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Lecture 6

Lecture 6 I. Using consumer loans I. Basic Features of Consumer Loans Formal, negotiated contracts Specify - terms for borrowing - repayment schedule One-time transaction Normally used to pay for big-ticket items Types of Consumer Loans Auto Durable goods Student loans Personal loans

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Lecture 6

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  1. Lecture 6 I. Using consumer loans

  2. I. Basic Features of Consumer Loans • Formal, negotiated contracts • Specify- terms for borrowing- repayment schedule • One-time transaction • Normally used to pay for big-ticket items

  3. Types of Consumer Loans • Auto • Durable goods • Student loans • Personal loans • Consolidation loans

  4. Sources of Consumer Loans: • Traditional financial institutions • Commercial banks • Credit Unions • Savings and Loan Associations • Consumer finance companies • Specialize in high-risk borrowers • Together with banks and credit unions make ~75% of consumer loans.

  5. Other sources include: • Sales finance companies • Third party financing • Include captive finance companies, such as GMAC • Life insurance companies • Loan against cash value of certain types of policies • Friends and relatives

  6. II. Shopping for Loans • Shop carefully before borrowing • Compare loan features • Finance charges and loan maturity • Total cost of transaction • Collateral requirements • Other features, such as prepayment penalties

  7. Keep Track of Your Credit! • Keep inventory sheet of debt • Know total monthly payments • Know total debt outstanding • Check your debt safety ratio— • total monthly consumer debt pmts • monthly take-home pay

  8. Single Payment Loans: • Is repaid in full with a single payment on a given due date • Specified time period,usually less than 1 year. • Payment includes principal and interest. • May require collateral.

  9. Calculating Finance Charges on Single-Payment Loans: • Simple Interest Method • calculated on the outstanding balance • Discount Method- not widely used anymore- interest calculated on the principal- then subtracted from loan amount; remainder goes to borrower- finance charges are paid in advance

  10. Example: Calculate the finance charges and APR on a $1000 loan for 2 years at an annual interest rate of 12%. (Assume interest is the only finance charge.)

  11. Using the Simple Interest Method: Interest = Principal x Rate x Time = $1000 x .12 x 2 Finance Charges = $240

  12. Using the Simple Interest Method: Annual Percentage Rate = average annual finance charge average loan balance outstanding APR = ($240  2)  $1000 = $120  $1000 = .12 = 12%

  13. Installment Loans: • Repaid in a series of equal payments. • Each payment is part principal and part interest. • Maturities range from 6 months to 7–10 years or longer. • Usually require collateral.

  14. Calculating Finance Charges on Installment Loans: • Simple Interest Method • calculated on the outstanding (declining) balance • Add-On Method • finance charges calculated on original loan balance and • then added to principal • costly form of consumer credit!

  15. Example: Calculate the finance charges and APR on a $1000 loan to be repaid in 12 monthly installments at an annual interest rate of 12%. (Assume interest is the only finance charge.)

  16. Using the Simple Interest Method: • Interest is figured on the outstanding loan balance each period. • Each payment causes principal to decrease. • Each subsequent payment, then, will incur a lower finance charge, so • More of the next payment will go towards repaying the principal.

  17. Simple Interest Method Continued: • This is the method used when computing with financial calculator. • With simple interest method Stated Rate = APR • In this example,APR = 12% and rate per period = 12% 12 = 1% per month.

  18. Mo. Beg. Bal. PMT Int. Principal End. Bal. 1 $1,000.00 $88.85 $10.00 $78.85 $921.15 2 $ 921.15 $88.85 $ 9.21 $79.64 $841.51 3 $ 841.51 $88.85 $ 8.42 $80.43 $761.08 4 $ 761.08 $88.85 $ 7.61 $81.24 $679.84 5 $ 679.84 $88.85 $ 6.80 $82.05 $597.79 6 $ 597.79 $88.85 $ 5.98 $82.87 $514.92 7 $ 514.92 $88.85 $ 5.15 $83.70 $431.22 8 $ 431.22 $88.85 $ 4.31 $84.54 $346.68 9 $ 346.68 $88.85 $ 3.47 $85.38 $261.30 10 $ 261.30 $88.85 $ 2.61 $86.24 $175.06 11 $ 175.06 $88.85 $ 1.75 $87.10 $ 87.96 12 $ 87.96 $88.85 $ 0.89 $87.96 $ 0

  19. Total amount paid over the 12-month period: $88.85 x 12 = $1,066.20 Loan amount = – 1,000.00 Interest paid = $ 66.20

  20. Using the Add-On Method: • Finance charges are calculated on the original loan amount: $1000 x .12 x 1 = $120 • Add these charges to principal: $120 + $1000 = $1,120 • Divide this amount by the number of periods to arrive at payment: $1,120  12 = $93.33

  21. Total amount paid over the 12-month period: $93.33 x 12 = $1,120.00 Loan amount = – 1,000.00 Interest paid = $ 120.00

  22. Comparing the Two Methods:

  23. More on Loans: • Carefully examine Installment Purchase Contract—it contains the terms of the loan. • Finance charges must include not only interest but also any other required charges. • Total charges, not just interest, must be used to calculate APR.

  24. Other Loan Features to Ask About: • Acceleration clause • Garnishment of wages • Repossession of collateral • Balloon payment • Prepayment penalties • Credit life insurance requirements (avoid if possible and get term insurance instead)

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