Personal Financial Management: What two questions should be answered before taking out a consumer loan??Explain. List and briefly discuss the different factors to consider when shopping

Week 8 (Chapter 7) Using Consumer Loans

Overview

Welcome to Week 8: This week we will cover Chapter 7 as we delve into using credit.

After reading Chapter 7, the student should be able to:

 Explain when to use consumer loans and be able to differentiate between the major types  Identify the various sources of consumer loans  Choose the best loans by comparing finance charges, maturity, collateral, and other loan

terms  Describe the features of, and calculate the finance charges on, single-payment loans  Evaluate the benefits of an installment loan  Determine the costs of installment loans and analyze whether it is better to pay cash or to

take out a loan

Week 8 Checklist

 Read Chapter  7 in your textbook  Read the Lecture Notes  Watch Videos  Complete Week 8 Assignment  Complete Week 8 Quiz

Welcome to Money Online!

Money Online is a set of links to relevant Web sites and companion exercises that will help you use the Web effectively in financial planning. By bookmarking (saving) the URLs, you will build a valuable library of personal finance Web sites.

Web site addresses may change over time, so if you have difficulty linking to a URL, please try using key words in your preferred search engine.

CHAPTER 7 – Using Consumer Loans 1. http://www.salliemae.com What are your student loan options? Whether you’re an undergraduate, graduate, or professional student, learn the basics of student loans from Sallie Mae, a leading national provider of higher-education loans for students and parents. Receive entrance and exit counseling, apply online, check on your loan’s status, and calculate your payments at this site as well.

2. https://nces.ed.gov/collegenavigator/ Find the college that best suits you. The National Center for Education Statistics in the U.S. Department of Education has prepared College Navigator to help students and their parents compare over 7,000 colleges and the costs to attend them.

3. https://www.usaaedfoundation.org/ Find useful information on obtaining loans and managing debt at the USAA Educational Foundation’s Web site. Click on “Personal Finances” and choose “Financing College” to search for scholarships, explore financial aid options, and find student loan information. Under “Personal Finance,” find topics on identity theft and avoiding fraud, and under “Basic Investing,” find out about managing debt.

4. http://www.asa.org/for-students/college-planning/ Don’t qualify for financial aid? Find student loans based on your creditworthiness rather than your family’s income. The Education Resources Institute (TERI), a private, not-for-profit institution, provides education financing and information services to students and their families. Their loan program is designed to meet the needs of students in all phases of their education—whether elementary, secondary, undergraduate, graduate, professional, or specialized programs of study.

5. http://www.bankrate.com Find the best loan rates in your area! Select the product you’re interested in and your state at Bankrate’s Web site to comparison shop among the loan, credit, or savings offerings in your area. Learn basic loan information, calculate your loan payment, or research your bank’s financial condition at this site as well.

Just for Fun! http://www.publicdebt.treas.gov Think you have a lot of debt? Check out the amount of the government’s debt on this day. Scroll down to “U.S. Public Debt” section and click on “See the U.S. Public Debt to the Penny” to find the full amount. Compare today’s debt with that from a year ago. Also learn about savings bonds, Treasury securities, and regulation of the government securities market at the Web site of the Bureau of the Public Debt.

© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 7-Using Consumer Loans

Lecture Notes

“College loans” Does that sound familiar? If it is, you must pay close attention to this Chapter as it could help you get rid of them easier and faster than you think. While there are many different types of consumer loans, I find student loans to be very unique in many ways. For instance, student loans are normally taken by college students who have not had any experience with loans or the financial knowledge to evaluate between many other options to finance their education. Another key difference is that student loans will follow you until they are paid off in full. No bankruptcy, crying, or pleading will help you make these loans go away. The only way to get rid of them is by paying them off. I’m not trying to scare you but we have to understand that although student loans are designed to make it possible for people to pursue a higher degree, this degree will cost money (I personally believe that education is one of the best investments you will make in your life time). These loans could range anywhere from a few thousand dollars all the way up to over a hundred thousand dollars. Choosing the right loan (or the right finance option) could make a huge difference in your life

Why Is This Chapter Important for you?

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.

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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 five major reasons to use consumer loans

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 7 to 10 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.

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 the SLS 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.

In contrast to regular consumer loans, these 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.

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The interest rate on fixed-rate loans remains the same over the life of the loan. With variable rate loans, the interest rate changes every 6 to 12 months in line with market conditions.

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.

Loan Providers 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.

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.

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.

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.

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 .

Factors to Consider When Shopping For a Consumer Loan

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 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.

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.

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.

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.

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.

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 10–15 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.

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.

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,

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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.

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 (sum-of-the-digits method) 12. Consumer loans 13. Collateral and collateral note 14. Interim financing 15. Captive finance company 16. Loan application 17. Lien 18. Chattel mortgage 19. Prepayment penalty 20. Loan rollover 21. Loan disclosure statement

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Using Consumer Loans Chapter 7

Learning Outcomes  Know when to use consumer loans and be able to differentiate

between the major types.  Identify the various sources of consumer loans.  Choose the best loans by comparing finance charges, maturity,

collateral, and other loan terms.  Describe the features of, and calculate the finance charges on,

single-payment loans.  Evaluate the benefits of an installment loan.  Determine the costs of installment loans and analyze whether it

is better to pay cash or to take out a loan

How Will This Affect You?  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.

What is a Consumer Loan

A  loan that establishes consumer credit  that is granted  for  personal use;

 Usually unsecured and based on the borrower's  integrity  and ability to pay

Using Consumer Loans  Loans made for specific purposes using formally negotiated

contracts that specify the borrowing terms and repayment.

 One shot transaction made for specific purpose

 Unlike a credit card, no more credit is available: the amount of the loan is fixed, specific to one transaction

 No credit cards or checks

 Used to borrow money to pay for big-ticket items

Consumer Loans  Ability to borrow does not mean that you

need to borrow funds  Purchases should only be made when you

have budgeted for the purchase.  Item purchased should have an useful life

longer than the term of the loan used to purchase the item.

 Should you borrow to pay for a wedding?  Should you borrow to pay for an education?

Type (Uses) of Consumer Loans

 Auto loans  Other durable goods loans, such as furniture  Education loans  Personal loans  Consolidation loans

Consumer Loans–Characteristics  Single Payment – Made for a specified period, at the

end of which time, full payment [principal plus interest] is due.

 Installment—Repaid in a series of fixed, scheduled payments, rather than in one lump sum. Payments are part interest and part principal.

 Fixed—Interest rate and payments remain the same

 Variable Rate—Interest rate and payments change periodically

Sources of Consumer Loans  Commercial Banks—loan to customers with good

credit  Consumer Finance companies—high rates, easy to get  Credit union—limited to members, but low rates  Savings and Loan Associations—similar to banks  Sales Finance Companies—supports sales of products  Life Insurance Companies—reduces your insurance

coverage  Friends and Relatives—not advisable

Features of Commercial Loans  Finance charges  Loan maturity  Total cost of the transaction  Collateral  Other

 Payment date  Prepayment penalties  Late fees

Features of Commercial Loans

 Finance charges  Loan maturity  Total cost of the transaction  Collateral  Other  Payment date  Prepayment penalties  Late fees

Keep Track of you Credit  Keep inventory sheet of debt  Know total monthly payments  Know total debt outstanding  Check your debt safety ratio − should be less

than 20  Debt safety ratio = [total monthly payments /

monthly take-home pay] * 100  Total monthly payments does not include Home

Mortgage

Single Payment Loans  Loan collateral, for example your car

 Lien  Chattel mortgage, borrower retains

possession of property  Collateral note, lender retains possession of

property  Loan maturity  Loan repayment

 Prepayment penalty  Loan rollover

Installment Loans  Repay debt in a series of equal payments

 Payments includes principal and interest

 Wide maturity range—6 months to 10 years or longer

Other Loan Considerations  Prepayment penalties

 Credit Life Insurance

 Rule of 78s (sum-of-the-digits)—A method of calculating interest that has extra-heavy interest charges in the early months of the loan.

 Credit life insurance: Very costly and gives more to lender

Buy on time or pay cash (1 of 2)  Do not deplete emergency fund  Worksheet 7.2

 Cost of Borrowing:  Total of all payments  Less principal of loan  Cost of interest  Tax impact – No tax effect except for home equity

loans used for home improvements  Cost of using cash to buy

 Opportunity cost of lost interest Tax impact, after tax rate is {1 – tax rate]

Buy on time or pay cash (1 of 2)

 Cost of borrowing greater than cost of using cash, use cash to purchase item

 If difference is small, may decide to borrow and maintain a higher level of liquidity