2012, Chapters 4 and 6
2. Personal Financial Planning: Theory and Practice, by Debbie Harrison, FT Prentice Hall, 2005, Chapter 8
3. Personal Finance, by Robert S. Rosefsky, Seventh Edition, Chapters 6, 7 and 12
4. The distribution of unsecured debt in the United Kingdom: survey evidence, By Merxe Tudela and Garry Young, Bank of England Quarterly Bulletin: Winter 2003
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Further reading
5. Household secured debt by Matthew Hancock, Bank of England Quarterly Bulletin: Autumn 2004
6. Household debt and spending, by Philip Bunn, Bank of England Quarterly Bulletin 2014 Q3
7. Household debt and the dynamic effects of income tax changes, by James Cloyne and Paolo Surico, Bank of England 2014, Working Paper No. 491
8. Financial pressures in the UK household sector: evidence from the British Household Panel Survey, by Pru Cox, John Whitley and Peter Brierley, Bank of England Quarterly Bulletin: Winter 2002
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