Using Consumer Loans

1
Chapter 7

• Using Consumer Loans

2
Types of Loans

• Auto
• Durable goods
• Education
• Personal
• Consolidation

3
Characteristics of Consumer Loans

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

4
Single-Payment Vs. Installment Loans

• Single-payment or balloon loans
• Bridge loans
• Loan repaid in one lump-sum with interest
• Installment loans
• Loan repaid at regular intervals
• Payment includes both principal and interest
• Examples are to finance cars, appliances, other
  expensive items, and school loans

5
Finance Charges 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.

6

• 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.)

7
Using the Simple Interest Method

• Interest Principal x Rate x Time
• 1000 x .12 x 2

Finance Charges 240

• Borrower receives loan amount (1000) now
• Pays back loan amount plus finance charges (1000
  240) at end of time period
• APR same as the stated rate (Single Payment)

8
Using the Simple Interest Method

• APR average annual finance charge
• average loan balance
  outstanding
• APR (240 ? 2)
• 1000
• 120
• 1000
• .12

12
9
Using the Discount Method

• Interest Principal x Rate x Time
• 1000 x .12 x 2

Finance Charges 240

• Finance charges calculated same way
• Then subtracted from loan amount (1,000 240).
• Borrower receives the remainder (760) now and
  pays back the loan amount (1000) at end of time
  period.

10
Using the Discount Method

• APR average annual finance charge
• average loan balance
  outstanding
• APR (240 ? 2)
• 1000 - 240
• 120
• 760
• .158

15.8
11
Comparing the Two Methods
12
Simple Interest Method Monthly

• Interest Principal x Rate x Time
• 1000 x .12 x 2

Finance Charges 240

• Borrower receives loan amount (1000) now
• Pays 1,240/24 51.67/month.
• What should it cost? 47.07/month

13
How Installment Loans Work

• Two Steps
• Determine the amount of each loan payment.
• Determine how much of each payment is interest
  versus principal.

14
Find the Size of the Payment

• Suppose we borrow 10,000 to be repaid in 5
  annual payments with a 10 annual interest rate.
• PV 10,000
• n 5
• i 10
• Compute PMT -- 2,637.97

15
Find Interest and Principal
16
Early Repayment of Installment Loans

• Outstanding balance is the present value of the
  future payments
• After 2 years how much do you owe?
• NOT 2,637.97 x 3 7,913.91
• BUT pmt 2,637.97, n 3, i10 PV6,560.25

17
Secured Versus Unsecured Loans

• Secured loans
• guaranteed by 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

18
Fixed-Rate Versus Variable-Rate Loans

• Fixed rate loans
• same interest rate for entire loan
• higher initial interest rate than variable-rate
• most consumer loans
• Variable rate loans
• interest rate tied to an index
• rate adjusts at intervals
• lifetime adjustment cap

19
The Loan Contract

• Insurance agreement clause
• Repossess collateral
• Acceleration clause
• Prepayment penalties
• Recourse clause

20
Interest Rate and Term Affect Payment

• The total interest cost of your loan is directly
  related to the interest rate and length of loan
• Your payment is inversely related to the length
  of loan and directly related to the interest rate

21
Sources of Loans

• Inexpensive sources of loans
• Family and friends
• home equity loans
• life insurance
• More expensive sources of loans
• credit unions
• savings and loans
• commercial banks
• Lending arms of companies (e.g., GE)

• Most expensive sources of loans
• retail stores
• finance companies
• payday and title firms

22
Title Loans -- Last Resort Borrowing

• Mr. J borrow 1,200 with title of 15K Honda in
  August
• Month later cant make 200 interest payment
• By October he owes 3,800 unpaid interest,
  principal, late fees, and repossession fee

200 interest in small print!
23
Getting the Most Favorable Interest Rate

• 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.

24
Student Loans

• Student loans (e.g., Stafford and Perkins loans)
• Parent loans (e.g., PLUS loans)
• Private student loans
• Consolidation loans

• Loan forgiveness and repayment plans
• Perform volunteer work
• Perform military service
• Teach or practice medicine in certain types of
  communities
• Others
• http//www.finaid.org/loans/forgiveness.phtml

25
Student Loan Debt

• 30 to 40 default rates in 2011
• Look at school cost relative to higher wages
• Highest risk is perennial students and those who
  drop out
• Law school worst payback
• Technical colleges for programmers and nurses
  best payback

http//online.wsj.com/article/SB100014240529702042
24604577030562170562088.html?KEYWORDSbellcurvem
apping
26
Delinquency Rates
New York Fed
27
Questions