Consumer credit chapter 4 PDF

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Capital Worth of the Borrower Fitz has Bills to Pay Fitz’s Credit History: • Credit Bureau verifies address and employment • No undisclosed debt • Everyday Bank MasterCard almost at the limit and 1 month behind with payments (rated R3) • 3 open loans with finance companies • 4 collection accounts including 2 judgments and 2 garnishees • 2 recent enquires from credit card companies may indicate that Fitz is seeking more credit Fitz’s credit bureau report verifies both his employment and his address and that he has no undeclared debt. It also confirms that he has made purchases at several furniture stores and an electronics store and that he has 4 collections outstanding which are considered major credit infractions. A lending officer could mitigate Fitz’s poor credit history relating it to the divorce and Fitz being forced to move however there are two sides to every story and we currently only have Fitz’s story to rely on. Positive Character Attributes

Negative Character Attributes

Kind and generous

Seasonal Employment

Full time employee

Divorced with alimony payments

Second Income in off-season

Future obligations from purchases

10 years on the job

Refuses to pay alimony (stubborn)

Excellent boat captain

Tax evasion

Never misses work

No $ to pay for work on house

Large catches provide extra $

Appears to be credit seeking

Non-smoker and Non-drinker

Lack of cash flow

Good team player Takes responsibility for kids Owns a home

Lobster season opens next week There are a number of positive and negative attributes to Fitz’s character. He appears to be very good at his job as a sea captain and he also works during the off-season to bring in more income. He also appears to keep his expenses down although his recent divorce has but a strain on him financially forcing him to purchase furniture and electronics on a plan that will soon have him dealing with finance companies and likely paying higher than market interest rates. Fitz also owns a home and he has taken full responsibility for his children. On the negative side Fitz is a bit stubborn in refusing to pay alimony and he does odd jobs for cash which is a form of tax evasion. His seasonal employment combined with the cost of the divorce has resulted in a negative cash flow situation which should start to turn around in the next few weeks once the lobster season opens. Market Conditions Positive Aspects

Negative Aspects

Record lobster catches predicted for the next few years

Reduced demand for Lobster in Canada due to

Recent discovery of a huge market for lobster in China

Decline in the value of the Canadian $ increases foreign demand

The future of the lobster industry is looking very bright which should reflect positively on Fitz’s cash flow as part of his compensation is based on the size of the day’s catch and Fitz consistently brings in the largest catch. Despite the reduced domestic market for lobster the export market is heating up due to new demand from China and a lower Canadian dollar and with record catches predicted for the next few years Fitz’s income should increase, helping him repay his debt obligations.

The 5 C’s of Credit • Capacity of the borrower to pay • Credit history of the borrower • Character of the borrower and Market Conditions • Capital worth of the borrower • Collateral available to secure to the loan The 4th “C” of Credit is the Capital worth of the borrower. This represents how much the borrower is worth financially and demonstrates the borrower’s ability to access funds should the need arise. Capital Worth of the Borrower

To calculate the Capital net worth of the borrowing customer the lending institution will total all of the customer’s assets and then subtract all of the customer’s liabilities. The result is the customer’s net worth and the calculation is similar to a balance sheet used by businesses to determine how much the business is worth. Lily’s and Eric’s TDSR Calculation Current TDSR = 2000 + 543 + 800 + 650 + 300 + 50 + 50 + 737 +100 (Taxes) = 29.89%

• 10,000 (Lily) + 7,500 (Eric) • (Note: you must include the cottage taxes in the TDSR calculation) • Revised TDSR = 2000 + 543 + 800 + 650 + 300 + 50 + 50 + 737 +100 + 1,500 = 38.45% • 10,000 (Lily) + 7,500 (Eric) To calculate Lily’s and Eric’s current TDSR we assume the credit cards are at their limits and the payment will be 5% of the limit. We will also include the private mortgage payment on the cottage of $737 and the taxes on the cottage of $100 (we are told that the cottage is not winterized so there is not likely to be any source of heating). To calculate Lily’s and Eric’s revised TDSR including the new credit product we assume the Line of Credit is fully utilized and the payment will be 3% of the balance owing ($1,500). The revised TDSR is still below the 40% TDSR threshold indicating that Lily and Eric have the capacity to repay the loan. Would you give Lily and Eric the loan? • Revised TDSR appears to be acceptable (yes) • Credit History is good (yes) • Character appears sound (yes) • Market conditions are acceptable (yes) • The couple has a Net worth of ($16,485) (no) The previous slide demonstrated that Lily and Eric have the capacity to repay the loan based on their monthly payments being less than the 40% threshold. Lily’s and Eric’s credit bureau report indicates that they have always made their payments as agreed and demonstrates that they have the willingness to repay their dept. From a Character perspective it appears that both Lily and Eric are very sound and the Market Conditions look favorable. Unfortunately Lily and Eric have a negative net worth. Their loan application indicates that they have a negative net worth of $9,485 however it is unlikely that the lending institution would allocate any value to the couple’s furniture and artwork so, from the lending institution’s perspective, the couple would have a negative net worth of $16,485. There may be a way for a lending institution to help the couple however providing them with an unsecured revolving facility would be an unlikely solution as most lending institutions require borrowing customers to have a positive net worth in excess of $50,000 before they would offer them a line of credit product. We don’t know the true value of the cottage since it was sold privately and it may be worth more than Lily and Eric paid for it. If this is the case it could be possible for the couple to obtain a second mortgage on the property for the extra funds they require (or a larger first mortgage, paying out the private mortgage and providing the couple with extra money to do the renovations). This would provide the couple with the funds they require while reducing the risk to the lending institution.

Valuing Assets

Real Estate

Gold and Silver

Cars and Trucks

RRSPs

Cruisers and Yachts

Foreign Investments

Other Motorized Vehicles

Jewelry and Art

Bonds and G.I.C.s

Furniture and Appliances

Stocks

Collections

The lending institution’s primary reason for establishing the capital net worth of the borrowing customer is to determine if the customer has a potential source of funds to draw from should they be unable to make the payments on their loan. Lending institutions have different ways of determining the value of assets for the purpose of calculating a borrowing customer’s net worth, particularly if they are planning to use the asset as collateral to support the loan. In some cases a customer may have an asset which they think has value however the lending institution will assign it no value as it is unlikely that the asset will be able to be sold for any significant amount (furniture and appliances for example). The following outlines some of the ways lending institutions use to determine a customer’s asset value: Real Estate – Have a licensed real estate appraiser complete an appraisal on the property Cars and Trucks – Use publications such as the Red Book or the Black Book to determine the wholesale value of the vehicle Cruisers and Yachts – Have a marine survey (appraisal) performed on the boat. Other Motorized Vehicles – Use the Red Book or the Black Book Bonds and G.I.C.s – Valued at face value of the investment Stocks – Use the bid price for the stock as listed on the local stock exchange Gold and Silver – Valued at the day’s closing price on the local exchange RRSPs – Valued at the amount listed on the most recent statement Jewelry and Art – Only assigned value if there is a recent professional appraisal on file

Furniture and Appliances – Generally not given any value Collections – Only given value if there is a recent professional appraisal on file Factors Impacting Asset Value 1. Liquidity 2. Fluctuation of Value 3. Location There are three primary factors that impact the value of an asset. 1. Liquidity – How quickly the asset can be converted to cash. The faster an asset can be converted to cash the easier it will be for the customer to use it as a source of funds for making payments on their loan. Savings accounts and redeemable GICs are examples of very liquid assets. 2. Fluctuation in Value - Some assets, such as stocks and other marketable securities, can change value quickly and if they decline in value the customer may lose money if they are required to liquidate the asset to make a loan payment. If the value of the asset drops significantly it may result in the borrowing customer’s net worth eroding to the point where they lack the funds to support the loan payments. Location – Assets located in Canada can often be liquidated quicker than those located in foreign countries and are often subject to less risk than foreign assets (foreign assets are subject to sovereignty risk and foreign currency risk to name a few). In addition, assets that are mobile (cars and boats) can be more difficult for a lending institution to locate in the event the customer stops making the loan payments and the lending institution is forced to find other means to recover the funds How Does Net Worth Reduce Risk? 1. Provides reserve for customer to fall-back on 2. Provides source of funds for lending institution A customer who has a positive net worth (equity) is less risky to lend to since they have assets they can utilize to repay the debt in the event they experience serious cash-flow challenges such as the loss of a job. Most responsible borrowing customers who are in this position will initiate the liquidation of assets to fund the repayment of their loan well before the bank is forced to ask them to do so. In some situations borrowing customers will not take action and will begin to fall behind on their loan payments. In situations like this the lending institution may be forced to take action to recover the borrowed funds and will request that the customer honors the lending agreement by liquidating assets and re-paying the loan. This may take the form of court action if the customer fails to act on the suggestions of the lending institution. What does Capital Worth tell us about a Customer? • Ability to manage money • Savings habits • Ability to live within their means

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Potential to retire Evidence of previous financial difficulties Reflects on a customer’s “Character”

Lending institutions learn many things by examining a customers net worth. In most cases the closer a customer is to retirement the higher their net worth should be. Customers in their late 50’s with minimal net worth may have experienced a significant financial setback such as a business failure, divorce or personal bankruptcy. Customers with a negative net worth are often living above their means (spending more than they earn) while customers who have a large positive net worth may be good money managers or they may have benefited by a large increase in real estate values. A customer’s net worth plays an important role as they approach retirement as it often determines if a customer will be able to retire at the age they want to and still meet all of their financial obligations Planning for Good Capital Net Worth 1. Look at your “Balance Sheet” annually 2. Beware of “Off-Shore” investments 3. Live within your means 4. Hire a good Financial Planner It is always a good idea for a customer to examine their personal balance sheet on an annual basis. In general a customer’s net worth should grow up to the point they retire after which it may begin to decline as they start using their savings to supplement their pension income. If a non-retired customer finds their net worth is dropping year over year it might be a good time to review what is happening and take corrective action to rectify the situation. There are many risks associated with off-shore investments not the least of which is foreign currency risk. Customers making these investments need to be aware of the potential for loss and also need to be able to absorb these losses without a major impact on their net worth. Customers who live within their means will find that their net worth will increase over time. To assist with this process it is always a good idea for a customer to hire a Certified Financial Planner to prepare a long term financial plan based on their goals and desires. Most people who travel use a map to help them find their way. A good CFP will help create a map for the customer to navigate their way to financial success....