PART 2: MANAGING YOUR MONEY Chapter 7 Using Consumer Loans: The Role of Planned Borrowing

PART 2:MANAGING YOUR MONEY

Chapter 7Chapter 7

Using Consumer Loans: The Using Consumer Loans: The Role of Planned Borrowing Role of Planned Borrowing

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Single-Payment Versus Single-Payment Versus Installment LoansInstallment Loans

Single-PaymentSingle-Payment Single lump-sum Single lump-sum

payment at payment at maturity.maturity.

Pay back principal Pay back principal and interest.and interest.

Have short Have short maturities – less maturities – less than 1 year.than 1 year.

Used as a bridge or Used as a bridge or interim loan. interim loan.

InstallmentInstallment Repayment of principal Repayment of principal

and interest at various and interest at various intervals.intervals.

With each payment, the With each payment, the interest portion interest portion decreases and principal decreases and principal increases; called loan increases; called loan amortization.amortization.

Used for financing Used for financing cars, and other big-cars, and other big-ticket items.ticket items.

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Secured Versus Secured Versus Unsecured LoansUnsecured Loans

SecuredSecured Guaranteed by a Guaranteed by a

specific asset.specific asset. If loan payments If loan payments

are not covered, are not covered, the asset is seized.the asset is seized.

Collateral reduces Collateral reduces risk, so lower risk, so lower interest rate.interest rate.

UnsecuredUnsecured Requires no Requires no

collateral.collateral. Large loans given Large loans given

only to those with only to those with excellent credit.excellent credit.

Quite expensive, Quite expensive, since lender only since lender only has the borrower’s has the borrower’s promise to pay.promise to pay.

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Variable-Rate Versus Fixed-Variable-Rate Versus Fixed-Rate LoansRate Loans

Variable-RateVariable-Rate Adjustable rate tied to Adjustable rate tied to

market interest rate.market interest rate. Based on prime rate or Based on prime rate or

6 month T-bill.6 month T-bill. Borrower pays prime Borrower pays prime

plus additional plus additional percent.percent.

Adjust monthly or Adjust monthly or annually, has rate annually, has rate caps.caps.

Borrower risks rate Borrower risks rate increase.increase.

Fixed-RateFixed-Rate Isn’t tied to changing Isn’t tied to changing

market interest rates.market interest rates. Maintains a single rate Maintains a single rate

for duration of loan.for duration of loan. Most consumer loans Most consumer loans

are fixed.are fixed. May cost more than May cost more than

variable rate.variable rate. Lender risks rate Lender risks rate

increase.increase.

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The Loan ContractThe Loan Contract Security agreementSecurity agreement states if purchased states if purchased

item will be used as collateral.item will be used as collateral.

NoteNote states payment schedule and states payment schedule and rights of borrower and lender if default.rights of borrower and lender if default.

A note is standard on all loans, and a A note is standard on all loans, and a security agreement is standard on security agreement is standard on secured loans. secured loans.

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The Loan ContractThe Loan ContractInsurance Agreement Insurance Agreement

ClauseClause Must purchase Must purchase

insurance to pay off insurance to pay off loan if death.loan if death.

Acceleration ClauseAcceleration Clause If one payment is If one payment is

missed, entire loan is missed, entire loan is due immediately.due immediately.

Deficiency Payments Deficiency Payments ClauseClause

If default on secured If default on secured loan, lender reposes loan, lender reposes item and borrower is item and borrower is billed for difference if billed for difference if necessary.necessary.

Recourse ClauseRecourse Clause Define lenders actions if Define lenders actions if

default (attach wages).default (attach wages).

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Special Types of Special Types of Consumer LoansConsumer Loans

Home Equity Loans – secured loan Home Equity Loans – secured loan using equity in home as collateral.using equity in home as collateral.

Advantages:Advantages: Interest is tax deductible up to $100,000.Interest is tax deductible up to $100,000. Carry lower interest than other consumer Carry lower interest than other consumer

loans.loans.

Disadvantages:Disadvantages: Puts your home at risk.Puts your home at risk. Limits future financing flexibility. Limits future financing flexibility.

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Student Loans – low, federally subsidized Student Loans – low, federally subsidized interest, based on financial need to those interest, based on financial need to those progressing towards a degree.progressing towards a degree.

Federal Direct/Stafford Loans:Federal Direct/Stafford Loans: Federal government makes direct loan to Federal government makes direct loan to

students through financial aid office.students through financial aid office.

PLUS Direct/PLUS Loans:PLUS Direct/PLUS Loans: Loans are made by private lenders such as Loans are made by private lenders such as

banks and credit unions to parents. banks and credit unions to parents.

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Automobile Loans – loan secured by Automobile Loans – loan secured by auto. auto. Duration usually for 24, 36, or 48 Duration usually for 24, 36, or 48

months.months. Low rates used as marketing tool on Low rates used as marketing tool on

slow selling vehicles.slow selling vehicles. Repossession if default on loan.Repossession if default on loan.

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Cost and Early Payment Cost and Early Payment ofof

Consumer LoansConsumer Loans Truth in Lending Act requires written Truth in Lending Act requires written

notification of total finance charges notification of total finance charges and APR before signing.and APR before signing.

APR is the annual percentage rate APR is the annual percentage rate showing the simple percentage cost showing the simple percentage cost of all finance charges over the life of of all finance charges over the life of the loan, on annual basis.the loan, on annual basis.

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Cost and Early Payment Cost and Early Payment ofof

Consumer LoansConsumer Loans Finance charges include all costs Finance charges include all costs associated with the loan:associated with the loan: Interest paymentsInterest payments Loan processing feesLoan processing fees Credit check feesCredit check fees Insurance feesInsurance fees

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Payday LoansPayday Loans

Payday loans:Payday loans: Given by check cashing companies.Given by check cashing companies. Aimed at those who need money until Aimed at those who need money until

their next “payday.”their next “payday.” Cost comes in form of a fee - $20-$30 for Cost comes in form of a fee - $20-$30 for

a 1- or 2-week loan.a 1- or 2-week loan. Banned in some states.Banned in some states.

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Cost of Single-Payment Cost of Single-Payment LoansLoans

Two ways loans are made:Two ways loans are made: Simple Interest Method:Simple Interest Method:

Interest = principal x interest rate x Interest = principal x interest rate x time.time.

Stated interest and APR are the same.Stated interest and APR are the same. Discount Method:Discount Method:

Entire interest charge is subtracted Entire interest charge is subtracted from loan principal before receiving the from loan principal before receiving the money.money.

Pay entire principal amount at maturity.Pay entire principal amount at maturity. Stated interest and APR will differ.Stated interest and APR will differ.

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Cost of Installment Cost of Installment LoansLoans

Repayment of both interest and Repayment of both interest and principal occurs at regular intervals.principal occurs at regular intervals.

Payment levels are set so loan Payment levels are set so loan expires at a preset date. expires at a preset date.

Use either simple interest or add-on Use either simple interest or add-on method to determine what payment method to determine what payment will be.will be.

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Early PaymentEarly Payment

If installment loan is repaid early, If installment loan is repaid early, determine amount of principal still determine amount of principal still owed.owed.

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Relationship of Payment, Relationship of Payment, Interest Rate, and Term Interest Rate, and Term

of the Loanof the Loan How does the duration of loan and How does the duration of loan and interest rate affect size of payments?interest rate affect size of payments? As interest rates rise, so do the monthly As interest rates rise, so do the monthly

payments and finance charges.payments and finance charges. Increasing the maturity will lower the Increasing the maturity will lower the

monthly payments, but result in higher monthly payments, but result in higher total finance charges.total finance charges.

Lenders charge a lower interest rate on Lenders charge a lower interest rate on shorter-term loans.shorter-term loans.

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Sources of Consumer Sources of Consumer LoansLoans

Inexpensive sources:Inexpensive sources: The least expensive source of funds is The least expensive source of funds is

your family.your family. Home equity loans and other secured Home equity loans and other secured

loans are inexpensive.loans are inexpensive. Insurance companies that lend the cash Insurance companies that lend the cash

value of life insurance policies also offer value of life insurance policies also offer low rates.low rates.

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Sources of Consumer Sources of Consumer LoansLoans

More Expensive Sources:More Expensive Sources: Credit unions, S&L’s, and commercial Credit unions, S&L’s, and commercial

banks.banks. Exact cost depends on type of loan Exact cost depends on type of loan

(secured or unsecured), length of loan, (secured or unsecured), length of loan, and fixed or variable rate loan. and fixed or variable rate loan.

Most Expensive Sources:Most Expensive Sources: Retail stores, finance companies, or Retail stores, finance companies, or

small loan companies.small loan companies.

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How and When to BorrowHow and When to Borrow

How do you get a favorable rate?How do you get a favorable rate? Have a strong credit rating.Have a strong credit rating. Loan must be relatively risk-free.Loan must be relatively risk-free.

Use variable rate loan.Use variable rate loan. Keep loan short-term.Keep loan short-term. Provide collateral.Provide collateral. Apply large down payment.Apply large down payment.

Debt affects future financial flexibility.Debt affects future financial flexibility.

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How and When to BorrowHow and When to Borrow When you borrow to invest:When you borrow to invest:

Hope to receive an income stream that Hope to receive an income stream that offsets the cost of borrowed funds.offsets the cost of borrowed funds.

Borrow with the goal of building wealth.Borrow with the goal of building wealth. Earnings > cost of borrowed funds.Earnings > cost of borrowed funds.

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Controlling Your Use of Controlling Your Use of DebtDebt

Determine how much debt you can Determine how much debt you can comfortably handle. comfortably handle. This changes during different stages of This changes during different stages of

life.life. Earlier years, debt builds up.Earlier years, debt builds up. Later years, income rises and debt declines.Later years, income rises and debt declines.

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Debt Limit Ratio measures the Debt Limit Ratio measures the percentage of take-home pay percentage of take-home pay committed to non-mortgage debt.committed to non-mortgage debt. Total debt can be divided into consumer Total debt can be divided into consumer

debt and mortgage debt.debt and mortgage debt. Ratio should be below 15%.Ratio should be below 15%.

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28/36 Rule28/36 Rule A good credit risk when mortgage A good credit risk when mortgage

payments are below 28% of gross payments are below 28% of gross monthly income, and total debt monthly income, and total debt payments are below 36%.payments are below 36%.

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Debt Resolution RuleDebt Resolution Rule

Debt resolution rule helps control Debt resolution rule helps control debt obligation, excluding borrowing debt obligation, excluding borrowing for education and home financing, for education and home financing, by forcing you to repay all by forcing you to repay all outstanding debt obligations every 4 outstanding debt obligations every 4 years. years.

Logic is that consumer credit should Logic is that consumer credit should be short-term. be short-term.

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What To Do If You Can’tWhat To Do If You Can’tPay Your BillsPay Your Bills

Go to creditors to get help resolving your Go to creditors to get help resolving your situation or see a credit counselor.situation or see a credit counselor.

Consider using savings to pay off debt. Consider using savings to pay off debt. Use a debt consolidation loan to lower Use a debt consolidation loan to lower

monthly payment and restructure debt.monthly payment and restructure debt. Final alternative is personal bankruptcy.Final alternative is personal bankruptcy.

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What To Do If You Can’tWhat To Do If You Can’tPay Your BillsPay Your Bills

Personal bankruptcy doesn’t wipe out all Personal bankruptcy doesn’t wipe out all obligations.obligations.

Chapter 13Chapter 13 The wage earner plan The wage earner plan Chapter 7 Chapter 7 Straight bankruptcyStraight bankruptcy Chapter 11 Chapter 11 For businesses or those For businesses or those

exceeding debt exceeding debt limitations or lack regular income.limitations or lack regular income.

Chapter 12 Chapter 12 Available to family farmers.Available to family farmers.

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Chapter 13: The Wage Chapter 13: The Wage Earner PlanEarner Plan

To file for Chapter 13, you must have:To file for Chapter 13, you must have: Regular incomeRegular income Secured debts under $922,975Secured debts under $922,975 Unsecured debts under $307,675Unsecured debts under $307,675

Repayment schedule is designed to Repayment schedule is designed to cover your normal expenses while cover your normal expenses while meeting repayment obligations. meeting repayment obligations.

For creditors, it means controlled For creditors, it means controlled repayment with court supervision.repayment with court supervision.

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Chapter 7: Straight Chapter 7: Straight BankruptcyBankruptcy

Allows individuals who don’t have Allows individuals who don’t have any chance of repaying debts to any chance of repaying debts to eliminate them and begin again. eliminate them and begin again.

While you will not lose everything, While you will not lose everything, courts confiscate and sell most courts confiscate and sell most assets to pay off debts.assets to pay off debts.

Some debts remain including child Some debts remain including child support, alimony, student loans, and support, alimony, student loans, and taxes.taxes.

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Chapter 7: Straight Chapter 7: Straight BankruptcyBankruptcy

To qualify, you must pass a “means To qualify, you must pass a “means test” and cannot file Chapter 7 test” and cannot file Chapter 7 bankruptcy if:bankruptcy if: Income is higher than median in your Income is higher than median in your

state.state. Have more than $100 in monthly Have more than $100 in monthly

disposable income.disposable income. Have sufficient disposable income to Have sufficient disposable income to

repay at least 25% of your debt over 5 repay at least 25% of your debt over 5 years. years.

Documents

PART 2: MANAGING YOUR MONEY Chapter 7 Using Consumer Loans: The Role of Planned Borrowing