You are a financial planner working for Personal Finance, Inc. in Boise, Idaho. The owner of the company, Andrew Burke, has asked you to meet with John and Mary Smith to discuss their financial plans and needs and provide a financial plan for them. Andrew would like to discuss the report with you prior to presenting it to John and Mary. Andrew strongly believes that personal debt is a burden and should be paid off as soon as possible, allowing individuals more financial independence.
You met with John and Mary at the beginning of June 2014 to gather their information. By the end of 2014, both John and Mary will be 30 years old. Further, they were expecting their first child to be born in the latter half of December 2014.
John and Mary are both employed and their pre-tax annual income is $75,000 and $60,000, respectively. The Smiths' income tax rate is 28%. They still owe student loans of $18,000; the annual interest rate on the loans is 3.45% and there are 24 monthly payments remaining. In addition, John and Mary have a consumer loan of $7,000 which carries an annual interest rate of 4.25% and it has 24 monthly payments remaining. Finally, due to their liberal spending John and Mary have amassed an unpaid credit card balance of $20,000. The annual interest rate on their credit card loan is 15.25% and they just make the minimum monthly required payment which is 2% of the balance currently owed.
When you inquired, John and Mary told you that they currently rent a nice apartment for $1,300 a month. However, they would like to explore the possibility of buying their own house as soon as possible after their child is born. Actually, they have already looked around and houses they liked in their area sell for $190,000. You told them that to get a mortgage loan to buy the house, the down payment is 10% of the house price and the closing costs are 2% of the loan amount. In light of the information you provided, they indicated that, since they have no savings currently, they would like to save the money required for the down payment and the closing costs during 2015 and then buy their house at the beginning of 2016. You also indicated to them that 30-year mortgage loans carry a 3.75% annual interest rate and require monthly payments. At the same time, you explained to John and Mary that they can put the money they will be saving in 2015 towards the down payment and the closing costs in an interest earning account.
John and Mary also wanted to know about saving money for their child's college education. You explained to them that currently the average annual cost of college is $35,000, increases by 4% each year, and college lasts for four years. As you told them, the good thing is that if they start saving once their child is born they will have 18 years to save the money needed for college.
Lastly, when you asked, John and Mary said they want to retire when they turn 65 and have enough savings by then to last them until they turn 80. "After that who knows," they said! However, they indicated that during their retirement they would like to have as much of a real after-tax annual income as they currently have.
Once you collected the above information, you agreed that you will meet with the Smiths in two weeks to explain to them your recommendations.
In preparing your report, you had to make the following simplifying assumptions:
- Rent is paid at the end of each month
- Payments on the mortgage loan, the credit card loan, consumer loan, and student loan take place at the end of each month
- Savings for the house down payment and closing costs, the child's college education cost, and retirement accrue at the end of each month
- The child's college tuition is due at the beginning of each of the four years
Then, you:
1. Calculated the monthly payments the Smiths currently make on the credit card loan, the consumer loan, and the student loan, as well as the monthly after-tax amount of money they have left over after they make these payments and also pay their rent.
2. Calculated the amount of money the Smiths have to deposit each month in their child's college fund account; deposits start on January 31, 2015 and end on the child's eighteenth birthday and you estimated the annual interest rate on their savings to be 5%.
3. Calculated the amount of money the Smiths have to save each month in 2015 to have enough money by December 31, 2015 to cover the down payment and the closing costs for their new house; you estimated the annual interest rate on their savings to be 2%.
4. Calculated the monthly payment on the 30-year mortgage loan the Smiths will take for their new house; payments start January 31, 2016.
5. Prepared an amortization schedule for the first year of the mortgage loan.
6. Calculated how long it will take the Smiths to pay off their credit card loan if they continued paying the minimum required payment (recall this payment is 2% of their $20,000 credit card loan) and the total interest they will pay on this credit card loan.
7. Calculated the amount of money the Smiths should save each month (starting January 31, 2015) towards their retirement goal; you estimated the annual inflation rate to be 2% and the annual interest on their savings to be 5% between now and the time the Smiths turn 80.