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Lecture 6 I. Using consumer loans I. Basic Features of Consumer Loans Formal, negotiated contracts Specify - terms for borrowing - repayment schedule One-time transaction Normally used to pay for big-ticket items Types of Consumer Loans Auto Durable goods Student loans Personal loans

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Lecture 6

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Lecture 6 l.jpg

Lecture 6

I. Using consumer loans


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I. Basic Features of Consumer Loans

  • Formal, negotiated contracts

  • Specify- terms for borrowing- repayment schedule

  • One-time transaction

  • Normally used to pay for big-ticket items


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Types of Consumer Loans

  • Auto

  • Durable goods

  • Student loans

  • Personal loans

  • Consolidation loans


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Sources of Consumer 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.


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Other sources include:

  • 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


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II. Shopping for Loans

  • Shop carefully before borrowing

  • Compare loan features

    • Finance charges and loan maturity

    • Total cost of transaction

    • Collateral requirements

    • Other features, such as prepayment penalties


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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:

  • 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.


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Calculating Finance Charges on Single-Payment Loans:

  • 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


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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.)


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Using the Simple Interest Method:

Interest = Principal x Rate x Time

= $1000 x .12 x 2

Finance Charges = $240


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Using the Simple Interest Method:

Annual Percentage Rate =

average annual finance charge

average loan balance outstanding

APR = ($240  2)  $1000

= $120  $1000

= .12 =

12%


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Installment Loans:

  • 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.


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Calculating Finance Charges on Installment Loans:

  • 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!


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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.)


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Using the Simple Interest Method:

  • 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.


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Simple Interest Method Continued:

  • 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.


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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


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Total amount paid over the 12-month period:

$88.85 x 12= $1,066.20

Loan amount= – 1,000.00

Interest paid= $ 66.20


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Using the Add-On Method:

  • 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


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Total amount paid over the 12-month period:

$93.33 x 12= $1,120.00

Loan amount= – 1,000.00

Interest paid= $ 120.00


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Comparing the Two Methods:


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More on Loans:

  • 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.


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Other Loan Features to Ask About:

  • Acceleration clause

  • Garnishment of wages

  • Repossession of collateral

  • Balloon payment

  • Prepayment penalties

  • Credit life insurance requirements (avoid if possible and get term insurance instead)


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