Personal Finance:A Gospel Perspective

Understanding Consumer and Other Loans

Objectives

A. Understand how consumer loans can keep you from your goals

B. Understand the types of consumer loans, their characteristics, and how to calculate the costs

C. Know the least expensive types of loans and how to reduce the cost of consumer loans

Your Personal Financial Plan

Section VII: Student/Consumer Loans and Debt Reduction• Consumer and Student Loans outstanding?

• What are your interest rates, costs, and other fees?

• Current Debt Situation.

• What rates are you paying? Costs, fees, etc.?

• What is your debt reduction strategy?

• What are your views on future debt?

A. Understand how Consumer Loans can Keep you from your Goals?

Consumer loans:• Encourage consumption now, rather than saving for

the future

• Don’t borrow for it, save for it

• Are very expensive, and reduce what you might otherwise have saved for your goals

• Earn interest, don’t pay it

• Are generally unnecessary

• Other than for education and a home (what the prophet has stated), they generally are not necessary!

How Consumer Loans Keep You From Your Goals (continued)

Key questions to ask when you are thinking of borrowing for consumer loans?• 1. Do you really need to make this purchase?

• Is it a need or a want? Separate them!• 2. Can you pay for it without borrowing?

• What is the after-tax cost of borrowing versus the after-tax lost return from using savings? Compare!

• 3. Is it in your budget/financial plan?• Should you save for it instead of borrow for

it? Save!

Key Questions (continued)

4. What is the all-in cost of this loan, including its impact on your other goals?• Can you maintain sufficient liquidity and still

achieve your other goals? Choose wisely!

5. Will this purchase bring you closer or take you farther away from your personal goals?• If it brings you closer to your goals, including your

goal of obedience to the Lord’s commandments, do it. If it takes you farther away, don’t!

Questions

Any questions on how consumer loans keep you from your goals?

B. Understand Consumer LoanTypes, Characteristics, and Costs

Types of Consumer Loans• General consumer loans

• Single payment loans• Installment loans

• Special consumer loans• Auto loans• Home equity loans• Student loans• Payday loans• Mortgage loans

Characteristics of Consumer Loans

Consumer Loan Characteristics• Secured versus Unsecured Loans

• Secured loans are guaranteed by a specific asset, i.e. a home or a car, and typically have lower rates

• Unsecured loans require no collateral, are generally offered to only borrowers with excellent credit histories, and have higher rates of interest – 12% to 28% (and higher) annually

Consumer Loan Characteristics (continued)

Fixed-rate loans• Have the same interest rate for the duration

of the loan. • Normally have a higher initial interest

rate as the lender could lose money if overall interest rates increase

Consumer Loan Characteristics (continued)

Variable-rate loans• Have an interest rate that is tied to a specific index

(e.g., prime rate, 6-month Treasury bill rate) plus some margin or spread, i.e. 9%)

• Can adjust on different intervals such as monthly, semi-annually, or annually, with a lifetime adjustment cap.

• Normally have a lower initial interest rate because the lender won’t lose money if overall interest rates increase

Consumer Loan Characteristics (continued)

Convertible loans• Begin as a variable rate loan and can be locked into

the current rate a some predetermined time in the future at a specific cost

Balloon loans• Loans which payments including interest and

principle are not sufficient to pay off the loan at the end of the loan period, but require a large “balloon” payment at some point in the future. This type of loan is not recommended.

Costs of Consumer Loans

What are the costs of consumer loans?

• Consumer loans are required by Regulation Z of the Truth in Lending Act to state the loan APR in bold on the loan documents

• The APR is the simple interest rate paid over the life of the loan.

• It takes into account all costs, including interest rate, cost of credit reports, and costs of all possible fees

Single Payment Loans

What are single payment (or balloon) loans?• A loan that is repaid in only one payment,

including interest. Characteristics of Single Payment loans

• Short-term lending of one year or less, sometimes called bridge or interim loans, often used until permanent financing can be arranged

• May be secured or unsecured

Single Payment Loans (continued)

Costs of single payment loans• Generally it is simple interest, or interest

rate times the loan amount times the period covered

The simple interest method• Both principal and interest are due at maturity• Interest = principal x interest rate x time• With not costs and fees, APR and simple interest

are the same

Cost of Consumer Loans (continued)

What is the cost of a $1,000 single payment loan for 1 year at an interest rate of 12%. By the way, there is a $20 loan processing fee, $20 credit check fee, and $60 insurance fee. What is your APR for the 1 year loan? What is the APR if this was a 2 year loan with principle paid only at maturity?

• The formula is (interest + fees) / amount borrowed. Your interest is: principle x interest rate x time.

• The APR for the 1 year loan is:

• (120 + 100) / 1,000 = 22.0%

• The APR for the 2 year loan is:

• [(240 + 100) / 2] / 1,000 = 17.0%

Single Payment Loans (continued)

The Discount Method (never borrow using this method of calculating your costs)• Subtracts the entire interest charge from the loan

principal before you receive the loan, so you are paying interest on money you have not received.

• You prepay the interest, so it inflates the rate of interest because the amount received is less than the amount borrowed.

• The APR will be much higher than the discount method rate

Single Payment Loans (continued)

What is the cost of the same $1,000 loan at 12% interest for 2 years using the discount rate method? What is the APR for this loan?• The discount method is: principle x interest rate x

time = interest. Subtract interest from the loan and divide the remainder by the number of payment periods (for more than one period)

• The cost of the loan is:• $1,000 – ($1,000 x 12% x 2) = $760

actually received • The APR is:

• ( 240 / 2 ) / 760 = 15.8%

Installment Loans

What are installment loans?• Installment loans are loans which are repaid at

regular intervals and where payment includes both principal and interest.

Installment Loan characteristics• Normally used to finance houses, cars, appliances,

and other expensive items

• Loans are amortized, which is the process of the payment going more toward principal and less toward interest each subsequent month

• May be secured or unsecured loans, variable-rate or fixed-rate loans

Installment Loans (continued)

Costs of Installment loans• Costs of installment loans are based on a simple-

interest calculation (using your calculator)• Repayment is simply the outstanding balance (each

month the interest portion of the payment decreases and the principal portion increases)

Installment Loans (continued)

What is the cost of the same $1,000 loan at 12% interest for 2 years using the simple interest method and monthly payments?

• The simple interest method for installment loans is simple loan amortization with your calculator:

• PV = -1,000 , I = 12%, P/Y = 12, N = 24, PMT=?

• PMT = $47.074

• Total Interest Paid = 47.074 x 24 – 1,000 = $129.76

• APR = [(interest + fees) / 2] / average amount borrowed (which changes each year as you pay it down)

• ($129.76 / 2) / $540.68 = 12%

Installment Loans (continued)

The add-on method • Never borrow using this method of calculating

your costs

• Adds the total interest payment to the principal of the loan, and is much more costly than the simple-interest method.

• It can double the stated APR rate as you are paying interest on money you have not received

Installment Loans (continued)

What is the cost of the earlier $1,000 installment loan at 12% interest for 2 years using the add on method? What is the APR?

• The add on method is amount borrowed plus Principle x interest rate x time divided by periods

• The cost of the loan is:

• 1,000 + ($1,000 x 12% x 2) = $1, 240 / 24 months = $51.66 payment per month

• The APR is determined using your calculator:

• 51.66 PMT, -1,000 PV, 24 N, I/Y = 21.6%

Home Equity Loans

What are home equity loans• Home equity loans are basically second mortgages

which use the equity in your home to secure your loan. Normally can borrow up to 80% of your equity in your home

Characteristics of home equity loans• Interest payments may be tax-deductible• Lower rates of interest than other consumer loans

Home Equity Loans (continued)

Costs of home equity loans• Home equity loans are generally either single

payment or installment loans. The benefit of these loans is that the interest may be tax deductible, reducing the cost of borrowing

• Keep people from making the hard financial choices to curb their spending

• Sacrifices future financial flexibility• Can put your home at risk if you default

Student Loans

Student Loans• Loans with low, federally subsidized interest rates

used for higher education. Examples include Federal Direct (S) and PLUS Direct (P) available through the school; Stafford (S) and PLUS loans (P) available through lenders.

• Student Loan Characteristics

• Some are tax-advantaged and have lower than market rates.

• Payment on Federal Direct and Stafford loans deferred for 6 months after graduation.

Student Loans (continued)

Costs of Student loans• Student loans are installment loans, with

either fixed or variable rates, and are repaid in installments.

• Reduces future flexibility

Auto Loans

Automobile Loans• Auto loans are consumer loans that are

secured with an automobile.• Auto loan characteristics

• Has a lower interest rate than an unsecured loan or credit card.

• Normally has a maturity length of 2 to 6 years.

• You will often be left with a vehicle that is worth less than what you owe on it

Auto Loans (continued)

Costs of Auto Loans:• You are looking to finance a used car for $9,000 for

three years at 12% interest. What are your monthly payments and how much will you pay in interest?

Answer:

• Set your PV= -9,000, I = 12, N=36, PMT=?

• Your payment is $298.93 per month * 36 months = $10,671.48 – $9,000 borrowed = $1,671.93 in interest or 20% of the value of the car.

Payday Loans

Payday Loans• Short-term loan of 1-2 weeks secured with a post-

dated check which is “held” by the lender and then cashed later

• Have very high interest rates and fees, APR > 450%

• Typical users are those with jobs and checking accounts but who have been unable to manage their finances effectively

How is it calculated?

• Take the APR of the loan in decimal form, divide it by the number of compounding periods, add 1, and take it to the power of the number of periods, and subtract 1.

Payday Loans (continued)

Cost of Payday Loans• Very high interest rates > 500% APR• Used by those who cannot get credit any other

way• Sacrifices future flexibility

Payday Loans (continued)

Jeremy is short on cash for date this weekend. He finds that he can give a post-dated check to a Payday lender who will give him $100 now for a $115 check which the lender can cash in 2 weeks. What is the APR and effective annual interest rate on this loan?

• The APR is the total fees divided by amount borrowed. The effective rate = (1 + APR/periods)periods -1

• APR = ($15 * 26 two-week periods)/$100 = 390%

• The effective annual interest rate is

• (1 +[ 3.90/26 periods])26 periods – 1 = 3,686%

• This is a very expensive loan

Mortgage Loans

Mortgage Loans• Fixed rate loans

• Installment loans with a fixed rate of interest

• Variable rate loans• Installment loans with a rate of interest

that is pegged to a specific index plus a margin that changes periodically

Mortgage Loans (continued)

NegAm or Negative Amortization loans• Loans in which scheduled monthly payments are

insufficient to amortize, or pay off the loan. Interest expense that has been incurred, but not paid is added to the principal amount, which increases the amount of the debt.

Balloon mortgages• Mortgages whose interest and principal payment won’t

result in the loan being paid in full at the end of the term. The final payment, or balloon, is significantly larger. These are often used when the debtor expects to refinance the loan closer to maturity

Mortgage Loans (continued)

Reverse mortgages• Mortgages whose proceeds are made available against

the homeowners equity. These are typically used by cash-poor but home-rich homeowners to need to access the equity in their homes to supplement their monthly income at retirement

Interest only loans• Loans in which payments cover the interest costs only

and do not cover repayment of principle. Often debtors will take out an interest only loan to free up principal to pay down other more expensive debt

Mortgage Loans (continued)

Interest only loans• Benefits

• Lower monthly payments and greater flexibility• Helpful if have better use for money elsewhere• Borrowers can afford more house, and may

move before the payments increase• Negatives

• Major rise in payments when the interest-only period ends

• No amortization of principle—must assume appreciation on the house to make money

• Many do not have the discipline to invest savings from principle elsewhere (they spend it)

Mortgage Loans (continued)

• Interest only loans• What is the monthly mortgage cost of a 6.0% 30

year amortizing loan versus a 7.0% 30 year 10 year interest only home mortgage of $300,000? What is the interest payment beginning in year 11

• The amortizing is PV = -300,000, I = 6.0%, P/Y = 12, n = 360, PMT = ? = $1,798.65

• The interest only payment would be $300,000 * 7.0% / 12 = $1,750.00

• One you pay off in 30 years, the other you never pay off

• After 10 years, your payment is PV = -300,000, I = 7.0%, P/Y = 12, N= 240, PMT = ?

• $2,325.89, a 33% increase

The Consumer Loan Contract

Key clauses for Consumer and Mortgage Loans—none are in your favor!• Note that all clauses are in the lenders favor, and

very few, if any, are in the borrowers favor.

• You are putting your future in someone else’s hands when you borrow!

• You are committing future earnings to today’s consumption!

• Know what your are doing before you do it!!!!!

• Read the documents very carefully and understand them before you sign!!!

The Consumer Loan Contract (continued)

Insurance agreement clause• Requires you to purchase life insurance that will

payoff your loan after your death

• Benefits only the lender, and Increases your total loan cost

Acceleration clause• Requires the entire loan to be paid-in-full if you

miss just one payment

• Normally (but not always) not invoked if you make a good faith effort to pay

The Consumer Loan Contract (continued)

Deficiency payments clause• Requires any amount in excess to be paid if the

collateral's value does not satisfy the loan.

• Borrower must also pay any outstanding charges incurred by the lender associated with the disposal of the collateral

Recourse clause• Defines the lender’s ability to collect any

outstanding balance via wage attachments and garnishments

• Can also include liens on other borrower’s property

C. How to Reduce your Borrowing Costs

Key Relationships on Borrowing:• The total interest cost of your loan is directly

related to the interest rate.

• Keep your interest rate as low as possible

• The total interest cost of your loan is inversely related to the maturity length.

• Keep your loan maturity short

• Your periodic payment is directly related to both the maturity and interest rate

• Keep both short

• Parents are cheaper than banks

Reducing Borrowing Costs (continued)

Least expensive• Borrowing from

parents and family• Home equity loans • Other secured loans

More expensive• Credit unions• Savings and loans• Commercial banks

Most expensive• Retail stores• Finance companies

Isn’t it interesting that those who are in the worst financial situation have to pay the most for credit.

Reducing Borrowing Costs (continued)

1. Don’t get into debt in the first place!• Follow the prophet—rather than your wants!

• Distinguish between true needs and wants

• Remember your goals

• Remember ignorance, carelessness, compulsiveness, pride, and necessity are offset by knowledge, exactness, discipline, humility, and self reliance

• Stick to your budget

• If you need it, plan and save for it

Reducing Borrowing Costs (continued)

2. Compare the after-tax cost of borrowing with the after-tax lost return from using savings• It makes little sense to borrow at a high interest

rate when you have savings earning a lower rate. The formula is:

• After-tax lost return = nominal interest rate * (1 – tax rate)

• Tax rate = Federal + State + Local marginal tax rate

Reducing Borrowing Costs (continued)

3. Maintain a strong credit rating• Increase your FICO score

• Make sure your credit reports have no mistakes

• Pay all your bills on-time

• Keep balances low, particularly on revolving debt

• Keep your oldest accounts, but not too many

• Don’t apply for too many new cards

• Don’t have too many of the same type of cards

Reducing Borrowing Costs (continued)

4. Reduce the lender’s risk• a. Use a variable rate loan• b. Keep the loan term as short as possible• c. Provide collateral for the loan• d. Pay a large down payment on the item to be

purchased with financing

Review of Objectives

A. Do you understand how consumer loans can keep you from your goals?

B. Are you aware of the characteristics of consumer loans and how to calculate costs?

C. Do you know the least expensive types of loans and how to reduce the cost of those loans?