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Chapter 7. Using Consumer Loans: The Role of Planned Borrowing. Learning Objectives. Understand the various consumer loans. Calculate the cost of a consumer loan. Pick an appropriate source for your loan. Control your debt. Introduction.
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Chapter 7 Using Consumer Loans: The Role of Planned Borrowing
Learning Objectives • Understand the various consumer loans. • Calculate the cost of a consumer loan. • Pick an appropriate source for your loan. • Control your debt.
Introduction • Consumer loans —formal contracts detailing how much you are borrowing and when and how you are going to pay it back. • Used for bigger purchases (not credit cards) • Debt and borrowing can easily get out of control.
First Decision: Single-Payment versus Installment Loans • Single-Payment or Balloon Loan—paid back in a single lump-sum payment, with interest, at maturity • Bridge or interim loan– short-term loan while waiting for long-term loan • For example, a bridge loan may be taken out while waiting for a mortgage loan Installment loan—repayment of both principal and interest at regular intervals, usually monthly
Amortized Loans • Installment loan that is amortized: • Loan amortization —with each payment, the interest portion of the payment decreases and principal portion of the payment increases. • Very common • Used to finance cars, appliances, etc.
Second Decision: Secured versus Unsecured Loans • Secured loan —guaranteed by an asset (collateral) which typically lowers the interest rate of the loan • If the collateral is repossessed, you may still owe money on the loan • Unsecured loan—not guaranteed by an asset or collateral • Sometimes called a “signature loan”. Credit cards are examples • Higher interest rates
Third Decision: Variable-Rate versus Fixed-Rate Loans Fixed-rate interest loan—rate stays fixed for entire duration of the loan, not tied to market interest rates (most consumer loans) • Variable-rate or adjustable interest rate loan—interest rate varies based on the market interest rate (credit cards) • Prime rate —the interest rate that banks charge to their most creditworthy, or “prime” customers • Convertible loan —variable-rate loan that can be converted to a fixed-rate loan.
Fourth Decision: The Loan’s Maturity—Shorter versus Longer Term Loans • Shorter term loan means lower interest rates and larger monthly payments • Lenders generally charge less interest on a shorter time-period loan • Longer term loan means smaller monthly payments and higher interest rate • You will end up paying more in total interest
Understand the Terms of the Loan: The Loan Contract • Security agreement • Default • Note • Acceleration clause • Deficiency payments clause • Recourse clause
Special Types of Consumer Loans • Home Equity Loan or Second Mortgage—secured loan using equity in home as collateral • Equity is the home’s value minus the mortgage loan balance. • Example: • The equity ($100,000) is the collateral on the loan House worth: $300,000 Mortgage balance: $200,000 Equity: $100,000
Home Equity Loan • Advantages: • Interest is tax deductible at your marginal tax rate. Example: • Usually lower interest than other consumer loans Marginal tax rate = 20% For every dollar in interest you pay, you save 20 cents in taxes If your marginal tax rate is 25%, for every dollar of interest you pay, you save 25 cents in taxes
Home Equity Loan • Disadvantages: • Puts your home at risk • If your home declines in value, you are still responsible for the loan • You could lose your home • You can only have one of these loans at a time • Limits future financing flexibility • Places an obligation on future earnings
Special Types of Consumer Loans • Student Loan—low, federally subsidized interest, based on financial need • Federal loans • Direct PLUS Loan for parents/graduate and professional students • In 2010, the amount of student loan debt exceeded the amount of credit card debt
Figure 7.2 Percent of Students at a 4-Year College Who Borrow
Special Types of Consumer Loans • Automobile Loan—loan secured by auto as collateral • Duration usually for 2, 3, or 4 years; even 5 to 6 years • Low-cost auto loan rates are used to lure customers, to push slow-selling vehicles or older models • A default on the loan will result in repossession of the car
Cost and Early Payment ofConsumer Loans • APR—annual percentage rate—simple percentage cost of all finance charges over the life of the loan, on annual basis. • Truth in Lending Act requires all consumer loan agreements disclose APR in bold print.
Cost and Early Payment ofConsumer Loans • Loan disclosure statement must give APR and finance charges of a loan • Simple interest method: interest = principal x interest rate x time (I=prt) Example for $10,000 borrowed at 12% for one year and for two years: $10,000 X .12 X 1 = $1,200 $10,000 X .12 X 2 = $2,400
Cost and Early Payment of Consumer Loans–Discount Method • The interest is subtracted from the proceeds of the loan • At maturity, the borrower pays back the full principal • Example: $10,000 loan at 12% for one year ($1,200 in finance charges) • You receive $8,800 ($10,000 - $1,200) • At maturity, you pay back $10,000 • The APR is $1200/$8800 = .1364 or 13.64% • This method always results in higher interest
Payday Loans—A dangerous kind of single-payment loan • $100 to $500 loan till next payday. • The borrower writes a post-dated check for principal plus fee. This is left with payday lender. • Lender will cash the check in 1-2 weeks • If the borrower doesn’t have enough to pay, he/she can: • Roll the loan over, paying an additional fee, or • Default, resulting in additional charges and legal action
PayDay Loans • Annualized interest rates up to 400% • Each state has laws governing payday lending • Utah doesn’t have a maximum interest rate • Utah has passed laws that govern how many payday loan stores can be opened, depending on population • Utah has also passed laws on the maximum number of times a loan can be rolled over.
Cost of Installment Loans • Repayment of both interest and principal occurs at regular intervals, usually monthly • Payment levels are set so loan expires at a preset date. • Most loans use the simple interest method (use a financial calculator or Appendix E) to find monthly payment
Installment Loans • There is usually no penalty for paying the loan off early • Avoid the add-on method, where you pay interest on the original principal for the life of the loan (not common)
Table 7.3 Monthly Installment Loan Tables ($1,000 loan with interest payments compounded monthly)
Amortization Table • An amortization table will show for each payment: • Beginning balance • Total payment • Amount paid for interest • Amount paid for principal • Ending balance • Date of last payment
Table 7.4 Amortization Table of a 12-Month Installment Loan for $5,000 at 14%
Getting the Best Rate on Your Consumer Loans • Inexpensive sources—family, home equity loans, cash value life insurance loans. • More expensive sources—credit unions, S&Ls, and commercial banks. • Most expensive sources—retail stores, finance companies or small loan companies
Keys to Getting the Best Rate • Strong credit rating • The lower the risk you are to the lender, the lower your interest rate • These features reduce risk for lender: • Variable-rate loan (the rate can go up if interest rates rise) • Short loan term (usually lower interest rates) • Secured loans (less risky because of collateral) • Large down payment (the larger the down payment the less you have to borrow)
Should You Borrow or Pay Cash? • Keep in mind that debt is expensive. • Don’t borrow to spend on unnecessary items • Use cash rather than credit, but be sure you still have enough liquidity – it’s a “balancing act” • If benefits of borrowing outweigh costs, borrowing makes sense.
Controlling Your Use of Debt • Determine how much debt you can comfortably handle • Debt level comfort and need changes at different stages of the financial life cycle • With age, debt proportion of income tends to decline. • Use measures to control debt commitments • Debt limit ratio • Debt resolution rule
Controlling Your Use of Debt • Debt Limit Ratio—percentage of take-home pay committed to non-mortgage debt • Total debt can be divided into consumer debt (everything but mortgage) and mortgage debt • Consumer debt ratio should be below 15% • If it is over 20%, you should avoid additional consumer debt • If it over 20%, you may not be able to borrow more money in an emergency
Debt-Limit Ratio Examples • Example 1: Josie • Example 2: Alexis Credit card and other loan payments per month: $700 Monthly take-home pay: $2,000 Debt Limit Ratio: 700/2,000 = .35 or 35% Credit card and other loan payments per month: $200 Monthly take-home pay: $2,000 Debt Limit Ratio: 200/2,000 = .1 or 10%
28/36 Rule for Mortgage Applications • You are a good credit risk if: • Total projected mortgage payment (including payment, insurance, taxes) is less than 28% of gross monthly income -and- • Total mortgage payment plus consumer debt is less than 36% • Example: for someone with gross pay of $5,000 Total mortgage payments: $1,350 1,350/5,000 = .27 or 27% Total consumer loan payments: $350 $1,350 + $350 / $5,000 = .34 or 34%
Debt Resolution Rule • Is used by financial planners to help control debt obligations, excluding borrowing for education and home financing, by forcing you to repay all outstanding debt obligations every 4 years • Logic is that consumer credit should be short-term.
Controlling Consumer Debt • Make sure it fits in with your goals and budget. • Understand how costly consumer debt is. • Understand that borrowing limits future financial flexibility. • Watch for clues that you might be in financial trouble.
What To Do If You Can’tPay Your Bills • Budget so more money comes in • Use self-control in the use of credit • Go to your creditor • Go to a credit counselor
What To Do If You Can’tPay Your Bills • Borrow inexpensively. • Use savings to pay off current debt. • Use a debt consolidation loan. • Bankruptcy—the last resort • doesn’t wipe out all obligations
What To Do If You Can’tPay Your Bills • Most common types of personal bankruptcy: • Chapter 13 The wage earner’s plan • You design a plan to pay back your bills • Chapter 7 Straight bankruptcy • Most debts are discharged
Bankruptcy • Primary contributors to bankruptcy: • Major illnesses, including loss of income because of the illness • Easy availability of credit leading to overspending • Divorce • Job losses
Chapter 13 Bankruptcy: The Wage Earner’s Plan (28% of filers) • Must have: • Regular income • Secured debts under $1,010,650 (2007) • Unsecured debts under $336,900 (2007) • More than $100 in disposable income/month • The borrower designs a repayment schedule to pay off all debt within 3-5 years • Assets are not sold to pay debt
Chapter 13 Bankruptcy • Benefit for the individual—relief from harassment of bill collectors • Benefit for creditors—controlled repayment with court supervision • Bankruptcy stays on credit report for 7 years from the end of repayment
Chapter 7 Bankruptcy (72% of filers) • Must have: • Less than the median income in your state (means test) • Less than $100/month in disposable income • Not enough disposable income to repay at least 25% of the debt over 5 years • Assets are sold to pay the debts • Filers can keep car and basic household possessions
Chapter 7 • Can eliminate debts and allow the filer to begin again • Most debts wiped out—but not child support, alimony, student loans, and taxes • Must complete credit counseling course • Will stay on credit report for 10 years
Summary • Consumer loans can be single-payment loans, installment loans, secured loans, or unsecured loans. • Loan costs are finance charges which include interest payments, processing fees,
Summary • Numerous sources of loans but key to getting favorable rate is a strong credit rating and reducing lender’s risk. • Control debt by borrowing when debt fits within your financial plan and budget, and know your debt limits using the debt limit ratio and debt resolution rule.
