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Chapter 7 Using Consumer Loans How Will This Affect Me? Consumer loan sources abound, and their terms vary significantly. The primary types are single-payment and installment consumer loans. It’s important to understand when to use each credit source, to be able to calculate and compare their costs, and to determine the circumstances in which it is best to take out a loan or pay cash. Practical examples considered in this chapter include taking out a car loan and borrowing to pay for a college education. The chapter provides you with an applied framework for evaluating the best ways to choose among and obtain consumer loans. One of the most important topics in the chapter is the computation of the annual percentage rate, the APR. The APR is the primary way to compare alternative loans, that is, same type of loans from two different sources. The nominal rate is not so useful. The key to successfully managing credit is to keep both the amount of debt used and the debt repayment burden well within your budget. Learning Objectives 6-1 Know when to use consumer loans and be able to differentiate between the major types. It is important to point out that the ability to get a loan does not mean that you need to get the loan. Loans are useful to help purchase high cost items but should be used only when you can afford the item being purchased and the related payoff of the loan. Major types of consumer loans are single-payment and installment loans. Consumer loans are formal, negotiated contracts that specify both the terms for borrowing and the repayment schedule. Each loan is a separate contract. 6-2 Identify the various sources of consumer loans. Section 7-1b has a list of common types of consumer loans. The power point slides has these loans listed and will be sufficient to discuss the various types. It may prove useful to ask students if they have one of the loans. You could ask a couple of students why they have that type of loan. Compare a single-payment loan to an installment loan. Term for single-payment is shorter, but no monthly payment as there is with an installment loan. An important topic in this section is student loans. Exhibit 7.1 lists the major characteristics of federal student loans. The section discusses how the size of student loans impact the first 10 years of life after graduation including strategies for reducing student loans costs. Section 7-1c lists sources of consumer loans. Commercial banks are the largest source of consumer loans providing about half of consumer loans. Second to banks are consumer finance companies followed by credit unions. 6-3 Choose the best loans by comparing finance charges, maturity, collateral and other loan terms. Here is the key point of the chapter. Worksheet 7.1, “An Inventory of consumer Debt”, organizes the various loans you may have and is very useful to see the impact of adding an additional loan. The debt safety ratio is a statistic that will help judge your ability to manage another loan. That ratio should be less than 20 to comfortably be able to pay off the debt. The ratio was discussed in section 6-1c. It will be useful to review the ratio—it is important. 6-4 Describe the features of, and calculate the finance charges on, single-payment loans. Computation of the APR is the key point here. [Average annual finance charge / Average loan balance outstanding] Go over the example in the chapter. The discount method will need to be explained; the students’ previous exposure most likely has been limited to simple interest loans. See example at end of section 7-3. 6-5 Evaluate the benefits of an installment loan. Installment loans are the most common consumer loans. The simple interest method of computing finance charges should be compared to the add-on method using the APR. Simple interest method APR is always the face rate. The add-on method will most likely be higher than the alternative simple interest. [See Exhibit 7.5] But an add-on loan may be the only one available to the consumer. The computation of the monthly payment using a financial calculator is demonstrated in the chapter. The Excel financial function PMT(rate, period, pv) may also be used. 6-6 Determine the costs of installment loans and analyze whether it is better to pay cash or take out a loan. Worksheet 7.2 organizes the comparison of pay cash or borrow. The key point is the rate of return on the cash available. It you can earn more than the interest cost, borrow. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • Buying a new car is the major reason that people borrow money through consumer loans. Fact: Buying a new car accounts for about 35 percent of all consumer loans outstanding, which is the single most common reason for taking out a consumer loan. • Consumer loans can be set up with fixed rates of interest or with variable loan rates. Fact: While fixed-rate loans still dominate the consumer loan market, variable-rate loans are becoming more common, particularly with longer-term debt. • An S&L is the only type of financial institution that is prohibited from making consumer loans. Fantasy: Financial deregulation opened up the consumer loan market to S&Ls and they are an important source of such credit. • Single-payment loans are often secured with some type of collateral and are usually relatively short-term in duration (maturities of one year or less). Fact: Because these loans require only one payment at maturity, banks and other lenders generally keep them fairly short-term and often require some type of collateral. • Using the discount method to figure interest is one way of lowering the effective cost of a consumer loan. Fantasy: Because the interest is paid in advance on discount loans, the net effect is to substantially raise the cost of borrowing. Specifically, a discount loan results in a true interest rate (APR) that is much higher than the stated rate. • The Rule of 78 is a regulation that grew out of the Consumer Credit Enhancement Act of 1978 and mandates how installment loans will be set up. Fantasy: The Rule of 78s is a procedure that is used to find the monthly finance charges on add-on loans. Financial Facts or Fantasies? These true/false questions may be used as quizzes or as pretest to get the students’ attention. 1. True False Buying a new car is the major reason that people borrow money through consumer loans. 2. True False Consumer loans can be set up with fixed rates of interest or with variable loan rates. 3. True False An S&L is the only type of financial institution that is prohibited from making consumer loans. 4. True False Single-payment loans are often secured with some type of collateral and are usually relatively short-term in duration (maturities of one year or less). 5. True False Using the discount method to figure interest is one way of lowering the effective cost of a consumer loan. 6. True False The Rule of 78 is a regulation that grew out of the Consumer Credit Enhancement Act of 1978 and mandates how installment loans will be set up. Answers: 1. True 2. True 3. False 4. True 5. False 6. False YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. Current Auto Loan Rates If you’re considering buying a car, you need to know current auto loan rates to estimate prospective monthly payments and what price you can afford to pay for an auto. Up-to-date market rates are available at http://www.bankrate.com. You’ll see how much higher used auto loan rates are than new auto loan rates. And you’ll get a sense of the trade-off between auto loan rates and maturity, e.g., between 48 and 60 month loan rates. Getting familiar with auto loan rates will help you be a more informed shopper – you can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Ann and Ezra Calculate their Auto Loan Backwards Ann and Ezra Reed budget and spend their money carefully. Their Honda CRV has over 150,000 miles and needs to be replaced. Because they drive their cars so long, John and Mary have decided to buy a new car and have saved a $5,000 down payment. They are willing to make a monthly car payment of about $350 while 48 month loans are at 3 percent. Before they choose a new car, they want to determine how much they can afford to spend. Ann and Ezra do their auto loan calculations backwards to figure out the size of the auto loan implied by a 48 month maturity and 3 percent interest. Using a calculator and the approach explained in this chapter, that loan amount is about $15,813. Thus, given their down payment of $5,000, John and Mary can afford a car selling for about $21,813 net of tax, title and licensing fees. They are indeed careful, if not “backward,” car shoppers who explore the angles. Financial Planning Exercises 1. Student loan options. Scarlett Hill is a sophomore at State College and is running out of money. Wanting to continue her education, Scarlett is considering a student loan. Explain her options. How can she minimize her borrowing costs and maximize her flexibility? Exhibit 7.1 gives basic information on the type of student loans available. It’s important to borrow as little as possible to cover college costs. This common-sense goal can be quantified by borrowing considering the student’s expected future salary. Based on that expected future salary, figure out what monthly payment the student will be able to afford [Debt Safety Ratio of 10} and then use a loan repayment calculator to determine the maximum amount that can be borrowed at the expected interest rate on the loan. For example, consider using the following online student loan calculator: http://www.bankrate.com/calculators/college-planning/loan-calculator.aspx. The analysis should also include looking for the lowest interest rate. Before borrowing, it makes sense to explore all possibly available grants and scholarships and to apply for federal student aid. And upon graduation, it is wise to explore the Public Service Loan Forgiveness and Loan Repayment Assistance programs. There could also be the option to consolidate federal student loans and to participate in an income-based repayment program. 2. Calculating debt safety ratio. Use Worksheet 7.1. Every six months, Leo Perez takes an inventory of the consumer debts that he has outstanding. His latest tally shows that he still owes $4,000 on a home improvement loan (monthly payments of $125); he is making $85 monthly payments on a personal loan with a remaining balance of $750; he has a $2,000, secured, single-payment loan that’s due late next year; he has a $70,000 home mortgage on which he’s making $750 monthly payments; he still owes $8,600 on a new car loan (monthly payments of $375); and he has a $960 balance on his MasterCard (minimum payment of $40), a $70 balance on his Shell credit card (balance due in 30 days), and a $1,200 balance on a personal line of credit ($60 monthly payments). Use Worksheet 7.1 to prepare an inventory of Leo’s consumer debt. Find his debt safety ratio given that his take-home pay is $2,500 per month. Would you consider this ratio to be good or bad? Explain. A useful credit guideline (and one widely used by lenders) is to make sure your monthly repayment burden [not including mortgages] doesn’t exceed 20 percent of your monthly take-home pay. Most experts, however, regard the 20 percent figure as the maximum debt burden and strongly recommend a debt safety ratio closer to 15 percent or 10 percent—perhaps even lower if you plan on applying for a new mortgage in the near future. Note that the monthly repayment burden here does include payments on your credit cards, but it excludes your monthly mortgage obligation. From Worksheet 7.1 below, Leo’s debt safety ratio is 30.2% which is over the desired maximum. He is in potential trouble and needs to reduce some debt. 3. Evaluating finance packages. Assume that you’ve been shopping for a new car and intend to finance part of it through an installment loan. The car you’re looking for has a sticker price of $18,000. Custom Vehicles has offered to sell it to you for $3,000 down and finance the balance with a loan that will require 48 monthly payments of $333.67. However, a competing dealer will sell you the exact same vehicle for $3,500 down, plus a 60-month loan for the balance, with monthly payments of $265.02. Which of these two finance packages is the better deal? Explain. The analysis should look at the total cost of the loan. Custom Vehicles: $3,000 down plus 48*$333.67; total payments of $19,016.16. Competing Dealer: $3,500 down plus $265.02 * 60 = $19,401.20. The total cost of Custom Vehicles is less. But the difference is not great. The competing dealer has a lower monthly payment and may be more doable for you. However, you have to keep the car running for five years. That may be an issue for an $18,000 car. Custom Vehicles is less in total and the term is two years less. Go with Custom Vehicles. 4. Calculating single payment loan amount due at maturity. Stanley Price plans to borrow $8,000 for five years. The loan will be repaid with a single payment after five years, and the interest on the loan will be computed using the simple interest method at an annual rate of 6 percent. How much will Jim have to pay in five years? How much will he have to pay at maturity if he’s required to make annual interest payments at the end of each year? $8,000 * (1.06)^5 = $10,705.80 $8,000 + .06*8000*5 = $10,400 over the life of the loan. The final payment would be the principal plus one year’s interest, $8,000 + (.06*8,000) = $8,480 5. Calculating the APR on simple interest and discount loans. Find the finance charges on a 6.5 percent, 18-month, single-payment loan when interest is computed using the simple interest method. Find the finance charges on the same loan when interest is computed using the discount method. Determine the APR in each case. Note: Assume a loan amount of $1,000. 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: 6. Calculating monthly installment loan payments. Using the simple interest method, find the monthly payments on a $3,000 installment loan if the funds are borrowed for 24 months at an annual interest rate of 6 percent Computation of the monthly payment amount: 7. Calculating interest and APR of installment loan. Assuming that interest is the only finance charge, how much interest would be paid on a $5,000 installment loan to be repaid in 36 monthly installments of $166.10? What is the APR on this loan? 8. Calculating payments, interest, and APR on auto loan. After careful comparison shopping, Isabella Green decides to buy a new Toyota Camry. With some options added, the car has a price of $23,558—including plates and taxes. Because she can’t afford to pay cash for the car, she will use some savings and her old car as a trade-in to put down $8,500. She plans to finance the rest with a $15,058, 60-month loan at a simple interest rate of 4 percent. a. What will her monthly payments be? b. How much total interest will Isabella pay in the first year of the loan? c. How much interest will Isabella pay over the full (60-month) life of the loan? [$277.32 * 60] = $16,639.20 – 15,058 = $1,581.20 d. What is the APR on this loan? [(1 + .04/12)^12] − 1 = (1.00333)^12 − 1 = 1.0407 − 1 = 4.07% The APR is 4%; the .07 is due to rounding in the computation. APR = Average annual finance charge / Average loan balance outstanding APR = (1580.95/5) / 7,905 = 3.999 = 4% Average loan balance computed by adding the beginning balance each month and dividing by 60. 9. Calculating and comparing add-on and simple interest loans. Eli Nelson is borrowing $10,000 for five years at 7 percent. Payments, which are made on a monthly basis, are determined using the add-on method. a. How much total interest will Chris pay on the loan if it is held for the full five-year term? Add-on = $10,000 * 7% * 5 years = $3,500, the total interest. b. What are Chris’s monthly payments? Principal + interest = total payments, divided by 60 months = monthly payment $10,000 + $3,500 = $13.500 / 60 = $225.00 per month. c. How much higher are the monthly payments under the add-on method than under the simple interest method? Using simple interest, payments using Exhibit 7.4 for 7% over 60 months is $19.80 per thousand, or $198 for $10,000. Thus, add-on payments are $27 per month [$225 - $198] higher than simple interest. 10. Comparing payments and APRs of financing alternatives. Because of a job change, Finn McBryde has just relocated to the southeastern United States. He sold his furniture before he moved, so he’s now shopping for new furnishings. At a local furniture store, he’s found an assortment of couches, chairs, tables, and beds that he thinks would look great in his new two-bedroom apartment; the total cost for everything is $6,400. Because of moving costs, Ben is a bit short of cash right now, so he’s decided to take out an installment loan for $6,400 to pay for the furniture. The furniture store offers to lend him the money for 48 months at an add-on interest rate of 6.5 percent. The credit union at Finn’s firm also offers to lend him the money—they’ll give him the loan at an interest rate of 6 percent simple, but only for a term of 24 months. a. Compute the monthly payments for both of the loan offers. From Furniture store: $6,400 * .065 = 416 annual add-on interest; total cost $6,400 + (4 *416) = $8,064. Divide by 48 months, equals monthly payment of $168. b. Determine the APR for both loans. 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 credit union is using simple interest; thus, the APR is the simple interest rate of 6%. c. Which is more important: low payments or a low APR? Explain. Low APR is more important. With loans, it is all about the APR and your ability to make payments. 11. Deciding whether to pay cash or finance a purchase. Use Worksheet 7.2. Matilda Edwards wants to buy a home entertainment center. Complete with a big-screen TV, DVD, and sound system, the unit would cost $4,500. Matilda has over $15,000 in a money fund, so she can easily afford to pay cash for the whole thing (the fund is currently paying 5 percent interest, and Matilda expects that yield to hold for the foreseeable future). To stimulate sales, the dealer is offering to finance the full cost of the unit with a 36-month installment loan at 4 percent, simple. Matilda wants to know: Should she pay cash for this home entertainment center or buy it on time? (Note: Assume Matilda is in the 22 percent tax bracket and that she itemizes deductions on her tax returns.) Briefly explain your answer. a. Should she pay cash for the entertainment center? Using the decision rule of Worksheet 7.2, she should borrow the $4,500. She will earn $243.61 more than the cost of borrowing, thus she should borrow. If she uses her money fund, she will lose interest on the entire $4,500. By borrowing, the principal of the loan will reduce each month, thus, she will pay interest on the average balance of the loan ($4,500 + 0) / 2 =$2,250. She should borrow to pay for the entertainment center. To help manage her funds, she can set up an automatic withdrawal from the money fund to her checking account and have the payment automatically transferred from her checking account to the vender. Making the Payments! A project to help understand how loan payments are determined For many of us, new cars can be so appealing! We get bitten by the “new car bug” and think how great it would be to have a new car. Then we tell ourselves that we really need a new car because our old one is just a piece of junk waiting to fall apart in the middle of the road. Of course, we don’t have the money to purchase a new car outright, so we’ll have to get a loan. That means car payments. The trouble is, car payments often turn out to be a lot less affordable after we actually get the loan than we thought they would be before we signed on the dotted line. And they last way beyond the time the new car aura wears off. This project will help you understand how loan payments are determined, as well as the obligation that they place on you as the borrower. Let’s assume for this project that your parents have promised to make the down payment on a new car once you have your degree in hand. They have agreed to pay 30 percent of the cost of any car you choose, so long as you are able to obtain a loan and make the payments on the remainder. Find the price of the vehicle you would like by visiting a car dealership or pulling up a Web site such as http://www.edmunds.com. Add another 4 percent to the price for tax, title, license, and so on (or ask a dealer to estimate these costs for you). Take 70 percent of the total to determine how much you’ll have to finance from your car loan. Then find out what the going rate is for car loans in your area by calling or visiting your bank or by consulting a Web site such as http://www.bankrate.com. Calculate what your monthly payments would be at this rate if you financed the loan for three, five, and six years. How well do you think these car payments would fit into your budget? What kind of income would you have to make to afford such payments comfortably? If the payments are more than you thought they would be, what can you do to bring them down? Test Yourself Questions 7-1 List and briefly discuss the five major reasons for borrowing money through a consumer loan. 1. Auto loans: The loan is secured with the auto, meaning that the vehicle serves as collateral for the loan and can be repossessed by the lender should the buyer fail to make payments. These loans generally have maturities ranging from 36 to 60 months. 2. Loans for other durable goods: Consumer loans can also be used to finance other kinds of costly durable goods, such as furniture, home appliances, TVs, home computers, recreational vehicles, and even small airplanes and mobile homes. 3. Education loans: These loans can be used to finance either undergraduate or graduate studies, and special government-subsidized loan programs are available to students and parents. 4. Personal loans: These loans are typically used for nondurable expenditures, such as an expensive European vacation or to cover temporary cash shortfalls. Many personal loans are unsecured. 5. Consolidation loans: This type of loan is used to straighten out an unhealthy credit situation. When consumers overuse credit cards, credit lines, or consumer loans and can no longer promptly service their debt, a consolidation loan may help control this deteriorating credit situation. By borrowing money from one source to pay off other forms of credit, borrowers can replace, say, five or six monthly payments that total $400 with one payment amounting to $250. Consolidation loans are usually expensive, and people who use them must be careful to stop using credit cards and other forms of credit until they repay the loans. Otherwise, they may end up right back where they started. 7-2 Identify several different types of federally sponsored student loan programs. The federal government (and some state governments) have available several different types of subsidized educational loan programs. The federally sponsored programs are: • Stafford loans (Direct and Federal Family Education Loans—FFELs) • Perkins loans The Stafford and Perkins loans have the best terms and are the foundation of the government’s student loan program. • Parent Loans (PLUS) PLUS (which stands for Parent Loans for Undergraduate Students) loans are supplemental loans for undergraduate students who demonstrate a need but, for one reason or another, don’t qualify for Stafford or Perkins loans or need more aid than they’re receiving. See Exhibit 7.1, Federal Government Student Loan Programs at a Glance for a concise explanation of the loan programs. 7-3 As a college student, what aspects of these student loan programs appeal to you the most? Most students will prefer subsidized loans with low rates and interest deferred until student leave school [only Stafford and Perkins loans allow deferral]. To help you service the debt, if you have several student loans outstanding, then you can consolidate the loans, at a single blended rate, and extend the repayment period to as long as 20 years. You also can ask for either an extended repayment for a longer term of up to 30 years; a graduated repayment schedule, which will give you low payments in the early years and then higher payments later on; or an income-contingent repayment plan, with payments that fluctuate annually according to your income and debt levels. 7-4 Explain some strategies for reducing the cost of student loans. It’s important to borrow as little as possible to cover college costs. This common-sense goal can be quantified by borrowing in light of the student’s expected future salary. Before borrowing, it makes sense to explore all possibly available grants and scholarships and to apply for federal student aid. And upon graduation, it is wise to explore the Public Service Loan Forgiveness and Loan Repayment Assistance programs. There could also be the option to consolidate federal student loans and to participate in an income-based repayment program. 7-5 Define and differentiate between (a) fixed- and variable-rate loans and (b) a single payment loan and an installment loan. Single-payment loans are made for a specified period of time, at the end of which payment in full (principal plus interest) is due. They generally have maturities ranging from 30 days to a year; rarely do these loans run for more than a year. Installment loans, in contrast, are repaid in a series of fixed, scheduled payments rather than in one lump sum. The payments are almost always set up on a monthly basis, with each installment made up partly of principal and partly of interest. 7-6 Compare the consumer lending activities of (a) consumer finance companies and (b) sales finance companies. Describe a captive finance company. Consumer finance companies make secured and unsecured (signature) loans to qualified individuals. These companies do not accept deposits but obtain funds from their stockholders and through open market borrowing. Because they don’t have the inexpensive sources of funds that banks and other deposit-type institutions do, their interest rates are generally quite high. Consumer finance companies specialize in small loans to high-risk borrowers. These loans are quite costly, but they may be the only alternative for people with poor credit ratings. Because of the high rates of interest charged, individuals should consider this source only after exhausting other alternatives. Businesses that sell relatively expensive items—such as automobiles, furniture, and appliances—often provide installment financing to their customers. Because dealers can’t afford to tie up their funds in installment contracts, they sell them to a sales finance company for cash. Most commercial banks act as sales finance companies by buying paper from auto dealers and other businesses. The cost of financing through a sales finance company is generally higher than the rates charged by banks and S&Ls, The largest sales finance organizations are the captive finance companies owned by the manufacturers of big-ticket items—automobiles and appliances. General Motors Acceptance Corporation (GMAC) and General Electric Credit Corporation (GECC) are just two examples of captive finance companies that purchase the installment loans made by the dealers of their products. 7-7 Discuss the role in consumer lending of (a) credit unions and (b) savings and loan associations. Point out any similarities or differences in their lending activities. How do they compare with commercial banks? A credit union is a cooperative financial institution that is owned and controlled by the people (“members”) who use its services. Only the members can obtain installment loans and other types of credit from these institutions, but credit unions can offer membership to just about anyone they want, not merely to certain groups of people. Because they are nonprofit organizations with minimal operating costs, credit unions charge relatively low rates on their loans. Membership in a credit union provides the most attractive borrowing opportunities available because their interest rates and borrowing requirements are usually more favorable than other sources of consumer loans. S&L associations (as well as savings banks) primarily make mortgage loans. They aren’t major players in the consumer loan field, but they do make loans for consumer durables and for home improvements. They also will make education loans. Rates of interest on consumer loans at S&Ls are fairly close to the rates charged by commercial banks; if anything, they tend to be a bit more expensive. 7-8 What two questions should be answered before taking out a consumer loan? Explain. From a financial planning perspective, you should ask yourself two questions when considering the use of a consumer loan: (1) does making this purchase fit into your financial plans; and (2) does the required debt service on the loan fit into your monthly cash budget? Indeed, when full consideration is given not only to the need for the asset or item in question but also to the repayment of the ensuing debt, sound credit management is the result. 7-9 List and briefly discuss the different factors to consider when shopping for a loan. How would you determine the total cost of the transaction? The major factors are: Finance Charges--What’s it going to cost me? That’s appropriate, because borrowers should know what they’ll have to pay to get the money The rate of interest, known as the APR (annual percentage rate), includes not only the basic cost of money but also any additional fees that might be required on the loan. Loan Maturity--Make sure that the size and number of payments will fit comfortably into your spending and savings plans. As a rule, the cost of credit increases with the length of the repayment period. Thus, to lower your cost, you should consider shortening the loan maturity—but only to the point were doing so won’t place an unnecessary strain on your cash flow. Total Cost of the Transaction--When comparison shopping for credit, always look at the total cost of both the price of the item purchased and the price of the credit. Retailers often manipulate both sticker prices and interest rates, so you really won’t know what kind of deal you’re getting until you look at the total cost of the transaction. Collateral--Make sure you know up front what collateral (if any) you’ll have to pledge on the loan and what you stand to lose if you default on your payments. Using collateral often makes sense--it may result in lower finance charges, perhaps half a percentage point or so. Other Loan Considerations In addition to following the guidelines just described, here are some questions that you should also ask. Can you choose a payment date that will be compatible with your spending patterns? Can you obtain the loan promptly and conveniently? What are the charges for late payments, and are they reasonable? Will you receive a refund on credit charges if you prepay your loan, or are there prepayment penalties? You should see to it that the consumer debt you undertake does, in fact, have the desired effects on your financial condition. 7-10 What is a lien, and when is it part of a consumer loan? Most single-payment loans are secured by certain specified assets. For collateral, lenders prefer items they feel are readily marketable at a price that’s high enough to cover the principal portion of the loan. The lenders don’t take physical possession of the collateral but instead file a lien, which is a legal claim that permits them to liquidate the collateral to satisfy the loan if the borrower defaults. The lien is filed in the county courthouse and is a matter of public record. 7-11 When might you request a loan rollover? An individual will borrow money using a single-payment loan and then discover that he or she is short of money when the loan comes due—after all, making one big loan payment can cause a real strain on one’s cash flow. Should this happen to you, don’t just let the payment go past due; instead, inform the lender in advance so that a partial payment, loan extension, or some other arrangement can be made. Under such circumstances, the lender will often agree to a loan rollover, in which case the original loan is paid off by taking out another loan. The lender will usually require that all the interest, and at least part of the principal, be paid at the time of the rollover. 7-12 Describe the two methods used to calculate the finance charges on a single payment loan. As a borrower, which method would you prefer? Explain. The two basic procedures used to calculate the finance charges on single-payment loans are the simple interest method and the discount method. Interest is charged only on the actual loan balance outstanding in the simple interest method. This method is commonly used on revolving credit lines by commercial banks, S&Ls, and credit unions. The discount method calculates total finance charges on the full principal amount of the loan, which is then subtracted from the amount of the loan. The difference between the amount of the loan and the finance charge is then disbursed (paid) to the borrower—in other words, finance charges are paid in advance and represent a discount from the principal portion of the loan. Because the interest is paid in advance on discount loans, the net effect is to substantially raise the cost of borrowing. Specifically, a discount loan results in a true interest rate (APR) that is much higher than the stated rate. Thus, borrowers would prefer the simple interest method. 7-13 Briefly describe the basic features of an installment loan. Installment loans differ from single-payment loans in that they require the borrower to repay the debt in a series of installment payments (usually monthly) over the life of the loan. Installment loans have long been one of the most popular forms of consumer credit. As a financing vehicle, there are few things that installment loans can’t do—which explains, in large part, why this form of consumer credit is so widely used. Most installment loans are secured with some kind of collateral—for example, the car or home entertainment center you purchased with the help of an installment loan usually serves as collateral on the loan. One rapidly growing segment of this market is installment loans secured by second mortgages referred to as home equity loans. Interest may be computed as simple and add-on interest to compute finance charges and monthly payments for installment loans. 7-14 What is a home equity loan, and what are its major advantages and disadvantages? An installment loans secured by second mortgages typically on personal residence is referred to as home equity loans. The major advantage of home equity loans is the relatively low rate of interest. The loan may be used for any purpose, but for the interest to be deductible, the principal must be no more than the lesser of fair market value of the home less the first mortgage, or $100,000 and the proceeds must be used for home improvement. Compared to a first mortgage, the closing costs are much less and the interest rate is frequently less than other installment loans. Repayment over ten years is common, but the term could be longer. The ease of obtaining such loans may put the home at risk especially if there is a turn down in value of real estate. 7-15 Explain why a borrower is often required to purchase credit life and disability insurance as a condition of receiving an installment loan. Sometimes, as a condition of receiving an installment loan, a borrower is required to buy credit life insurance and possibly credit disability insurance. Credit life (and disability) insurance is tied to a particular installment loan and provides insurance that the loan will be paid off if the borrower dies (or becomes disabled) before the loan matures. These policies essentially insure the borrower for an amount sufficient to repay the outstanding loan balance. From the borrower’s perspective, credit life and disability insurance is not a good deal: It’s very costly and does little more than give lenders a lucrative source of income. Not surprisingly, because it’s so lucrative, some lenders aggressively push it on unsuspecting borrowers and, in some cases, even require it as a condition for granting a loan. The best advice is to avoid it if at all possible! 7-16 Define simple interest as it relates to an installment loan. Are you better off with add-on interest? Explain. When simple interest is used with installment loans, interest is charged only on the outstanding balance of the loan. Thus, as the loan principal declines with monthly payments, the amount of interest being charged also decreases. Some installment loans, particularly those obtained directly from retail merchants or made at finance companies and the like, are made using the add-on method. Add-on loans are very expensive. Indeed, they generally rank as one of the most costly forms of consumer credit, with APRs that are often well above the rates charged even on many credit cards. With add-on interest, the finance charges are calculated using the original balance of the loan; this amount (of the total finance charges) is then added on to the original loan balance to determine the total amount to be repaid. Thus, the amount of finance charges on an add-on loan can be found by using the familiar simple interest formula: Finance Charge (Add-On) = Amount of Loan x Interest Rate x Term of Loan 7-17 When does it make more sense to pay cash for a big-ticket item than to borrow the money to finance the purchase? Essentially, it all boils down to this: If it costs more to borrow the money than you can earn in interest, then withdraw the money from your savings to pay cash for the purchase; if not, you should probably take out a loan. Critical Thinking Cases 7.1 Financing Zoe’s Education At age 19, Zoe Trainor is in the middle of her second year of studies at a community college in Charlotte. She has done well in her course work; majoring in pre-business studies, she currently has a 3.75 grade point average. Zoe lives at home and works part-time as a filing clerk for a nearby electronics distributor. Her parents can’t afford to pay any of her tuition and college expenses, so she’s virtually on her own as far as college goes. Zoe plans to transfer to the University of Tennessee [Go Vols!] next year. (She has already been accepted.) After talking with her counselor, Zoe feels she won’t be able to hold down a part-time job and still manage to complete her bachelor’s degree program at UT in two years. Knowing that on her 22nd birthday, she will receive approximately $35,000 from a trust fund left her by her grandmother, Zoe has decided to borrow against the trust fund to support herself during the next two years. She estimates that she’ll need $25,000 to cover tuition, room and board, books and supplies, travel, personal expenditures, and so on during that period. Unable to qualify for any special loan programs, Zoe has found two sources of single-payment loans, each requiring a security interest in the trust proceeds as collateral. The terms required by each potential lender are as follows: a. Tennessee State Bank will lend $30,000 at 6 percent discount interest. The loan principal would be due at the end of two years. b. National Bank of Knoxville will lend $25,000 under a two-year note. The note would carry a 7 percent simple interest rate and would also be due in a single payment at the end of two years. Critical Thinking Questions 1. How much would Zoe (a) receive in initial loan proceeds and (b) be required to repay at maturity under the Tennessee State Bank loan? a. Amount received is the principal less the interest. $30,000 * 6% * 2 = $3,600 Proceeds from the loan are $30,000 - $3,600 = $26,400 b. Amount required to be repay in two years is $30,000. 2. Compute (a) the finance charges and (b) the APR on the loan offered by Tennessee State Bank. a. The finance charges are the amount of discount, $3,600. b. The APR is Average Annual Finance charge / Average Loan Balance Outstanding = ($3,600/2) / ($26,400) = $1,800 / $26,400 = 6.8% 3. Compute (a) the finance charges and (b) the APR on the loan offered by the National Bank of Knoxville. How big a loan payment would be due at the end of two years? a. The finance charge is the simple interest for the period of the loan. [$25,000 * 7%] * 2 = $3,500 b. The APR is Average Annual Finance charge / Average Loan Balance Outstanding = ($3,500/ 2) / $25,000 = 7%, which is the stated rate on the simple interest loan. The amount to be repaid at the end of two years is principal + interest, $25,000 + $3,500 = $28,500 4. Compare your findings in Questions 2 and 3, and recommend one of the loans to Zoe. Explain your recommendation.
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 $28,500 7%
The discount loan from Tennessee State Bank will give her an additional $1,400 now and she will have to pay back an additional $1,500 in two years. The APR is lower than the simple interest loan. The lower APR is attractive and I would go with it. Just because she gets an additional $1,400 does not mean that she needs to spend it. 5. What other recommendations might you offer Zoe regarding disposition of the loan proceeds? Since Zoe 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 Zoe 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 Zoe avoid paying interest on currently unneeded funds while assuring her that her $25,000 college education expense will be met. 7.2 Grant Gets His Outback Grant Tyson, a 27-year-old bachelor living in Arlington, Virginia, has been a high-school teacher for five years. For the past four months, he’s been thinking about buying a Subaru Outback, but he feels that he can’t afford a brand-new one. Recently, however, his friend Martin Grubbs has offered to sell Grant his fully loaded Subaru Outback 3.6R. Martin wants $26,900 for his Outback, which has been driven only 8,000 miles and is in very good condition. Grant is eager to buy the vehicle but has only $10,000 in his savings account at Central Bank. He expects to net $8,000 from the sale of his Chevrolet Malibu, but this will still leave him about $8,900 short. He has two alternatives for obtaining the money: a. Borrow $8,900 from the First National Bank of Arlington at a fixed rate of 6 percent per annum, simple interest. The loan would be repaid in equal monthly installments over a three-year (36-month) period. b. Obtain a $8,900 installment loan requiring 36 monthly payments from the Arlington Teacher’s Credit Union at a 4.5 percent stated rate of interest. The add-on method would be used to calculate the finance charges on this loan. Critical Thinking Questions 1. Using Exhibit 7.6 or a financial calculator, determine the required monthly payments if the loan is taken out at First National Bank of Arlington. Monthly payments using this method are calculated with the financial calculator as follows. Set your calculator on End Mode and 12 payments/year. 2. Compute (a) the finance charges and (b) the APR on the loan offered by First National Bank of Arlington. a. Finance charges Total payments less principal, 36 * $270.74 = $9,746.64 less $8,900 = $846.64 b. APR = (846.64 / 3) divided by ($8,900/2) = 6.34% 3. Determine the size of the monthly payment required on the loan from the Arlington Teacher’s Credit Union. (Principal + interest ) / 36, [$8,900 + 3 *(.045 * 8,900)] / 36 = $280.60 4. Compute (a) the finance charges and (b) the APR on the loan offered by the Arlington Teacher’s Credit Union. a. The finance charges are 36 * $280.60 - $8,900 = $1,201.60. As a rule of thumb, the add-on method of computing finance charges will be about twice the simple interest rate. Here the simple interest rate is 4.5% times 2 = 9%. 5. Compare the two loans and recommend one of them to Grant. Explain your recommendation. 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 First National of Arlington (line a) has a slight edge over the one from the credit union (line b), which has a slightly higher monthly payment, total finance charge, and APR. Such being the case, Grant 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 Rec’d. Amount Repaid APR
a. Simple interest loan 6% $846.64 $270.74 $8,900 $9.746.64 6.34%
b. Add-on loan 4.5% $1,201.60 $280.60 $8,900 $10,101.60 8.41%
Terms Found in the Chapter
529 college savings plan A government-sponsored investment vehicle that allows earnings to grow free from federal taxes, so long as they are used to meet college education expenses.
add-on method A method of calculating interest by computing finance charges on the original loan balance and then adding the interest to that balance.
cash value (of life insurance) An accumulation of savings in an insurance policy that can be used as a source of loan collateral.
captive finance company A sales finance company that is owned by a manufacturer of big-ticket merchandise. GMAC is a captive finance company.
chattel mortgage A mortgage on personal property given as security for the payment of an obligation.
collateral An item of value used to secure the principal portion of a loan.
collateral note A legal note giving the lender the right to sell collateral if the borrower defaults on the obligation.
consumer finance company A firm that makes secured and unsecured personal loans to qualified individuals; also called a small loan company.
consumer loans Loans made for specific purposes using formally negotiated contracts that specify the borrowing terms and repayment.
credit life (or disability) insurance A type of life (or disability) insurance in which the coverage decreases at the same rate as the loan balance.
discount method A method of calculating finance charges in which interest is computed and then subtracted from the principal, with the remainder being disbursed to the borrower.
installment loan A loan that is repaid in a series of fixed, scheduled payments rather than a lump sum.
interim financing The use of a single payment loan to finance a purchase or pay bills in situations where the funds to be used for repayment are known to be forthcoming in the near future.
lien A legal claim permitting the lender, in case the borrower defaults, to liquidate the items serving as collateral to satisfy the obligation.
loan application An application that gives a lender information about the purpose of the loan as well as the applicant’s financial condition.
loan disclosure statement A document, which lenders are required to supply borrowers, that states both the dollar amount of finance charges and the APR applicable to a loan.
loan rollover The process of paying off a loan by taking out another loan.
Rule of 78s (sum-of the-digits method) A method of calculating interest that has extra-heavy interest charges in the early months of the loan.
sales finance company A firm that purchases notes drawn up by sellers of certain types of merchandise, typically big-ticket items.
simple interest method A method of computing finance charges in which interest is charged on the actual loan balance outstanding.
single-payment loan A loan made for a specified period, at the end of which payment is due in full.
Using Consumer Loans Chapter Outline Learning Objectives I. Basic Features of Consumer Loans A. Using Consumer Loans B. Different Types of Loans 1. Common loans a. Auto loans b. Loans for other durable goods c. Education loans d. Personal loans 2. Single-Payment or Installment Loans 3. Student loans a. Government loans v normal consumer loans b. Type of government loans – See Exhibit7.1 c. Obtaining a student loan d. Are student loans programs “too big to fail” e. Strategies for reducing student loan costs 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 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 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 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 C. Buy on Time or Pay Cash? Planning Over a Lifetime Financial Impact of Personal Choices Financial Planning Exercises Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
