Introducingthe DebtPolicyStatement

byShawnBrayman

ShawnBrayman
PresidentofPlanPlusInc.,aCanadianbasedfirmthat providesfinancialplanningsoftwareandtraining worldwide. BachelorsandmastersdegreesfromYorkUniversity, Toronto,andisaCharteredFinancialPlanner. Toronto and is a Chartered Financial Planner RecipientofaFinancialFrontiersAwardin2007.

ExecutiveSummary
Manyconsumershavelosttheirhomesasaresultofpoorlending practicesorafailuretounderstandandplantheirborrowing decisions. IntroducingaDebtPolicyStatementmodeledoffthesame principlesasanInvestmentPolicyStatement. Educating consumers about their debt portfolioandhowto Educatingconsumersabouttheir debtportfolio and how to minimizeinterestcosts Risksassociatedwithinterestrates,realestatevalues,andother aspectsofthedebtportfolio Relationshipbetweenrisktoleranceandthestructureofhisor herdebtportfolio Debtclasseshaveattributessimilartoassetclasses Understandtheclientsfuturefinancialgoalstoensureshort termadvicedoesnotcreatefuturelimitations

InvestmentPolicyStatement
Collectfactualinformation Performarisktoleranceassessment Determineinvestmentobjectivesorgoals Analyzetheclientscurrentportfolio Potentiallyproposeanewportfoliostructure Recommendspecificinvestmentproductstoimplement theproposedportfolio 7. Periodicallyrebalancetheportfolioand/orcompletea reviewoftheIPS 1. 2. 3. 4. 5. 6.

IssuesinLending
CanadianBankingAssociationJune2010,Asmuchas51 percentofbank revenuesareearnedmainlythrough lendingactivities. Investmentindustryisevolvingfromsellwhatyoucan thatwillgenerategoodcommissions to processes to that will generate good commissionstoprocessesto ensurediversifying,avoidingemotionaltrading,andthe suitabilityofproducts SearchGooglefordebtmanagementplan,16million hitsrefertoaplantohelpconsumerswhoareinover theirheadswithtoomuchdebt.

PolicyBasedPlanning
PolicyBasedFinancialPlanningProvidesTouchstoneina TurbulentWorld,JournalofFinancialPlanning,July2006by DavidB.Yeske&ElissaBuie
Policyontheusesofdebt.Interiormotivation:Theclienthasanaversiontodebt (mightbebasedonfamilyhistoryandattitudesoranegativepersonalexperience involvingtoomuchdebt).Thecorrespondingpolicyfollows: For convenience we will use credit cards when buying items that are part of the Forconvenience,wewillusecreditcardswhenbuyingitemsthatarepartofthe monthlybudget. Forpurchasesrepresenting10percentorlessofannualearnings,wewillset asidefundsmonthlyuntilwe'veaccumulatedthepurchaseprice. Forpurchasescostingmorethan10percentofannualearnings,suchascarsor homes,wewilluseamortizeddebt,nottoexceedadebtserviceequalto30 percentofgrossincome. Withthispolicyasaguide,theclientcanalwaysfigureouttheappropriateactionto takewhenfacedwithabuyingdecision,evenifthespecificitemtobeboughtwas neverpreviouslycontemplated.Example:Save$500amonthtowardpurchaseof newlivingroomfurniture.

DebtPolicyStatement
Applylendingcriteriademandedbyregulatorsandthe industry Sensitivetoclientsgoals,risktolerance,andresources Applyfinancialplanningprinciplesonhowdebtrelatestoour lifestages life stages Createdebtportfolioappropriatetotheindividual Quantifybenefitsofrestructuringofdebtportfoliosocan understandcurrentsituationvs.recommended Besensitivetofeesandcostsassociatedwithimplementation ofthestrategy

ObjectivesforaPersonal DebtPolicyStatement
Regulatorstighteningaspectsoflendingprocess.Governor ElizabethA.DukeoftheU.S.FederalReserveJuly23,2009: Boardrecognizeddisclosuresalonenotsufficienttoprotectfrom unfairpractices.Topreventmortgageloanoriginatorsfrom steeringconsumerstomoreexpensiveloans,prohibit commissionsbasedoninterestrateorotherterms commissions based on interest rate or other terms Loanapplicationaboutqualificationforassumingdebt Reviewthenetworthstatement Costsforservicingexistingdebt Incomeandfixedcoststhataffectcashflowsuchaspropertytax onhome DPSnotbasedoniftheyqualifybutifwhattheyaskedformakes sense

RiskToleranceAssessment
Istherevalueinidentifyingaclientsrisktoleranceaspartof thelendingexercise? Debtmagnifierofriskrelativetovolatilityofinvestments FinancialrisktoleranceisasingleattributelikeIQwithnosub factors.Psychometrictestisrelevantforboth Howistherisktoleranceappliedtothedebtpolicydecision? Howgoodaretheclientsatmanagingdebt?Ifpoordowe lockthingsdownasopposedtoestablishingcreditlines? Otherrisktoincomefrompoorhealth,lossofjob

UnderstandingClientsCurrent andFutureFinancialGoals
Whyunderstandboththeclientscurrentandfuturefinancial goals? Directcostsrelatedtostructureofadebtportfolio.Bad decisionsnowwithoutunderstandingthefutureconsequences canleadtoexpensiveconflicts. Gatheringandprioritizingcurrentandfuturefinancialgoals. Howmuchisrequired,when,andforhowlong?Howwillthey befinanced? Debtallowsclientstoachieveimportantgoalsinadvanceof accumulatingsignificantcapital.Clientsshouldbedebtfreeby thetimetheyretire.

SidebarFromUKRegulator
1.14 Inappropriatefocusontheriskacustomeriswillingtotake Some firms unduly focus on the risk a customer is willing to take and fail to take sufficient account of the customers other needs, objectives and circumstances: for example g failing to consider whether the customer would be better placed repaying debt FSA January 2011

EstablishingDebtClasses
CreditCardDebt:Thesmallcapequityofthedebtworld. UnsecuredLinesofCredit:Formofconsumerdebtoften usedforlifestyleexpenditures. DebtonDepreciatingAssets:Loansassociatedwithcarsand boats. boats DebtonAppreciatingAssets:Onahomeorcottagethatis expectedtogrowinvalue. DebtonIncomeEarningAssets:Onincomeproducingreal estateorotherinvestmentassets. Equity:Theultimateandpreferreddebtclass.

AClientExample
Couple35yearsold Homeworth$330,000,$300,000remainingover25years.Fixed 5%interestfor5years Multiplecreditcardsbalances$15,000at20%variableinterest. $30 000 in investments $30,000ininvestments. $40,000carwith$35,000owingat8%over5years Twochildrenages7and5.Borrow$10,000annuallyforeach childforeducationcostsduringfouryearsofcollege. Boatafterkidsdoneschoolat$50,000willfinance75% Combinedincome$100,000/yearwithincreases.

DebtPortfolio

LendingMetrics
GrossDebtServiceRatio:Costofowning homedividedbygross income(maximum32%to35%) TotalDebtServiceRatio:Alldebtservicepaymentsdividedbygross income.Limitsof40% Interest/Payments:Ratioof100%verybad;0%onlyrepaymentof principal. principal DebtRatio:Totalliabilitiesdividedbytotalassets.Below40%is good,higherthan40%needsfixedassetsandabove70%isvery high. CurrenttoTotalLiabilities:Ratioofliabilitiesdueinnext12months dividedbythetotalliabilities. CreditUsedRatio:Balanceoncreditcardsandrevolvingaccounts anddividebytheavailablelimitsontheseinstruments.100%means usedallavailablecredit.

MetricsOverTime

DebtRiskConsiderations
InterestRateRisk riskthatratesincrease. Weightedaveragetermondebtindicateshowlongbeforerate increasesimpact.Fixedrateloansstableuntiltermexpires,variable rateloansimmediatelysubjecttorisk. Totalprincipaltorepaydependsoncurrentliabilitiesandfuture goals.Changeinterestrateschangetotalinterestpaidandtotal goals Change interest rates change total interest paid and total payments.Onthemortgageonlyappliesatrenewal. Increasesininterestratecouldincreasetotaldebtserviceabove supportablelimitsforcingareductionintheamountorextending amortizationsathigherinterestrate. Overthepast60yearsweseethatcurrentratesarelow: Inflation:3.8% 3.2% Cash:5.8% 3.9% Longtermfixedincome:6.7% 8.5%

ImpactofInterestIncrease

RealEstateValueRisk
Negativecorrelation(0.12)betweenfixedincomeand realestate.Mortgageratesincrease,realestatevalues drop. Investmentrealestatehasreturnof7.4%witha standarddeviationof10.6% standard deviation of 10 6%

RealEstateRisk

Thefiveyearperiodhasallowedpaydownofthemortgage 84.1%chanceequitywillhaveincreasedfrom$30,000to $43,114orbetter Mayhavedeclinedfrom5.6%to10% Balanceowingcouldbe$70,815morethanthevalueofthe home.

ARealExample
Clientplanningonretiringin5yearswenttoBanktogetamortgageto purchase theirdreamretirement home. Bothwereworking,hadagoodincomeanddownpaymentandGDS/TDS werewithintheratioswith5to10%tospare.TotheBankatthistimein theirlifeapprovalwasanobrainer. AlthoughtheLenderknewwereretiringin5years,theydidnotreview whatthecircumstanceswouldbeatthattime. Inthiscase,oncethey retiredtheirdebtservicewasmorelike65%TDS. Tomakemattersworse,theyhadabunchofcreditcardsthatoncethey retiredtheyusedtocoverthemonthlydeficits. Bythetimetheytriedtofixthings,theyhadamortgageof$400,000ona propertyworthabout$400,000thattheyweretryingtosellfor$500,000 (Paid$500,000butmarkethaddecreased)andowedabout$150,000in creditcarddebtandhadapensionincome of$50,000. Bankruptcy.

AnotherExample

DualincomefamilylivinginFlorida nurseandcarsalesman Ownedhomefor10years Propertydevalues,heworksforPontiac Bankmetricsmeantheyhaveamajorproblemonrenewal

GeneratingaProposedDebtPortfolio
Reducethecostofborrowingandtheriskofinterestrate changes. Considerrisktolerance,interestrateriskandrealestaterisk. Lowerrisktolerance=lowertotaldebtservice,morefixed rate,higherdownpayments. Limitcreditcardsto2monthsgrossincome. Equityandkeyratios.Especiallyearlyoptionsmaybelimited tounsecuredlinesofcredittoclearupcreditcarddebt. Unpaidcreditcarddebttounsecuredlineofcreditatbetter rates,orlinesofcredittosecuredlinesofcreditwithbest rates.

GeneratingaProposedDebtPortfolio
Consolidatingaffectsgrossdebtserviceifreducingpayments asopposedtoreducingtheamortization. Consolidationshouldnotreducetheprincipalrepaidover time Value of the next dollar saved versus the next dollar of debt Valueofthenextdollarsavedversusthenextdollarofdebt repaid. Ifequityof50%,debtagainstappreciatingassetsconsolidate intosecuredlineofcredit(75%or80%ofvalue)versus unsecuredline. Beawareofdifferentrisksassociatedwithdebtstructuresin eventofdefault.

SavingswithIncreasedPayments

Ifsalariesindexedat3%andloanpaymentsareindexedat1%and redirectedtoalternatedebt,resultsismorethan36percentless interestpaidbytheclient.

ImplementationandRecommendations
StrategicmodelOKbutchangedebtproducts. Introduceunsecuredlineofcredit. Ashomevalueincreases(10years)asecuredlineofcreditto financekidseducation,cars,andboat. Allinone accounts if need for emergency funds does credit Allinoneaccounts ifneedforemergencyfundsdoescredit remainsavailableintheeventofjobloss? Lifeanddisabilityinsurancecoverageforliabilitycoverage. Maintainconsistentpaymentsassomedebtretired,payments areredirectedtootherdebt. Increasepaymentswithincreasesinsalary.

Conclusion
DebtPolicyStatementisbuiltfromprocessfamiliartoplanners. Includetheclientsrisktolerancealongwithfuturegoalsthat mayrequiredebtfinancing. Visualizetheirfinancialfutureincludingrisksassociatedwith currentoraproposedapproachtodebt. Debtcategorizationtodifferentiateoncostandrisks associatedwithdebtinstrumentchoices. Encouragebehavioursthataretotheclientsbettermentsuch asaccelerateddebtreduction. Providebestpracticesondebtmanagementandensure consistencyandobjectivityintherecommendationsofdebt products.

Endnotes
1. CanadianBankingAssociation:www.cba.ca/en/mediaroom/50 backgroundersonbankingissues/119bankrevenuesandearningsprofits. 2. BoardofGovernorsoftheFederalReserveSystem: www.federalreserve.gov/newsevents/press/bcreg/20090723a.htm. 3. Ibid. , , y, g 4. Roszkowski,MichaelJ.,GeoffDavey,andJohnE.Grable.2005.Insightsfrom PsychologyandPsychometricsonMeasuringRiskTolerance.Journalof FinancialPlanning(April). 5. FinaMetrica:www.riskprofiling.com. 6. BasedonGovernmentofCanadaCPI,91DayTreasurybills,DEXUniverse Bondfrom1950to2009.Overthepast30yearsU.S.CPIwasverysimilarat 3.91percent+/ 2.89percentandU.S.192DayTbillswere5.70percent+/ 3.23percent. 7. BasedonanaggregateindexoftheMorguardFund,RussellRealEstate,and GlobeRealEstatePeerIndexbetween1950and2009.

10