Using Consumer Loans: The Role of Planned Borrowing Chapter 7 Using Consumer Loans: The Role of Planned Borrowing

Characteristics of Consumer Loans Single-payment versus installment loans Secured versus unsecured loans Variable-rate versus fixed-rate loans

Single-Payment Loans Versus Installment Loans Single-payment or balloon loans sometimes called bridge or interim loans, because they are used until permanent financing can be arranged loan is repaid in one lump-sum, including interest normally for short-term lending of one year or less

Single-Payment Loans Versus Installment Loans (cont’d) loan is repaid at regular intervals payment includes both principal and interest normally used to finance cars, appliances, and other expensive items

Installment Loan Amortization The process of your payment going more toward principal and less toward interest each subsequent month. Based on a simple-interest calculation.

Secured Versus Unsecured Loans are guaranteed by a specific asset typically have lower rates

Secured Versus Unsecured Loans (cont’d) require no collateral offered to borrowers with excellent credit histories normally have high rates of interest – 12% to 21% annually

Fixed-Rate Versus Variable-Rate Loans Fixed-rate loans have the same interest rate for the duration of the loan normally have a higher initial interest rate because the lender could lose money if the rates increase most consumer loans are fixed-rate loans

Fixed-Rate Versus Variable-Rate Loans (cont’d) have an interest rate that is tied to an index (e.g., prime rate, 6-month Treasury bill rate) can adjust on different intervals such as monthly, semi-annually, or annually have a lifetime adjustment cap normally have a lower initial interest rate because the lender won’t lose money if the rates increase

Fixed-Rate Versus Variable-Rate Loans (cont’d) Convertible loans begin as a variable rate loan and can be locked into the current rate a some predetermined time in the future.

The Loan Contract Insurance agreement clause Acceleration clause Deficiency payments clause Recourse clause

Insurance Agreement Clause Requires you to purchase life insurance that will payoff your loan after your death Normally benefits only the lender Increases your total loan cost

Acceleration Clause Requires the entire loan to be paid-in-full if you miss just one payment Are standard on most loans Normally not invoked if you make a good faith effort to pay

Deficiency Payments Clause Requires any amount in excess to be paid if the collateral's value does not satisfy the loan. Also requires payment of any outstanding charges incurred by the lender associated with the disposal of the collateral.

Recourse Clause Defines the lender’s ability to collect any outstanding balance wage attachments and garnishments liens on other property (secondary collateral)

Special Types of Consumer Loans Home equity loans Student loans Automobile loans

Home Equity Loans Are basically second mortgages Use the equity in your home to secure your loan Normally allow you to borrow up to 80% of your equity

Home Equity Loans (cont’d) Advantages interest payments are tax-deductible lower rates of interest than other types of consumer loans Disadvantages puts your home at risk if you default sacrifices future financial flexibility because you can only have one outstanding home equity loan

Student Loans Loans with low, federally subsidized interest rates used for higher education. Are tax-advantaged under the 1997 Taxpayer Relief Act. Examples – Federal Direct/Stafford loans for students; PLUS Direct/PLUS Loans for parents.

Student Loans (cont’d) Federal Direct and PLUS Direct available through the school; Stafford and PLUS loans available through lenders. Payment on Federal Direct and Stafford loans deferred for 6 months after graduation. Borrowing limits apply.

Automobile Loans A consumer loan that is secured with an automobile. Has a lower interest rate than an unsecured loan. Normally has a maturity length of 2 to 6 years.

Cost and Early Payment of Consumer Loans Cost of single-payment loans. Cost of installment loans. Early repayment of installment loans. Understanding the relationship between your payments, interest rates, and the term of the loan.

Payday Loans High fees charged. Short-term loan of 1-2 weeks. Those with jobs and checking accounts and students are typical users. Check “held” by the payday lender.

Cost of Single-Payment Loans The simple interest method both principal and interest are due at maturity interest = principal x interest rate x time The discount method subtracts the entire interest charge from the loan principal before you receive the loan inflates the rate of interest because the amount received is less than the amount borrowed

Cost of Installment Loans Repayment of both principal and interest occur at regular intervals The simple interest method this is the most common calculation method remember, with each month the interest portion of the payment decreases and the principal portion increases you pay interest only on the outstanding balance

Cost of Installment Loans (cont’d) The add-on method adds the total interest payment to the principal of the loan much more costly than the simple-interest method can double the stated rate

Early Repayment of Installment Loans With the simple interest method, it is simply the outstanding balance. With the add-on method, use the rule of 78s or sum of the year’s digits methods.

Payment, Interest Rate and Loan Term The total interest cost of your loan is directly related to the interest rate. The total interest cost of your loan is inversely related to the maturity length. Your periodic payment is directly related to both the duration and interest rate.

Sources of Consumer Loans Inexpensive sources of loans home equity loans other secured loans More expensive sources of loans credit unions savings and loans commercial banks

Sources of Consumer Loans (cont’d) Most expensive sources of loans retail stores finance companies Those who are in the worst financial shape have to pay the most for credit. You must have a solid credit rating to borrow from the cheaper lenders.

Know How to Borrow Maintain a strong credit rating Reduce the lender’s risk use a variable rate loan. keep the loan term as short as possible. provide collateral for the loan. pay a large down payment on the item to be purchased with financing.

Know When to Borrow Do you really need to make this purchase? Does it fit into your financial plan? If cash is used, can you maintain sufficient liquidity? What is the after-tax cost of borrowing versus the after-tax lost return from using savings to make the purchase?

Control Your Use of Debt Calculate the debt limit ratio Apply the debt resolution rule Control your consumer debt

Take Steps When You Can’t Pay Your Bills Implement a budget that brings in more money than you spend. Use self-control to limit credit usage. Talk to the creditor about restructuring the debt repayment. Seek help from a credit counselor.

Take Steps When You Can’t Pay Your Bills (cont’d) Consider a cheaper loan to pay back more expensive debt. Use savings to pay off current debt. Consider a debt consolidation loan.

Chapter 13: The Wage Earner’s Plan Is a viable possibility if you have a regular source of income have less than $350,000 secured debt have less than $100,000 unsecured debt Sets-up a controlled repayment schedule Allows you to maintain possession of your assets Is reported on your credit report for 7 years

Chapter 11: Debt Reorganization Not very common because it is intended for businesses. Is viable if you exceed the liability limits of Chapter 13. Allows your creditors to vote on the repayment plan.

Chapter 7: Straight Bankruptcy Provides the opportunity to eliminate most of your debts and begin again. Requires the liquidation of most of your assets by a court appointed trustee. Allows you to keep some equity in your house, but the amount varies by state. Should only be considered after you consult with a financial advisor and a lawyer.

Summary Secured and unsecured loans Single-payment loans secured loans are guaranteed by a specific asset and typically have lower rates unsecured loans require no collateral but normally have higher rates of interest Single-payment loans both principal and interest are due at maturity

Summary (cont’d) Installment loans Repayment of both principal and interest occur at regular intervals. Fixed-rate interest versus variable-rate Fixed-rate loans normally have a higher interest rate that remains constant throughout the loan. Variable-rate loans have an interest rate based on an index, such as the prime rate or the 6-month treasury bill rate.

Summary (cont’d) Loan costs vary with the methods of computing finance charges Sources of consumer loans—know the costs Four ways to reduce your interest rate use a variable-rate loan keep loan term short provide collateral make a large down payment

Summary (cont’d) Determine how much debt you can afford review your budget analyze debt commitments calculate your financial ratios apply the debt resolution rule Seek help if you get into trouble