Chapter 7 Student and Consumer Loans: The Role of Planned Borrowing Professor Payne, Finance 4100

Learning Objectives Understand the various consumer loans. Calculate the cost of a consumer loan. Pick an appropriate source for your loan. Control your debt. Understand the alternatives for financing your college education.

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 versus installment Secured versus unsecured Variable-rate versus fixed rate Shorter- versus longer-term

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 Insurance agreement clause 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 Automobile loans—secured loan specifically for purchasing an automobile Usually 24, 36, or 48 months Can extend to 5 or 6 years Low risk to lender because of collateral

Cost and Early Payment of Consumer 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 of Single-Payment Loans Loan disclosure statement gives APR and finance charges of a loan States interest calculation Simple interest method: Discount method: Interest is subtracted from loan amount received

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.

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, savings and loans, and commercial banks Most expensive sources—retail stores, finance companies or small loan companies

Keys to Getting the Best Rate Strong credit rating Reduces risk 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 obligations, 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. Look for clues that you might be in financial trouble.

What To Do If You Can’t Pay 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’t Pay 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’t Pay Your Bills Most common types of personal bankruptcy: Chapter 13 The wage earner’s plan Chapter 7 Straight bankruptcy

Chapter 13: The Wage Earner Plan Must have: Regular income Secured debts under $1,149,525 (2014) Unsecured debts under $383,175 (2014) For the individual—relief from harassment of bill collectors; retain possession of assets 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.

Student Loans and Paying for College Understand the consequences of your choice of school and major Understand the full costs of school and what you can do to borrow less and borrow smarter Manage your money well while on campus Repay your loans without sacrificing your financial goals

So Many Choices—Schools and Majors Research what your expected salary will be so you do not take on too much debt Understand the positive and negative aspects of your school and major choices

Borrowing Less and Borrowing Smarter Compare financial aid packages and college costs Apply for federal financial aid first Look for state and local grants and scholarships Use tax credits and deductions to your advantage

Paying for Your College Education 529 plan Prepaid tuition plans College savings plans Coverdell Education Savings Account (ESA)

Federal Student Loans Department of Education is your lender Interest is fixed over the life of the loan Federal Perkins Loan Program Direct Subsidized Loans Direct Unsubsidized Loans Direct PLUS Loans Direct Consolidation Loans

Private Loans Provides you with funds after you have exhausted all federal financial aid Offered by commercial banks and credit unions Interest rate varies Rates are usually higher than federal student loan rates Generally do not offer deferment or forbearance options

Manage Your Money Responsibly Choose a bank that charges low fees Use direct deposit

Repaying Your Loans Repayment Plans Deferment Forbearance Standard Extended Income-Based Graduated Deferment Enrolled at least half-time, unemployed, or meet hardship standards you can postpone payments for up to 3 years No interest is accrued on subsidized loans Forbearance Delay payments due to illness, financial hardship, or residency requirement Interest accrues

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, credit check fees, and insurance fees.

Summary There are numerous sources of loans, but the key to getting a 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.

Summary Understand the role your school and major play in student loan debt. Use tax-advantaged accounts like 529 plans and Coverdell Educational Savings Accounts to save for college. Use federal student loans as your first borrowing alternative.

End of Chapter 7 Slides