The goals of this chapter are: Develop debt strategies, understand the many facets of debt, calculate and comprehend the rates charged on loans, identify the factors that enter into selecting credit, evaluate a fixed versus a variable rate mortgage, specify the advantages and disadvantages of a credit card loan, interpret debt financial ratios. | Chapter 7 Debt Chapter Goals Develop debt strategies. Understand the many facets of debt. Calculate and comprehend the rates charged on loans. Identify the factors that enter into selecting credit. Evaluate a fixed versus a variable rate mortgage. Specify the advantages and disadvantages of a credit card loan. Interpret debt financial ratios. Risk and Leverage The higher the debt, the higher the household’s risk. People who have too much debt are said to be overleveraged. Operating risk arises from uncertainties in connection with household activities. Financial risk comes from the amount of debt outstanding relative to your assets. Risk and Leverage, cont. Operating leverage is the degree to which you have fixed costs in your budget that come from household operating functions. The greater the percentage of your non-discretionary costs, the greater your operating leverage. When you have high fixed costs, a modest increase or decrease in your income can have a material impact on your free cash flow. Risk and Leverage, cont. Financial leverage arises from the amount of debt outstanding and its contribution to household fixed costs. The greater the amount of your interest expense and debt repayment commitments, the greater your financial leverage. When you have high fixed financial costs, a change in your income can have substantial effects on your free cash flow. Financial Leverage and Returns Financial leverage can increase potential rewards for the household. Many first time homebuyers undertake significant financial leverage by making an expensive purchase of a dwelling. Should the home subsequently rise sharply in price, that financial leverage can enable the member-owners to make a high return on their household investment. Undertaking additional debt has two effects: It not only raises risk; it also increases potential returns. Financial Leverage and Returns, cont. The amount of money a household borrows depends on: The cost of borrowing in | Chapter 7 Debt Chapter Goals Develop debt strategies. Understand the many facets of debt. Calculate and comprehend the rates charged on loans. Identify the factors that enter into selecting credit. Evaluate a fixed versus a variable rate mortgage. Specify the advantages and disadvantages of a credit card loan. Interpret debt financial ratios. Risk and Leverage The higher the debt, the higher the household’s risk. People who have too much debt are said to be overleveraged. Operating risk arises from uncertainties in connection with household activities. Financial risk comes from the amount of debt outstanding relative to your assets. Risk and Leverage, cont. Operating leverage is the degree to which you have fixed costs in your budget that come from household operating functions. The greater the percentage of your non-discretionary costs, the greater your operating leverage. When you have high fixed costs, a modest increase or decrease in your income can have a material impact
