Personal Finance for Accountants (U13763)

Lecture 3 Banking & Debt

Lecture 3 Banking & Debt

• Criteria for selecting a banks services

• Examining debit and credit cards

• Debt

• The annual percentage rate

• Consumer protection

• Debt consolidation

Criteria for selecting a banks services

• Features to consider when choosing a current account:

• The rate of interest and the qualifying criteria, for example you may need to keep a minimum balance on the account.

• Overdraft availability and charges.

• Access to your money. If the account includes Internet access you have the ease of move surplus funds into a higher interest account and also paying bills online. You can also update standing orders.

Other considerations:• Some banks have specialist accounts for groups such as: children; school leavers;

students and high earners. These accounts have additional perks or services attached to them such as interest free overdraft and free travel insurance.

Criteria for selecting a banks services

• To get the best out of your bank it’s important to build up a relationship with your local branch. So if you need an overdraft or mortgage you are a known customer.

• The Internet makes it easier to compare products many website offer comparisons across different accounts e.g. Motley fool:

• http://www.fool.co.uk/current-accounts/compare-all-current-accounts.aspx

Examining debit and credit cards

Debit card

• The debit card is an electronic cheque, when you make a payment using this card the amount will be deducted from your current account within 2-3 days. On your statement you will see the name of the supplier. Retailers such as supermarkets will allow you to draw cash as well as pay for goods. You also have access to draw cash from cash machines.

Examining debit and credit cards

Credit card

• A credit card allows you to purchases goods and defer the payment. Most credit cards offer an interest free period up to a maximum of 59 days depending upon the timing of your purchase. Interest rates on credit cards are high they should only be used for very short term loans such as financing a holiday.

• Each month the credit card company sends a statement and the customer has to pay an amount which must be at least the amount given as the minimum payment. Paying only the minimum payment is dangerous to your financial health. The interest charge at these high rates will accumulate to an unmanageable level.

Examining debit and credit cards

Interest Free Credit cards

• As an introductory offer many credit cards offer 6 -12 month interest free on balance transfers, after that period the normal interest rate will be charged. If you are well organised it is possible to move between credit cards leaving one just before the interest free period runs out to go to another interest free period. Personal Finance websites such as the Motley fool shows comparisons of the deals available. Note that a set up fee is charged at around 3%.

Debt

• Social attitudes to debt have changed over the last 50 years. In the 1950-60s before the invention of the credit card it was considered very undesirable to have debt. Typically people took out loans to buy houses or large purchases such as washing machines but everything else was purchased with cash.

• Forty years ago the first credit card was introduced into the UK by Barclays following this there was a high social status in having a credit card if fact the more credit cards at your disposal the better!

• Today living with credit is a normal part of life.

Debt

• In the UK in the average consumer is borrowing via credit cards, motor and retail finance deals, overdrafts and unsecured personal loans has risen to £4,845 per average UK adult at the end of August 2008 (source creditaction). The financial crises of 2008 is starting to change the attitudes to debt and consumers are be coming more cautious.

Debt

• Given that credit is a part of every day life it is very important to have the appropriate loan for the activity that you are financing e.g. if you have a temporary cash shortage the overdraft facility is good for a short period but if you want the cash for a longer period then you should get a personal loan from the bank see below:

Debt

Financing a university degree• Student loans and grants are available for UK students, the

government website shows the latest information.• Student loans are issued by Student Finance Direct on

behalf of the government – they are not commercial loans.• Interest is charged on a student loan from the date you

receive it to the date you finish repaying it. The interest rate is linked to the rate of inflation, so the amount you repay is the same in real terms as the amount you borrow. The current interest rate is 3.8% (9/08).

• You only begin to repay the loan after you leave your course and are earning more than £15,000 a year.

• The student loan is of the cheapest type of financing available.

The annual percentage rate (APR)• One of the main themes in the Consumer Credit Act

1974 is that there should be 'truth in lending’ particularly in advertising for credit and any documentation. The Act defined the Total Charge for Credit (TCC) which includes interest and any other charges such as set-up fees that effect the real cost of borrowing. This was to create greater transparency across the industry so that a consumer could compare the cost of credit across different companies and different products. The act defines how the Annual Percentage Rate (APR) will be calculated.

• The APR will take into account the size, number and frequency of payments and any other built in charges.

Equivalent Annual Rate (EAR)

• It's used to illustrate the full percentage cost of overdrafts and any type of account that can be in credit and also go overdrawn

• The calculation shows you the true cost if you use the overdraft facility

• In common with the APR calculation, EAR takes account of the basic rate of interest and when the interest is charged to the account plus any additional charges

• So in most respects EAR and APR achieve the same thing – it's just that APR applies to a pure lending product whereas EAR applies to a product, such as a bank current account, that can be in credit or go overdrawn

• Note that the calculations for both EAR and APR always exclude any Payment Protection Insurance you've bought to ensure the monthly repayments are maintained if you are off work due to accident, sickness or unemployment

Annual Equivalent Rate (AER)• AER is only used in relation to savings and interest based

investments • It's all about the rate of interest you'll receive on your

money • AER shows the true rate of interest you will have received

by the end of the year taking into account the regularity of which interest is added to the account (as the payment frequency has a compounding affect on the amount of interest you receive)

• The AER calculation also removes the affect of any promotional offer that disappear after a few months - a popular trick used by banks and other institutions to boost their savings products to the top of the Best Buy tables

APR Calculation

• Interest is calculated on a daily basis.

• A borrower is lent £1,500 on Friday 14th December 2001 and this is to be repaid in a single instalment of £1,750 on Thursday 22nd May 2003. There are no other payments or charges.

• We need to establish the period of the loan: 14/12/01 - 22/5/03

• This needs to be calculated in whole and part years.

APR Calculation• The period is one year and 159 days:• 14/12/01 - 13/12/02 - 1 year

• 14/12/02 - 31/12/02 17 days

• Jan 03 31 days• Feb 03 28 days• March 03 31 days• April 03 30 days• To May 22nd 22 days

• Total 159 days

APR Calculation• 1 year counts as 365.25 days so this is expressed as 1 year

159/365.25

• = 1.435318 years

• Apr calculation =

• (1750/1500 power of 1/1.435318) - 1

• = 0.11337

• 11.3%

Consumer protection

• Confusion over the terms of a loan and a lack of awareness of the consequences are considered to be largely responsible for consumers over borrowing.

• There are certain pitfalls to be aware of:

• Early settlement fees, this is a penalty for paying the loan back early. Often applied when you have a discounted fixed rate mortgage for a set period.

• APR calculations - there is still confusion between credit cards and store cards. AER and EAR now in common use.

Consumer protection• Payment protection insurance (PPI) The

consumers association show that there is widespread mis-selling of PPI. PPI claims to protect individuals if they are unable to meet their credit card payments if they are unable to work. This is a limited version of income protect and is considered expensive and restrictive.

• Some mortgage companies make this a condition of your loan if you are borrowing over a certain percentage (e.g. 90%) of the value of your property.

Debt consolidation

• Debt consolidation is where an person takes out a new loan or credit agreement in order to pay off two or more existing debts.

• This process has received very bad press recently with licensed credit brokers earning huge commission payments and extortionate interest rates being levied. Often the consumers home is used to secure such loans.

Seminar Work

• Review Qs pp 113, MCQs and APR Calculation.

• Required Reading

• Core Text - Personal Finance and Planning Theory and Practice by Debbie Harrison Chapter 8.