FNCE20003 Introductory Personal Finance Lecture 3 PDF

FNCE20003 Introductory Personal Finance Lecture 3 Money, income, credit, debt, and taxation Lecturer – Tony Cusack August 2024  Family ‘life cycle’ realities phase (iv) is typically one of consolidation of course, one’s life cycle plan can be interrupted by numerous contingenci...

FNCE20003 Introductory Personal Finance Lecture 3 Money, income, credit, debt, and taxation Lecturer – Tony Cusack August 2024  Family ‘life cycle’ realities phase (iv) is typically one of consolidation of course, one’s life cycle plan can be interrupted by numerous contingencies such as absence from work force (e.g. travel, child raising), divorce, death/incapacity of a partner, retrenchment, pandemics, etc. the (financial) impact of these contingencies can be serious and most will typically result in a savings shortfall, but some planning mechanisms exist – binding financial agreements (BFAs) are useful in relation to divorce – most employees will be covered by life insurance, often (but not exclusively) under superannuation arrangements – in addition, it may be advisable at certain times (e.g. when starting a family / during early child-rearing years) to invest in term life insurance July 2024 FNCE20003 Lecture 2 2  The road to retirement in summary, there are numerous issues, risks and opportunities arising in phases (i) to (iv) for phase (v) – retirement – the key issue is that there is an adequate RIS we will see that by making reasonable assumptions about superannuation, i.e. – commencing superannuation contributions in mid-20s – contributing at least the compulsory 11.5% (increasing to 12% from 1/7/2025) – long-term historical investment earnings are stable and doing nothing else to provide for retirement, then s/he is likely to end up with at least $800,000 lump sum in today’s dollars leading back to the key question: is that enough? July 2024 FNCE20003 Lecture 2 3  Lecture 3 topics Money and income Credit and debt The impact of taxation August 2024 FNCE20003 Lecture 3 4  What is money? money is commonly defined through its functions: 1. Medium of exchange eliminates inefficiencies of barter (double coincidence of wants) facilitates financial transactions 2. Store of value can be stored and used for future consumption 3. Unit of account enables valuation of different elements using a common unit can be used for calculation, valuation, comparison August 2024 FNCE20003 Lecture 3 5  The value of money historically, money was backed by a physical asset (typically gold, therefore the “gold standard”) meaning that each unit of currency had a specific (intrinsic) value in the backing asset (e.g. $1 bought ‘x’ units of gold) however, the world has now moved to a system of ‘fiat’ currencies, whereby the currency is declared by government as ‘legal tender’, meaning it can be used to acquire goods and services, and meet financial obligations in that sense, money derives its value from the trust people place in it, as there is very little intrinsic value in physical notes and coins – a possible problem arises: a loss of trust may lead to hyperinflation (very high and quick inflation) where a local currency erodes in value very quickly as people stop accepting local currency (e.g. Venezuela currently, Zimbabwe 2008 - example) August 2024 FNCE20003 Lecture 3 6  Digital vs ‘physical’ money today, most money is in digital (electronic) form, such as bank account balances, and an increasing number of payments are made digitally so, there is a declining use of banknotes and increasing use of electronic forms of payment, including Buy Now Pay Later programs – only approximately 8% of ‘regulated’ money exists in physical form, and many people no longer use cash in any form other observed trends relating to the payments system include greater use of digital wallets, growing involvement of the ‘big techs’ in payments, and growing community and political interest in the security, reliability and cost of payments August 2024 FNCE20003 Lecture 3 7  What is income? we all understand the concept of income, even though (according to Investopedia) there is no single, standard definition, i.e. income is defined according to the context in which the concept is used for individuals, income is either earned in the form of salary / wages; passive, i.e. return on investments (e.g. interest, dividends, rent); or other receipts some receipts like capital amounts (from sale of assets), gambling winnings, and gifts (from family or others) are not income in the traditional sense – however, there are certain rules defining income for tax purposes as we have previously covered, income is the main source of spending (making payments) and savings August 2024 FNCE20003 Lecture 3 8  Salary / wages for most people, their main source of income will be salary / wages from employment (= earned income) we saw that the life cycle model assumes regular growth of earned income, and historically that has been the case – e.g. the next slide from the ABS shows positive (and increasing) wage growth each quarter over a long period however, nominal wage growth doesn’t tell the full story – the most informative measure is that of real wages, that is, inflation-adjusted as the following slides indicate, the situation is currently not good in terms of financial wellbeing related to income available for consumption and savings August 2024 FNCE20003 Lecture 3 9  Annual wages growth 4.1% in March quarter 2024 source August 2024 FNCE20003 Lecture 3 10  Inflation and real wages discussion August 2024 FNCE20003 Lecture 3 11  Lecture 3 topics Money and income Credit and debt August 2024 FNCE20003 Lecture 3 12  Credit and debt up front: be aware that the difference between credit and debt is purely a technical one – credit is the earlier portion of a debt transaction, i.e. a borrower should obtain credit prior to taking on a debt credit is broadly categorised into two types: fixed payment loans (repaid in instalments) and revolving credit – fixed payment loans include personal loans, car loans, Buy Now Pay Later, and home mortgage loans – revolving credit facilities include credit cards, overdrafts and lines of credit for clarity, each of these loans / facilities are offered in the form of credit, which becomes debt of the borrower once it is obtained August 2024 FNCE20003 Lecture 3 13  Common personal debt the most common types of credit available include: 1. Personal loans – personal loans are individual borrowings that can be used to fund purchases of items such as cars; they can be secured and unsecured, short or longer term – typically require repayment of principal and interest as fixed monthly payments 2. Home loans – borrowing by individuals or couples to finance the purchase of a home – the property acquired forms security for the loan (mortgage) – they generally require repayment of principal and interest for terms between 10 and 30 years August 2024 FNCE20003 Lecture 3 14  Common personal debt 3. Credit cards – there are different types of credit cards available (branded, advance cards, store cards, line of credit cards), at varying – but high – rates of interest (comparer) – the use of credit cards can be appropriate, yet they are often used inappropriately (funding excessive consumption) 4. Buy Now, Pay Later finance – interest-free finance, commonly referred to as “Buy Now, Pay Later (BNPL)”, has become an increasingly popular way to pay for purchases – platforms such as Afterpay, Zip, Openpay and others allow you to spread the cost of a purchase over time without having to pay interest although interest-free, there are still costs involved (especially late fees)(report) August 2024 FNCE20003 Lecture 3 15  The changing landscape of credit historically, there was always plenty of (usually negative) press about credit card debt – Glimmer of hope: credit card debt drops for first time in six months 9 July 2024 – ASIC report finds credit card debt still a pain for many Australians 30 July 2024 – Australian Credit Card Debt Statistics 2024 10 July 2024 BNPL is also well covered, most recently focused on the move to stronger regulation of BNPL – More consumers relying on BNPL 22 May 2023 – ‘It’s a trap’: Australians using buy now, pay later for groceries, fuel 28 July 2024 – Australia: Long awaited buy now pay later reforms arrive 24 April 2024 we saw that COVID-19 resulted in a fundamental (savings / spending) change, and now we are experiencing the impact of rising costs of living – Australia’s cost-of-living crisis has reached a critical juncture (AFR) 10 June 2024 – Record call volume to debt helpline amid cost of living crisis (ABC) 8 July 2024 August 2024 FNCE20003 Lecture 3 16 August 2024 Personal Finance Lecture Series 17  Using debt to fund consumption debt can be – and often is – used to fund consumption (lifestyle) expenditure the use of debt to fund short-term consumption – e.g. nights out, meals, holidays, clothing – is considered financially irrational* i.e. it is considered ‘bad’ use of debt because: – there is no asset being purchased – the interest paid is not tax deductible, and – once spent, there are only intangible benefits (if any) gained from debt however, funding long-term consumption – i.e. depreciating assets with a useful lifetime, such as ‘white goods’, cars or furniture – is not as bad August 2024 FNCE20003 Lecture 3 18  Funding assets of course, not all debt is used to fund consumption, and borrowing to fund the purchase of appreciating assets is generally considered a sound strategy the first in this category is borrowing to fund non-investment appreciating assets (such as a home, vintage car, boat, holiday home or renovations, etc.), where the asset is expected to increase in value – such assets can generate a capital gain upon eventual disposal, which will result in a positive return if it covers borrowing costs the other is funding of investments, i.e. where the borrowing is used to fund appreciating assets in the expectation of returns that will pay the costs associated with the borrowing, to provide a positive net investment return August 2024 FNCE20003 Lecture 3 19  Paying off non-deductible debt a home mortgage loan typically takes up to about 20-40% of disposable income, but sometimes it’s even more (a source of financial stress …) it’s not immediately apparent, but investing by paying off home mortgage loans (and other non-tax deductible debt) is a low-risk strategy that delivers a relatively high effective return: the amount of the interest saved sometimes this is not appreciated, as the return from saving outgoings is not tangible compared to a cash return on an investment comparing the required returns on investment vs paying off non-deductible (personal) debt demonstrates that often the best ‘return’ is to pay off any non-deductible debt August 2024 FNCE20003 Lecture 3 20  Paying off non-deductible debt the result arises due to the taxation of investment income, versus saving of a non-deductible expense e.g. at the top marginal tax rate of 45%+2%, you would need to achieve a rate of return of 11.3% to better the ‘return’ from paying off mortgage at 6% p.a. – i.e. 11.3% * (1 - 0.47) = 6% achieving this increased return is unlikely without taking on significantly more investment risk note also that paying off the mortgage is not subject to market volatility, although there is some variability of return with variable rate loans, so in a sense the saving of mortgage interest is a risk-free return August 2024 FNCE20003 Lecture 3 21  Example – personal loan you have graduated, landed a great job, and need a reliable car for your job (and/or for your image) so, it’s off to the bank to arrange a personal loan for $25,000 assume that the agreed loan conditions are as follows: – to be repaid in 12 equal monthly instalments, starting at the end of the first month – annual interest rate of 10% applies – interest compounded monthly what is the monthly repayment amount? August 2024 FNCE20003 Lecture 3 22  Solution – personal loan as the loan requires equal periodic repayments, this is an annuity problem therefore, we input the known variables into the ordinary annuity formula (solving for A), i.e. PV = A[(1 - (1+r)-n))/r] A = 25,000 / [(1 - (1+(0.1/12))-12))/(0.1/12)] = $2,197.90 observe that the interest rate used is the quoted nominal rate divided by compounding periods, which is always the case with annuity formulae (note: it’s easy to do this calculation in Excel) August 2024 FNCE20003 Lecture 3 23  Repayment schedule Amount owing Amount owing Month Beginning mth Repayment Interest End month 1 $25,000.00 $2,197.90 $208.33 $23,010.43 2 23,010.43 $2,197.90 $191.75 $21,004.29 3 21,004.29 $2,197.90 $175.04 $18,981.42 4 18,981.42 $2,197.90 $158.18 $16,941.70 5 16,941.70 $2,197.90 $141.18 $14,884.98 6 14,884.98 $2,197.90 $124.04 $12,811.12 7 12,811.12 $2,197.90 $106.76 $10,719.98 8 10,719.98 $2,197.90 $89.33 $8,611.42 9 8,611.42 $2,197.90 $71.76 $6,485.28 10 6,485.28 $2,197.90 $54.04 $4,341.42 11 4,341.42 $2,197.90 $36.18 $2,179.70 12 2,179.70 $2,197.90 $18.16 ($0.04) August 2024 FNCE20003 Lecture 3 24  Example 2 – home mortgage loan you’ve saved a deposit, spent your weekends looking at potential homes, decided on the one, and been successful at the auction now you need to borrow $550,000 from your bank agreed conditions of the loan are as follows: – to be repaid in equal monthly instalments over 25 years, beginning the end of month one – annual (variable) interest rate of 7% applies – interest compounded monthly what is the monthly repayment amount? August 2024 FNCE20003 Lecture 3 25  Solution – home mortgage loan again, the loan requires equal periodic repayments, which indicates it is an annuity the known variables are again the PV (loan amount), interest rate and compounding periods A = PV / [(1 - (1+r)-n))/r] A = 550,000 / [(1 - (1+(0.07/12))-300))/(0.07/12)] = $3,887.29 this is the monthly mortgage repayment - see repayment schedule (1st year) August 2024 FNCE20003 Lecture 3 26  Repayment schedule Amount owing Amount owing Principal Month Beginning mth Repayment Interest End month repaid 1 $550,000.00 $3,887.29 $3,208.33 $549,321.04 $678.96 2 549,321.04 $3,887.29 $3,204.37 $548,638.13 $682.92 3 548,638.13 $3,887.29 $3,200.39 $547,951.23 $686.90 4 547,951.23 $3,887.29 $3,196.38 $547,260.32 $690.91 5 547,260.32 $3,887.29 $3,192.35 $546,565.38 $694.94 6 546,565.38 $3,887.29 $3,188.30 $545,866.39 $698.99 7 545,866.39 $3,887.29 $3,184.22 $545,163.32 $703.07 8 545,163.32 $3,887.29 $3,180.12 $544,456.15 $707.17 9 544,456.15 $3,887.29 $3,175.99 $543,744.85 $711.30 10 543,744.85 $3,887.29 $3,171.84 $543,029.41 $715.45 11 543,029.41 $3,887.29 $3,167.67 $542,309.79 $719.62 12 542,309.79 $3,887.29 $3,163.47 $541,585.97 $723.82 August 2024 FNCE20003 Lecture 3 27  Example 2b – home mortgage loan what happens if the variable interest rate increases to 8%p.a. after 6 months? first, we need to determine the amount owing after six months (i.e. before the rate change): PV = 3,887.29 * [(1 - (1+ 0.07/12))-294))/(0.07/12)] = $545,866.41 (agrees with table – 2c out) now use this new PV to determine new A at new interest rate, 8%: A = 545,866 / [(1 - (1+(0.08/12))-294))/(0.08/12)] = $4,240.29 this illustrates interest rate risk, i.e. the monthly mortgage repayment has increased significantly due to a 1% interest rate increase (~9% in this case) August 2024 FNCE20003 Lecture 3 28  Refinancing and debt consolidation scenario: you took out your current home mortgage loan several years ago and are now reviewing it issues to consider are: – what interest rate are you currently paying? – how does this compare to the rates now on offer in the market? we address these issues using an example where there has been what looks like a small drop in interest rates from what you are still paying this will enable determination of whether a re-financing of the mortgage loan is appropriate August 2024 FNCE20003 Lecture 3 29  Refinancing example (1) five years ago, you purchased a small apartment for $385,000 you paid a 20% deposit ($77,000), so the original loan amount was $308,000 and therefore the original loan-to-value ratio (LVR) was 80% – note, 80% is the usual cut-in level for compulsory lenders mortgage insurance initial term of mortgage – 25 years (so, 20 years remaining) you are paying the current standard variable rate of 5.88%, giving current monthly payments $1,962 your property is now valued at $517,500 and the mortgage balance (i.e. the amount still owed by you) = $276,526 (how is this calculated?) – updated LVR is 276,526/517,500 = 53.4% (so what?) August 2024 FNCE20003 Lecture 3 30  Refinancing example (1) you consult a mortgage broker to find a suitable current deal and find you can now get a fixed rate of 4.69% it is possible to revert to a 25-year term again, but to reduce the repayment time (and thus, save interest), you decide on a 20-year term on the new loan, paying monthly as before at the new interest rate of 4.69% and given the remaining term of mortgage of 20 years, your new monthly repayments will be $1,778 the end result is that you will be paying off your mortgage over exactly the same time period as before, except you now pay $184 per month less (equating to $2,208 less per year and $44,160 less over the life of the loan) August 2024 FNCE20003 Lecture 3 31  Refinancing example (2) we now consider another example that is similar, but goes an extra step and consolidates some other debts into the mortgage loan – this is possible due to the net equity implied by the relatively low LVR assume that not only do you have a mortgage, but there is (i) a balance outstanding on a car loan, and (ii) you would like to reduce the amount of interest you are paying on credit card balances the interest rate that you pay on these loans is higher than that on a standard mortgage – car loan interest rates are currently ~8% p.a. – credit card interest rates are ~20% p.a. August 2024 FNCE20003 Lecture 3 32  Refinancing example (2) assume the interest rate for the car loan is 7.5% and the credit cards average 19.9% the total amount you owe on the car loan plus the credit card is $25,000 and your monthly repayments are $550 for the car and $200 for the credit card if you were to consolidate, this extra loan amount of $25,000 is added to the mortgage, meaning the mortgage balance outstanding becomes $301,526 with the house valued at $550,000 the LVR is now 301,526/517,500 = 58.3% – i.e. still well below the 80% compulsory mortgage insurance level, which is effectively the upper limit on these home equity loans August 2024 FNCE20003 Lecture 3 33  Refinancing example (2) your property is now valued at $517,500 loan balance with debt consolidation: $301,526 (so, >$200k net equity) new interest rate: 4.69% term of mortgage: 20 years new monthly repayments: $1,939 if you stayed with the original mortgage, you would be paying $1,962 for the house, around $550 for the car and $200 for the credit card (per month) – a total of $2,712 August 2024 FNCE20003 Lecture 3 34  Refinancing example (2) with a re-financing consolidation, we now pay a monthly total of $1,939 – a difference of $773 per month / $9,276 per year a possible downside is that you are now paying off the car loan and the credit card over a longer period … but given the advantage of this lower rate, there is nothing to stop you paying down more of the consolidated mortgage loan each month, i.e. increasing your monthly repayment therefore, you could effectively pay off the car / credit card just as quickly and at this much lower rate paying more than the minimum $1,939 p.m. will save more interest August 2024 FNCE20003 Lecture 3 35  Credit traps borrowers need to be aware of the risk involved in seemingly good deals (e.g. ‘0% interest’ deals) as they can quickly become non-affordable 1. Hidden costs – fees, charges and taxation can change a positive outcome into a negative one (e.g. low interest, but up-front fee); note this for BNPL alternatives 2. Credit cards with interest free periods – can be effective, but this depends upon the holder’s payment discipline 3. Low introductory credit offers – banks often offer low introductory rates on credit cards (say 8%) that last for six months or so and then revert to the current market rate (currently near 20%) August 2024 FNCE20003 Lecture 3 36  Lecture 3 topics Money and income Credit and debt The impact of taxation August 2024 FNCE20003 Lecture 3 37  Income Tax – Australia like most countries, in Australia there is a distinction between personal taxation and corporate taxation – individuals are subject to marginal tax rates (MTR), ranging between zero and a maximum of 45%* – companies (all public and private) pay a flat rate of 30% marginal rates mean a progressive tax system, where the MTR > average rate note that for companies, the amount that is subject to tax (taxable income) is not necessarily equal to accounting (before-tax) profit – net profit before tax is the starting point, and then there are adjustments based on tax legislation August 2024 FNCE20003 Lecture 3 38  Taxation of income in Australia, income tax is levied on taxable income taxable income is made up of assessable income, less allowable deductions assessable income of individuals includes (but is not limited to) the following amounts received: – earned income (salary, wages, fees, etc.) – interest income – dividends and distributions – rental income – royalties – short- and long-term capital gains August 2024 FNCE20003 Lecture 3 39  Treatment of expenses allowable deductions include losses and outgoings (expenses) incurred in gaining or producing assessable income or in carrying on a business – e.g. protective clothing, home office, travel* expenses that are not tax deductible include those of a private or domestic nature, i.e. not incurred in producing assessable income or in a business – e.g. housing costs, living expenses, personal travel (including to and from work) there are also specific inclusions and exclusions of both income and expenses under tax laws – in addition, special rules can apply (e.g. higher deduction for R&D expense) to re-iterate, taxable income = assessable income - allowable deductions August 2024 FNCE20003 Lecture 3 40  Personal tax rates 2023-24 and 2024-25 source in addition, Medicare Levy is charged at 2% on income above $29,033 * August 2024 FNCE20003 Lecture 3 41  Calculating income tax payable August 2024 FNCE20003 Lecture 3 42  Income tax calculation example assume an individual who earns a gross salary of $125,000 (including super*), has interest income of $500 and work-related deductions of $1,800 – this example could also accommodate a negative gearing scenario (covered later), where the net negative cash flow is just another tax deduction – LITO doesn’t apply due to income level taxable income (TI) is determined by income and deductions, and is reduced by the mandatory superannuation contribution (11.5% of salary = $14,375) TI = $109,325 (i.e. $125,000 - 13,750 + 500 - 1,800) tax on TI = $4,288 + 0.325*(109,325 - 45,000) + 0.02*109,325 = $25,772.00 [note: total ‘retained’ = $109,325 - 25,772 + (14,375*0.85) = $95,771.75] August 2024 FNCE20003 Lecture 3 43  Rules amending tax payable as indicated, the tax-free threshold is the first $18,200 of income – important exception: unearned income of a minor (threshold is $416) the Low Income Tax Offset (LITO) applies to reduce tax (but not Medicare Levy) for taxpayers earning up to $66,667 – there is a maximum reduction of $700 for income up to $37,000 – an individual can earn up to $21,884 before any income tax is payable various other offsets / rebates apply in limited circumstances August 2024 FNCE20003 Lecture 3 44  Taxation of investment income since the returns from investments – interest, dividends, rent – are (assessable) income, they will be taxed in the hands of the investor the amount of tax payable is dependent upon the investor’s marginal tax rate (MTR), which is determined by other income of the investor e.g. assume two individuals, A and B, each receive $1,000 of interest income – A earns a salary of $200,000 p.a. – B is semi-retired and earns $30,000 p.a. A would pay $470 tax on the interest (MTR = 45+2%) B would pay $180 tax on the interest (MTR = 16+2%) August 2024 FNCE20003 Lecture 3 45  Dividends and capital gains whilst in most cases, every extra $ of income is assessed at the individual’s MTR, there are special rules in relation to dividends and capital gains (CG) in Australia, dividends are subject to taxation under the dividend imputation system, which takes into account the amount of corporate income tax that was paid before dividends are paid – it replaced a ‘classical’ taxation system, which resulted in an effective double taxation of corporate income (and is still the system in some other countries) in relation to CG, if gains are classified as long-term (asset held > 1 year), a discount applies to the amount that is subject to tax (generally, 50%) August 2024 FNCE20003 Lecture 3 46