Personal Loans and Credit Cards © Dr. B. C. Paul 2002 revisions 2008 Note – The subject covered in these slides is considered to be “common knowledge”

Personal Loans and Personal Loans and Credit CardsCredit Cards© Dr. B. C. Paul 2002 revisions 2008© Dr. B. C. Paul 2002 revisions 2008

Note – The subject covered in these slides is considered to be “common Note – The subject covered in these slides is considered to be “common knowledge” to those familiar with the subject and books or articles knowledge” to those familiar with the subject and books or articles covering the concepts are widespread. covering the concepts are widespread.

Herby’s Personal Loan Herby’s Personal Loan ChoiceChoice

$5,000 in initial repairs$5,000 in initial repairs The Old Rational Bank Loan OptionThe Old Rational Bank Loan Option

$200 loan application fee$200 loan application fee 10% compounded monthly10% compounded monthly 5 year amortization5 year amortization

Convert a present loan amount into an Convert a present loan amount into an annuity of payments in the futureannuity of payments in the future A/P * Present Loan Amount A/P * Present Loan Amount checkcheck

A Bank Loan for HerbyA Bank Loan for Herby

A/PA/P n = 60 = 5 years * 12 months per yearn = 60 = 5 years * 12 months per year i = 10% per year/ 12 months per year = i = 10% per year/ 12 months per year =

0.008330.00833 A/PA/P0,00833, 60 0,00833, 60 = 0.021247= 0.021247

Monthly cost for initial repairsMonthly cost for initial repairs 0.021247 * $5000 = $106.240.021247 * $5000 = $106.24

Also an initial fee of $200Also an initial fee of $200

If Herby Picks the Bank If Herby Picks the Bank LoanLoan

Herby’s $5,000 repair money

Herby’s$200 loanInitiationfee

Herby’s $106.24 per month for the next 5 years

Herby Also had a Simple Herby Also had a Simple Interest Loan Option with Interest Loan Option with Sleezy MoneySleezy Money

The Sleezy Money loan has no up front The Sleezy Money loan has no up front $200 loan initiation fee$200 loan initiation fee

The Sleezy Money loan has an interest The Sleezy Money loan has an interest rate of 9% instead of 10%rate of 9% instead of 10%

What a Deal! Who needs the Banker?!!What a Deal! Who needs the Banker?!! Just One QuestionJust One Question What the Heck is a Simple Interest Loan?What the Heck is a Simple Interest Loan?

Simple Interest or Simply Simple Interest or Simply

_ _ _ _ _ _ __ _ _ _ _ _ _ Is a special type of Loan known as a Is a special type of Loan known as a

Simple Interest or Add Interest LoanSimple Interest or Add Interest Loan Main Places FoundMain Places Found

Sleezy Finance Houses (such as Herby’s Sleezy Finance Houses (such as Herby’s Sleezy Money Finance Company)Sleezy Money Finance Company)

Auto LoansAuto Loans Most that come from Car DealersMost that come from Car Dealers A lot of Car Loans from BanksA lot of Car Loans from Banks

Calculating Simple Calculating Simple InterestInterest

Interest Rate is Reported on an annual Interest Rate is Reported on an annual basisbasis

There is no compounding or interest There is no compounding or interest charged on interestcharged on interest You still need to get the period interest rate You still need to get the period interest rate

by dividing by number of payments per yearby dividing by number of payments per year If Sleezy money charges 9% with monthly If Sleezy money charges 9% with monthly

payments for 5 yearspayments for 5 years Period Interest Rate is 9/12 = 0.75%Period Interest Rate is 9/12 = 0.75% Still need to convert to decimal for calculation 0.0075Still need to convert to decimal for calculation 0.0075

The TrickThe Trick

Interest is charged as one lump sumInterest is charged as one lump sum Loan Amount * Period Interest Rate * Loan Amount * Period Interest Rate *

Number of payments = InterestNumber of payments = Interest For Herby 5000 * 0.0075 * 60 = $2,250For Herby 5000 * 0.0075 * 60 = $2,250

The Interest is then added to loan The Interest is then added to loan immediatelyimmediately Ie Herby’s loan is for $5,000 + $2,250 = Ie Herby’s loan is for $5,000 + $2,250 =

$7,250$7,250 (Can see why they are called Add Interest (Can see why they are called Add Interest

Loans)Loans)

Calculating PaymentsCalculating Payments

Loan amount with interest added is just Loan amount with interest added is just divided by number of paymentsdivided by number of payments For Herby $7,250 / 60 = $120.83For Herby $7,250 / 60 = $120.83

Whats Wrong with That?Whats Wrong with That?

Notice that you paid full interest rate on Notice that you paid full interest rate on all the money that you borrowed even all the money that you borrowed even after you have paid the money offafter you have paid the money off

If Herby tries to pay a simple interest loan If Herby tries to pay a simple interest loan off the next month he’ll still pay $7,250 or off the next month he’ll still pay $7,250 or full interest for 5 yearsfull interest for 5 years

The ImpactThe ImpactHerby's Interest Rate

0

100

200

300

400

500

600

1 7 13 19 25 31 37 43 49 55

Month

% A

nn

ual

In

tere

st

Series1

Herby’s interest rateStarts at 9% butClimbs over time toOver 450%

Herby’s regularBank loan costs$1,458 in interest

Herby’s SimpleInterest Loan willCost $2,250(half again asMuch)

The DeceptionThe Deception

Auto Dealers and Some Finance Houses Auto Dealers and Some Finance Houses quote attractive interest ratesquote attractive interest rates Only in the fine print is simple interest Only in the fine print is simple interest

discloseddisclosed Herby’s 9% Simple interest loan is Herby’s 9% Simple interest loan is

equivalent of 13.5% of a regular equivalent of 13.5% of a regular compound interest loancompound interest loan Allows organizations to quote far lower rates Allows organizations to quote far lower rates

than competition than competition

Herby’s Credit CardHerby’s Credit Card

Credit cards usually do not charge a fixed Credit cards usually do not charge a fixed monthly payment monthly payment (except for some minimum (except for some minimum usually around $15 to $25)usually around $15 to $25) Instead they charge a fixed percentage of Instead they charge a fixed percentage of

the outstanding balancethe outstanding balance will produce a declining monthly payment like a will produce a declining monthly payment like a

reverse geometric gradient going downreverse geometric gradient going down We have no super hero for thatWe have no super hero for that We do have a spreadsheetWe do have a spreadsheet

We Will Use the Interest We Will Use the Interest Rate Comparison Rate Comparison SpreadsheetSpreadsheet

Begins with calculatingPeriod interest rate(ie annual rate divided byThe # of compoundingPeriods per year).

Credit Card(with single cycle average daily balance)(minimum a % of principal + interest)

13 Interest Rate365 Number of Compounding Periods/Year

0.000356 Period Interest Rate12 Number of Payments/Year

0.01089 Payment Interest Rate19.41667 Years for Loan Payoff

5000 Loan Amount

0 Percent Transaction Fee Rolled Into Loan 0 Transaction Fee0 Minimum Fee

none Maximum Fee (enter none if no maximum)

1 % of balance required20 Monthly Minimum Payment

104.4514 Maximum Payment Amount 9.697733 Final Payment Amount4805.44 Interest Paid

0 Fees Paid

Calculates A Payment Calculates A Payment Interest RateInterest Rate

This is really an approximation.Average Daily balanceCharges each transaction fromThe time it occurs.This spreadsheet wasDesigned to compare differentWays to borrow a lump sum.

(1+daily int)^(365/12)Same way you found actualAnnual interest on a Credit Cd.

Credit Card(with single cycle average daily balance)(minimum a % of principal + interest)




5000 Loan Amount





0 Fees Paid

Enter Loan Amount

And Payment Calculation Terms

Shows the Transaction Shows the Transaction FeesFeesCredit Card(with single cycle average daily balance)(minimum a % of principal + interest)




5000 Loan Amount





0 Fees Paid

We assume we have noneAnd that they just charge theSupplies with a credit cardAt Home Peephole.

Working Up CostsWorking Up Costs

Period Debt Interest Payment Principal1 5000 62.87926 112.8793 50 02 4950 62.25046 111.7505 49.5 03 4900.5 61.62796 110.633 49.005 04 4851.495 61.01168 109.5266 48.51495 05 4802.98 60.40156 108.4314 48.0298 06 4754.95 59.79755 107.3471 47.5495 07 4707.401 59.19957 106.2736 47.07401 08 4660.327 58.60758 105.2108 46.60327 09 4613.723 58.0215 104.1587 46.13723 0

10 4567.586 57.44129 103.1171 45.67586 011 4521.91 56.86687 102.086 45.2191 012 4476.691 56.2982 101.0651 44.76691 0

Principal is 1% ofdebtInterest is the debt X monthly yield

Payment is the sum ofPrinciple + interest

(Note I assume there is never a late or over-limit fee)

Spreadsheet Calculates Spreadsheet Calculates Some Interesting StatisticsSome Interesting Statistics

Note that the credit card will take nearly 19.5 years to pay off (provided no bodyCharges anything new for 19.5 years)

There will be $4,800 in interest charges and they will pay almost $2 forEvery dollar they spend. (Bankers will almost get more money than theStore and all the materials suppliers combined).

19.41667 Years for Loan Payoff5000 Loan Amount

0 Percent Transaction Fee Rolled Into Loan0 Minimum Fee




The Game AfootThe Game Afoot

Why are credit cards so hard to pay-offWhy are credit cards so hard to pay-off The minimum payments are generally set to The minimum payments are generally set to

be competitive with signature loans at banksbe competitive with signature loans at banks But the modest payment hides a high interest But the modest payment hides a high interest

rate and results in slow payment of the debtrate and results in slow payment of the debt

The Declining Payment - Why?The Declining Payment - Why? Official Answer - to better service the Official Answer - to better service the

customer by minimizing demands made upon customer by minimizing demands made upon himhim

Its A TRAPIts A TRAP

By directing a high percentage of your By directing a high percentage of your payments to interest and then slowly payments to interest and then slowly declining those payments - credit card debt declining those payments - credit card debt takes a long time to pay-offtakes a long time to pay-off

The Credit Card Company’s bet you a life The Credit Card Company’s bet you a life time of debt that if you ever get a good credit time of debt that if you ever get a good credit card debt - you won’t be able to avoid using card debt - you won’t be able to avoid using your card again for 20 years - You'll your card again for 20 years - You'll recharge the debt.recharge the debt.

Other Credit Card GamesOther Credit Card Games

Credit Cards have “Cash Advance Fees”Credit Cards have “Cash Advance Fees” Credit Card Checks or getting cash from an ATM is Credit Card Checks or getting cash from an ATM is

considered a “Cash Advance”considered a “Cash Advance” Cash advances are usually 3% to 5% of the amount Cash advances are usually 3% to 5% of the amount

advanced (or a minimum fee of $10 or $25)advanced (or a minimum fee of $10 or $25) some cards do have a maximum fee alsosome cards do have a maximum fee also

If Herby gets a cash advance on his credit card If Herby gets a cash advance on his credit card he will payhe will pay $5,000 * 0.03 = $150$5,000 * 0.03 = $150

so much for getting out of that loan initiation feeso much for getting out of that loan initiation fee

More GamesMore Games

If Herby Charges supplies at Smowe’s or If Herby Charges supplies at Smowe’s or Home Peephole he does not pay a cash Home Peephole he does not pay a cash advance fee.advance fee. But the credit card company charges a But the credit card company charges a

fraction of a percent to the merchant (hidden fraction of a percent to the merchant (hidden in higher prices)in higher prices) Reason some gas stations have a higher price Reason some gas stations have a higher price

for credit cards than cashfor credit cards than cash Reason that not every store takes credit cardsReason that not every store takes credit cards

Cash Advance vs. Cash Advance vs. PurchasePurchase

In addition to cash advance fee credit cards charge a In addition to cash advance fee credit cards charge a higher interest rate for cash advances than higher interest rate for cash advances than purchasespurchases purchases are often 7.9% to 23%purchases are often 7.9% to 23% cash advances are typically 12.9 to 32%cash advances are typically 12.9 to 32%

If you get a cash advance on your credit card - all If you get a cash advance on your credit card - all your payments will go to cover purchases your payments will go to cover purchases (lower rate)(lower rate) until the low rate stuff is paid off until the low rate stuff is paid off (never if you fall in the (never if you fall in the declining payment trap)declining payment trap) About the only way to get a cash advance off your back is About the only way to get a cash advance off your back is

to pay-off the entire card.to pay-off the entire card.

The Promotional OfferThe Promotional Offer

Many credit cards offer promotional Many credit cards offer promotional interest ratesinterest rates They last around 3 to 12 months depending They last around 3 to 12 months depending

on the card - on the card - And then they jump to a higher And then they jump to a higher interest rateinterest rate The idea is to get you to run up a balance that The idea is to get you to run up a balance that

you won’t be able to dig out ofyou won’t be able to dig out of

Often they will charge a cash advance Often they will charge a cash advance fee with a promotional interest rate checkfee with a promotional interest rate check

The Grace PeriodThe Grace Period

Most cards offer a grace periodMost cards offer a grace period If you pay-off your balance in full each month there is no If you pay-off your balance in full each month there is no

interest BUTinterest BUT

Many credit cards are shortening grace period from Many credit cards are shortening grace period from 25 days to 2025 days to 20 They wait about a week to 10 days after your “statement date” to send They wait about a week to 10 days after your “statement date” to send

the billthe bill Takes about 3 or 4 days in the mailTakes about 3 or 4 days in the mail They warn you in fine print that it may take 3 to 5 days to credit your They warn you in fine print that it may take 3 to 5 days to credit your

paymentpayment Takes you about 3 or 4 days to get payment to their officeTakes you about 3 or 4 days to get payment to their office Result - Result - you may have only a day or two to have the money in your you may have only a day or two to have the money in your

checking account ready to pay them.checking account ready to pay them.

Bankers GraceBankers Grace

If your payment doesn’t make it on timeIf your payment doesn’t make it on time ( (I I wonder how much hustle they put into processing your payment if wonder how much hustle they put into processing your payment if its close - I wonder how you’d prove it)its close - I wonder how you’d prove it)

Credit Cards Charge a late fee (usually $35 Credit Cards Charge a late fee (usually $35 or now a graduated scale) in addition to or now a graduated scale) in addition to interestinterest

If they can catch you several times, most will If they can catch you several times, most will raise the interest rate that they charge on raise the interest rate that they charge on your account (after all you’re a bad credit your account (after all you’re a bad credit risk because you don’t pay on time)risk because you don’t pay on time) They will revoke any special rates you haveThey will revoke any special rates you have

Dynamic Interest RatesDynamic Interest Rates

Universal DefaultUniversal Default If they find you are ever late on payments to anyone If they find you are ever late on payments to anyone

they can raise your interest ratethey can raise your interest rate The Stealth AlternativeThe Stealth Alternative

If you are ever late to them or an affiliate or if they If you are ever late to them or an affiliate or if they periodically re-evaluate your credit worthiness periodically re-evaluate your credit worthiness based on secret factors they can raise your ratebased on secret factors they can raise your rate

Most cards have floating interest rates – it is an Most cards have floating interest rates – it is an index value plus a spreadindex value plus a spread You take all the market risk.You take all the market risk.

Billing Cycle TricksBilling Cycle Tricks

Some credit cards change the way they calculate Some credit cards change the way they calculate the “average daily balance”the “average daily balance” They do the average daily balance as a two cycle They do the average daily balance as a two cycle

average (ie the average over two months instead of average (ie the average over two months instead of each billing cycle)each billing cycle)

ResultsResults If you try to take a promotional offer and then pay off the balance If you try to take a promotional offer and then pay off the balance

before the rate goes up - they get to zap you even after the balance before the rate goes up - they get to zap you even after the balance is paid.is paid.

They can continue to charge you interest on purchases after they They can continue to charge you interest on purchases after they are paid offare paid off

You have to keep your credit card paid off for many months straight You have to keep your credit card paid off for many months straight to stop monthly interest charges.to stop monthly interest charges.

Now We Have Looked at Now We Have Looked at Bank Loans, Simple Interest Bank Loans, Simple Interest Loans, and Credit CardsLoans, and Credit Cards

Now you get the opportunity to make a comparison of your own

Assignment #8

Help Fred and Fanny Furniture Decide whether to buy $4,000 worthOf furniture using a Personal Loan from a Bank, a Simple InterestLoan, or a Credit Card.

Documents

Personal Loans and Credit Cards © Dr. B. C. Paul 2002 revisions 2008 Note – The subject covered in these slides is considered to be “common knowledge”