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Chapter 7
Using Consumer Loans: The Role
of Planned Borrowing
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Introduction
• Consumer loans—formal contracts detailing how much you’re borrowing and when and how you’re going to pay it back.
• Used for bigger purchases.
• Debt and borrowing can get out of control.
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Consumer Loans—Your 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 Loan—paid back in a single lump-sum payment with interest at maturity.– Bridge or interim loan– short-term loan.
Installment loan—repayment of both principal and interest at various intervals.– Loan amortization—with each payment, the
interest portion covered decreases and principal portion covered increases.
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Second Decision: Secured versus Unsecured Loans
• Secured loan—guaranteed by an asset which typically lowers the rate of the loan.
• Unsecured loan—not guaranteed by an asset or collateral
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Third Decision: Variable-Rate versus Fixed-Rate Loans
Fixed-rate interest rate loan—stays fixed for entire duration of the loan, not tied to market interest rates.
• Variable-rate or adjustable interest rate loan—interest rate varies based on the market interest rate.
• Prime rate—the interest rate that banks charge to their most creditworthy, or “prime” customers
• Convertible loan—variable-rate loan that can be converted to a fixed-rate loan.
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Fourth Decision: The Loan’s Maturity—Shorter 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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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 Loan—low, 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 Loan—loan 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 slow-selling vehicles or older models.
– Repossession if default on loan.
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Cost and Early Payment ofConsumer Loans
• APR—annual percentage rate—simple 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 ofConsumer 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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Payday Loans—A 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 7.4 Illustration of a 12-Month Installment Loan for $5,000 at 14%
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Getting the Best Rate on Your Consumer Loans
• Inexpensive sources—family, home equity loans, cash value life insurance loans.
• More expensive sources—credit unions, S&Ls, and commercial banks.
• Most expensive sources—retail 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.
• Don’t borrow to spend.
• Use cash rather than credit.
• If benefits outweigh costs, borrowing makes sense.
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Controlling Your Use of Debt
• Debt Limit Ratio—percentage of take-home 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 Can’tPay 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 Can’tPay Your Bills
• Borrow inexpensively.
• Use savings to pay off current debt.
• Use a debt consolidation loan.
• Bankruptcy—the last resort• doesn’t wipe out all obligations.
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What To Do If You Can’tPay Your Bills
• Most common types of personal bankruptcy:
• Chapter 13 The wage earner’s plan
• Chapter 7 Straight bankruptcy
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Chapter 13: The Wage Earner’s Plan
• Must have:– Regular income– Secured debts under $1,010,650 (2007)– Unsecured debts under $336,900 (2007)
• For the individual—relief from harassment of bill collectors
• For creditors—controlled repayment with court supervision.
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Chapter 7: Straight Bankruptcy
• Can eliminate debts and begin again.
• “Means test”
• Most debts wiped out—not child support, alimony, student loans, and taxes.
• Trustee collects, sells all nonexempt property.
• Must complete credit counseling course.
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Figure 7.3 The Rise of Student Loan Debt