Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 8 Personal Loans

What Is Consumer Borrowing?
Obtaining funds from a lender under specific loan provisions.
Called “Consumer Loans.”
Made for a specified purpose.
Must be repaid according to a specified schedule.
Consumer loans are necessary because few people can pay cash for big-ticket items.

Advantages of Consumer Loans
Permits buying expensive items.
Permits you to use the item while paying for it.
Provides financial flexibility--spread payments over long period of time.
To cover unexpected expenses and emergencies.

Disadvantages of Consumer Loans
You must pay interest on the loan.
Must provide collateral or security for the loan.
If overused, may be unable to repay your debts.

Chapter 8 Personal Loans

Chapter Objectives
Provide a background on personal loans
Outline the types of interest rates that are charged on personal loans
Describe home equity loans
Discuss car loans

Chapter Objectives
Explain how to decide between financing the purchase of a car and leasing a car
Describe the key features of student loans

Background on Personal Loans
Usually obtained to finance a large purchase
Has a specific repayment schedule
Sources of loans
Commercial banks, savings institutions, finance companies, credit unions, some automobile manufacturers, friends, or family members

The personal loan process
Application process
Personal balance sheet
Personal cash flow statement
Loan contract: a contract that specifies the terms of a loan, as agreed to by the borrower and the lender
Amount of the loan
Interest rate

Loan repayment schedule
Amortize: to repay the principal of a loan through a series of equal payments
Each payment includes part of the principal and part of the interest
Maturity: the life or duration of the loan
Longer maturity equals lower payments, but more interest is paid over the life of the loan

Collateral: assets of a borrower that back a secured loan in the event that the borrower defaults
Secured loan: a loan that is backed or secured by collateral which could be repossessed if the lender defaulted on the loan
Unsecured loan: a loan that is not backed by collateral
Cosigning is sometimes required if credit history is weak

Background on Personal Loans Exhibit 8.1: An Example of a Loan Application

Five Cs of Consumer Borrowing
Character - refers to the integrity of the prospective borrower.
Have you met your previous obligations?
Capital - refers to the net worth position of the applicant.
Have you sufficient financial assets?
Capacity - refers to the ability of the borrower to repay borrowed amounts.
Can you meet your future obligations?

Five Cs of Consumer Borrowing
Collateral - consists of items of value that may be pledged to secure the loan.
Conditions - refers to general economic conditions.

Managing Debt
To determine how much you can borrow, debt payments should be compared to disposable income, and the amount borrowed should be compared to net worth.

Amount of Debt
Ratio of debt payment to disposable income (should not exceed 20%)
measures you ability to make your non-mortgage debt payments from current disposable income.
Is a “flow” measure--matches cash inflow with cash outflows.
A low ratio (<10%) indicates you can borrow more.
Ratios over 20% indicates too much has been borrowed.

Amount of debt (continued)
Ratio of debt to net worth.
Excludes mortgage debt and the value of your home.
“ stock” measure - relates debt to accumulated net worth.
A ratio of more than 100% indicates no additional debt should be undertaken.

Financial Planning Online: Loan Request Online
Go to: http:// www.lendingtree.com
This Web site provides a set of questions that you can answer to specify the type of loan that you desire. You will then receive up to four loan offers from various financial institutions within the next business day.

Focus on Ethics: Predatory Lending
Beware of illegal lending practices
Lender charging high loan fees
Lender provides home equity loan with the expectation of default so he can take ownership
Lender ties other products to loan approval
Lender includes balloon payment at end of loan
Loan agreement includes confusing information
Shop around for best loan terms

Methods of Computing Interest
Simple interest method
single payment loan
installment loan
Discount method
Add-on method

Simple Interest Method
Single payment loan
interest is charged on amount owed.
interest is charged only once.
Installment loan
interest is calculated on outstanding balance.
installment payments are equal.
amount applied to principal increases with each payment.
amount applied to interest decreases with each payment.

Discount Method
Finance charges are calculated based upon the loan principal, and then deducted from the principal, with the borrower receiving the net amount.
3000 x 10% = 300 interest
3000 - 300 = 2700 amount received

Add-on Method
Finance charges are calculated based on the loan principal, then the finance charges are added back to the principal. Loan payments are based upon the sum of these 2 values.
3000 + 300 -:- 12 = 275

Interest Rates on Personal Loans
Annual percentage rate (APR): a rate that measures the finance expenses (including interest and other expenses) on a loan on an annualized basis
Add-on interest method: a method of determining the monthly payment on a loan

Interest on Personal Loans

Interest Rates on Personal Loans
Simple interest: interest on a loan computed as a percentage of the existing loan amount (or principal)
Size of payment depends on size of loan, interest rate and maturity
The higher the interest rate, the higher the payment
The longer the maturity, the lower the payment

Interest Rates on Personal Loans Exhibit 8.3: Example of a Loan Repayment Schedule

Home Equity Loan
Home equity loan: a loan where the equity in a home serves as collateral for the loan
Equity of a home: the market value of a home minus the debt owed on the home
Credit limit on a home equity loan
Limit based on equity invested
Financial institutions usually loan up to 80% of the equity in a home

Home Equity Loan
Interest rate is typically variable
Rate is usually tied to an interest rate index and adjusted periodically
Interest on most home equity loans is tax deductible

Financial Planning Online: Applying for a Home Equity Loan
Go to: http:// www.bloomberg.com
Click on: Mortgage Calculator, then Online Home Equity
This Web site provides access to home equity loan applications.

Car Loans
Selecting the car — things to consider
Personal preferences
Price
Insurance
Resale value
Repair expenses
Financing rate

Car Loans
Negotiating the price
Negotiating by phone may be beneficial
Trade-in tactics can be misleading
No-haggle dealers can save time and stress
Information is valuable – shop around
Purchasing a car online is possible, but not yet a streamlined process

Car Loans
Financing decisions
Estimate dollar amount of monthly payment you can afford before shopping

Financial Planning Online: Prices of New Cars
Go to: http:// autos.yahoo.com /
Click on: “New Car Guide” under “New Cars” heading
This Web site provides estimates of what you should pay for any new car, based on the car’s features and options that you specify.

Car Loans Exhibit 8.4: Stephanie Spratt’s Car Analysis

Car Loans Exhibit 8.5: Stephanie’s Possible Monthly Loan Payments

Financial Planning Online: Trade-In and Retail Value of Used Cars
Go to: http:// www.kbb.com
This Web site provides trade-in and retail values for a used car, based on the condition of the car, its age, and other characteristics that you specify.

Financial Planning Online: Car Loan Interest Rate Quotation
Go to: http:// autos.yahoo.com/buy.html
Click on: “Car Financing,” then “Get An Auto Loan”
This Web site provides a car loan interest rate quotation based on your desired car, the amount you need to borrow, and the term of the loan.

Financial Planning Online: Prevailing Car Loan Interest Rates
Go to: http:// biz.yahoo.com/b/r/a.html
This Web site provides average car loan interest rates across the United States and in various states, which provide a useful benchmark for you to consider before obtaining a car loan.

Financial Planning Online: What Is the Optimal Loan Maturity?
Go to: http:// www.financenter.com /products/ sellingtools /calculators
Click on: “Auto,” then “What term of loan should I choose?”
This Web site provides a comparison of what your car loan payments will be based on loan maturity.

Purchase versus Lease Decision
Leasing is a popular alternative to buying a car
Advantages of leasing
Lower down payment
Just return the car at the end of the lease period

Purchase versus Lease Decision
Disadvantages of leasing
You build no equity in the car
You are still responsible for maintenance and damages
Additional charges may be imposed
Too many miles
Ending the lease before the specified period

Financial Planning Online: Should You Lease or Buy?
Go to: http:// www.bloomberg.com
Click on: Tools, then Lease/Buy calculator
This Web site provides a comparison of the cost of leasing versus purchasing a car.

Purchase versus Lease Decision Exhibit 8.6: Stephanie’s Comparison of the Cost of Purchasing versus Leasing

Student Loans
Student loan: a loan provided to finance part of the expenses a student incurs while pursuing a degree
Loan may be provided to either the student or the student’s parents
Repayment typically deferred until student is out of school
Interest may be tax deductible

How Personal Loans Fit within Your Financial Plan
Key personal loan decisions for your financial plan are:
How much money can you afford to borrow on a personal loan?
If you obtain a personal loan, should you pay it off early?

Integrating the Key Concepts

Integrating the Key Concepts
Part 1: Financial Planning Tools
Part 2: Liquidity Management
Part 3: Financing
In Chapter 8 we learned about personal loans
Chapter 9 teaches about purchasing and financing a home
Part 4: Protecting Your Wealth
Part 5: Investing
Part 6: Retirement and Estate Planning

Copyright ©2004 Pearson Education, Inc. All rights reserved.

by Saina33

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