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Chapter 7

Student and Consumer Loans:

The Role of Planned

Borrowing

© 2016 Pearson Education, Inc. All rights reserved. 7-2

Learning Objectives

1. Understand the various consumer loans.

2. Calculate the cost of a consumer loan.

3. Pick an appropriate source for your loan.

4. Control your debt.

5. Understand the alternatives for financing your college education.


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

1. Single-payment versus installment2. Secured versus unsecured3. Variable-rate versus fixed rate4. Shorter- versus longer-term


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

• Insurance agreement clause

• 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.


Special Types of Consumer Loans

• Automobile loans—secured loan specifically for purchasing an automobile

• Usually 24, 36, or 48 months

• Can extend to 5 or 6 years

• Low risk to lender because of collateral


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 of Single-Payment Loans

• Loan disclosure statement gives APR and finance charges of a loan– States interest calculation

• Simple interest method:

• Discount method:– Interest is subtracted from loan amount received


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%


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.


Early Payment of an Add-on Loan

• If installment loan is repaid early, determine amount of principal still owed.

• Most common method for add-on loan is Rule of 78 or sum of the year’s digits.

• Rule of 78 determines what proportion of each payment goes towards principal.

• Prepayment penalty


Getting the Best Rate on Your Consumer Loans

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

• More expensive sources—credit unions, savings and loans, 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

• Determine how much debt you can comfortably handle.

• Debt level comfort and need changes at different stages of the financial life cycle.

• With age, debt proportion of income tends to decline.

• Use several measures to control debt commitments.


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’t Pay 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 Plan

• Must have:– Regular income– Secured debts under $1,149,525 (2014)– Unsecured debts under $383,175 (2014)

• For the individual—relief from harassment of bill collectors; retain possession of assets

• 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.


Student Loans and Paying for College

• Understand the consequences of your choice of school and major

• Understand the full costs of school and what you can do to borrow less and borrow smarter

• Manage your money well while on campus• Repay your loans without sacrificing your

financial goals


So Many Choices—Schools and Majors

• Research what your expected salary will be so you do not take on too much debt

• Understand the positive and negative aspects of your school and major choices


Borrowing Less and Borrowing Smarter

• Compare financial aid packages and college costs

• Apply for federal financial aid first

• Look for state and local grants and scholarships

• Use tax credits and deductions to your advantage


Paying for Your College Education

• 529 plan• Prepaid tuition plans• College savings plans• Coverdell Education Savings Account (ESA)


Federal Student Loans

• Department of Education is your lender• Interest is fixed over the life of the loan

– Federal Perkins Loan Program– Direct Subsidized Loans– Direct Unsubsidized Loans– Direct PLUS Loans – Direct Consolidation Loans


Private Loans

• Provides you with funds after you have exhausted all federal financial aid

• Offered by commercial banks and credit unions

• Interest rate varies• Rates are usually higher than federal

student loan rates• Generally do not offer deferment or

forbearance options


Manage Your Money Responsibly

• Choose a bank that charges low fees

• Use direct deposit


Repaying Your Loans

• Repayment Plans– Standard– Extended– Income-Based– Graduated

• Deferment– Enrolled at least half-time, unemployed, or meet hardship

standards you can postpone payments for up to 3 years– No interest is accrued on subsidized loans

• Forbearance– Delay payments due to illness, financial hardship, or

residency requirement– Interest accrues


Summary

• Consumer loans can be single-payment loans, installment loans, secured loans, or unsecured loans.

• Loan costs are finance charges which include interest payments, processing fees, credit check fees, and insurance fees.


Summary

• There are numerous sources of loans, but the key to getting favorable rate is a strong credit rating and reducing lender’s risk.

• Control debt by borrowing when debt fits within your financial plan and budget, and know your debt limits using the debt limit ratio and debt resolution rule.


Summary

• Understand the role your school and major play in student loan debt.

• Use tax-advantaged accounts like 529 plans and Coverdell Educational Savings Accounts to save for college.

• Use federal student loans as your first borrowing alternative.

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