Chapter 7 Using Consumer Loans Chapter Outline Learning Goals I. Basic Features of Consumer Loans A. Using Consumer Loans B. Different Types of Loans 1. Student Loans a. Obtaining a Student Loan b. Are Student Loans “Too Big to Fail”? c. Strategies for Reducing Student Loan Costs 2. Single-Payment or Installment Loans 3. Fixed- or Variable-Rate Loans C. Where Can You Get Consumer Loans? 1. Commercial Banks 2. Consumer Finance Companies 3. Credit Unions 4. S&L Associations 5. Sales Finance Companies 6. Life Insurance Companies 7. Friends and Relatives *Concept Check* II. Managing Your Credit A. Shopping for Loans 1. Finance Charges 2. Loan Maturity 3. Total Cost of the Transaction 4. Collateral 5. Other Loan Considerations B. Keeping Track of Your Consumer Debt *Concept Check* III. Single-Payment Loans A. Important Loan Features 1. Loan Collateral 2. Loan Maturity 3. Loan Repayment B. Finance Charges and the Annual Percentage Rate 1. Simple Interest Method 2. Discount Method *Concept Check* IV. Installment Loans A. A Real Consumer Credit Workhorse B. Finance Charges, Monthly Payments, and the APR 1. Using Simple Interest 2. Add-on Method 3. Prepayment Penalties 4. Credit Life Insurance C. Buy on Time or Pay Cash? *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Making the Payments! Critical Thinking Cases 7.1 Financing Anita’s Education 7.2 Michael Gets His Outback Money Online! Major Topics Although saving is an important way to reach a financial goal, borrowing by using a consumer loan may also help you attain your personal financial goals. Consumer loans are an important part of achieving financial goals, particularly when the amount borrowed and the debt repayment requirements are well within the budget. There are a variety of consumer loans available for a variety of purposes. The major topics covered in this chapter include: 1. One of the most legitimate reasons for going into debt is to pay for a college education. There are several federally sponsored, subsidized student loan programs available: Stafford Loans, Perkins Loans, and Parent Loans (PLUS). 2. Installment loans are frequently preferred to single-payment loans because of the ease of repayment over time. 3. Consumer loans can be obtained from commercial banks, consumer finance companies, credit unions, savings and loan associations, sales finance companies, life insurance companies, and friends or relatives. 4. When shopping for a loan, the borrower should be aware of finance charges and other terms of the loan, as well as the total cost of the debt. 5. Single-payment loans usually mature in one year or less, and interest can be calculated using the simple method or the discount method. 6. Installment loans can have maturities of up to seven to ten years, and interest can be calculated using the simple method or the add-on method. 7. Consumer loans may have various provisions, including collateral requirements, variable or fixed interest rates, recourse clauses, and other clauses that protect the position of the lender. 8. Comparisons among various loans should include calculation of the annual interest rate charged on the loan. Key Concepts This chapter introduces a number of key phrases and concepts associated with consumer loans. It continues to stress the relationship of consumer actions, such as borrowing to fulfill a personal financial goal, and the requirements of good financial planning so that the burden of borrowing fits into the budget. The following phrases represent the key concepts stressed in this chapter. 1. Student loans 2. Single-payment and installment loans 3. Fixed- or variable-rate loans 4. Consumer finance and sales finance companies 5. Cash value of life insurance policies 6. Loan provisions to protect the lender 7. Finance charges and total cost of the loan 8. Annual percentage rate calculation 9. Simple interest method and discount method for single-payment loans 10. Simple interest method and add-on method for installment loans 11. Rule of 78s Answers to Concept Check Questions 7-1. The five major reasons to use consumer loans are: a. To buy a new car. Auto loans account for nearly 35% of all consumer loans. As a rule, 80 to 90% of the cost of a new vehicle will be financed with credit; the buyer must come up with the rest through a down payment. The auto is the collateral for the loan, and it can be repossessed in the event that the buyer fails to make payments. These loans generally mature in 36 to 60 months. b. To purchase other costly durable goods. These loans are used to purchase such things as furniture, appliances, recreational vehicles, even mobile homes. The item purchased serves as collateral, and some down payment is almost always required. The loans can mature in as short a time as 9 to 12 months for less costly items all the way to 10 to 15 years or longer for purchases such as a mobile home. c. To pay for an education. Many students, or their parents, have taken out loans to pay for high-cost college education. These loans often carry low interest rates, and loan repayment often does not start until the student is out of school. d. As a personal loan. This type of credit is used to make expenditures for nondurables, such as an expensive vacation, or to cover temporary cash shortfalls. Many personal loans are made on an unsecured basis. e. As a consolidation loan. These loans are used to straighten out an unhealthy credit situation. For various reasons, consumers sometimes use their available credit to such an extent that they are no longer able to service the debt promptly and in a timely manner. When this happens, they can often consolidate the loans to systematically bring the credit under control. In effect, they borrow money from one source to pay off the other forms of borrowing. The usual effect of such a move is to reduce the total payment, but payments may have to be made for a longer time period. 7-2. The federal government makes available several different types of subsidized educational loan programs: • Stafford loans • Perkins loans • Parent loans (PLUS) The Stafford and Perkins loans form the foundation of the government's student loan programs, and PLUS loans are supplemental programs for students who either need the funds but do not qualify for Stafford/Perkins loans, or who do qualify for Stafford/Perkins loans but need additional funds. Generally speaking, the loans carry very low, government-subsidized interest rates, and with Stafford and Perkins loans, repayment does not begin until the student is out of school. As long as the student is making satisfactory progress academically and can show a need financially, the loans are fairly easy to obtain and do not involve a lot of "red tape." There are limits on the amount that can be borrowed each year, though there is no limit on the number of loans you can take out. 7-3. In contrast to regular consumer loans, the subsidized student loan programs are very lenient; they may not even involve credit checks, and they are less costly and have more accommodating loan repayment provisions. Repayment with some loans does not even begin until after graduation, and then the student can take as long as 10–20 years to pay off the loans. Also, interest on student loans is tax deductible. This question deals with the students' views of these loans; this could provide some lively discussion of what they think of these loans, what they see as the positive and negative aspects of the programs, etc. 7-4. Borrowing as little as possible is an upfront strategy on student loans. A student should consider how much to borrow in light of his/her expected future salary. In addition, explore all possible grants and scholarships, as well as apply to federal student aid. Upon graduation, explore the Public Service Loan Forgiveness and Loan Repayment Assistance programs. There may also be an option to consolidate federal student loans and to participate in an income-based repayment program. 7-5. a. The interest rate as well as monthly payment on fixed-rate loans remains the same over the life of the loan. With variable rate loans, the interest rate changes monthly, quarterly, or semiannually in line with market conditions. b. Single-payment loans are made for a specified period of time at the end of which full payment is due. They are available primarily from commercial banks, consumer finance companies, life insurance companies, sales finance companies, pawnshops, and friends and relatives. Installment loans are made generally for six months or more and are repaid in a series of fixed scheduled payments. They are primarily available from commercial banks, consumer finance companies, credit unions, savings and loan associations, and sales finance companies. 7-6. a. Consumer finance companies—A consumer finance company, often called a small loan company, provides secured and unsecured or signature loans to qualified individuals. They acquire their funds from stockholders or borrow funds from various sources. They loan these funds to borrowers at generally high annual interest rates. The amount they loan and the rate charged are normally dependent on state laws. Loans are usually for a short period of time to high-risk borrowers. b. Sales finance companies—A sales finance company provides installment financing for a retailer's customers who may purchase such items as automobiles, furniture, or appliances. The retailer originally lends its money to the customer to promote the sale and initially holds the loan contract. The retailer may not want to tie up its money for very long with installment loans, so the retailer then sells the customers' contracts to a finance company. The customer will then be notified to make his or her payment directly to the finance company. Interest rates will usually be higher than those offered by banking institutions and will vary depending on the maturity date of the loan and the amount of the purchase. Captive finance companies—Captive finance companies, such as General Motors Acceptance Corporation (GMAC) and General Electric Credit Corporation (GECC), are the largest sales finance companies and are owned by large corporations. These institutions usually purchase the installment loan contracts made by their product dealers. 7-7. a. Credit unions offer loans to people and their immediate families who belong to the credit union and who are members of a particular working environment or organization. No nonmembers are allowed to save, loan, or participate in the activities of the lending organization. Interest rates are low relative to other institutions. The loans may be secured or unsecured. An added feature is that loan payments may be deducted from payroll checks. This type of borrowing is one of the most favorable for non-housing consumer loans. b. Savings and loan associations deal primarily in home mortgages, but they also make consumer loans to qualified borrowers. S&Ls are regulated with regard to how much they can put into consumer loans; as a rule, their loans tend to go for consumer durables or for home improvements. The interest rates charged typically depend on a number of factors and are usually slightly above commercial bank rates. 7-8. Basically, before taking out a consumer loan you should ask yourself: 1) Does making this acquisition fit into your financial plans? and 2) Does the required debt service on the loan fit into your monthly cash budget? If the expenditure in question will seriously jeopardize your financial plans and/or the repayment of the loan is likely to place an undue strain on your cash flow, you should reconsider the purchase. 7-9. When shopping for a consumer loan, you should pay particular attention to the following loan features: • Finance charges (APR)—how much are you going to have to pay? • Loan maturity—does the term of the loan (and, therefore, the size of the payment) fit your needs and your budget? • Collateral—is there going to be any, and if so, what? • Other considerations—what is the total cost of the transaction, including all finance charges, when are the payments due, how is interest figured (simple vs. add-on), and what kind of an interest refund will you receive if you prepay your loan? To determine the total cost of the transaction, multiply the monthly loan payments by the number of payments to be made. Then add the down payment and any other fees and charges to determine the total. 7-10. A lien gives the lender the power to liquidate loan collateral to satisfy its claim in the event of default. It is part of a secured loan. 7-11. A loan rollover is requested when the borrower is unable to repay the loan when it matures. It involves taking out another loan to repay the original loan in full. 7-12. Under the simple interest method, interest is charged on the actual loan balance outstanding. The discount method first computes interest and then subtracts it from the principal. The borrower gets the difference, not the full amount of the loan. While the amount of interest paid is the same, the APR is higher with the discount method, because you receive less in loan proceeds for the same amount of interest. The simple interest method is better for the borrower. 7-13. An installment loan can be used for many types of purchases and can range from a few hundred dollars to thousands of dollars. These loans are usually calculated at a fixed interest rate, and set payments are made at given intervals, such as monthly or yearly. These loans typically have maturities of 6 months to 15 years. Most are secured, either by the item purchased, a financial asset, or your home. 7-14. A home equity loan lets a homeowner use his or her home as collateral to borrow a given amount of money for a set period of time at either a fixed or variable rate of interest. Except for the collateral (home-equity loans take a second mortgage on the borrower's home), there is really no difference between a home equity loan and a regular installment loan. They both involve a fixed amount of money that is paid back in monthly installments over time. Advantages of a home equity loan: They can be used to obtain large sums of money; they have long repayment periods (of as long as15 years), which keeps payments low; they generally carry lower interest rates than other forms of consumer loans; and (their biggest advantage) the interest on the loans is still tax-deductible for those who itemize their deductions (some limits apply). Disadvantages: The availability of these loans may encourage people to take out big loans that can far outlive the assets acquired with the loans; there are costs involved in setting up these loans; and, of course, you stand to lose your home if you cannot repay the loan. 7-15. Purchasing credit life and disability insurance may be a condition of receiving an installment loan. This assures the lender that in the event of death or disability of the borrower, the loan will still be repaid. Credit life insurance provides for repayment of the entire outstanding loan balance at the death of the borrower. Credit disability insurance assures the lender the scheduled installment payments will continue in the event the borrower becomes disabled and unable to meet the scheduled installment payments. The seller's or lender's ability to dictate the terms of these insurance requirements is restricted by law in many states. From the borrower's perspective, such insurance is not a very good deal—it is very costly and really does little more than provide lenders with a very lucrative source of income. Purchasing term life insurance instead is usually more cost effective. 7-16. The simple interest method on installment loans refers to the fact that interest is charged only on the actual installment loan balance outstanding each period and not on the entire original balance. Each time a payment is made, the principal is reduced somewhat, and the interest for the next period is calculated on the remaining installment loan balance. You are better off, as a borrower, with simple interest versus add-on interest. 7-17. If the consumer has adequate liquid reserves and if those reserves are held in an interest-earning account, then if it costs more to borrow the money than can be earned in interest in the savings account, one should not borrow but draw down from savings. In contrast, borrowing becomes the better course of action if the borrowing cost is less than the rate earned on savings, or if the borrower does not have any liquid reserves to draw on. Financial Planning Exercises 1. Although Bridget could borrow money for college through normal channels through a regular consumer loan from the bank, better avenues exist such as several federal and state subsidized educational loans Federally sponsored programs include: • Stafford Loans (Direct and Federal Family Loans--FFELs). • Perkins Loans • Parents Loans (PLUS) Stafford and Perkins Loans have the best terms and are the foundation of the government’s student loan programs. In contrast, PLUS loans are supplementary loans for undergraduate students who demonstrate a need for funding but do not qualify for Stafford or Perkins Loans. The best place to look for funding is on the Internet through such sites as FASTWEB, which can provide loan and scholarship information as well as form type application letters. Exhibit 7.1 could help understand interest rates, borrowing limits and terms. To minimize her borrowing costs and maximize her flexibility, Bridget should borrow as little as possible to cover college costs. One way to meet this goal is to quantify borrowing based on future expected salary and then figure out what amount of monthly payment will be affordable. This analysis should also look for the lowest interest rate. Before making the final decision, Bridget should explore all possible grants and scholarships and apply for Federal aid. At graduation, there are also money saving forgiveness and deferment programs to explore, as well as options to consolidate federal student loans and participate in an income-based repayment program. 2. The Auto Boss deal total cost: $3,000.00 down + (48 × $333.67) = $3,000 + $16,016.16 = $19,016.16 The Four Wheel Specialists deal total cost: $3,500.00 down + (60 × $265.02) = $3,500 + $15,901.20 = $19,401.20 Based on total cost, the Auto Boss loan is better. The monthly payment offered by Four Wheel Specialists is lower, but the longer time period makes the total cost paid higher with Four Wheel Specialists, and they require a higher down payment. 3. As shown on Worksheet 7.1, Brad’s debt safety ratio for his consumer debt is 30.2%, considerably higher than the suggested maximum of 20%. He has overextended himself, particularly since he also has his mortgage payments, and chances are that he will have difficulty continuing to meet these payments and the single-payment loan when it comes due. Worksheet 7.1 4. On a single-payment loan, the finance charge using the simple interest method or Fs = Principal × Rate × Time. So Kevin will owe the original principal plus interest at the end of the time period or $8,000 + ($8,000 × 0.06 × 5) = $8,000 + $2,400 = $10,400. If Kevin must pay the interest annually on this loan, then he would owe $480 each year ($8,000 × .06 × 1). At the end of year 5, he would owe the interest for that year plus the principal, or $8,000 + $480 = $8,480. 5. Use the financial calculator set on End Mode and 12 payments/year to solve for the payment: As explained in problem 3 above, when you use the financial calculator to solve for payment, you are using the simple interest on the installment method. Your calculator may also have an Amortization feature to help you with determining how much of each payment goes toward principal and how much goes toward interest. An Excel spreadsheet was used to create the following table. The monthly interest rate is found by dividing the yearly rate of 6% by 12 or 0.06/12 = 0.005. Outstanding Monthly Interest Charges Principal Balance Loan Balance Payment [(1) × .005] [(2) - (3)] Remaining Month (1) (2) (3) (4) After Payment 1 $3,000.00 $132.96 $15.00 $117.96 $2,882.04 2 $2,882.04 $132.96 $14.41 $118.55 $2,763.49 3 $2,763.49 $132.96 $13.82 $119.14 $2,644.35 4 $2,644.35 $132.96 $13.22 $119.74 $2,524.61 5 $2,524.61 $132.96 $12.62 $120.34 $2,404.27 6 $2,404.27 $132.96 $12.02 $120.94 $2,283.33 7 $2,283.33 $132.96 $11.42 $121.54 $2,161.79 8 $2,161.79 $132.96 $10.81 $122.15 $2,039.64 9 $2,039.64 $132.96 $10.20 $122.76 $1,916.88 10 $1,916.88 $132.96 $9.58 $123.38 $1,793.50 11 $1,793.50 $132.96 $8.97 $123.99 $1,669.51 12 $1,669.51 $132.96 $8.35 $124.61 $1,544.90 13 $1,544.90 $132.96 $7.72 $125.24 $1,419.66 14 $1,419.66 $132.96 $7.10 $125.86 $1,293.80 15 $1,293.80 $132.96 $6.47 $126.49 $1,167.31 16 $1,167.31 $132.96 $5.84 $127.12 $1,040.19 17 $1,040.19 $132.96 $5.20 $127.76 $912.43 18 $912.43 $132.96 $4.56 $128.40 $784.03 19 $784.03 $132.96 $3.92 $129.04 $654.99 20 $654.99 $132.96 $3.27 $129.69 $525.30 21 $525.30 $132.96 $2.63 $130.33 $394.97 22 $394.97 $132.96 $1.97 $130.99 $263.98 23 $263.98 $132.96 $1.32 $131.64 $132.34 24 $132.34 $133.00 $0.66 $132.34 $0.00 Adding the interest charges for the first 12 months of the loan, you can see that $140.42 in interest will be paid during the first year of this loan. 6. [We will assume that the loan amount requested is $1,000 and compute the interest rate using both methods.] Using the simple interest method, the finance charges on a 6.5 %, 18-month single-payment loan would be: Using the discount method, the finance charge is the same dollar amount as that obtained with the simple interest method. However, the finance charges are subtracted first from the amount requested, and then the borrower receives what’s left, or the proceeds. Using the same setup as in the example above: APR for the simple interest method is calculated by dividing the finance charge by the life of the loan and then dividing this annual charge by the loan balance ($1,000 in our example). 7. First State Bank will lend Kristin the $4,000 for 12 months through a single-payment loan at 8% discount. The APR on this loan is calculated as follows: Home Savings and Loan will make the $4,000 single-payment, 12-month loan at 10% simple interest. The APR on this loan is: Kristin should borrow the money from First State Bank because they will charge her an annual percentage rate (APR) of 8.7%, while Home Savings and Loan will charge her an APR of 10%. 8. a. FS = $10,000 × .07 × 5 = $3,500. b. Monthly payment = ($10,000 + $3,500)/60 = $225.00 c. Payments under the simple interest method (determined using a calculator or approximated using Exhibit 7.5) are $198.00. So the add-on method costs $27 more a month than the simple interest method ($225 − $198). 9. Using the financial calculator, set on End Mode and 12 payments/year: 10. a. Using the financial calculator, set on End Mode and 12 payments/year: c. ($368.33 × 60) = $22,099.80 − $20,000 = $2,099.80 d. [(1 + .04/12)^12] − 1 = (1.0033)^12 − 1 = 1.0403 − 1 = 4.03% 11. To solve for the APR, divide the purchase price of $2,000 by $1,000 to get 2. Then divide the payments given by 2 and look up that amount in the columns under the given time periods. Clearly, Dealer A is offering the better deal. Dealer A: Divide the quoted monthly payment of $119.20 by 2 to get $59.60. Look under the 18 month column to find that the APR is 9%. Dealer B: Divide the quoted monthly payment of $69.34 by 2 to get $34.67. Look under the 36 month column to find that the APR is 15%. You can also use the financial calculator to find the APR as shown below. Set your calculator on End Mode and 12 payments/year. You must put in either the PV or PMT as a negative in order to solve the problem. 12. a. Patricia Fox plans to borrow $5,000 to be paid back in 36 monthly payments. At an annual add-on interest rate of 7 1/2%, the total finance (interest) charges are: Finance Charge using Add-On Method = Principal × Rate × Time FS = $5,000 × 0.075 × 3 = $1,125 b. The monthly payment on the loan is: c. Use the financial calculator to find the annual percentage rate (APR) of interest on this loan. Set your calculator on End Mode and 12 payments/year. Note that the reason the financial calculator can be used to solve for the APR is because the time value of money formulas programmed into the calculator are based on the simple interest method. For installment loans, simple interest is calculated on the outstanding loan balance for each time period. Since the definition of APR is based on simple interest as well, when you solve for I% on the financial calculator, you have also calculated the APR, assuming that the interest is the only finance charge involved. 13. a. Using Worksheet 7.2 on whether to borrow or pay cash, we see that line 12 is negative, indicating that the better option is to borrow the money on an installment loan. Therefore, Constance will lose less in interest if she borrows the funds rather than draws down her savings. Therefore, she should finance the home entertainment center. b. Because line 12 is still negative, Constance is still better off financing the entertainment center with a home equity loan rather than using savings that is earning 5%. Even with the higher interest rate of 6% on the loan, the tax deductibility makes it less expensive to borrow the money. Problem 13a—Worksheet 7.2 Problem 13b—Worksheet 7.2 14. a. The furniture store will lend Charles the $6,400 for 48 months at 6.5% add-on. Monthly payments using this method are calculated as follows: The credit union will lend Charles the $6,400 for 24 months at 6% simple interest. Monthly payments using this method are calculated with the financial calculator as follows. Set your calculator on End Mode and 12 payments/year. b. The APR for the loan from the furniture store can be calculated with the financial calculator, because the time value of money equations programmed into the financial calculator use the simple interest method, which yields the APR. Set your calculator on End Mode and 12 payments/year. The APR for the loan from the credit union is the stated rate of 6%, because APR is calculated using the simple interest method. To prove this point, we can create a Monthly Payment Analysis Table for the first year's payments to derive the numbers necessary to calculate the APR. Month Outstanding Loan Balance (1) Monthly Payment (2) Interest Charges [(1) × .005] (3) Principal [(2) – (3)] (4) 1 $6,400.00 $283.65 $32.00 $251.65 2 $6,148.35 $283.65 $30.74 $252.91 3 $5,895.44 $283.65 $29.48 $254.17 4 $5,641.27 $283.65 $28.21 $255.44 5 $5,385.83 $283.65 $26.93 $256.72 6 $5,129.08 $283.65 $25.65 $258.00 7 $4,871.08 $283.65 $24.36 $259.29 8 $4,611.79 $283.65 $23.06 $260.59 9 $4,351.20 $283.65 $21.76 $261.89 10 $4,089.31 $283.65 $20.45 $263.20 11 $3,826.10 $283.65 $19.13 $264.52 12 $3,561.58 $283.65 $17.81 $265.84 Total Interest Paid in First Year: $299.58 To calculate the APR, take the interest paid in year 1 and divide by the average outstanding loan balance: c. A loan over the same time period with a lower APR will save the consumer more in interest charges. In the loan examples given in this problem, the furniture store offered a higher stated rate (6.5% vs. 6%) and lower monthly payments ($168 vs. $283.65). The APR on the furniture store's offer was higher (11.83% vs. 6.18%) as was the total cost of the interest over the life of the loan ($1,664 vs. $407.65). It stands to reason that because the credit union's loan was over a shorter time period, the interest charges would be less. While it is difficult to evaluate loans over different time periods, here both the interest rate and time period for the credit union are less resulting in less interest paid. However, sometimes consumers may be forced to go with the loan which offers the lowest monthly payments, whether it's the most cost effective or not, because of budget constraints. Then consumers need to ask themselves if they really need to make the purchase now or if they would be better off waiting. [Note: To find the total cost of interest over the life of a loan, multiply the monthly payments by the number of months on the loan and then subtract the principal amount.] Solutions to Critical Thinking Cases 7.1 Financing Anita’s Education 1. With the North Carolina State Bank discount interest loan: a. Anita would receive initial proceeds of $26,400 calculated as follows: b. At maturity, Anita would be required to repay the $30,000 principal. 2. a. The finance charges on the North Carolina State Bank loan would be $3,600 as shown above in the interest calculation. b. The APR on the North Carolina State Bank loan can be calculated using the equation: The average annual finance charge is $1,800 ($3,600/2). The average loan balance is the initial loan proceeds, $26,400. Substituting into the equation, the APR is: 3. a. The finance charge on the simple interest loan from the National Bank of Chapel Hill is $25,000 × .07 × 2 years = $3,500. b. The APR on this loan is found by substituting the appropriate values into the APR equation: This result is not surprising, since the APR and the stated rate of interest on a simple interest loan are always equal. The loan payment due at the end of two years is $30,000 ($25,000 principal + $3,500 interest). 4. The discount loan from North Carolina State Bank (line an in the table below) is preferred since it has a lower APR and she will spend a little less in finance charges while receiving a bit more in proceeds. The following table illustrates the features of each loan: Method Stated Rate Finance Charge Amount Received Amount Repaid APR a. Discount loan 6% $3,600 $26,400 $30,000 6.8% b. Simple interest loan 7% $3,500 $25,000 $30,000 7% 5. Since Anita plans to spend the $25,000 over the following two years, she should either (1) try to arrange a line of credit in which she can draw the money as needed, with the interest being charged only as the funds are disbursed, or (2) immediately invest the funds in a highly liquid savings instrument, such as a savings account or money market mutual fund. Each of these alternatives should allow Anita to reduce the total finance charges, either (1) by only paying interest on needed funds or (2) by earning a return on the unneeded portion of the loan until the funds are needed. These two approaches should help Anita avoid paying interest on currently unneeded funds while assuring her that her $25,000 college education expense will be met. 7.2 Michael Gets His Outback 1. The First National Bank of Charlottesville will lend Michael the $8,900 for 36 months at 6% simple interest. Monthly payments using this method are calculated with the financial calculator as follows. Set your calculator on End Mode and 12 payments/year. 2. a. The total finance charges on this installment loan can be found by subtracting the loan principal from the total payments of $9,747.36 (36 months × $270.76/month): Total finance charges = ($9.747.36 – $8,900) = $847.36 b. Since interest on this simple interest installment loan is charged only on the outstanding loan balance, the APR equals the stated interest rate of 6%. 3. The first step in determining the monthly payment required on the add-on interest loan from the Charlottesville Teacher's Credit Union is to calculate the total finance charges. The monthly payment can then be found by adding the principal to the finance charges and dividing by the number of monthly payments: 4. a. The finance charges on the Charlottesville Teachers' Credit Union loan are $1,201.50 per question 3 above. b. To find the APR, use the financial calculator. Set on End Mode and 12 payments/year: 5. The following table summarizes the key characteristics of the two loans. Comparing the monthly payment, total finance charges, and APR on the two loans, it's clear that while the two loans are about equal, the one from the credit union (line b) has a slight edge over the one from the bank (line a), which has a slightly higher monthly payment, total finance charge, and APR. Such being the case, Michael should then compare the institutions on other features that are important to him, such as convenience, helpfulness, or possibly one might lower the interest rate if he allows the institution to take automatic payments from his account. Method Stated Rate Finance Charge Monthly Pmt. Amount Recv. Amount Repaid APR a. Simple interest loan 6% $847.36 $270.76 $8,900 $9.747.36 6% b. Add-on loan 4.5% $1,201.50 $280.60 $8,900 $10,101.50 8.41% Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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