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Chapter 7

Using Consumer Loans: The Role of Planned Borrowing

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Learning Objectives
1. Understand the various consumer loans. 2. Calculate the cost of a consumer loan. 3. Pick an appropriate source for your loan. 4. Control your debt.

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Introduction
Consumer loansformal contracts detailing how much youre borrowing and when and how youre going to pay it back. Used for bigger purchases. Debt and borrowing can get out of control.

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Consumer LoansYour Choices


Single-payment loans Variable-rate installment loans Unsecured fix-rate loans Secured loans

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First Decision: Single-Payment versus Installment Loans


Single-Payment or Balloon Loanpaid back in a single lump-sum payment with interest at maturity.
Bridge or interim loan short-term loan.

Installment loanrepayment of both principal and interest at various intervals.


Loan amortizationwith each payment, the interest portion covered decreases and principal portion covered increases.
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Second Decision: Secured versus Unsecured Loans


Secured loanguaranteed by an asset which typically lowers the rate of the loan. Unsecured loannot guaranteed by an asset or collateral

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Third Decision: Variable-Rate versus Fixed-Rate Loans


Fixed-rate interest rate loanstays fixed for entire duration of the loan, not tied to market interest rates. Variable-rate or adjustable interest rate loaninterest rate varies based on the market interest rate.
Prime ratethe interest rate that banks charge to their most creditworthy, or prime customers Convertible loanvariable-rate loan that can be converted to a fixed-rate loan.
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Fourth Decision: The Loans MaturityShorter versus Longer Term Loans Shorter term loan means lower interest rate and larger monthly payments Longer term loan means smaller monthly payments and higher interest rate

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Understand the Terms of the Loan: The Loan Contract


Security agreement Note Default

Acceleration clause
Deficiency payments clause

Recourse clause

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Figure 7.1 An Installment Purchase Contract

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Special Types of Consumer Loans


Home Equity Loan or Second Mortgage secured loan using equity in home as collateral. Advantages: Interest is tax deductible Lower interest than other consumer loans. Disadvantages: Puts your home at risk. Limits future financing flexibility.
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Special Types of Consumer Loans


Student Loanlow, federally subsidized interest, based on financial need Federal Direct/Stafford Loans:
Federal government makes direct loan to students through financial aid office.

PLUS Direct/PLUS Loans:


Loans are made by private lenders such as banks and credit unions to parents.

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Figure 7.2 Percent of Students at a 4-Year College Who Borrow

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Special Types of Consumer Loans


Automobile Loanloan secured by auto.
Duration usually for 24, 36, or 48 months or even 5 to 6 years.
Low-cost auto loan rates used to push slowselling vehicles or older models. Repossession if default on loan.

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Cost and Early Payment of Consumer Loans


APRannual percentage ratesimple percentage cost of all finance charges over the life of the loan, on annual basis. Truth in Lending Act requires all consumer loan agreements disclose APR in bold print.

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Cost and Early Payment of Consumer Loans


Cost of single-payment loans: Loan disclosure statement gives APR and finance charges of a loan

Simple interest method:


interest = principal x interest rate x time

Discount method

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Figure 7.4 A Loan Disclosure Statement

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Payday LoansA dangerous kind of single-payment loan


$100 to $500 loan till next payday.

Post-dated check with fee and principal left with payday lender.
Due in 1 or 2 weeks. Annualized interest rates up to 400%

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TABLE 7.2 Payday Loan Facts

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Cost of Installment Loans


Repayment of both interest and principal occurs at regular intervals. Payment levels are set so loan expires at a preset date. Use either simple interest or add-on method to determine what payment will be.

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Table 7.3 Monthly Installment Loan Tables ($1,000 loan with interest payments compounded monthly)

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Table 7.4 Illustration of a 12-Month Installment Loan for $5,000 at 14%

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Table 7.5 Calculating the APR for an Add-On Loan

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Early Payment of an Add-on Loan


If installment loan is repaid early, determine amount of principal still owed. Most common method for add-on loan is Rule of 78 or sum of the years digits. Rule of 78 determines what proportion of each payment goes towards principal. Prepayment penalty
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Table 7.6 Early Payoff of an Add-On Loanthe Rule of 78s

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Getting the Best Rate on Your Consumer Loans


Inexpensive sourcesfamily, home equity loans, cash value life insurance loans. More expensive sourcescredit unions, S&Ls, and commercial banks. Most expensive sourcesretail stores, finance companies or small loan companies

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Keys to Getting the Best Rate


Strong credit rating

Relatively risk-free to lender:


Use variable-rate loan Short loan term Collateral Large down payment

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Should You Borrow or Pay Cash?


Keep in mind that debt is expensive. Dont borrow to spend. Use cash rather than credit.

If benefits outweigh costs, borrowing makes sense.

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Controlling Your Use of Debt


Determine how much debt you can comfortably handle. Debt level comfort and need changes at different stages of the financial life cycle. With age, debt proportion of income tends to decline. Use several measures to control debt commitments.

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Controlling Your Use of Debt


Debt Limit Ratiopercentage of takehome pay committed to non-mortgage debt.
Total debt can be divided into consumer debt and mortgage debt.

Ratio should be below 15%.


~20% should avoid additional debt.

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Debt Resolution Rule


Control debt obligation, excluding borrowing for education and home financing, by forcing you to repay all outstanding debt obligations every 4 years.

Logic is that consumer credit should be short-term.

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Controlling Consumer Debt


Make sure it fits in with your goals and budget. Understand how costly consumer debt is. Borrowing limits future financial flexibility. Clues you might be in financial trouble.

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What To Do If You Cant Pay Your Bills


Budget so more money comes in.

Use self-control in the use of credit.


Go to your creditor.

Go to a credit counselor.

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What To Do If You Cant Pay Your Bills


Borrow inexpensively.

Use savings to pay off current debt.


Use a debt consolidation loan.

Bankruptcythe last resort


doesnt wipe out all obligations.

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What To Do If You Cant Pay Your Bills


Most common types of personal bankruptcy:

Chapter 13
Chapter 7

The wage earners plan


Straight bankruptcy

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Figure 7.5 Chapter 7 and 13 Bankruptcy Filings

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Figure 7.6 Personal Bankruptcy Options

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Chapter 13: The Wage Earners Plan


Must have:
Regular income Secured debts under $1,010,650 (2007) Unsecured debts under $336,900 (2007)

For the individualrelief from harassment of bill collectors


For creditorscontrolled repayment with court supervision.

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Chapter 7: Straight Bankruptcy


Can eliminate debts and begin again. Means test Most debts wiped outnot child support, alimony, student loans, and taxes. Trustee collects, sells all nonexempt property.

Must complete credit counseling course.

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Summary
Consumer loans can be single-payment loans, installment loans, secured loans, or unsecured loans. Loan costs are finance charges which include interest payments, processing fees,

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Summary
Numerous sources of loans but key to getting favorable rate is a strong credit rating and reducing lenders risk. Control debt by borrowing when debt fits within your financial plan and budget, and know your debt limits using the debt limit ratio and debt resolution rule.

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Figure 7.3 The Rise of Student Loan Debt

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Table 7.1 Student Loan Comparisons

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Table 7.7 Possible Sources of Credit

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