Using Consumer Loans

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Using Consumer Loans

#7

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning GoalsKnow 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 takeout a loan

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Using Consumer Loans

Formal, negotiated contracts

One-time transaction - usually for big-ticket items

No more credit is available once repaid

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Different Types of Loans

Auto loans

Other durable goods loans

Education loans

Personal loans

Consolidation loans

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Student Loans

Federally sponsored loans:

Stafford Loans (Direct & Federal Family Education Loans—FEEL)

Perkins Loans

Parent Loans (PLUS)

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Exhibit 7.1 Federal Government Student Loans

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Consumer Loans

Single Payment • Specified period• Lump sum

payment due

Installment• Fixed, scheduled

payments

Fixed• Interest rate and

payments remain the same

Variable Interest Rate

• Interest rate and payments change periodically

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Where Can You Get Consumer Loans?

Commercial Banks

Consumer Finance Companies

Credit Unions

Savings and Loan Associations

Sales Finance Companies

Life Insurance Companies

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Managing Your Credit

Compare loan features• Finance charges • Loan maturity • Total cost of transaction• Collateral • Other considerations such as

payment date, prepayment penalties, late fees

Shop carefully before borrowing!

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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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Single-Payment Loans

Loan collateralLienChattel mortgageCollateral note

Loan maturity Loan repayment

Prepayment penaltyLoan rollover

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Finance Charges and the APR

Discount Method - Interest (calculated on principal) is subtracted from loan amount and remainder goes to borrower– Finance charges paid in advance– APR will be higher than stated interest rate

Simple Interest Method – Calculated on outstanding balance

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FS = P x r x tWhere

FS = finance charge using simple interest methodP = principal loan amountr = stated annual interest ratet = term of loan

Simple Interest Method

Example- Calculate finance charges and APR on a $1000 loan for 2 years at 8% interest rate (Assume interest is the only finance charge)

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Using the Simple Interest Method

Interest = Principal x Rate x Time = $1000 x .08 x 2Finance Charge = $160

• Receive full loan amount ($1000) but pay back $1600 (loan amount + finance charge)

• Most consumer friendly method

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Annual Percentage Rate =

Average annual finance charge Average loan balance outstanding

Simple Interest Method

APR = ($160 2) $1000 = 8%

APR is same as stated rate

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Discount Method

Interest = Principal x Rate x Time= $1000 x .08 x 2

Finance Charges = $160

Calculate same as simple interest method but subtract finance charges from loan amount ($1000 – $160)

Borrower receives $840 now, pays back $1000

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Annual Percentage Rate =

Average annual finance chargeAverage loan balance outstanding

Discount Method

APR = ($160 2) = $80 ($1000 – $160) = $840

= 9.52%

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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

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Calculating Finance Charges on Installment Loans

Simple Interest Method

• Calculated on outstanding (declining) balance each period

Add-On Method• Finance charges

calculated on original loan balance added to principal

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ExampleCalculate the finance charges and APR on a $1000 loan to be repaid in 12 monthly installments at an annual interest rate of 8% (Assume interest is the only finance charge)

Calculating Finance Charges on Installment Loans

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Calculator(Set on 12 P/YR and

END mode) 1000 +/- PV

8 I/YR

12 N PM = $86.99

Use Exhibit 7.4 (Table calculated using $1000 loan)

Find payment for 12 months at 8% interest:

$86.99

Calculating Finance Charges on Installment Loans

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Simple Interest Method

Simple interest calculated on outstanding loan balance each period

Each payment decreases outstanding loan balance

Subsequent payments incur a lower finance charge -- More of next payment goes towards repaying principal

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$86.99 x 12 = $1,043.88Loan amount = – 1,000.00

Interest paid = $ 43.88

Total amount paid over 12 months

Simple Interest Method

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Add-On Method

• Calculate finance charges on the original loan amount

$1000 x .08 x 1 = $80• Add these charges to principal

$80 + $1000 = $1,080• Divide this amount by the number of periods

to arrive at payment$1,080 12 = $90.00

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Add-On Method

• Use financial calculator to figure APR for the Add-On Method using payment just determined and solve for interest

Set on 12 P/YR and END mode:

1000 +/- PV90.00 PMT12 N

I/YR 14.45%

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Other Loan Considerations

Prepayment penalties

Rule of 78s = sum-of- the-digits method

Buy on time or pay cash?

May be better to pay cash — If you have it

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Comparative Finance Charges and APRs ($1000, 8%, 12 mo)