© 2013 pearson education, inc. all rights reserved.7-1 chapter 7 using consumer loans: the role of...

© 2013 Pearson Education, Inc. All rights reserved. 7-1

Chapter 7

Using Consumer Loans: The Role

of Planned Borrowing


Introduction

• Consumer loans—formal contracts detailing how much you’re borrowing and when and how you’re going to pay it back.

• Used for bigger purchases.

• Debt and borrowing can get out of control.


Consumer Loans—Your Choices

• Single-payment loans

• Variable-rate installment loans

• Unsecured fix-rate loans

• Secured loans


First Decision: Single-Payment versus Installment Loans

• Single-Payment or Balloon Loan—paid back in a single lump-sum payment with interest at maturity.– Bridge or interim loan– short-term loan.

Installment loan—repayment of both principal and interest at various intervals.– Loan amortization—with each payment, the

interest portion covered decreases and principal portion covered increases.


Second Decision: Secured versus Unsecured Loans

• Secured loan—guaranteed by an asset which typically lowers the rate of the loan.

• Unsecured loan—not guaranteed by an asset or collateral


Third Decision: Variable-Rate versus Fixed-Rate Loans

Fixed-rate interest rate loan—stays fixed for entire duration of the loan, not tied to market interest rates.

• Variable-rate or adjustable interest rate loan—interest rate varies based on the market interest rate.

• Prime rate—the interest rate that banks charge to their most creditworthy, or “prime” customers

• Convertible loan—variable-rate loan that can be converted to a fixed-rate loan.


Fourth Decision: The Loan’s Maturity—Shorter versus Longer Term Loans

• Shorter term loan means lower interest rate and larger monthly payments

• Longer term loan means smaller monthly payments and higher interest rate


Understand the Terms of the Loan: The Loan Contract

• Security agreement

• Note

• Default

• Acceleration clause

• Deficiency payments clause

• Recourse clause


Special Types of Consumer Loans

• Home Equity Loan or Second Mortgage—secured loan using equity in home as collateral.

• Advantages:•Interest is tax deductible•Lower interest than other consumer loans.

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



• Student Loan—low, federally subsidized interest, based on financial need

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

students through financial aid office.

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

banks and credit unions to parents.


Figure 7.2 Percent of Students at a 4-Year College Who Borrow



• Automobile Loan—loan secured by auto. – Duration usually for 24, 36, or 48 months or

even 5 to 6 years.

– Low-cost auto loan rates used to push slow-selling vehicles or older models.

– Repossession if default on loan.


Cost and Early Payment ofConsumer Loans

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

• Truth in Lending Act requires all consumer loan agreements disclose APR in bold print.


Cost and Early Payment ofConsumer Loans

• Cost of single-payment loans:• Loan disclosure statement gives APR and

finance charges of a loan

• Simple interest method: interest = principal x interest rate x time

• Discount method


Payday Loans—A dangerous kind of single-payment loan

• $100 to $500 loan till next payday.

• Post-dated check with fee and principal left with payday lender.

• Due in 1 or 2 weeks.

• Annualized interest rates up to 400%


TABLE 7.2 Payday Loan Facts


Cost of Installment Loans

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

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

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


Table 7.4 Illustration of a 12-Month Installment Loan for $5,000 at 14%


Getting the Best Rate on Your Consumer Loans

• Inexpensive sources—family, home equity loans, cash value life insurance loans.

• More expensive sources—credit unions, S&Ls, and commercial banks.

• Most expensive sources—retail stores, finance companies or small loan companies


Keys to Getting the Best Rate

• Strong credit rating

• Relatively risk-free to lender:– Use variable-rate loan– Short loan term– Collateral– Large down payment


Should You Borrow or Pay Cash?

• Keep in mind that debt is expensive.

• Don’t borrow to spend.

• Use cash rather than credit.

• If benefits outweigh costs, borrowing makes sense.


Controlling Your Use of Debt

• Debt Limit Ratio—percentage of take-home pay committed to non-mortgage debt.

– Total debt can be divided into consumer debt and mortgage debt.

– Ratio should be below 15%.

– ~20% should avoid additional debt.


Debt Resolution Rule

• Control debt obligation, excluding borrowing for education and home financing, by forcing you to repay all outstanding debt obligations every 4 years.

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


Controlling Consumer Debt

• Make sure it fits in with your goals and budget.

• Understand how costly consumer debt is.

• Borrowing limits future financial flexibility.

• Clues you might be in financial trouble.


What To Do If You Can’tPay Your Bills

• Budget so more money comes in.

• Use self-control in the use of credit.

• Go to your creditor.

• Go to a credit counselor.



• Borrow inexpensively.

• Use savings to pay off current debt.

• Use a debt consolidation loan.

• Bankruptcy—the last resort• doesn’t wipe out all obligations.



• Most common types of personal bankruptcy:

• Chapter 13 The wage earner’s plan

• Chapter 7 Straight bankruptcy


Chapter 13: The Wage Earner’s Plan

• Must have:– Regular income– Secured debts under $1,010,650 (2007)– Unsecured debts under $336,900 (2007)

• For the individual—relief from harassment of bill collectors

• For creditors—controlled repayment with court supervision.


Chapter 7: Straight Bankruptcy

• Can eliminate debts and begin again.

• “Means test”

• Most debts wiped out—not child support, alimony, student loans, and taxes.

• Trustee collects, sells all nonexempt property.

• Must complete credit counseling course.


Figure 7.3 The Rise of Student Loan Debt

© 2013 pearson education, inc. all rights reserved.7-1 chapter 7 using consumer loans: the role of...

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