Personal Loans and Credit Cards © Dr. B. C. Paul 2002 revisions 2008 Note – The subject covered in these slides is considered to be “common knowledge” to those familiar with the subject and books or articles covering the concepts are widespread.

Herby’s Personal Loan Choice  $5,000 in initial repairs  The Old Rational Bank Loan Option  $200 loan application fee  10% compounded monthly  5 year amortization  Convert a present loan amount into an annuity of payments in the future  A/P * Present Loan Amount check

A Bank Loan for Herby  A/P  n = 60 = 5 years * 12 months per year  i = 10% per year/ 12 months per year =  A/P 0,00833, 60 =  Monthly cost for initial repairs  * $5000 = $  Also an initial fee of $200

If Herby Picks the Bank Loan Herby’s $5,000 repair money Herby’s $200 loan Initiation fee Herby’s $ per month for the next 5 years

Herby Also had a Simple Interest Loan Option with Sleezy Money  The Sleezy Money loan has no up front $200 loan initiation fee  The Sleezy Money loan has an interest rate of 9% instead of 10%  What a Deal! Who needs the Banker?!!  Just One Question  What the Heck is a Simple Interest Loan?

Simple Interest or Simply _ _ _ _ _ _ _  Is a special type of Loan known as a Simple Interest or Add Interest Loan  Main Places Found  Sleezy Finance Houses (such as Herby’s Sleezy Money Finance Company)  Auto Loans  Most that come from Car Dealers  A lot of Car Loans from Banks

Calculating Simple Interest  Interest Rate is Reported on an annual basis  There is no compounding or interest charged on interest  You still need to get the period interest rate by dividing by number of payments per year  If Sleezy money charges 9% with monthly payments for 5 years  Period Interest Rate is 9/12 = 0.75%  Still need to convert to decimal for calculation

The Trick  Interest is charged as one lump sum  Loan Amount * Period Interest Rate * Number of payments = Interest  For Herby 5000 * * 60 = $2,250  The Interest is then added to loan immediately  Ie Herby’s loan is for $5,000 + $2,250 = $7,250  (Can see why they are called Add Interest Loans)

Calculating Payments  Loan amount with interest added is just divided by number of payments  For Herby $7,250 / 60 = $120.83

Whats Wrong with That?  Notice that you paid full interest rate on all the money that you borrowed even after you have paid the money off  If Herby tries to pay a simple interest loan off the next month he’ll still pay $7,250 or full interest for 5 years

The Impact Herby’s interest rate Starts at 9% but Climbs over time to Over 450% Herby’s regular Bank loan costs $1,458 in interest Herby’s Simple Interest Loan will Cost $2,250 (half again as Much)

The Deception  Auto Dealers and Some Finance Houses quote attractive interest rates  Only in the fine print is simple interest disclosed  Herby’s 9% Simple interest loan is equivalent of 13.5% of a regular compound interest loan  Allows organizations to quote far lower rates than competition

Herby’s Credit Card  Credit cards usually do not charge a fixed monthly payment (except for some minimum usually around $15 to $25)  Instead they charge a fixed percentage of the outstanding balance  will produce a declining monthly payment like a reverse geometric gradient going down  We have no super hero for that  We do have a spreadsheet

We Will Use the Interest Rate Comparison Spreadsheet Begins with calculating Period interest rate (ie annual rate divided by The # of compounding Periods per year).

Calculates A Payment Interest Rate This is really an approximation. Average Daily balance Charges each transaction from The time it occurs. This spreadsheet was Designed to compare different Ways to borrow a lump sum. (1+daily int)^(365/12) Same way you found actual Annual interest on a Credit Cd. Enter Loan Amount And Payment Calculation Terms

Shows the Transaction Fees We assume we have none And that they just charge the Supplies with a credit card At Home Peephole.

Working Up Costs Principal is 1% of debt Interest is the debt X monthly yield Payment is the sum of Principle + interest (Note I assume there is never a late or over-limit fee)

Spreadsheet Calculates Some Interesting Statistics Note that the credit card will take nearly 19.5 years to pay off (provided no body Charges anything new for 19.5 years) There will be $4,800 in interest charges and they will pay almost $2 for Every dollar they spend. (Bankers will almost get more money than the Store and all the materials suppliers combined).

The Game Afoot  Why are credit cards so hard to pay-off  The minimum payments are generally set to be competitive with signature loans at banks  But the modest payment hides a high interest rate and results in slow payment of the debt  The Declining Payment - Why?  Official Answer - to better service the customer by minimizing demands made upon him

Its A TRAP  By directing a high percentage of your payments to interest and then slowly declining those payments - credit card debt takes a long time to pay-off  The Credit Card Company’s bet you a life time of debt that if you ever get a good credit card debt - you won’t be able to avoid using your card again for 20 years - You'll recharge the debt.

Other Credit Card Games  Credit Cards have “Cash Advance Fees”  Credit Card Checks or getting cash from an ATM is considered a “Cash Advance”  Cash advances are usually 3% to 5% of the amount advanced (or a minimum fee of $10 or $25)  some cards do have a maximum fee also  If Herby gets a cash advance on his credit card he will pay  $5,000 * 0.03 = $150  so much for getting out of that loan initiation fee

More Games  If Herby Charges supplies at Smowe’s or Home Peephole he does not pay a cash advance fee.  But the credit card company charges a fraction of a percent to the merchant (hidden in higher prices)  Reason some gas stations have a higher price for credit cards than cash  Reason that not every store takes credit cards

Cash Advance vs. Purchase  In addition to cash advance fee credit cards charge a higher interest rate for cash advances than purchases  purchases are often 7.9% to 23%  cash advances are typically 12.9 to 32%  If you get a cash advance on your credit card - all your payments will go to cover purchases (lower rate) until the low rate stuff is paid off (never if you fall in the declining payment trap)  About the only way to get a cash advance off your back is to pay-off the entire card.

The Promotional Offer  Many credit cards offer promotional interest rates  They last around 3 to 12 months depending on the card - And then they jump to a higher interest rate  The idea is to get you to run up a balance that you won’t be able to dig out of  Often they will charge a cash advance fee with a promotional interest rate check

The Grace Period  Most cards offer a grace period  If you pay-off your balance in full each month there is no interest BUT  Many credit cards are shortening grace period from 25 days to 20  They wait about a week to 10 days after your “statement date” to send the bill  Takes about 3 or 4 days in the mail  They warn you in fine print that it may take 3 to 5 days to credit your payment  Takes you about 3 or 4 days to get payment to their office  Result - you may have only a day or two to have the money in your checking account ready to pay them.

Bankers Grace  If your payment doesn’t make it on time ( I wonder how much hustle they put into processing your payment if its close - I wonder how you’d prove it)  Credit Cards Charge a late fee (usually $35 or now a graduated scale) in addition to interest  If they can catch you several times, most will raise the interest rate that they charge on your account (after all you’re a bad credit risk because you don’t pay on time)  They will revoke any special rates you have

Dynamic Interest Rates  Universal Default  If they find you are ever late on payments to anyone they can raise your interest rate  The Stealth Alternative  If you are ever late to them or an affiliate or if they periodically re-evaluate your credit worthiness based on secret factors they can raise your rate  Most cards have floating interest rates – it is an index value plus a spread  You take all the market risk.

Billing Cycle Tricks  Some credit cards change the way they calculate the “average daily balance”  They do the average daily balance as a two cycle average (ie the average over two months instead of each billing cycle)  Results  If you try to take a promotional offer and then pay off the balance before the rate goes up - they get to zap you even after the balance is paid.  They can continue to charge you interest on purchases after they are paid off  You have to keep your credit card paid off for many months straight to stop monthly interest charges.

Now We Have Looked at Bank Loans, Simple Interest Loans, and Credit Cards Now you get the opportunity to make a comparison of your own Assignment #8 Help Fred and Fanny Furniture Decide whether to buy $4,000 worth Of furniture using a Personal Loan from a Bank, a Simple Interest Loan, or a Credit Card.