7-1 Copyright  2002 by Harcourt, Inc. All rights reserved. CHAPTER 7: USING CONSUMER LOANS Clip Art  2001 Microsoft Corporation. All rights reserved.

7-2 Copyright  2002 by Harcourt, Inc. All rights reserved. Consumer Loans  Formal, negotiated contracts  Specify the terms for borrowing  Specify the repayment schedule  One-time transaction  Normally used to pay for big- ticket items

7-3 Copyright  2002 by Harcourt, Inc. All rights reserved. Types of Consumer Loans  Auto  Durable goods  Education loans  Personal loans  Consolidation loans Clip Art  2001 Microsoft Corporation. All rights reserved.

7-4 Copyright  2002 by Harcourt, Inc. All rights reserved. Sources of Consumer Loans :  Traditional financial institutions –Commercial banks –Credit Unions –Savings and Loan Associations  Consumer finance companies –Specialize in high-risk borrowers –Together with banks and credit unions make ~75% of consumer loans.

7-5 Copyright  2002 by Harcourt, Inc. All rights reserved. Other sources include:  Sales finance companies –Third party financing –Include captive finance companies, such as GMAC  Life insurance companies –Loan against cash value of certain types of policies  Brokerage firms  Pawn shops  Friends and relatives

7-6 Copyright  2002 by Harcourt, Inc. All rights reserved. Managing Your Credit  Shop carefully before borrowing  Compare loan features –Finance charges and loan maturity –Total cost of transaction –Collateral requirements –Other features, such as prepayment penalties and late fees

7-7 Copyright  2002 by Harcourt, Inc. All rights reserved. Keep Track of Your Credit!  Keep inventory sheet of debt.  Know total monthly payments.  Know total debt outstanding.  Check your debt safety ratio— total monthly consumer debt pmts monthly take-home pay

7-8 Copyright  2002 by Harcourt, Inc. All rights reserved. Repaying Your Loan 1. Single payment loans 2. Installment loans BANK Clip Art  2001 Microsoft Corporation. All rights reserved.

7-9 Copyright  2002 by Harcourt, Inc. All rights reserved. 1. Single Payment Loans:  Specified time period, usually less than 1 year.  Payment due in full at maturity.  Payment includes principal and interest.  May require collateral.  Loan rollover may be possible if borrower is unable to repay in time.

7-10 Copyright  2002 by Harcourt, Inc. All rights reserved. Calculating Finance Charges on Single-Payment Loans:  Simple Interest Method –Calculated on the outstanding balance.  Discount Method –Interest calculated on the principal, –Then subtracted from loan amount; remainder goes to borrower. –Finance charges are paid in advance. –APR will be higher than stated interest rate.

7-11 Copyright  2002 by Harcourt, Inc. All rights reserved. Example: Calculate the finance charges and APR on a $1000 loan for 2 years at an annual interest rate of 12%. (Assume interest is the only finance charge.)

7-12 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Simple Interest Method: Interest = Principal x Rate x Time = $1000 x.12 x 2 Finance Charges = $240  Borrower receives loan amount ($1000) now—  And pays back loan amount plus finance charges ($ $240) at end of time period.  Most consumer friendly method—APR will be the same as the stated rate.

7-13 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Simple Interest Method: Annual Percentage Rate = average annual finance charge average loan balance outstanding APR = ($240  2) $1000 = $120 $1000 =.12 = 12%

7-14 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Discount Method: Interest = Principal x Rate x Time = $1000 x.12 x 2 Finance Charges = $240  Finance charges calculated the same way as in simple interest method—  But are then subtracted from loan amount ($1000 – $240).  Borrower receives the remainder ($760) now and pays back the loan amount ($1000) at end of time period.

7-15 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Discount Method: Annual Percentage Rate = average annual finance charge average loan balance outstanding APR = ($240  2) ($1000 – $240) = $120 $760 =.158 = 15.8%

7-16 Copyright  2002 by Harcourt, Inc. All rights reserved. Comparing the Two Methods:

7-17 Copyright  2002 by Harcourt, Inc. All rights reserved. 2. Installment Loans:  Repaid in a series of equal payments.  Each payment is part principal and part interest.  Maturities range from 6 months to 7–10 years or longer.  Usually require collateral.

7-18 Copyright  2002 by Harcourt, Inc. All rights reserved. Calculating Finance Charges on Installment Loans:  Simple Interest Method –Calculated on the outstanding (declining) balance each period.  Add-On Method –Finance charges calculated on original loan balance, – And then added to principal. –Costly form of consumer credit!

7-19 Copyright  2002 by Harcourt, Inc. All rights reserved. Example: Calculate the finance charges and APR on a $1000 loan to be repaid in 12 monthly installments at an annual interest rate of 12%. (Assume interest is the only finance charge.)

7-20 Copyright  2002 by Harcourt, Inc. All rights reserved. Set on 12 P/YR and END mode: /-PV 12I/YR 12 N PMT$88.85 Use the financial calculator to compute payment: Set on 1 P/YR and END mode: /-PV 12/12I/YR 12 N PMT$88.85 [Note: Use the AMORT feature on your calculator to create following table.]

7-21 Copyright  2002 by Harcourt, Inc. All rights reserved. Mo.Beg. Bal.PMTInterest PrincipalEnd. Bal. 1$1,000.00$88.85$10.00 $78.85$ $ $88.85 $ 9.21 $79.64$ $ $88.85 $ 8.42 $80.43$ $ $88.85 $ 7.61 $81.24$ $ $88.85 $ 6.80 $82.05$ $ $88.85 $ 5.98 $82.87$ $ $88.85 $ 5.15 $83.70$ $ $88.85 $ 4.31 $84.54$ $ $88.85 $ 3.47 $85.38$ $ $88.85 $ 2.61 $86.24$ $ $88.85 $ 1.75 $87.10$ $ 87.96$88.85 $ 0.89 $87.96$ 0

7-22 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Simple Interest Method:  Simple interest is figured on the outstanding loan balance each period.  Each payment causes principal to decrease.  Each subsequent payment, then, will incur a lower finance charge, so  More of the next payment will go towards repaying the principal.

7-23 Copyright  2002 by Harcourt, Inc. All rights reserved. Simple Interest Method Continued:  This is the method financial calculators use when solving for interest.  When simple interest method is used, whether for single payment or installment loans, Stated Rate = APR  In this example, APR = 12% and rate per period = 12%  12 = 1% per month

7-24 Copyright  2002 by Harcourt, Inc. All rights reserved. $88.85 x 12= $1, Loan amount= – 1, Interest paid= $ Total amount paid over the 12- month period:

7-25 Copyright  2002 by Harcourt, Inc. All rights reserved. Using the Add-On Method:  Calculate finance charges on the original loan amount: $1000 x.12 x 1 = $120  Add these charges to principal: $120 + $1000 = $1,120  Divide this amount by the number of periods to arrive at payment: $1,120  12 = $93.33

7-26 Copyright  2002 by Harcourt, Inc. All rights reserved. Add-On Method Continued:  Use financial calculator to figure APR for the Add-On Method using the payment just determined and solve for interest: Set on 12 P/YR and END mode: /-PV 93.33PMT 12 N I/YR21.45% Set on 1 P/YR and END mode: /-PV 93.33PMT 12 N I/YR1.79% x 12 = 21.45%

7-27 Copyright  2002 by Harcourt, Inc. All rights reserved. $93.33 x 12= $1, Loan amount= – 1, Interest paid= $ Total amount paid over the 12- month period:

7-28 Copyright  2002 by Harcourt, Inc. All rights reserved. Comparing the Two Methods:

7-29 Copyright  2002 by Harcourt, Inc. All rights reserved. More on Loans:  Carefully examine Installment Purchase Contract—it contains the terms of the loan.  Finance charges must include not only interest but also any other required charges.  Total charges, not just interest, must be used to calculate APR.

7-30 Copyright  2002 by Harcourt, Inc. All rights reserved. Other Loan Features to Ask About:  Acceleration clause  Garnishment of wages  Repossession of collateral  Balloon payment  Prepayment penalties  Credit life insurance requirements (avoid if possible and get term insurance instead)

7-31 Copyright  2002 by Harcourt, Inc. All rights reserved. THE END!