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Chapter 7. Using Consumer Loans: The Role of Planned Borrowing. Learning Objectives. Understand the various consumer loans. Calculate the cost of a consumer loan. Pick an appropriate source for your loan. Control your debt. Introduction.
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Chapter 7 Using Consumer Loans: The Role of Planned Borrowing
Learning Objectives • Understand the various consumer loans. • Calculate the cost of a consumer loan. • Pick an appropriate source for your loan. • Control your debt.
Introduction • Consumer loans—formal contracts detailing how much you’re borrowing and when and how you’re going to pay it back. • Used for bigger purchases. • Debt and borrowing can get out of control.
Consumer Loans—Your Choices • Single-payment loans • Variable-rate installment loans • Unsecured fix-rate loans • Secured loans
First Decision: Single-Payment versus Installment Loans • Single-Payment or Balloon Loan—paid back in a single lump-sum payment with interest at maturity. • Bridge or interim loan– short-term loan. Installment loan—repayment of both principal and interest at various intervals. • Loan amortization—with each payment, the interest portion covered decreases and principal portion covered increases.
Second Decision: Secured versus Unsecured Loans • Secured loan—guaranteed by an asset which typically lowers the rate of the loan. • Unsecured loan—not guaranteed by an asset or collateral
Third Decision: Variable-Rate versus Fixed-Rate Loans Fixed-rate interest rate loan—stays fixed for entire duration of the loan, not tied to market interest rates. • Variable-rate or adjustable interest rate loan—interest rate varies based on the market interest rate. • Prime rate—the interest rate that banks charge to their most creditworthy, or “prime” customers • Convertible loan—variable-rate loan that can be converted to a fixed-rate loan.
Fourth Decision: The Loan’s Maturity—Shorter versus Longer Term Loans • Shorter term loan means lower interest rate and larger monthly payments • Longer term loan means smaller monthly payments and higher interest rate
Understand the Terms of the Loan: The Loan Contract • Security agreement • Note • Default • Acceleration clause • Deficiency payments clause • Recourse clause
Special Types of Consumer Loans • Home Equity Loan or Second Mortgage—secured loan using equity in home as collateral. • Advantages: • Interest is tax deductible • Lower interest than other consumer loans. • Disadvantages: • Puts your home at risk. • Limits future financing flexibility.
Special Types of Consumer Loans • Student Loan—low, federally subsidized interest, based on financial need • Federal Direct/Stafford Loans: • Federal government makes direct loan to students through financial aid office. • PLUS Direct/PLUS Loans: • Loans are made by private lenders such as banks and credit unions to parents.
Figure 7.2 Percent of Students at a 4-Year College Who Borrow
Special Types of Consumer Loans • Automobile Loan—loan secured by auto. • Duration usually for 24, 36, or 48 months or even 5 to 6 years. • Low-cost auto loan rates used to push slow-selling vehicles or older models. • Repossession if default on loan.
Cost and Early Payment ofConsumer Loans • APR—annual percentage rate—simple percentage cost of all finance charges over the life of the loan, on annual basis. • Truth in Lending Act requires all consumer loan agreements disclose APR in bold print.
Cost and Early Payment ofConsumer Loans • Cost of single-payment loans: • Loan disclosure statement gives APR and finance charges of a loan • Simple interest method: interest = principal x interest rate x time • Discount method
Payday Loans—A dangerous kind of single-payment loan • $100 to $500 loan till next payday. • Post-dated check with fee and principal left with payday lender. • Due in 1 or 2 weeks. • Annualized interest rates up to 400%
Cost of Installment Loans • Repayment of both interest and principal occurs at regular intervals. • Payment levels are set so loan expires at a preset date. • Use either simple interest or add-on method to determine what payment will be.
Table 7.3 Monthly Installment Loan Tables ($1,000 loan with interest payments compounded monthly)
Table 7.4 Illustration of a 12-Month Installment Loan for $5,000 at 14%
Early Payment of an Add-on Loan • If installment loan is repaid early, determine amount of principal still owed. • Most common method for add-on loan is Rule of 78 or sum of the year’s digits. • Rule of 78 determines what proportion of each payment goes towards principal. • Prepayment penalty
Getting the Best Rate on Your Consumer Loans • Inexpensive sources—family, home equity loans, cash value life insurance loans. • More expensive sources—credit unions, S&Ls, and commercial banks. • Most expensive sources—retail stores, finance companies or small loan companies
Keys to Getting the Best Rate • Strong credit rating • Relatively risk-free to lender: • Use variable-rate loan • Short loan term • Collateral • Large down payment
Should You Borrow or Pay Cash? • Keep in mind that debt is expensive. • Don’t borrow to spend. • Use cash rather than credit. • If benefits outweigh costs, borrowing makes sense.
Controlling Your Use of Debt • Determine how much debt you can comfortably handle. • Debt level comfort and need changes at different stages of the financial life cycle. • With age, debt proportion of income tends to decline. • Use several measures to control debt commitments.
Controlling Your Use of Debt • Debt Limit Ratio—percentage of take-home pay committed to non-mortgage debt. • Total debt can be divided into consumer debt and mortgage debt. • Ratio should be below 15%. • ~20% should avoid additional debt.
Debt Resolution Rule • Control debt obligation, excluding borrowing for education and home financing, by forcing you to repay all outstanding debt obligations every 4 years. • Logic is that consumer credit should be short-term.
Controlling Consumer Debt • Make sure it fits in with your goals and budget. • Understand how costly consumer debt is. • Borrowing limits future financial flexibility. • Clues you might be in financial trouble.
What To Do If You Can’tPay Your Bills • Budget so more money comes in. • Use self-control in the use of credit. • Go to your creditor. • Go to a credit counselor.
What To Do If You Can’tPay Your Bills • Borrow inexpensively. • Use savings to pay off current debt. • Use a debt consolidation loan. • Bankruptcy—the last resort • doesn’t wipe out all obligations.
What To Do If You Can’tPay Your Bills • Most common types of personal bankruptcy: • Chapter 13 The wage earner’s plan • Chapter 7 Straight bankruptcy
Chapter 13: The Wage Earner’s Plan • Must have: • Regular income • Secured debts under $1,010,650 (2007) • Unsecured debts under $336,900 (2007) • For the individual—relief from harassment of bill collectors • For creditors—controlled repayment with court supervision.
Chapter 7: Straight Bankruptcy • Can eliminate debts and begin again. • “Means test” • Most debts wiped out—not child support, alimony, student loans, and taxes. • Trustee collects, sells all nonexempt property. • Must complete credit counseling course.
Summary • Consumer loans can be single-payment loans, installment loans, secured loans, or unsecured loans. • Loan costs are finance charges which include interest payments, processing fees,
Summary • Numerous sources of loans but key to getting favorable rate is a strong credit rating and reducing lender’s risk. • Control debt by borrowing when debt fits within your financial plan and budget, and know your debt limits using the debt limit ratio and debt resolution rule.
