1. Certificate for Introduction to Securities & Investment (Cert.ISI)
4cis
Certificate for Introduction to Securities & Investment (Cert.ISI)
Unit 1
Lesson 4:
Borrowing money:

2. Borrowing money
Individuals can borrow money from banks and building societies in three main ways:
Loans
Overdrafts
Credit cards
Each type of borrowing is suitable for different purposes. Get that wrong and it could end up costing you a lot of money.

3. Bouncing cheques
In 1972, Gordon Brown tried to pay for his university lodgings with a cheque for £3
“Refer to Drawer” is bank-speak for “this person has insufficient funds in his account to pay the cheque”

4. Overdrafts
These days, if the sum is relatively small, a bank is unlikely to “bounce” a cheque.
Instead, it is more likely to honour the cheque but charge the account holder a fee and a high rate of interest for going “overdrawn”.
An account which has gone overdrawn is called an overdraft. There are two types of overdraft:
Authorised, or “planned” overdrafts
The bank agrees in advance with the account holder to allow the account to go overdrawn up to a certain limit
Unauthorised, or “unplanned” overdrafts
No prior agreement is in place. The bank might bounce the cheque or refuse a standing order unless the sum is relatively small
Some banks allow their customers to overdrawn for small amounts (usually less than £50) without charging them any fees at all
Banks make a lot of money from charging interest and fees on overdrafts
Banks charge much higher fees and interest for unauthorised overdrafts

5. Unauthorised overdrafts
Fees and interest rates for unauthorised overdrafts are much more reasonable these days, thanks to legal action by consumer groups. However, they are still very high.
2002: LLoyds TSB
Authorised overdraft rate interest rate: 17.30%.
Unauthorised overdraft interest rate: 29.80%
Fee for bouncing a cheque: £20
Fee for unauthorised overdraft: £20 per month.
Daily fee for additional unauthorised withdrawals:
£10 up to a maximum of £80 per month.
2010: LLoyds TSB
Authorised overdraft interest rate: 19.30%.
Unauthorised overdraft interest rate: 19.30%
Fee for bouncing a cheque: £10
Fee for unauthorised overdraft: £5 per month.
Daily fee for additional unauthorised withdrawals:
£5-10, up to a maximum of £80 per month.

6. Unauthorised overdraft fees
If not paid off promptly, unauthorised overdraft fees can accumulate and push up the overdraft to many times the original sum owed to the bank.

7. The proper way to use overdrafts
Hot Dog Express Ltd is due to pay its meat supplier £7,000 on 5th February but does not have enough money in its account to pay the bill. The Finance Director knows he is due to receive £8,500 from a multiplex cinema in Croydon customer on the 19th February but the gap leaves him with a cash-flow problem. He decides to arrange a £10,000 overdraft with a bank to cover that payment and any other expenses over the 14-day period
Hot Dog Express Ltd can now pay the bill for £7,000 and not worry about the cheque 'bouncing'. Not only would bounced cheques cost the business money in bank charges but the company’s relationship with its meat supplier would be damaged. The supplier might in future refuse to offer three-months credit and demand cash up front.
Hot Dog Express Ltd will get charged interest only on the amount it has actually borrowed. The overdraft facility is £10,000. If the business only uses £7,750 , it only pays interest on the £7,750, not the whole £10,000.

8. Exercise
Hot Dog Express Ltd has arranged an overdraft facility for £10,000 with its bank. It uses the facility regularly for the first 6 months of the year and on average has an overdraft of £7,750 each month. The interest rate on the overdraft is set at 19.3% per annum.
1. How much interest does the business pay over that 6 month period? Use the formula: I = p x r x t, where I = the interest charge, p = the principle (the amount borrowed), r = the interest rate, and t = the time period)
2. As a result of a change in the interest rate set by the Bank of England, Hot Dog Express is informed by its bank that the interest rate on its overdraft will rise to 19.85%. If Hot Dog Express wishes to keep its borrowing costs down to the previous level, by roughly how much does it need to reduce its overdraft?
Rhino rugby overdraft

9. Loans
Hot Dog Express Ltd is worried that its bank might withdraw the overdraft facility without any warning. It does not want to suffer the same problems as Rhino Rugby.
Hot Dog Express decides to take out a loan at 13% for £10,000 for a fixed, three-year period. What are the advantages and disadvantages of using a loan instead of an overdraft?
Pros:
As long as Hot Dog Express complies with the conditions of the loan agreement, the bank cannot demand repayment of the loan before the term expires.
The interest rate is only 13.0% - much cheaper than the overdraft rate of 19.3%
Cons:
Hot Dog Express has to borrow the full amount of the loan, which is more than it needs for most of the time
It pays interest on the full amount of the loan
It may have to offer security to prove it can repay the loan

10. Loans: secured and unsecured
A secured loan is one where the bank gets the right to seize the borrower’s asset if the borrower defaults on the terms of the loan. For example:
The borrower fails to make several interest payments
The borrower fails to make repayments of the principle (original sum borrowed)
Rubbish!
With a secured loan, the bank is less likely to lose its money:
The risk of default is lower
The lower the risk, the lower the interest rate the bank is likely to charge
The higher the risk, the higher the reward must be to compensate for that risk
The lower the risk, the lower the interest rate

11. Loans: secured and unsecured
An unsecured loan is one where the bank has to rely on its assessment if the ability of the borrower to service and repay the loan
Unsecured loans are often used to buy consumer goods
Retailers have to offer credit to get people to buy
Student loans are unsecured:
it is expected that the student will be able to repay eventually
The lender of an unsecured loan will check the credit history of the borrower:
If the would-be borrower has County Court Judgments against him / her for previous non-payment of loans, his / her credit rating will be low
If the would-be borrower has no fixed address, his /her credit rating will be low

12. Bad credit history?
There are plenty of firms willing to lend money to people with bad credit ratings…at a price
Credit cards are much more widely used in the UK than in other European countries. Most people cannot live without them. Unfortunately, a lot of businesses use them too.

13. Credit card usage Most retail goods can be bought with a credit card
Retailer is paid for the goods by the credit card company
Retailer pays a transaction fee to the credit card company
Transaction fee is about 1-3% of the purchase price
Retailer usually wins more custom by offering customers the ability to pay by credit card
Credit card customers are sent a monthly statement
Customer can either pay outstanding balance in full each month
No interest is then payable
Or customer can pay a portion of the statement balance
Interest is then charged on the outstanding amount
Credit card interest is so profitable to banks that they entice people to switch their outstanding balance over to a new card.
The bait is 0% interest charged on transferred balances for and extended period. The catch is there’s a fee that has to be paid on the balanced transferred – in this case 2.98%

14. Interest rate confusion
It is important to understand what sort of interest rate is being quoted by your credit card company
A credit card company might advertise an annual rate of 3.99% on the balance you transfer to them
Interest is charged monthly
3.99% divided by 12 months = % per month on outstanding balance
This interest is added to the balance, making it bigger each month
Interest is then charged the next month on the larger balance
To find out what the true interest rate is, use the following formula
Take % and express this as
Then multiply by 12 months: =
re-expressed as a percentage is 4.06%
Effective Annual Rate (EAR) is 4.06%
The average credit card balance in Bromley is £1,800.
£1,800 x 3.99% is £71.82
£1800 x 4.06% is £73.08

15. Interest rate confusion
EAR – Effective Annual Rate
the annual rate of interest assuming the addition of interest charges to the principal sum (i.e. outstanding balance)
APR – Annual Percentage Rate
the Effective Annual Rate of interest you must pay, and
certain fees associated with the loan.
Under UK law, all lenders have to tell you what their APR is before you sign. The APR doesn’t include all the costs associated with a credit agreement – such as:
charges for late or missed payments
balance transfer fees on a credit card
charges for optional payment protection insurance

16. Exercise Virgin is offering: Minimum agreement period of two years
0% introductory rate for 14 months on all balance transfers
2.98% fee payable upon transfer of balance
16.6% APR on the balance from month 15 onwards
Magic Bank is offering:
Minimum agreement period of two years
3.5% introductory rate for first 12 months on all balance transfers
No fee payable upon transfer of balance
12% on the balance from month 13 onwards
You are Average Bromley Person with a credit card balance of £1,800. You want to switch to a new credit card company. You are determined not to put any more spending on your new card at all. You just want the cheapest cost over the life of the two year deal. Which offer do you choose?

17. Solution

18. Flat percentage rates
Before consumer protection legislation in the UK, this was used by most credit providers. In some countries, flat interest rates are still quoted

19. Flat interest rates on car loans
Before consumer protection legislation, flat interest rates were quoted by many car dealers, offering finance. Car loans are usually for 3-5 years, with monthly payments of the principal sum (the capital) and the interest.
Example assuming a typical 2nd-hand car loan of £5,000 repayable over five years:
With a flat rate the interest is charged on the original amount borrowed, no matter what's been repaid, so in the last year you still pay interest on the whole £5,000.
With a 9% flat rate, the total interest is £2,250 (£450 x 5)
With APR interest, the rate is charged on any outstanding debt, which declines with every monthly repayment
Borrow £5,000 over 5 years and by the last year you only pay interest on the amount remaining, say £1,000.
At 9% APR the total interest is £1,200.
Hence a flat rate of 9% sounds cheap but is roughly equivalent to a costly 18% APR