1. CHAPTER 7: USING CONSUMER LOANS

2. 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

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

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

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

6. 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!

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

8. 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

9. 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

10. 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

11. 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?

12. 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.

13. 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:
$ 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 .

14. 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

15. 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.

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

17. 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.

18. 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.

19. 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.)

20. Using the Simple Interest Method:
Interest = Principal x Rate x Time
= $1000 x .12 x 2
Finance Charges = $240
Borrower receives loan amount ($1000) now—
And pays back loan amount plus finance charges ($ $240) at end of time period.
Most consumer friendly method—APR will be the same as the stated rate.

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

22. 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.

23. 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%

24. Comparing the Two Methods:

25. 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.

26. 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!

27. 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.)

28. (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.]

29. Mo. Beg. Bal. PMT Interest Principal End. Bal.
1 $1, $88.85 $ $78.85 $921.15
2 $ $ $ $79.64 $841.51
3 $ $ $ $80.43 $761.08
4 $ $ $ $81.24 $679.84
5 $ $ $ $82.05 $597.79
6 $ $ $ $82.87 $514.92
7 $ $ $ $83.70 $431.22
8 $ $ $ $84.54 $346.68
9 $ $ $ $85.38 $261.30
10 $ $ $ $86.24 $175.06
11 $ $ $ $87.10 $
12 $ $ $ $87.96 $

30. 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!

31. 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.

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

33. 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

34. 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%

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

36. Comparing the Two Methods:

37. 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.

38. 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!

39. 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