Using Consumer Loans: The Role of Planned Borrowing 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

Figure 7.1 An Installment Purchase Contract

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 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 and Early Payment of Consumer 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

Figure 7.4 A Loan Disclosure Statement

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%

TABLE 7.2 Payday Loan Facts

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%

Table 7.5 Calculating the APR for an Add-On Loan

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

Table 7.6 Early Payoff of an Add-On Loan—the Rule of 78s

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’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

Figure 7.5 Chapter 7 and 13 Bankruptcy Filings

Figure 7.6 Personal Bankruptcy Options

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.

Figure 7.3 The Rise of Student Loan Debt

Table 7.1 Student Loan Comparisons

Table 7.7 Possible Sources of Credit