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CHAPTER 7: USING CONSUMER LOANS

CHAPTER 7: USING CONSUMER LOANS. Consumer Loans. Formal, negotiated contracts Specify the terms for borrowing Specify the repayment schedule One-time transaction Normally used to pay for big-ticket items. Types of Consumer Loans. Auto Durable goods Education loans Personal loans

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CHAPTER 7: USING CONSUMER LOANS

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  1. CHAPTER 7: USING CONSUMER LOANS

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

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

  4. Student Loans Federally sponsored loans: • Stafford loans (Direct & Federal Family Education Loans—FFEL) • Perkins loans • Supplemental Loans for Students (SLS) • Parent Loans (PLUS)

  5. Obtaining a Student Loan: * It all starts with a FASFA! • Demonstrate financial need • Make satisfactory progress in school • No defaults on other student loans!

  6. Repaying Student Loans • Low interest rates • With Stafford & Perkins loans — interest doesn’t accrue until you’re out! • Consolidate your loans and repay: • Extended repayment plan • Graduated repayment schedule • Income-contingent repayment plan • Don’t default!

  7. Repaying Consumer Loans • Single Payment or Installment • Fixed or Variable Interest Rate

  8. Where Can You Get 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

  9. 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 • Pawn shops

  10. Managing Your Credit • Shop carefully before borrowing • Compare loan features • Finance charges and loan maturity • Total cost of transaction • Collateral requirements • Other features, such as payment date, prepayment penalties and late fees

  11. Low Rate or a Rebate? • Example: buying a new car with a price of $20,000, with two financing options: • 1.9% financing (60 months) from car dealer • $2,500 rebate, then 10% (60 months) financing from your bank • Which option should you choose?

  12. 1.9% financing Find monthly payment 20,000 +/- PV 1.9 I/YR 60 N PMT $349.68 $2,500 rebate Find monthly payment 17,500 +/- PV 10 I/YR 60 N PMT $371.82 1.9% financing is the better deal because of the lower monthly payments.

  13. If we were to make a monthly payment of $349.68, we would need to borrow from the bank: $349.68 PMT 10 I/YR 60 N PV $16,458 If we take the $2,500 rebate, we would need to borrow: $20,000 – $2,500 = $17,500 from the bank. 1.9% financing is the better deal because it represents a lower cost in present value .

  14. 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

  15. Keep Track of Your Credit! • Use Worksheet 7.1 to track your consumer debt • A desirable debt safety ratio should be 20% or lower, otherwise you are relying too heavily on credit.

  16. Repaying Your Loan 1. Single payment loans 2. Installment loans BANK

  17. 1. Single Payment Loans: • Specified time period, usually less than 1 year. • Payment due in full at maturity. • Payment includes principal and interest. • May require collateral. • Loan rollover may be possible if borrower is unable to repay in time.

  18. Calculating Finance Charges on Single-Payment Loans: • Simple Interest Method • Calculated on the outstanding balance. • Discount Method • Interest calculated on the principal, • Then subtracted from loan amount; remainder goes to borrower. • Finance charges are paid in advance. • APR will be higher than stated interest rate.

  19. 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.)

  20. Using the Simple Interest Method: Interest = Principal x Rate x Time = $1000 x .12 x 2 Finance Charges = $240 • Borrower receives loan amount ($1000) now— • And pays back loan amount plus finance charges ($1000 + $240) at end of time period. • Most consumer friendly method—APR will be the same as the stated rate.

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

  22. Using the Discount Method: Interest = Principal x Rate x Time = $1000 x .12 x 2 Finance Charges = $240 • Finance charges calculated the same way as in simple interest method— • But are then subtracted from loan amount ($1000 – $240). • Borrower receives the remainder ($760) now and pays back the loan amount ($1000) at end of time period.

  23. Using the Discount Method: Annual Percentage Rate = Average annual finance charge Average loan balance outstanding APR = ($240 2) ($1000 – $240) = $120 $760 = .158 = 15.8%

  24. Comparing the Two Methods:

  25. 2. 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.

  26. Calculating Finance Charges on Installment Loans: • Simple Interest Method • Calculated on the outstanding (declining) balance each period. • Add-On Method • Finance charges calculated on original loan balance — • And then added to principal. • Costly form of consumer credit!

  27. 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.)

  28. Use Exhibit 7.6 (Table calculated using $1000 loan) Find payment for 12 months at 12% interest: $88.85 Calculator (Set on 12 P/YR and END mode:) 1000 +/- PV 12 I/YR 12 N PMT $88.85 [Note: We can use a spreadsheet to create the following table.]

  29. Mo. Beg. Bal. PMT Interest 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

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

  31. Simple Interest Method Continued: • This is the method financial calculators use when solving for interest. • When simple interest method is used, whether for single payment or installment loans, Stated Rate = APR • In this example, APR = 12% and rate per period = 12%  12 = 1% per month.

  32. $88.85 x 12 = $1,066.20 Loan amount = – 1,000.00 Interest paid = $ 66.20 Total amount paid over the 12-month period:

  33. Using the Add-On Method: • Calculate finance charges 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

  34. Add-On Method Continued: • Use financial calculator to figure APR for the Add-On Method using the payment just determined and solve for interest: Set on 12 P/YR and END mode: 1000 +/- PV 93.33 PMT 12 N I/YR 21.45%

  35. $93.33 x 12 = $1,120.00 Loan amount = – 1,000.00 Interest paid = $ 120.00 Total amount paid over the 12-month period:

  36. Comparing the Two Methods:

  37. 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.

  38. Other Loan Considerations: • Prepayment penalties • Does the lender use Rule of 78s? • Rule of 78s (sum-of-the-digits method) • Charge more interest in earlier months of the loan • Producing a much higher principal balance than the regular installment payment would result in • Credit life insurance and disability requirements • Avoid if possible and get term insurance instead!

  39. Other Loan Considerations: • Buy on time or pay cash? • Use Worksheet 7.2 for this analysis • If all of the following conditions are satisfied, you should pay cash: • You have sufficient amount of cash to pay off the item • Paying off the item does not exhaust your savings • It costs more to borrow than you can earn in interest from the savings • Also should consider the tax features

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