CHAPTER 4 / Consumer Credit
Student Solutions
Concept Review Questions
1. Select the true statement from the list below.
(a) Capacity means that the loan will be repaid as a matter of principle.
(b) Character refers to the ability to make timely payments from cash flows.
(c) Collateral means assets have been pledged to the lender to reduce credit risk.
(d) Capital refers to the general lending environment, including unemployment
rates and the economic cycle.
(e) Conditions focus on the borrower’s assets and net worth.
Answer: (c) Collateral means assets pledged to the lender to reduce credit risk.
3. Give an example and description of an installment loan. Explain the difference between
an installment loan and revolving credit.
An installment loan is a credit facility that is used to finance a specific item for purchase,
such as a car, recreational vehicle, vacation, etc. These loans are also called consumer
loans. They are called installment loans because payments are made regularly over a
defined time period. An installment loan has a set principal amount, and once repaid
based on a repayment schedule the loan is extinguished. The use of the loan is also stated
in the loan document, and as such the money must be used specifically for that purpose.
Revolving credit means that the outstanding principal can revolve, that is as the credit
facility is drawn upon the amount increased and as payments are made, decreases. It can
be increased by the borrower up to the pre-established limit at any time. Once the
principal is repaid, the amount can be accessed again. At least an interest payment is
required monthly, and sometimes a portion of the principal too. This type of credit can
be used for any type of purchase, or even to take cash advances.
5. Describe the advantages of each of the following credit card types:
i. Reward
These cards typically come with some form of points to be redeemed for
merchandise or travel, cash back based on amounts spent on the card each year,
or services such as free auto towing, car rental insurance, extended warranty,
theft and loss protection on purchased merchandise, free travel insurance, cash
towards purchases, etc.
ii. Affinity
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These cards provide benefits for the user at the associated organization. These
could be post-secondary institutions, charitable organizations, arts or cultural
organizations, sports leagues, etc. A portion of card revenues is provided by the
card issuer to help support the efforts of these organizations.
iii. Student
These cards allow for easier qualifying in light of little-to-no credit history. They
often have a lower interest rate and no fees to make it more attractive and
affordable.
iv. Secured
This type of cards is helpful for a cardholder to establish or re-establish a good
credit history by attaching collateral security to the card.
v. Co-branded
Similar to affinity cards, these cards are associated with a for-profit organization.
Cardholder receives points for purchases that may be redeemed for products or
services at the co-branded organization.
7. In one paragraph, define the term “traditional credit”.
Traditional credit is when services are received, such as a visit to the dentist, and the bill
follows in the mail with defined terms, such as payment is required within 30 days from
the date of receipt. Often, an interest rate may apply on late remittances. Payment is
usually made at the place where the service was received.
9. List and discuss at least eight ways in which credit card fraud could be protected against.
• Never give out the card personal identification number (PIN).
• Never provide the account number, expiry date and secret code on the back (usually
a three-digit number used for on-line transactions).
• Never access the card account online while connected through an unsecure or
unverified internet access provider.
• Never let the merchant, such as a restaurant take the card out of sight. Ask if a wireless
transaction device is used by the restaurant or pay with cash.
• Never throw out credit card receipts or statements without shredding them firstly.
• Ensure the card is never lost and minimize opportunities of having it stolen. Lock it
up in a safe whenever it is not being used, or if it is being left in a hotel room. Never
leave a credit card in a vehicle that is unattended. Ensure the card is returned after
use at a merchant.
• Sign the back of the card upon receipt.
• Review the statement (on-line through a secure internet access or the paper version).
• Communicate with the card issuer about travel abroad, or unusual activity that is
forthcoming.
• Keep the authorization as low as possible, especially if using the card to make on-line
purchases.
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• If fraudulent activity is suspected, or the card is lost or stolen, let the card issuer know
immediately.
• Check the credit bureau report annually and watch for cases where someone may
have applied for credit.
11. Explain the primary purpose of having overdraft protection. Include in your discussion
any disadvantages of accessing the overdraft protection and the general requirements
of qualifying for overdraft protection.
Overdraft protection is primarily for protecting an account when a cheque has been
written and the account has insufficient funds to cover it. In the absence of overdraft
protection, the cheque would “bounce” or be returned non-sufficient funds (NSF). The
disadvantage is that overdrawn accounts face a very high interest rate, often as high as
24%. For a customer to qualify, a strong credit history and rating will typically be needed.
13. A single-purpose loan has a catch-up payment during the amortization period to make
up for payments that should have been made earlier to keep the repayment on
schedule for payout. True or false? Explain.
False. The statement describes a balloon payment loan. A single purpose loan is one with
a specific purpose for the loan to exist, and once repaid the purpose is extinguished.
15. Explain the main difference between a condominium and a co-operative home.
In a condominium, there is ownership of a specific unit which can be lived in. With a co-
op, shares of the entire building are owned; and rather than having ownership of a specific
unit, members have the right to live in one.
17. List and describe at least six extra costs that could arise upon the purchase of a home.
Below is a list of common costs that are extra to a house purchase. Refer to the text pages
for more detailed explanations.
• Mortgage Loan Application Fee — may apply and the amount varies between lenders,
but often this will be waived.
• Appraisal — the value of the home is appraised by a qualified appraiser based on
location, size of structure and the lot it sits on, extra structures on the lot (e.g.,
detached garage, shed, gazebo) the age and condition of the home, amenities within
the building in the case of condominiums or co-operatives, and so on. The appraisal
helps determine the amount that the lender will provide as a mortgage loan. The
appraisal cost is often reimbursed to the borrower or paid directly by the lender.
• Inspection Report — purchasers should make the purchase of a home subject to being
satisfied with the results of the inspection. The advantages are two-fold. Firstly, the
home may need serious repair that could get very expensive such as fixing foundation
cracks to prevent water leaks. Secondly, smaller, unnoticed repair costs to bring the
home up to living standards may be revealed, such as minor roof repair, and the age
of the furnace and hot water tanks that may require imminent replacement.
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• Legal Fees — the title and search, title transfer, mortgage document execution and
funds distribution will typically be done on behalf of the purchaser by a lawyer at a
cost.
• Goods and Services Tax (GST) — on new home purchases GST will apply, while a
rebate on a portion of it may be possible.
• Life Insurance — the lender will normally offer the mortgagor(s) life insurance that
will cover the outstanding balance of the mortgage loan on the life insured person(s).
• Property Survey — the lender will likely require this and is typically the responsibility
of the seller to provide.
• Utilities and Property Tax — there may be hook-up costs for utilities and a prepaid
amount on the property tax to be paid to the home seller.
• Moving Expenses — the costs associated for moving of personal belongings to the
new place of residence.
• Incidentals — costs such as restaurant meal expenses, gasoline for transporting of
vehicles, etc.
• Title Insurance — a cost that protects the purchaser from such things as easements,
encroachments, fraud, zoning con-compliance costs. This is a one-time cost and may
be purchased at the time of the home purchase, or after.
• Land/Property Transfer Tax — provinces and territories have a land or property
transfer tax, except in Alberta, Saskatchewan, Nunavut and Yukon, which may charge
a smaller fee for title transfer.
19. Explain what a stress test is when qualifying for a mortgage. Include in your explanation
how it differs between conventional and high-ratio mortgages and the purpose of
having a stress test.
Federal mortgage stress test rules require borrowers to qualify at an interest rate set by
the Bank of Canada, referred to as the benchmark rate.
For a conventional mortgage loan, the stress test requires that a borrower qualify at the
higher of the 5-year Bank of Canada benchmark rate, or the lender’s offered rate plus 2%.
When qualifying for a high ratio mortgage loan (insured loan), borrowers must qualify
based on the higher of the 5-year Bank of Canada benchmark rate, or the lender’s offered
rate (without the additional 2% that is required for conventional mortgage loans).
The stress test rules were put into place by the Office of the Superintendent of Financial
Institutions (OSFI) to increase the likelihood that borrowers will still be able to afford the
mortgage loan payments even if rates increase by term renewal time.
21. In one sentence for each, define the terms “assumable mortgage” and “mortgage
portability”.
Mortgage loans may be assumable by the home purchaser and the mortgage loan is being
purchased along with the house.
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Mortgage portability relates to the ability to take along the mortgage from the old house
being sold to a new purchase.
23. Describe the bankruptcy process. How does it differ between individuals and
businesses?
When an individual or company declares bankruptcy, proposals are made to extend the
credit repayment terms, or to repay only a percentage of the outstanding balance, or both
if obligations cannot be met. Once made, creditors will vote on acceptance of the
proposal, but a court must approve it before it becomes binding. Once approved, the
borrower and creditors will be bound to it.
Consumer proposals must be less than $250,000 excluding a mortgage, whereas division
1 proposals (businesses) have no limit.
Problems
1. Together, the Abes have a gross income of $125,000 per year. Their student loans, car
loan, and revolving credit facility require a total payment of $550 per month. The single-
family house they wish to purchase has been appraised at $400,000; however, the
purchase price will be $405,000 because it’s a seller’s market, with few houses on the
market and many buyers at this time. The property tax is $325 per month, and the
heating cost is estimated at only $75 per month because it is an R2000 home. The Abes
want a conventional mortgage. Their preferred term is for 5 years, fixed at 3.29% by the
lender. The 5-year Bank of Canada benchmark rate for the stress test is 5.34% at this
time. The Abes plan to pay it off with monthly payments over 25 years. Their lender
uses GDS and TDS ratios of 32% and 40%, respectively. Round to the nearest dollar.
i. Estimate (calculate) the amount of the mortgage loan that the Abes will qualify
for.
1. GDS ratio:
[($125,000 × 32% GDS = $40,000) ÷ 12 months = $3,333] – $400 property
tax and heat expense
= $2,933 available for mortgage debt servicing.
Calculate the PV(annuity) based on the payment available for servicing
above:
2 C/Y*, 12 P/Y, 5.34 I/Y, -2,933 PMT, 300 N, PV = 487,930
The maximum mortgage loan that they would qualify for based on the
GDS ratio would be $487,930.
2. TDS ratio:
[($125,000 × 40% GDS = $50,000) ÷ 12 months] = $4,167 – $400 property
tax and heat expense – $550 consumer loan payments
= $3,217 available for mortgage debt servicing.
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Calculate the PV(annuity) based on the payment available for servicing
above:
2 C/Y*, 12 P/Y, 5.34 I/Y, -3,217 PMT, 300 N, PV = 535,176
The maximum mortgage loan that they would qualify for based on the
TDS ratio would be $535,176.
* Fixed rate, residential mortgages must be compounded semi-annually based on
regulations (refer section above on fixed rate mortgages).
** The stress test requires the higher of the 5-year Bank of Canada benchmark
rate of 5.34% and the lender’s offered rate of 3.29% + 2%.
3. The lesser of the purchase price and the appraised amount is the latter at
$400,000. Accordingly, $400,000 × 80% (conventional mortgage
maximum mortgage loan allowed) = $320,000
The Abe’s would qualify to borrow the least of the three above, i.e., $320,000.
ii. How much down payment will they require (exclude extra costs)?
The Abes will need a down payment of $85,000 ($405,000 purchase price -
$320,000 mortgage loan).
