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

Types of Consumer Loans Auto Durable goods Education loans Personal loans Consolidation loans

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

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

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 Graduated repayment schedule Income-contingent repayment plan Don’t default!

Repaying Consumer Loans Single Payment or Installment Fixed or Variable Interest Rate

Where Can You Get Consumer Loans? Traditional financial institutions Commercial banks Credit Unions Savings and Loan Associations Consumer finance companies Specialize in high-risk borrowers Together with banks and credit unions make ~75% of consumer loans

Other sources include: Sales finance companies Third party financing Include captive finance companies, such as GMAC Life insurance companies Loan against cash value of certain types of policies Friends and relatives Pawn shops

Managing Your Credit Shop carefully before borrowing Compare loan features Finance charges and loan maturity Total cost of transaction Collateral requirements Other features, such as payment date, prepayment penalties and late fees

Low Rate or a Rebate? Example: buying a new car with a price of $20,000, with two financing options: 1.9% financing (60 months) from car dealer $2,500 rebate, then 10% (60 months) financing from your bank Which option should you choose?

1.9% financing $2,500 rebate Find monthly payment 20,000 +/- PV 1.9 I/YR 60 N PMT $349.68 $2,500 rebate Find monthly payment 17,500 +/- PV 10 I/YR 60 N PMT $371.82 1.9% financing is the better deal because of the lower monthly payments.

If we take the $2,500 rebate, we would need to borrow: If we were to make a monthly payment of $349.68, we would need to borrow from the bank: $349.68 PMT 10 I/YR 60 N PV $16,458 If we take the $2,500 rebate, we would need to borrow: $20,000 – $2,500 = $17,500 from the bank. 1.9% financing is the better deal because it represents a lower cost in present value .

Keep Track of Your Credit! Keep inventory sheet of debt Know total monthly payments Know total debt outstanding Check your debt safety ratio— Total monthly consumer debt pmts Monthly take-home pay

Keep Track of Your Credit! Use Worksheet 7.1 to track your consumer debt A desirable debt safety ratio should be 20% or lower, otherwise you are relying too heavily on credit.

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

1. 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.

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.

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.)

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.

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

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.

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%

Comparing the Two Methods:

2. 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.

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!

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.)

(Table calculated using $1000 loan) (Set on 12 P/YR and END mode:) Use Exhibit 7.6 (Table calculated using $1000 loan) Find payment for 12 months at 12% interest: $88.85 Calculator (Set on 12 P/YR and END mode:) 1000 +/- PV 12 I/YR 12 N PMT $88.85 [Note: We can use a spreadsheet to create the following table.]

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

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!

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.

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

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

Add-On Method Continued: Use financial calculator to figure APR for the Add-On Method using the payment just determined and solve for interest: Set on 12 P/YR and END mode: 1000 +/- PV 93.33 PMT 12 N I/YR 21.45%

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

Comparing the Two Methods:

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.

Other Loan Considerations: Prepayment penalties Does the lender use Rule of 78s? Rule of 78s (sum-of-the-digits method) Charge more interest in earlier months of the loan Producing a much higher principal balance than the regular installment payment would result in Credit life insurance and disability requirements Avoid if possible and get term insurance instead!

Other Loan Considerations: Buy on time or pay cash? Use Worksheet 7.2 for this analysis If all of the following conditions are satisfied, you should pay cash: You have sufficient amount of cash to pay off the item Paying off the item does not exhaust your savings It costs more to borrow than you can earn in interest from the savings Also should consider the tax features