2 Consumer Loans Formal, negotiated contracts Specify the terms for borrowingSpecify the repayment scheduleOne-time transactionNormally used to pay for big-ticket items
3 Types of Consumer Loans AutoDurable goodsEducation loansPersonal loansConsolidation loans
4 Student Loans Federally sponsored loans: Stafford loans (Direct & Federal Family Education Loans—FFEL)Perkins loansSupplemental Loans for Students (SLS)Parent Loans (PLUS)
5 Obtaining a Student Loan: * It all starts with a FASFA!Demonstrate financial needMake satisfactory progress in schoolNo defaults on other student loans!
6 Repaying Student Loans Low interest ratesWith Stafford & Perkins loans — interest doesn’t accrue until you’re out!Consolidate your loans and repay:Extended repayment planGraduated repayment scheduleIncome-contingent repayment planDon’t default!
7 Repaying Consumer Loans Single Payment or InstallmentFixed or Variable Interest Rate
8 Where Can You Get Consumer Loans? Traditional financial institutionsCommercial banksCredit UnionsSavings and Loan AssociationsConsumer finance companiesSpecialize in high-risk borrowersTogether with banks and credit unions make ~75% of consumer loans
9 Other sources include: Sales finance companiesThird party financingInclude captive finance companies, such as GMACLife insurance companiesLoan against cash value of certain types of policiesFriends and relativesPawn shops
10 Managing Your Credit Shop carefully before borrowing Compare loan featuresFinance charges and loan maturityTotal cost of transactionCollateral requirementsOther features, such as payment date, prepayment penalties and late fees
11 Low Rate or a Rebate?Example: buying a new car with a price of $20,000, with two financing options:1.9% financing (60 months) from car dealer$2,500 rebate, then 10% (60 months) financing from your bankWhich option should you choose?
12 1.9% financing $2,500 rebate Find monthly payment 20,000 +/- PV 1.9 I/YR60 NPMT $349.68$2,500 rebateFind monthly payment17,500 +/- PV10 I/YR60 NPMT $371.821.9% financing is the better deal because of the lower monthly payments.
13 If we take the $2,500 rebate, we would need to borrow: If we were to make a monthly payment of $349.68, we would need to borrow from the bank:$ PMT10 I/YR60 NPV $16,458If we take the $2,500 rebate, we would need to borrow:$20,000 – $2,500= $17,500from the bank.1.9% financing is the better deal because it represents a lower cost in present value .
14 Keep Track of Your Credit! Keep inventory sheet of debtKnow total monthly paymentsKnow total debt outstandingCheck your debt safety ratio—Total monthly consumer debt pmtsMonthly take-home pay
15 Keep Track of Your Credit! Use Worksheet 7.1 to track your consumer debtA desirable debt safety ratio should be 20% or lower, otherwise you are relying too heavily on credit.
16 Repaying Your Loan1. Single payment loans2. Installment loansBANK
17 1. Single Payment Loans:Specified time period, usually less than 1 year.Payment due in full at maturity.Payment includes principal and interest.May require collateral.Loan rollover may be possible if borrower is unable to repay in time.
18 Calculating Finance Charges on Single-Payment Loans: Simple Interest MethodCalculated on the outstanding balance.Discount MethodInterest calculated on the principal,Then subtracted from loan amount; remainder goes to borrower.Finance charges are paid in advance.APR will be higher than stated interest rate.
19 Example:Calculate the finance charges and APR on a $1000 loan for 2 years at an annual interest rate of 12%. (Assume interest is the only finance charge.)
20 Using the Simple Interest Method: Interest = Principal x Rate x Time= $1000 x .12 x 2Finance Charges = $240Borrower 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.
22 Using the Discount Method: Interest = Principal x Rate x Time= $1000 x .12 x 2Finance Charges = $240Finance 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.
25 2. Installment Loans: Repaid in a series of equal payments. Each payment is part principal and part interest.Maturities range from 6 months to 7–10 years or longer.Usually require collateral.
26 Calculating Finance Charges on Installment Loans: Simple Interest MethodCalculated on the outstanding (declining) balance each period.Add-On MethodFinance charges calculated on original loan balance —And then added to principal.Costly form of consumer credit!
27 Example:Calculate the finance charges and APR on a $1000 loan to be repaid in 12 monthly installments at an annual interest rate of 12%. (Assume interest is the only finance charge.)
28 (Table calculated using $1000 loan) (Set on 12 P/YR and END mode:) Use Exhibit 7.6(Table calculated using $1000 loan)Find payment for12 months at12% interest:$88.85Calculator(Set on 12 P/YR and END mode:)1000 +/- PV12 I/YR12 NPMT $88.85[Note: We can use a spreadsheet to create the following table.]
30 Using the Simple Interest Method: Simple interest is figured on the outstanding loan balance each period.Each payment causes the outstanding loan balance to decrease.Each subsequent payment, then, will incur a lower finance charge, so —More of the next payment will go towards repaying the principal or outstanding loan balance!
31 Simple Interest Method Continued: This is the method financial calculators use when solving for interest.When simple interest method is used, whether for single payment or installment loans,Stated Rate = APRIn this example, APR = 12% andrate per period = 12% 12= 1% per month.
32 Total amount paid over the 12-month period: $88.85 x 12 = $1,066.20Loan amount = – 1,000.00Interest paid = $
33 Using the Add-On Method: Calculate finance charges on the original loan amount:$1000 x .12 x 1 = $120Add these charges to principal:$120 + $1000 = $1,120Divide this amount by the number of periods to arrive at payment:$1,120 12 = $93.33
34 Add-On Method Continued: Use financial calculator to figure APR for the Add-On Method using the payment just determined and solve for interest:Set on 12 P/YRand END mode:1000 +/- PV93.33 PMT12 NI/YR 21.45%
35 Total amount paid over the 12-month period: $93.33 x 12 = $1,120.00Loan amount = – 1,000.00Interest paid = $
37 More on Loans:Carefully examine Installment Purchase Contract—it contains the terms of the loan.Finance charges must include not only interest but also any other required charges.Total charges, not just interest, must be used to calculate APR.
38 Other Loan Considerations: Prepayment penaltiesDoes the lender use Rule of 78s?Rule of 78s (sum-of-the-digits method)Charge more interest in earlier months of the loanProducing a much higher principal balance than the regular installment payment would result inCredit life insurance and disability requirementsAvoid if possible and get term insurance instead!
39 Other Loan Considerations: Buy on time or pay cash?Use Worksheet 7.2 for this analysisIf all of the following conditions are satisfied, you should pay cash:You have sufficient amount of cash to pay off the itemPaying off the item does not exhaust your savingsIt costs more to borrow than you can earn in interest from the savingsAlso should consider the tax features