Fin442_ch7.ppt

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Fin442_ch7.ppt

  1. 1. CHAPTER 7: USING CONSUMER LOANS
  2. 2. Consumer Loans <ul><li>Formal, negotiated contracts </li></ul><ul><li>Specify the terms for borrowing </li></ul><ul><li>Specify the repayment schedule </li></ul><ul><li>One-time transaction </li></ul><ul><li>Normally used to pay for big-ticket items </li></ul>
  3. 3. Types of Consumer Loans <ul><li>Auto </li></ul><ul><li>Durable goods </li></ul><ul><li>Education loans </li></ul><ul><li>Personal loans </li></ul><ul><li>Consolidation loans </li></ul>
  4. 4. Student Loans <ul><li>Federally sponsored loans: </li></ul><ul><li>Stafford loans (Direct & Federal Family Education Loans—FFEL) </li></ul><ul><li>Perkins loans </li></ul><ul><li>Supplemental Loans for Students (SLS) </li></ul><ul><li>Parent Loans (PLUS) </li></ul>
  5. 5. Obtaining a Student Loan : <ul><ul><li>Demonstrate financial need </li></ul></ul><ul><ul><li>Make satisfactory progress in school </li></ul></ul><ul><ul><li>No defaults on other student loans! </li></ul></ul>* It all starts with a FASFA!
  6. 6. Repaying Student Loans <ul><li>Low interest rates </li></ul><ul><li>With Stafford & Perkins loans — interest doesn’t accrue until you’re out! </li></ul><ul><li>Consolidate your loans and repay: </li></ul><ul><ul><li>Extended repayment plan </li></ul></ul><ul><ul><li>Graduated repayment schedule </li></ul></ul><ul><ul><li>Income-contingent repayment plan </li></ul></ul><ul><li>Don’t default! </li></ul>
  7. 7. Repaying Consumer Loans <ul><li>Single Payment or Installment </li></ul><ul><li>Fixed or Variable Interest Rate </li></ul>
  8. 8. Where Can You Get Consumer Loans ? <ul><li>Traditional financial institutions </li></ul><ul><ul><li>Commercial banks </li></ul></ul><ul><ul><li>Credit Unions </li></ul></ul><ul><ul><li>Savings and Loan Associations </li></ul></ul><ul><li>Consumer finance companies </li></ul><ul><ul><li>Specialize in high-risk borrowers </li></ul></ul><ul><ul><li>Together with banks and credit unions make ~75% of consumer loans </li></ul></ul>
  9. 9. Other sources include: <ul><li>Sales finance companies </li></ul><ul><ul><li>Third party financing </li></ul></ul><ul><ul><li>Include captive finance companies, such as GMAC </li></ul></ul><ul><li>Life insurance companies </li></ul><ul><ul><li>Loan against cash value of certain types of policies </li></ul></ul><ul><li>Friends and relatives </li></ul><ul><li>Pawn shops </li></ul>
  10. 10. Managing Your Credit <ul><li>Shop carefully before borrowing </li></ul><ul><li>Compare loan features </li></ul><ul><ul><li>Finance charges and loan maturity </li></ul></ul><ul><ul><li>Total cost of transaction </li></ul></ul><ul><ul><li>Collateral requirements </li></ul></ul><ul><ul><li>Other features, such as payment date, prepayment penalties and late fees </li></ul></ul>
  11. 11. Low Rate or a Rebate? <ul><li>Example: buying a new car with a price of $20,000, with two financing options: </li></ul><ul><ul><li>1.9% financing (60 months) from car dealer </li></ul></ul><ul><ul><li>$2,500 rebate, then 10% (60 months) financing from your bank </li></ul></ul><ul><li>Which option should you choose? </li></ul>
  12. 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. 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. 14. Keep Track of Your Credit ! <ul><li>Keep inventory sheet of debt </li></ul><ul><li>Know total monthly payments </li></ul><ul><li>Know total debt outstanding </li></ul><ul><li>Check your debt safety ratio— </li></ul><ul><ul><li>Total monthly consumer debt pmts </li></ul></ul><ul><ul><li>Monthly take-home pay </li></ul></ul>
  15. 15. Keep Track of Your Credit ! <ul><li>Use Worksheet 7.1 to track your consumer debt </li></ul><ul><li>A desirable debt safety ratio should be 20% or lower, otherwise you are relying too heavily on credit. </li></ul>
  16. 16. Repaying Your Loan <ul><li>1. Single payment loans </li></ul><ul><li>2. Installment loans </li></ul>BANK
  17. 17. 1. Single Payment Loans : <ul><li>Specified time period, usually less than 1 year. </li></ul><ul><li>Payment due in full at maturity. </li></ul><ul><li>Payment includes principal and interest. </li></ul><ul><li>May require collateral. </li></ul><ul><li>Loan rollover may be possible if borrower is unable to repay in time. </li></ul>
  18. 18. Calculating Finance Charges on Single-Payment Loans: <ul><li>Simple Interest Method </li></ul><ul><ul><li>Calculated on the outstanding balance. </li></ul></ul><ul><li>Discount Method </li></ul><ul><ul><li>Interest calculated on the principal, </li></ul></ul><ul><ul><li>Then subtracted from loan amount; remainder goes to borrower. </li></ul></ul><ul><ul><li>Finance charges are paid in advance. </li></ul></ul><ul><ul><li>APR will be higher than stated interest rate. </li></ul></ul>
  19. 19. <ul><li>Example : </li></ul><ul><li>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.) </li></ul>
  20. 20. Using the Simple Interest Method: <ul><li>Interest = Principal x Rate x Time </li></ul><ul><li> = $1000 x .12 x 2 </li></ul>Finance Charges = $240 <ul><li>Borrower receives loan amount ($1000) now— </li></ul><ul><li>And pays back loan amount plus finance charges ($1000 + $240) at end of time period. </li></ul><ul><li>Most consumer friendly method—APR will be the same as the stated rate. </li></ul>
  21. 21. Using the Simple Interest Method: <ul><li>Annual Percentage Rate = </li></ul><ul><li>Average annual finance charge </li></ul><ul><li>Average loan balance outstanding </li></ul><ul><li>APR = ($240  2) </li></ul><ul><li> $1000 </li></ul><ul><li>= $120 </li></ul><ul><li> $1000 </li></ul><ul><li>= .12 = </li></ul>12%
  22. 22. Using the Discount Method: <ul><li>Interest = Principal x Rate x Time </li></ul><ul><li> = $1000 x .12 x 2 </li></ul>Finance Charges = $240 <ul><li>Finance charges calculated the same way as in simple interest method— </li></ul><ul><li>But are then subtracted from loan amount ($1000 – $240). </li></ul><ul><li>Borrower receives the remainder ($760) now and pays back the loan amount ($1000) at end of time period. </li></ul>
  23. 23. Using the Discount Method: <ul><li>Annual Percentage Rate = </li></ul><ul><li>Average annual finance charge </li></ul><ul><li>Average loan balance outstanding </li></ul><ul><li>APR = ($240  2) </li></ul><ul><li> ($1000 – $240) </li></ul><ul><li>= $120 </li></ul><ul><li> $760 </li></ul><ul><li>= .158 = </li></ul>15.8%
  24. 24. Comparing the Two Methods :
  25. 25. 2. Installment Loans : <ul><li>Repaid in a series of equal payments. </li></ul><ul><li>Each payment is part principal and part interest. </li></ul><ul><li>Maturities range from 6 months to 7–10 years or longer. </li></ul><ul><li>Usually require collateral. </li></ul>
  26. 26. Calculating Finance Charges on Installment Loans: <ul><li>Simple Interest Method </li></ul><ul><ul><li>Calculated on the outstanding (declining) balance each period. </li></ul></ul><ul><li>Add-On Method </li></ul><ul><ul><li>Finance charges calculated on original loan balance — </li></ul></ul><ul><ul><li>And then added to principal. </li></ul></ul><ul><ul><li>Costly form of consumer credit! </li></ul></ul>
  27. 27. <ul><li>Example : </li></ul><ul><li>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.) </li></ul>
  28. 28. <ul><li>Calculator </li></ul><ul><li>(Set on 12 P/YR and END mode:) </li></ul><ul><li>1000 +/- PV </li></ul><ul><li> 12 I/YR </li></ul><ul><li> 12 N </li></ul><ul><li>PMT $88.85 </li></ul>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. 29. <ul><li>1 $1,000.00 $88.85 $10.00 $78.85 $921.15 </li></ul><ul><li>2 $ 921.15 $88.85 $ 9.21 $79.64 $841.51 </li></ul><ul><li>3 $ 841.51 $88.85 $ 8.42 $80.43 $761.08 </li></ul><ul><li>4 $ 761.08 $88.85 $ 7.61 $81.24 $679.84 </li></ul><ul><li>5 $ 679.84 $88.85 $ 6.80 $82.05 $597.79 </li></ul><ul><li>6 $ 597.79 $88.85 $ 5.98 $82.87 $514.92 </li></ul><ul><li>7 $ 514.92 $88.85 $ 5.15 $83.70 $431.22 </li></ul><ul><li>8 $ 431.22 $88.85 $ 4.31 $84.54 $346.68 </li></ul><ul><li>9 $ 346.68 $88.85 $ 3.47 $85.38 $261.30 </li></ul><ul><li>10 $ 261.30 $88.85 $ 2.61 $86.24 $175.06 </li></ul><ul><li>11 $ 175.06 $88.85 $ 1.75 $87.10 $ 87.96 </li></ul><ul><li>12 $ 87.96 $88.85 $ 0.89 $87.96 $ 0 </li></ul>Mo. Beg. Bal. PMT Interest Principal End. Bal.
  30. 30. Using the Simple Interest Method: <ul><li>Simple interest is figured on the outstanding loan balance each period . </li></ul><ul><li>Each payment causes the outstanding loan balance to decrease. </li></ul><ul><li>Each subsequent payment, then, will incur a lower finance charge, so — </li></ul><ul><li>More of the next payment will go towards repaying the principal or outstanding loan balance! </li></ul>
  31. 31. Simple Interest Method Continued: <ul><li>This is the method financial calculators use when solving for interest. </li></ul><ul><li>When simple interest method is used, whether for single payment or installment loans, </li></ul><ul><li>Stated Rate = APR </li></ul><ul><li>In this example, APR = 12% and </li></ul><ul><li>rate per period = 12%  12 </li></ul><ul><li>= 1% per month. </li></ul>
  32. 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. 33. Using the Add-On Method: <ul><li>Calculate finance charges on the original loan amount: </li></ul><ul><li>$1000 x .12 x 1 = $120 </li></ul><ul><li>Add these charges to principal: </li></ul><ul><li>$120 + $1000 = $1,120 </li></ul><ul><li>Divide this amount by the number of periods to arrive at payment: </li></ul><ul><li>$1,120  12 = $93.33 </li></ul>
  34. 34. Add-On Method Continued: <ul><li>Use financial calculator to figure APR for the Add-On Method using the payment just determined and solve for interest: </li></ul>Set on 12 P/YR and END mode: 1000 +/- PV 93.33 PMT 12 N I/YR 21.45%
  35. 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. 36. Comparing the Two Methods :
  37. 37. More on Loans : <ul><li>Carefully examine Installment Purchase Contract—it contains the terms of the loan. </li></ul><ul><li>Finance charges must include not only interest but also any other required charges. </li></ul><ul><li>Total charges, not just interest, must be used to calculate APR. </li></ul>
  38. 38. Other Loan Considerations : <ul><li>Prepayment penalties </li></ul><ul><ul><li>Does the lender use Rule of 78s? </li></ul></ul><ul><li>Rule of 78s (sum-of-the-digits method) </li></ul><ul><ul><li>Charge more interest in earlier months of the loan </li></ul></ul><ul><ul><li>Producing a much higher principal balance than the regular installment payment would result in </li></ul></ul><ul><li>Credit life insurance and disability requirements </li></ul><ul><ul><li>Avoid if possible and get term insurance instead! </li></ul></ul>
  39. 39. Other Loan Considerations : <ul><li>Buy on time or pay cash? </li></ul><ul><ul><li>Use Worksheet 7.2 for this analysis </li></ul></ul><ul><ul><li>If all of the following conditions are satisfied, you should pay cash: </li></ul></ul><ul><ul><ul><li>You have sufficient amount of cash to pay off the item </li></ul></ul></ul><ul><ul><ul><li>Paying off the item does not exhaust your savings </li></ul></ul></ul><ul><ul><ul><li>It costs more to borrow than you can earn in interest from the savings </li></ul></ul></ul><ul><ul><ul><li>Also should consider the tax features </li></ul></ul></ul>

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