Personal Financial Management

1. Personal Financial Management Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.uk

2. Reading • Callaghan: Chapter 4 • McRae: Chapter 8

3. Interest and Interest Rates Some basic information on interest rates • Bank of England base rate • Set by Monetary Policy Committee • Provides a basis for other rates • No-one can trade at a lower rate (arbitrage) • Objectives of the MPC • To control the rate of inflation (target band) • Increase in interest rate reduces demand • Reduction in interest rate stimulates demand • Base decisions on economic data

4. Other Important Rates • LIBOR: London Interbank Offered Rate • The rate at which banks are willing to lend to each other • The basis for many financial calculations • Mortgage rates • Mortgages are the safest form of lending to individual so have lowest interest rates • Market rate is determined by competition between lenders

5. Other Important Rates • Personal loans • Loans for purchases other than property (more risk) • Higher interest rate than mortgages • More variation in interest rates than for mortgages • Collateral • Secured loan: an asset is held as collateral • Unsecured loan: no collateral • Interest rate is lower on a secured loan

6. Credit Creation • How does the banking system function? • Savers deposits funds • At any time only a fraction of funds withdrawn • The remaining fraction leant to borrowers • The process is repeated eventually multiplying initial deposit • Banks profit from the difference in interest rates • So borrowing rate is higher than the saving rate (lack of competition, asymmetric information, risk)

7. Loans • Open-ended • An upper limit is agreed, borrower has flexibility • Specific • For the purchase of a defined item, with a clear payment schedule • What determines the interest rate? • Lowest when secured on a safe asset • Highest when unsecured and open • Depends also on credit worthiness of borrower

8. Profit • Earning money from issuing loans is easy • Lenders borrow at one rate • Lend at a higher rate • A loss can occur through default and poor risk management • Current bank losses can be interpreted as poor risk management • Bad debts increase costs • This is why those perceived to be safe will be offered a lower rate of interest

9. Credit Rating Agencies • Hold data on borrowers to advise lenders of previous history • Can make mistakes • For example assigning bad risk to an address • If refused credit • Can ask whether because of a credit agency report • Can then contact agency to correct any false information

10. Credit Cards • Credit Cards: offer free credit if repaid monthly, but otherwise incur a very high interest rate • Table of Rates • Strategy: carry debt from card to card to take advantage of introductory offers • Store Cards: usually an even higher rate • Store Card • The only reason to hold these is to benefit from card-holder discounts

11. Interest Rate Calculations • To understand interest rates, need to go some through some basic calculations • Interest is compounded at a specified interval • The interval can make a difference • Assume interval is one year • Then borrowing £100 at a rate of 10% for one year implies a total repayment of

12. Compounding Interval • Now consider what happens if we compound interest more frequently • If every 6 months, then rate of 10% for a year becomes 5% for six months so • If compounded every 3 months • The general formula for interest at rate r compounded m times a year for nyears on a loan of L is

13. Continuous Interest • Continuous interest is the limit of more frequent compounding:

14. Effects • The difference between £110 and £110.52 may seem small • It is equivalent to 0.52% on the annually-compounded interest rate of 10% • On a large loan this could be significant effect • Compounding period • Matters for repayment • Needs to be clarified before alternative loans can be compared

15. Flat Rate Interest • Interest can also be quoted as a flat rate • Consider £100 borrowed for 5 years, with a flat rate of interest of 10% • This means £10 of interest is paid per year • Over 5 years the total payments on the loan are £10+£10+£10+£10+£10+£100 = £150 • The repayment structure is 5 payments of £30 • This is equivalent to an APR of 15.2% (see later or use mortgage calculation)

16. Annual Percentage Rate • These compounding issues motivate the need to find a standard of comparison • The government has chosen to use the Annual Percentage Rate (APR) • This interest rate converts any interest schedule (such as the flat rate) to the annual equivalent • Annual Percentage Rate

17. Annual Percentage Rate • Consider receiving m payments Ak at times tk and making n payments Ak′ at times tk ′ • The interest rate that makes the present discounted value of both flows equal solves • The solution r to this equation is the APR

18. Example 1 • Receive £100 at t1 = 0 • Pay £10 at t1′ = 1, pay £110 at t2′ = 2 • Solution is r = 10% • This is just a standard loan at 10% interest

19. Example 2 • Receive £100 at t1 = 0, receive £50 at t2 = 1.5 • Pay £90 at t1′ = 1, pay £80 at t2′ = 2 • Solution is r = 13.5% • How is this found? • Draw a graph • Trial and error

20. Example 2

21. Example 3 • Flat rate interest of 10% • £100 is received at time 0 • Five payments of £30 are made • The APR solves • The solution is 15.2% as claimed earlier

22. Example 3

23. Comparison • The APR is quoted with all adverts for loans • It is a simple means of contrasting the rates on loans with different structures