Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 8 Personal Loans

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Copyright ©2004 Pearson Education, Inc. All rights reserved.8-8 What Is Consumer Borrowing? Obtaining funds from a lender under specific loan provisions. Called “Consumer Loans.” –Made for a specified purpose. –Must be repaid according to a specified schedule. Consumer loans are necessary because few people can pay cash for big-ticket items.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-9 Advantages of Consumer Loans Permits buying expensive items. Permits you to use the item while paying for it. Provides financial flexibility--spread payments over long period of time. To cover unexpected expenses and emergencies.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-10 Disadvantages of Consumer Loans You must pay interest on the loan. Must provide collateral or security for the loan. If overused, may be unable to repay your debts.

Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 8 Personal Loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-12 Chapter Objectives Provide a background on personal loans Outline the types of interest rates that are charged on personal loans Describe home equity loans Discuss car loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-13 Chapter Objectives Explain how to decide between financing the purchase of a car and leasing a car Describe the key features of student loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-14 Background on Personal Loans Usually obtained to finance a large purchase Has a specific repayment schedule Sources of loans –Commercial banks, savings institutions, finance companies, credit unions, some automobile manufacturers, friends, or family members

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-15 Background on Personal Loans The personal loan process –Application process Personal balance sheet Personal cash flow statement –Loan contract: a contract that specifies the terms of a loan, as agreed to by the borrower and the lender Amount of the loan Interest rate

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-16 Background on Personal Loans –Loan repayment schedule Amortize: to repay the principal of a loan through a series of equal payments Each payment includes part of the principal and part of the interest –Maturity: the life or duration of the loan Longer maturity equals lower payments, but more interest is paid over the life of the loan

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-17 Background on Personal Loans –Collateral: assets of a borrower that back a secured loan in the event that the borrower defaults Secured loan: a loan that is backed or secured by collateral which could be repossessed if the lender defaulted on the loan Unsecured loan: a loan that is not backed by collateral –Cosigning is sometimes required if credit history is weak

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-18 Background on Personal Loans Exhibit 8.1: An Example of a Loan Application

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-19 Five Cs of Consumer Borrowing Character - refers to the integrity of the prospective borrower. –Have you met your previous obligations? Capital - refers to the net worth position of the applicant. –Have you sufficient financial assets? Capacity - refers to the ability of the borrower to repay borrowed amounts. –Can you meet your future obligations?

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-20 Five Cs of Consumer Borrowing Collateral - consists of items of value that may be pledged to secure the loan. Conditions - refers to general economic conditions.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-21 Managing Debt To determine how much you can borrow, debt payments should be compared to disposable income, and the amount borrowed should be compared to net worth.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-22 Amount of Debt Ratio of debt payment to disposable income (should not exceed 20%) –measures you ability to make your non-mortgage debt payments from current disposable income. –Is a “flow” measure--matches cash inflow with cash outflows. –A low ratio (<10%) indicates you can borrow more. –Ratios over 20% indicates too much has been borrowed.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-23 Amount of debt (continued) Ratio of debt to net worth. –Excludes mortgage debt and the value of your home. –“stock” measure - relates debt to accumulated net worth. –A ratio of more than 100% indicates no additional debt should be undertaken.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-24 Financial Planning Online: Loan Request Online Go to: This Web site provides a set of questions that you can answer to specify the type of loan that you desire. You will then receive up to four loan offers from various financial institutions within the next business day.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-25 Background on Personal Loans Focus on Ethics: Predatory Lending –Beware of illegal lending practices Lender charging high loan fees Lender provides home equity loan with the expectation of default so he can take ownership Lender ties other products to loan approval Lender includes balloon payment at end of loan Loan agreement includes confusing information –Shop around for best loan terms

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-26 Methods of Computing Interest Simple interest method –single payment loan –installment loan Discount method Add-on method

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-27 Simple Interest Method Single payment loan –interest is charged on amount owed. –interest is charged only once. Installment loan –interest is calculated on outstanding balance. –installment payments are equal. –amount applied to principal increases with each payment. –amount applied to interest decreases with each payment.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-28 Discount Method Finance charges are calculated based upon the loan principal, and then deducted from the principal, with the borrower receiving the net amount x 10% = 300 interest = 2700 amount received

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-29 Add-on Method Finance charges are calculated based on the loan principal, then the finance charges are added back to the principal. Loan payments are based upon the sum of these 2 values :- 12 = 275

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-30 Interest Rates on Personal Loans Annual percentage rate (APR): a rate that measures the finance expenses (including interest and other expenses) on a loan on an annualized basis Add-on interest method: a method of determining the monthly payment on a loan

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-31 Interest on Personal Loans

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-32 Interest Rates on Personal Loans Simple interest: interest on a loan computed as a percentage of the existing loan amount (or principal) –Size of payment depends on size of loan, interest rate and maturity –The higher the interest rate, the higher the payment –The longer the maturity, the lower the payment

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-33 Interest Rates on Personal Loans Exhibit 8.3: Example of a Loan Repayment Schedule

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-34 Home Equity Loan Home equity loan: a loan where the equity in a home serves as collateral for the loan Equity of a home: the market value of a home minus the debt owed on the home Credit limit on a home equity loan –Limit based on equity invested –Financial institutions usually loan up to 80% of the equity in a home

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-35 Home Equity Loan Interest rate is typically variable –Rate is usually tied to an interest rate index and adjusted periodically –Interest on most home equity loans is tax deductible

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-36 Financial Planning Online: Applying for a Home Equity Loan Go to: Click on: Mortgage Calculator, then Online Home Equity This Web site provides access to home equity loan applications.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-37 Car Loans Selecting the car — things to consider –Personal preferences –Price –Insurance –Resale value –Repair expenses –Financing rate

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-38 Car Loans Negotiating the price –Negotiating by phone may be beneficial –Trade-in tactics can be misleading –No-haggle dealers can save time and stress –Information is valuable – shop around –Purchasing a car online is possible, but not yet a streamlined process

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-39 Car Loans –Financing decisions Estimate dollar amount of monthly payment you can afford before shopping

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-40 Financial Planning Online: Prices of New Cars Go to: Click on: “New Car Guide” under “New Cars” heading This Web site provides estimates of what you should pay for any new car, based on the car’s features and options that you specify.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-41 Car Loans Exhibit 8.4: Stephanie Spratt’s Car Analysis

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-42 Car Loans Exhibit 8.5: Stephanie’s Possible Monthly Loan Payments

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-43 Financial Planning Online: Trade-In and Retail Value of Used Cars Go to: This Web site provides trade-in and retail values for a used car, based on the condition of the car, its age, and other characteristics that you specify.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-44 Financial Planning Online: Car Loan Interest Rate Quotation Go to: Click on: “Car Financing,” then “Get An Auto Loan” This Web site provides a car loan interest rate quotation based on your desired car, the amount you need to borrow, and the term of the loan.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-45 Financial Planning Online: Prevailing Car Loan Interest Rates Go to: This Web site provides average car loan interest rates across the United States and in various states, which provide a useful benchmark for you to consider before obtaining a car loan.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-46 Financial Planning Online: What Is the Optimal Loan Maturity? Go to: sellingtools/calculators sellingtools/calculators Click on: “Auto,” then “What term of loan should I choose?” This Web site provides a comparison of what your car loan payments will be based on loan maturity.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-47 Purchase versus Lease Decision Leasing is a popular alternative to buying a car Advantages of leasing –Lower down payment –Just return the car at the end of the lease period

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-48 Purchase versus Lease Decision Disadvantages of leasing –You build no equity in the car –You are still responsible for maintenance and damages –Additional charges may be imposed Too many miles Ending the lease before the specified period

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-49 Financial Planning Online: Should You Lease or Buy? Go to: Click on: Tools, then Lease/Buy calculator This Web site provides a comparison of the cost of leasing versus purchasing a car.

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-50 Purchase versus Lease Decision Exhibit 8.6: Stephanie’s Comparison of the Cost of Purchasing versus Leasing

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-51 Purchase versus Lease Decision Exhibit 8.6: Stephanie’s Comparison of the Cost of Purchasing versus Leasing

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-52 Student Loans Student loan: a loan provided to finance part of the expenses a student incurs while pursuing a degree Loan may be provided to either the student or the student’s parents Repayment typically deferred until student is out of school Interest may be tax deductible

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-53 How Personal Loans Fit within Your Financial Plan Key personal loan decisions for your financial plan are: –How much money can you afford to borrow on a personal loan? –If you obtain a personal loan, should you pay it off early?

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-54 Integrating the Key Concepts

Copyright ©2004 Pearson Education, Inc. All rights reserved.8-55 Integrating the Key Concepts Part 1: Financial Planning Tools Part 2: Liquidity Management Part 3: Financing –In Chapter 8 we learned about personal loans –Chapter 9 teaches about purchasing and financing a home Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning