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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 :
      • Demonstrate financial need
      • Make satisfactory progress in school
      • No defaults on other student loans!
    * It all starts with a FASFA!
  • 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. $2,500 rebate Find monthly payment 17,500 +/- PV 10 I/YR 60 N PMT $371.82 1.9% financing Find monthly payment 20,000 +/- PV 1.9 I/YR 60 N PMT $349.68 1.9% financing is the better deal because of the lower monthly payments.
  • 13. If we take the $2,500 rebate, we would need to borrow: $20,000 – $2,500 = $17,500 from the bank. 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 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.
    • Calculator
    • (Set on 12 P/YR and END mode:)
    • 1000 +/- PV
    • 12 I/YR
    • 12 N
    • PMT $88.85
    Use Exhibit 7.6 (Table calculated using $1000 loan) Find payment for 12 months at 12% interest: $88.85 [Note: We can use a spreadsheet to create the following table.]
  • 29.
    • 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
    Mo. Beg. Bal. PMT Interest Principal End. Bal.
  • 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