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CHAPTER 7: USING CONSUMER LOANS

CHAPTER 7: USING CONSUMER LOANS. 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. Understanding the Financial Crisis. Types of Consumer Loans. Auto Durable goods

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CHAPTER 7: USING CONSUMER LOANS

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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. Understanding the Financial Crisis

  4. Types of Consumer Loans • Auto • Durable goods • Education loans • Personal loans • Consolidation loans

  5. Student Loans Federally sponsored loans: • Stafford loans (Direct & Federal Family Education Loans—FEEL) • Perkins loans • Supplemental Loans for Students (SLS) • Parent Loans (PLUS)

  6. Obtaining a Student Loan: * It all starts with a FASFA! • Demonstrate financial need • Make satisfactory progress in school • No defaults on other student loans!

  7. 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—longer term to pay loan back (up to 30 years) • Graduated repayment schedule—low payments in beginning; higher payments later on • Income-contingent repayment plan—payments fluctuate annually according to income and debt • Loan Forgiveness Programs • Don’t default!

  8. Repaying Consumer Loans • Single Payment or Installment • Fixed or Variable Interest Rate

  9. Where Can You Get Consumer Loans? • Commercial banks • Consumer finance companies • Credit Unions • Savings and Loan Associations • Sales Finance Companies • Life Insurance Companies • Friends and Relatives

  10. Commercial banks • Dominate the field • Typically charge lowest rates • Usually lend only to customers with good credit ratings • Give preference to loan applicants who are account holders

  11. Consumer Finance Companies • Specialize in high-risk borrowers • Interest rates are generally quite high • Loans are quite costly • Consider this source only after exhausting other alternatives

  12. Credit Unions • Charge relatively low interest rates • Borrowing requirements are more favorable • Loan payments can often be deducted directly from payroll checks

  13. Savings and Loan Associations • Primarily make mortgage loans • Can make certain types of home improvement and mobile-home loans, personal and educational loans • Interest rates fairly close to rates charged by commercial banks

  14. Sales Finance Companies • Third Party Financing--“Selling Paper”—merchants sell their loans to a third party. • Include captive finance companies (which are owned by manufacturers of big ticket items) such as GMAC. • Costs may be higher than rates charged by banks and S&Ls.

  15. Life Insurance Companies • Certain types of policies have a savings function • Required by law to make loans again the cash value • No maturity date • Amount of loan plus accrued interest is deducted from amount of coverage if you die before repayment

  16. Other sources include: • Friends and relatives • Not advisable because of the risks of alienating the friend or relative • Pawn shops • Borrower leaves something of value as collateral • If borrower doesn’t repay loan, pawn shop sells the asset to recover the loan • Interest rates can be extremely high • Example

  17. Managing Your Credit • Two questions to ask when considering the use of a consumer loan: 1. Does making this acquisition fit into your financial plans? 2. Does the required debt service on the loan fit into your monthly cash budget?

  18. The Mortgage Meltdown

  19. Shopping for Loans • Shop carefully before borrowing • Compare loan features • Finance charges—APR (annual percentage rate) • Loan maturity—altering loan maturity is one way of coming up with affordable payments • Total cost of transaction—look at both price of item purchased and price of the credit • Collateral requirements—what do you have to pledge on loan and what you will lose if you default • Other features, such as payment date, prepayment penalties and late fees

  20. Keep Track of Your Credit! • Keep inventory sheet of debt • Know total monthly payments • Know total debt outstanding • Check your debt safety ratio (should not exceed 20%) • Total monthly consumer debt pmts • Monthly take-home pay

  21. Repaying Your Loan 1. Single payment loans 2. Installment loans BANK

  22. 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.

  23. 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.

  24. 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.)

  25. 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.

  26. Using the Simple Interest Method: Annual Percentage Rate = Average annual finance charge Average loan balance outstanding APR = ($240 2) $1000 = $120 $1000 = .12 = 12%

  27. 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.

  28. 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%

  29. Comparing the Two Methods:

  30. 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.

  31. 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!

  32. 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.)

  33. Mo. Beg. Bal. PMT Interest Principal End. Bal. 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

  34. 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!

  35. 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.

  36. $88.85 x 12 = $1,066.20 Loan amount = – 1,000.00 Interest paid = $ 66.20 Total amount paid over the 12-month period:

  37. 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

  38. $93.33 x 12 = $1,120.00 Loan amount = – 1,000.00 Interest paid = $ 120.00 Total amount paid over the 12-month period:

  39. Comparing the Two Methods:

  40. 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.

  41. Other Loan Considerations: • Prepayment penalties Does the lender use Rule of 78s?—charges more interest in the early months of the loan • Credit life insurance and disability requirements Avoid if possible and get term insurance instead; very costly and really does little more than provide lenders with income • Buy on time or pay cash? May be better to pay cash — If you have it!

  42. THE END!

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