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Lecture 6

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Lecture 6

I. Using consumer loans

- Formal, negotiated contracts
- Specify- terms for borrowing- repayment schedule
- One-time transaction
- Normally used to pay for big-ticket items

- Auto
- Durable goods
- Student loans
- Personal loans
- Consolidation loans

- Traditional financial institutions
- Commercial banks
- Credit Unions
- Savings and Loan Associations

- Consumer finance companies
- Specialize in high-risk borrowers
- Together with banks and credit unions make ~75% of consumer loans.

- Sales finance companies
- Third party financing
- Include captive finance companies, such as GMAC

- Life insurance companies
- Loan against cash value of certain types of policies

- Friends and relatives

- Shop carefully before borrowing
- Compare loan features
- Finance charges and loan maturity
- Total cost of transaction
- Collateral requirements
- Other features, such as prepayment penalties

- 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

- Is repaid in full with a single payment on a given due date
- Specified time period,usually less than 1 year.
- Payment includes principal and interest.
- May require collateral.

- Simple Interest Method
- calculated on the outstanding balance

- Discount Method- not widely used anymore- interest calculated on the principal- then subtracted from loan amount; remainder goes to borrower- finance charges are paid in advance

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.)

Interest = Principal x Rate x Time

= $1000 x .12 x 2

Finance Charges = $240

Annual Percentage Rate =

average annual finance charge

average loan balance outstanding

APR = ($240 2) $1000

= $120 $1000

= .12 =

12%

- Repaid in a series of equal payments.
- Each payment is part principal and part interest.
- Maturities range from 6 months to 7–10 years or longer.
- Usually require collateral.

- Simple Interest Method
- calculated on the outstanding (declining) balance

- Add-On Method
- finance charges calculated on original loan balance and
- then added to principal
- costly form of consumer credit!

Example:

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

- Interest is figured on the outstanding loan balance each period.
- Each payment causes principal to decrease.
- Each subsequent payment, then, will incur a lower finance charge, so
- More of the next payment will go towards repaying the principal.

- This is the method used when computing with financial calculator.
- With simple interest method Stated Rate = APR
- In this example,APR = 12% and rate per period = 12% 12 = 1% per month.

Mo.Beg. Bal.PMT Int. PrincipalEnd. Bal.

1$1,000.00$88.85$10.00 $78.85$921.15

2$ 921.15$88.85 $ 9.21 $79.64$841.51

3$ 841.51$88.85 $ 8.42 $80.43$761.08

4$ 761.08$88.85 $ 7.61 $81.24$679.84

5$ 679.84$88.85 $ 6.80 $82.05$597.79

6$ 597.79$88.85 $ 5.98 $82.87$514.92

7$ 514.92$88.85 $ 5.15 $83.70$431.22

8$ 431.22$88.85 $ 4.31 $84.54$346.68

9$ 346.68$88.85 $ 3.47 $85.38$261.30

10$ 261.30$88.85 $ 2.61 $86.24$175.06

11$ 175.06$88.85 $ 1.75 $87.10$ 87.96

12$ 87.96$88.85 $ 0.89 $87.96$ 0

Total amount paid over the 12-month period:

$88.85 x 12= $1,066.20

Loan amount= – 1,000.00

Interest paid= $ 66.20

- Finance charges are calculated on the original loan amount:
$1000 x .12 x 1 = $120

- Add these charges to principal:
$120 + $1000 = $1,120

- Divide this amount by the number of periods to arrive at payment:
$1,120 12 = $93.33

Total amount paid over the 12-month period:

$93.33 x 12= $1,120.00

Loan amount= – 1,000.00

Interest paid= $ 120.00

- Carefully examine Installment Purchase Contract—it contains the terms of the loan.
- Finance charges must include not only interest but also any other required charges.
- Total charges, not just interest, must be used to calculate APR.

- Acceleration clause
- Garnishment of wages
- Repossession of collateral
- Balloon payment
- Prepayment penalties
- Credit life insurance requirements (avoid if possible and get term insurance instead)