Document7

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Copyright 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 7:

USING CONSUMER LOANS

Clip Art 2001 Microsoft Corporation. All rights reserved.

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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

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Types of Consumer Loans

Auto

Durable goods

Education loans

Personal loans

Consolidation loans


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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.

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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

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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

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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

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Repaying Your Loan

1. Single payment loans

2. Installment loansBANK


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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.

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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.

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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.)

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Using the Simple Interest Method:Interest = Principal x Rate x Time

= $1000 x .12 x 2Finance Charges = $240

Borrower receives loan amount ($1000) now—

And pays back loan amount plus finance charges ($1000 + $240) at end of time period.

Most consumer friendly method—APR will be the same as the stated rate.

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Using the Simple Interest Method:

Annual Percentage Rate =

average annual finance charge

average loan balance outstanding

APR = ($240 2)

$1000

= $120

$1000

= .12 =12%

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Using the Discount Method:Interest = Principal x Rate x Time

= $1000 x .12 x 2Finance 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.

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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%

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Comparing the Two Methods:

MethodStatedRate

FinanceCharge

AmountRec’d

AmountRepaid APR

SimpleInterest

12% $240 $1000 $1240 12%

Discount 12% $240 $ 760 $1000 15.8%

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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.

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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!

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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.)

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Set on 12 P/YR

and END mode:

1000 +/- PV

12 I/YR

12 N

PMT $88.85

Use the financial calculator to compute payment:

Set on 1 P/YR

and END mode:

1000 +/- PV

12/12 I/YR

12 N

PMT $88.85

[Note: Use the AMORT feature on your calculator to create following table.]

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Mo. Beg. Bal. PMT Interest Principal End. Bal.

1 $1,000.00 $88.85 $10.00 $78.85 $921.15

2 $ 921.15 $88.85 $ 9.21 $79.64 $841.51

3 $ 841.51 $88.85 $ 8.42 $80.43 $761.08

4 $ 761.08 $88.85 $ 7.61 $81.24 $679.84

5 $ 679.84 $88.85 $ 6.80 $82.05 $597.79

6 $ 597.79 $88.85 $ 5.98 $82.87 $514.92

7 $ 514.92 $88.85 $ 5.15 $83.70 $431.22

8 $ 431.22 $88.85 $ 4.31 $84.54 $346.68

9 $ 346.68 $88.85 $ 3.47 $85.38 $261.30

10 $ 261.30 $88.85 $ 2.61 $86.24 $175.06

11 $ 175.06 $88.85 $ 1.75 $87.10 $ 87.96

12 $ 87.96 $88.85 $ 0.89 $87.96 $ 0

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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.

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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

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$88.85 x 12 = $1,066.20

Loan amount = – 1,000.00

Interest paid = $ 66.20

Total amount paid over the 12-month period:

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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

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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:

1000 +/- PV

93.33PMT

12 N

I/YR 21.45%

Set on 1 P/YR

and END mode:

1000 +/- PV

93.33PMT

12 N

I/YR 1.79% x 12 = 21.45%

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$93.33 x 12 = $1,120.00

Loan amount = – 1,000.00

Interest paid = $ 120.00

Total amount paid over the 12-month period:

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Comparing the Two Methods:

MethodStatedRate

FinanceCharge

AmountRec’d

AmountRepaid APR

SimpleInterest

12% $ 66.20 $1000 $1,066.20 12%

Add-On 12% $120.00 $1000 $1,120.00 21.45%

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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.

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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)

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THE END!

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