Using Consumer Loans:

1
Chapter 7

• Using Consumer Loans
• The Role of Planned Borrowing

2
Characteristics of Consumer Loans

• Single-payment versus installment loans
• Secured versus unsecured loans
• Variable-rate versus fixed-rate loans

3
Single-Payment Loans Versus Installment Loans

• Single-payment or balloon loans
• Sometimes called bridge or interim loans, because
  they are used until permanent financing can be
  arranged
• Loan is repaid in one lump sum, including
  interest
• Normally for short-term lending of one year or
  less

4
Single-Payment Loans Versus Installment Loans
(contd)

• Installment loans
• Loan is repaid at regular intervals
• Payment includes both principal and interest
• Normally used to finance cars, appliances, and
  other expensive items

5
Installment Loan Amortization

• The process of your payment going more toward
  principal and less toward interest each
  subsequent month
• Based on a simple-interest calculation

6
Secured Versus Unsecured Loans

• Secured loans
• Are guaranteed by a specific asset
• Typically have lower rates

• Unsecured loans
• Require no collateral
• Offered to borrowers with excellent credit
  histories
• Normally have high rates of interest 12 to 21
  annually

7
Fixed-Rate Versus Variable-Rate Loans

• Fixed-rate loans
• Same interest rate for the duration of the loan
• Higher initial interest rate as the lender could
  lose money if the rates increase
• Most consumer loans are fixed-rate loans
• Convertible loans
• Begin as a variable rate loan
• Can be locked into the current rate at some
  predetermined time in the future

8
Fixed-Rate Versus Variable-Rate Loans (contd)

• Variable-rate loans
• Have an interest rate that is tied to an index
  (e.g., prime rate, 6-month Treasury bill rate)
• Can adjust on different intervals (e.g., monthly,
  semi-annually, or annually)
• Have a lifetime adjustment cap
• Normally have a lower initial interest rate
  because the lender wont lose money if the rates
  increase

9
Special Types of Consumer Loans

• Home equity loans
• Student loans
• Automobile loans

10
Home Equity Loans

• Basically second mortgages
• Use the equity in your home to secure your loan
• Normally allow you to borrow up to 80 of your
  equity

11
Home Equity Loans (contd)

• Advantages
• Interest payments are tax-deductible
• Lower rates of interest than other types of
  consumer loans
• Disadvantages
• Puts your home at risk if you default
• Sacrifices future financial flexibility because
  you can only have one outstanding home equity loan

12
Student Loans

• Have low, federally subsidized interest rates
  used for higher education
• Tax-advantaged under the 1997 Taxpayer Relief Act
  and the Tax Relief Act of 2001
• Can claim 2,500 in interest paid per year as an
  adjustment to income
• Examples
• Federal Direct/Stafford loans for students PLUS
  Direct/PLUS Loans for parents

13
Student Loans (contd)

• Federal Direct and PLUS Direct available through
  the school Stafford and PLUS loans available
  through lenders
• Payment on Federal Direct and Stafford loans
  deferred for 6 months after graduation
• Borrowing limits apply

14
Automobile Loans

• Consumer loan secured with an automobile
• Lower interest rate than an unsecured loan
• Normally has a maturity length of 2 to 6 years

15
Payday Loans

• High fees charged
• Short-term loan of 1-2 weeks
• Those with jobs and checking accounts and
  students are typical users
• Check held by the payday lender

16
Cost of Single-Payment Loans

• The simple interest method
• Principal and interest are due at maturity
• Interest principal x interest rate x time
• The discount method
• Subtracts the entire interest charge from the
  loan principal before you receive the loan
• Inflates the rate of interest because the amount
  received is less than the amount borrowed

17
Cost of Installment Loans

• Repayment of both principal and interest occur at
  regular intervals
• Loan expires on a preset date
• Use one of two types of interest calculations

18
Cost of Installment Loans (contd)

• The simple interest method
• Most common calculation method
• Each month the interest portion of the payment
  decreases and principal portion increases
• Pay interest only on outstanding balance
• The add-on method
• Adds total interest payment to the principal of
  the loan
• More costly than simple-interest method

19
Early Repayment of Installment Loans

• With the simple interest method, it is simply the
  outstanding balance
• With the add-on method, use the rule of 78s or
  sum of the years digits methods

20
Sources of Consumer Loans

• Inexpensive sources of loans
• Home equity loans
• Other secured loans
• More expensive sources of loans
• Credit unions
• Savings and loans
• Commercial banks

21
Sources of Consumer Loans (contd)

• Most expensive sources of loans
• Retail stores
• Finance companies
• Note Those who are in the worst financial shape
  have to pay the most for credit. You must have a
  solid credit rating to borrow from the cheaper
  lenders.

22
Know How to Borrow

• Maintain a strong credit rating
• Reduce the lenders risk
• Use a variable rate loan
• Keep the loan term as short as possible
• Provide collateral for the loan
• Pay a large down payment on the item to be
  purchased with financing

23
Know When to Borrow

• Do you really need to make this purchase?
• Does it fit into your financial plan?
• If cash is used, can you maintain sufficient
  liquidity?
• What is the after-tax cost of borrowing versus
  the after-tax lost return from using savings to
  make the purchase?

24
Control Your Use of Debt

• Calculate the debt limit ratio
• Debt limit ratio monthly nonmortgage debt /
  monthly take-home pay
• Apply the debt resolution rule
• Control your consumer debt

25
Warning Signs of Debt Problems

• Emotional problems
• The use of money to punish
• The Expectation of instant comfort
• Keeping up with the Joneses
• Expensive indulgence of children
• Misunderstand or lack of communications
• The amount of the finance charge

26
Bankruptcy The Last Resort

• Chapter 7
• Grants debtor a chance to make a fresh start
• Chapter 13
• Sets up a controlled repayment schedule