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  • 1. Consumer Cash Loan Credit When consumers obtain retail credit, they get goods or services, which they then pay for over time along with a finance charge. When consumers obtain cash credit, they get cash, which they then pay back over time along with a finance charge. Some Reasons for Using Cash Credit Instead of Retail Credit • Consolidate other debts o to lower monthly payments o to reduce costs o to clear up a delinquency o to improve credit rating o to get rid of debt with unfavorable terms • Direct cash credit may carry a lower interest rate than is available in a proposed retail purchase. • Retail credit may not be available for what they want to use the cash for: ordinary living expenses, vacation, taxes, large transactions between individuals, • Personal preference and habits • Close ties to a particular financial institution Financial Institutions That Make Consumer Cash Loans • Commercial banks • Credit unions • Consumer finance companies • Industrial banks • Savings and loans (thrifts) • Pawnbrokers • Insurance companies
  • 2. • Loan sharks
  • 3. -2- There is a growing convergence between the types of financial institutions. Banks can create bank holding companies that then buy or create subsidiaries which operate like other kinds of financial institutions. The large holding companies refer to themselves as financial services companies, hoping to provide every kind of financial service you might possibly need or want. Loans Installment Loans Installment loans require a specific application, a written agreement, and terms specifying regular monthly payments of a fixed amount for a given length of time at an agreed upon interest rate. Because the credit plan ends at a specific date, installment loans are considered closed-end credit plans. Conventional installment loans. These loans are often secured by the item being purchased, e.g. autos, boats, etc. But bigger expenses can be financed this way: vacations, weddings, dental and medical bills, etc. Home equity loans. This is an installment loan secured by a second mortgage on the consumer’s home. It uses as collateral the equity in the property the owner has built up over time. The amount that can be borrowed is frequently well under the equity that exists, but banks or finance companies willing to take bigger risks will loan more than the equity (for a higher interest rate, of course).
  • 4. -3- Home equity loans are popular because a) interest charges on consumer credit is not tax deductible and b) interest rates on mortgages (even second mortgages) is usually much less than on unsecured credit, like credit cards. Student loans. These are installment loans used to pay education expenses. Banks found these loans attractive because of federal subsidies and guarantees. Open-End Revolving Loans Open-end credit plans do not expire at some specified time. Borrowers still make regular monthly payments at a specified interest rate, but the size of the payment will depend on how much the borrower has borrowed and/or paid back during a month. Cash advances. Credit cards can usually be used to simply obtain cash rather pay for a purchase at a retail establishment. Cash advances usually carry higher interest rates than purchases. (Credit card purchase rates are usually higher than installment credit loan interest rates to begin with.) Banks consider cash advances riskier than purchases because they have no idea what the consumer is going to use the cash for. Cash advances also incur an immediate cash advance fee as well as start accruing interest immediately. The cash advance credit limit on a credit card can be less than the purchase credit limit.
  • 5. -4- Overdraft plans. Overdraft plans allow a consumer to simply write a check on the consumer’s checking account for more than the balance. This goes beyond simply overdraft protection, which merely protects the consumer from small inadvertent overdrafts. The consumer has a prearranged agreement with the bank to, in effect, take out a loan as needed. Home equity lines of credit. Instead of borrowing a lump sum as with a home equity installment loan, the consumer can borrow up to a prearranged limit, using only as much of line of credit as the consumer “needs.” Single-Payment Loans Single-payment loans. These are short-term consumer loans in which payment of the entire amount due is made at the end of the loan period. Interest on single- payment loans can be paid in two ways:
  • 6. -5- Interest Rates on Single-Payment Loans Discount loan: interest is deducted from the principal advanced; paying back the entire principal pays the interest as well. The actual interest rate is higher than the quoted interest rate because the consumer does not get use of the full principal during the loan period. Add-on method: the amount of interest due is paid at the end of the loan period along with the principal. Interest Rates on Installment Loans Simple interest method. Interest is calculated on the outstanding balance until the payment is made. Each payment of part of the principal reduces the interest charge the next month Add-on method. The total amount of interest to be charged is calculated as if the loan were a single-payment loan. The monthly payment is simply a fixed fraction of the sum of the principal and the interest charge. The actual interest rate is about double the stated interest rate because the borrower gets the use of only half the principal on average over the length of the loan period.
  • 7. -6- The Various Types of Financial Institutions Involved Commercial banks were originally created to make loans to commerce. But consumer lending, especially through credit cards, has become a big source or income for them. Banks are being created to nothing more than offer credit cards. This is becoming much easier with online banking. Banks can offer cards in all states without ever seeing any of the customers. Bank ATMs provide a convenient source of cash for customers. Credit unions require a common bond among the people in the association. Members of a credit union own the credit union. Deposits are called share accounts, etc. Credit unions typically cater to the small consumer borrower. Credit unions are decreasing in number but increasing in size. The bigger the credit union, the more likely it is to offer much the same services as a bank would. Consumer finance companies usually cater to the smaller, higher- risk consumer. The loans are usually quite small compared to bank loans, have much greater default rates, and carry much higher interest rates than bank loans. Previous to the 1980s savings and loan associations did not make many consumer loans (or commercial loans). They specialized in home mortgages. (Still do.) But S&Ls were forced to pay high market rates of interest on their deposits in 1980s and to stay competitive, regulations allowed S&Ls to make more consumer loans (and commercial loans), which carry higher interest rates than do home mortgages.
  • 8. -7- Factors Affecting the Cost of Consumer Credit • Banks, thrifts, and credit unions take in deposits, which are less expensive than the bank loans finance companies use to fund their loans. • The smaller the loan, the more expensive it is (as a percentage of the principal) to originate and service the loan. • The less creditworthy the customer base, the greater the default experience to the lending institution, and the more the nondefaulters will have to pay to cover the cost of defaults. • Finance companies face higher credit investigation costs than do banks, thrifts, and credit unions because of the nature of the clientele. • The smaller the loan defaulted on, the more expensive it is to collect on it (as a percentage of the principal). • The more an institution emphasizes installment loans rather than single-payment loans, the more costly the servicing of the loans. • The more diversified the source of income for a financial institution, the less risk in any one area of loan activity. • The fixed costs of finance companies are higher as a percentage of revenue than are the fixed costs of other institutions. Finance companies often have many offices for the convenience of customers. The net result of all of the above is that finance companies have higher costs associated with their loan activity and can rationalize a higher interest rate on loans.