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The Wise Use of Debt

Learning Objectives

Upon reading this chapter, students should:
*   Be able to compare types of consumer loans and lenders
*   Recognize and assess the characteristics of different types of loans
*   Know how to manage your debts wisely
*   Understand how to establish a plan for managing your consumer credit and reducing outstanding

Chapter Summary

This chapter teaches the student about consumer loans and their characteristics. Consumer loans vary
in the interest rates charged, payment arrangements, and collateral required. Interest rates can either
be fixed or variable. On a fixed rate loan, the interest rate applies throughout the life of the loan. On a
variable rate loan, the interest rate changes periodically. The prime rate, the rate banks charge to their
most preferred customers, is commonly used as a base rate for variable-rate loans. Most loans are
installment loans which require the borrower to repay over time. In the event of default, loan
agreements contain an acceleration clause, which makes the entire balance payable when the borrower
falls behind in payments. In addition, some lenders include a prepayment penalty, which is a fee
charged for early repayment. A secured loan gives the lender the right to take certain aspects of
property in the event the loan is not repaid. The pledged property, is also known as collateral. If real
property is used to secure a loan, a lien is placed on the property and recorded at a county clerk’s
office to put the public on notice of the lien.

The first type of consumer loan is a home equity loan. Home equity is the difference between the
market value of your home and the remaining balance on your mortgage loan. A home equity loan
allows someone to borrow against a valuable asset, their home. They are often established as a line of
credit and can be used for any purpose. An important feature of home equity loans is that the interest
is tax deductible up to $100,000. The second type of consumer loan is an automobile loan. An auto
loan is made specifically for the purpose of buying an auto. Due to the relatively short economic life
of a car, most loan maturities are between two and six years. The third type of consumer loan is a
student loan.

A student loan is made for the purposes of paying for educational expenses. The interest rates charged
on student loans tend to be more favorable than other rates and in some cases are subsidized by the
federal government. Eligibility for a student loan is based on; (1) must be a U.S. citizen with a high
school diploma or its equivalent; (2) be taking courses to fulfill requirements for a degree or
certificate; (3) make satisfactory progress toward the completion of the degree; (4) certify that you are
not in default on any other federal student loan. There are different types of student loans:

    1. A subsidized loan is awarded on the basis of need and does not require the payment of
       interest or repayment of principal until six months after graduation. To qualify for this loan, a
       student most demonstrate financial need by completing a Free Application for Student Aid
    2. An unsubsidized loan accrues interest from the time they are awarded, although it is
       sometimes possible to defer payment until after graduation.

Most financial institutions offer one or more types of consumer loans. Depository institutions are able
to offer low rates because they pay low rates to their depositors, from whom they obtain the funds to
provide borrowers. Under some circumstances, individuals are unable to secure loans from a
depository institution and will turn to a consumer finance company. A consumer finance company
obtains funds from their investors and through short term borrowing. The advantages of consumer
finance companies include access and speed. A sales finance company also makes consumer loans to
buyers of products offered through its parent company, as do large department stores, like Sears.

For many consumers, controlling the use of consumer credit is the most difficult aspect of their
financial plan. Most consumer debt is used to finance assets that decline in value over time. A wise
consumer will only; (1) borrow money for items they can afford to repay, (2) pay their credit card
balance in full each billing cycle, and (3) keep track of monthly expenses to keep your net monthly
cash flow on target, (4) limit themselves to a small number of credit cards, (5) avoid consumer credit
cards that charge high annual fees, (6) avoid high interest loans.

Consumer credit expert, Greg Pahl, in his book The Unofficial Guide to Beating Debt, lists a series of
questions. If an individual answers “yes” to many or most of the following questions, you definitely
have a problem with credit. Some of the questions are as follows:

    1.   Are your spending increasing amounts of your income to pay your bills?
    2.   Are you making only minimum payments on your bills?
    3.   Are you paying off one loan with another one?
    4.   Do you worry a lot about money?

Individuals in these situations need to develop a plan to get out of debt. Debt reduction is the ideal
outcome but is not always possible depending on cash flow. Some suggestions for getting out of debt

    1. Obtain a debt consolidation loan at a lower rate of interest. This will allow you to consolidate
       your payments and pay a lower rate of interest.
    2. Take a second job specifically earmarked to pay down the debt. Although working two jobs
       may not sound like fun, it’s often the fastest way to reduce your outstanding credit card debt.
    3. Develop a zero-based budget. Zero based budgeting is a strategy planners often recommend.
    4. Live with your parents or other family members to cut down your expenses.
    5. Sell assets. You may need to sell valuables to minimize your debt. However, be sure to get
       the best value for your property.
     If an individual is unable to use any of the alternative strategies for reducing debt, the following is
a list of steps an individual should take. The following are some responsible options:

    1. Contact your creditors directly and try to work out some type of payment plan.
    2. Use a consumer credit counseling service to assist you.
    3. Some people are so deep in debt they must file for bankruptcy. Bankruptcy is the legal right
       to ask a court of law to relieve you of certain debts and obligations. If a court grants
       bankruptcy, your creditors will divide up your assets in a fair and equitable process overseen
       by the court. The implementation of the new bankruptcy laws have made it more difficult for
       people to file for bankruptcy.

Bankruptcies take several forms. The first form is Chapter 7 bankruptcy. A Chapter 7 bankruptcy
requires the liquidation, or sale, of most of the debtor’s assets. Under current law, the debtor is
allowed to keep a small amount of home equity, Social Security and unemployment insurance
payments. A Chapter 13 bankruptcy is a method of protecting a debtor from creditors’ claims while
that person develops and implements a plan to repay his or her debts. The plan, which is approved by
the court, normally allows the debtor to keep his or her assets and repay their outstanding debts.

Key Terms

Acceleration clause                 A loan term that requires immediate repayment of the total amount
                                    due on an installment loan that is in default.
Bankruptcy                          The legal right to ask a court of law for relief of certain debts and
Collateral                          Valuable assets or real property that can be taken by a lender in the
                                    event of loan default.
Consumer finance company            A nondepository institution that makes loans to risky consumers.
Default                             Failure to meet the terms of a loan agreement, such as when
                                    payments are not made in a timely fashion.
Fixed-rate loan                     A loan for which the rate of interest remains the same throughout
                                    the term of the loan.
Home equity                         The market value of a home minus the remaining mortgage balance.
Installment loan                    A loan that requires repayment in equal periodic installments that
                                    include both interest and principal.
Lien                                Public notice of a right to real property.
Prepayment penalty                  A fee charged to a borrower when he or she pays a loan balance
                                    before the end of the loan term. Not all loans are subject to
                                    prepayment penalties.
Prime rate                          The interest rate that banks charge on loans to their most favored
                                    business customers.
Principal                           The original amount borrowed or invested.
Real property                       Land and anything attached to it, such as a home or commercial
Sales finance company            A nondepository institution that makes consumer loans to buyers of
                                 products offered through its parent company.
Secured loan                     A loan that includes a pledge of collateral.
Single-payment loan              A loan that requires the repayment of interest and principal in a
                                 single payment at a specified date in the future.
Subsidized loans                 Student loans awarded on the basis of need that do not require the
                                 payment of interest or repayment of principal until six months after
Unsubsidized loans               Student loans that accrue interest from the time they are awarded,
                                 although it is sometimes possible to defer the repayment until after
Variable-rate loan               A loan for which the rate of interest varies periodically with a
                                 changing market rate, such as the prime rate.

Lecture Notes

   1. With consumer loans, students sometimes have difficulty in realizing that actions taken today
      will have an impact on future loans. Stress for students that they should develop a repayment
      plan before taking a loan. Review with students the three types of consumer loans in class
      and use examples of current interest rates on each of the loans. Have students compare loan
      payments of varying amounts and ask students to identify which loan is more desirable.
      Students may identify with a lower monthly payment amount, however, this exercise will
      allow students to see that term and interest rates are the most important part of a loan.
   2. Everyday consumers are bombarded in stores, online and in the mail with offers to open a line
      of credit. Have students analyze a number of different credit cards and the rates that are
      charged. Ask students to compare a bank card and a retail card. What is the rate of interest
      on these cards? Is there an acceleration clause? Have students look at the prime rate over the
      past six months. What implications does a change in the prime rate have for consumes on
   3. A home equity line of credit allows a homeowner to borrow against a valuable asset. Have
      students review current variable rates on home equity lines of credit. Ask students to review
      the actions taken by the Federal Reserve in relation to a home equity line of credit. Does an
      increase in rates, also translate into a rate increase on a variable rate loan? In addition, real
      property is used as collateral. If a borrower defaults on their line of credit, what impact does
      that have on their asset?
   4. Students may not intuitively understand the process of and the differences in the type of
      bankruptcy a debtor may file for. Have students compare the difference between Chapter 7
      and Chapter 13 bankruptcy. How long does this information remain on someone’s credit
      report? Have students compare the advantages and disadvantages of each.

Suggestions for Learning Activities

   1. Have students prepare a chart comparing the four major student loan programs. Ask students
      to highlight the purpose of each program, its advantages and disadvantages. These charts
      could be presented in class and used to stimulate a class discussion over types of interest rates
     and the future liabilities students incur in taking loans. For example, what are the
     implications of an unsubsidized vs. a subsidized loan for a student pursuing an education.
  2. Divide the students into groups of two. Have the students individually answer the first ten
     questions on the signs of credit trouble list. Ask the students to tally the number of questions
     to which they answered yes. After ten minutes, have the students compare the number of yes
     answers with their partner. Ask the pair to develop a couple of strategies to assist one another
     in reducing debt. If the students have not answered yes to a number of questions, have the
     students develop of list of suggestions for someone facing credit problems.
  3. Ask students to write a 1-2 page paper detailing the pros and cons of a home equity line of
     credit. The essay should be written after reading the following article available at,
  4. Ask the class to conduct research on a reputable credit counseling service. Have the students
     find at least one service. After finding the service, ask the students to interview the company.
     For example, what is their success rate, what fees do they charge? Have the students write a
     one page essay on the service and the role it provides to consumers. An oral report could also
     be made to the class.

Suggestions for Additional Resources

  4.   For articles on consumer loans, The Wall Street Journal
  5.   Money Magazine
  6.   Kiplingers

Answers to Self-check Questions
 1. Define collateral, variable rate loan, and lien.
    Collateral: Valuable assets or real property that can be taken by the lender in the event of a
     loan default.
    Variable-rate loan: Loan for which the rate of interest varies periodically with a changing
     market rate, such as the prime rate.
    Lien: Public notice of a right to real property.
 2. What types of loan payment arrangements are available? Single-payment or installment

 1. Define home equity. The difference between the market value of your home and the
    remaining balance on your mortgage loan
 2. List 3 types of consumer loans. Home equity, auto loans and student loans.
 3. Name 2 types of student loans. Stafford loans, PLUS loans and Perkins loans.
 1. List two types of companies that finance higher risk customers. Consumer and sales finance
 2. Name two advantages of nonbank loans. Access and speed.

 1. List eight signs that you may be in consumer credit trouble.
     You are at or over the limit on your credit account
     You make only minimum payments on your bills
     You pay your bills with money that was supposed to go for something else
     You use credit card debt to pay for normal living expenses
     You use dip into your savings to pay your bills
     You pay off one loan with another one
     You have had a credit card cancelled due to poor payment history
     You get letters or phone calls from creditors regarding overdue payments

  2. What are some guidelines for using credit appropriately?
       Don’t borrow money to pay for items you can’t afford to buy with cash, unless you
        have a specific plan for repaying the debt.
       If possible, pay your credit card balance in full by the due date in order to avoid
        finance charges.
       Keep track of monthly expenditures to ensure that your net monthly cash flow is on
       Limit yourself to a small number of credit cards.
       Avoid high-interest consumer credit.
       Avoid consumer credit with annual fees.
       Don’t use consumer credit to pay for regular expenditures unless you’re doing so in
        order to take advantage of free frequent flier miles and discounts and you plan to pay
        the balance in full each month.

 3. Name five debt reduction strategies recommended by financial counselors for people in
    trouble. Consolidate your debt at a lower rate, take a second job, develop a zero-based
    budget, live with family, sell assets.

 1. Cite the first two steps you should take if you can’t pay your debts. Immediately contact
    your creditors, obtain professional credit counseling.
 2. What are the two types of personal bankruptcy? Chapter 7 and Chapter 13.

Answers to Summary Questions

 1. When real property is used as collateral to secure a loan, the lender records a _______ against
    the property.
      a. deed
      b. judgment
      c. lien
      d. mortgage
 2.   Fixed-rate loans usually carry lower initial interest rates than do variable-rate loans. True or
 3.   Which of the following statements is true concerning home equity loans?
      a. Home equity loan proceeds are generally restricted as to purpose.
      b. Home equity loans are generally installment loans with a 1-10 year term.
      c. Home equity loan interest is tax-deductible up to a maximum of $100,000.
      d. All of the above are true
 4.   Which of the following is not a requirement to be eligible for a federal student loan?
      a. Comply with Selective Service registration
      b. Be enrolled in a federally accredited college
      c. Be taking courses to fulfill degree or certificate requirements
      d. Be a U.S citizen with a high-school diploma or equivalent
 5.   Ford Motor Credit, which finances Ford autos for customers, is an example of a:
      a. consumer finance company
      b. sales finance company
      c. retail finance company
      d. wholesale finance company
 6.   Borrowers who might not qualify for loans at commercial banks are often able to obtain loans
      at consumer finance companies. True or false?
 7.   Which of the following is not one of the recommended solutions if you are having trouble
      making payments on your consumer credit?
      a. take a second job
      b. live with your parents or other family members
      c. transfer balances to another credit card
      d. sell some assets to raise money to pay back the debt
 8.   It is recommended that borrowers take the shortest loan they can afford to take when obtaining
      debt consolidation loans. True or false?
 9.   Which type of bankruptcy requires the liquidation of most of your assets?
      a. Chapter 5
      b. Chapter 7
      c. Chapter 11
      d. Chapter 13
10.   Which type of bankruptcy implements a payment plan for the debtor and generally allows the
      debtor to keep all of his or her assets?
      a. Chapter 5
      b. Chapter 7
      c. Chapter 11
      d. Chapter 13
Answers to “Applying this Chapter” Questions

 1. You’re considering an unsecured loan at 7 percent interest from your local home improvement
    store for the purchase of new kitchen cabinets. Alternatively, you could take out a home
    equity loan at a rate of 8.5 percent. Assume that your marginal tax rate is 25 percent. What are
    the advantages and disadvantages of these different courses of action?
    The home equity loan is tax-deductible, while the store loan is not. You must consider the
    after-tax cost when comparing them. If you itemize deductions, the after-tax cost on the
    home equity loan is 8.5 percent X (1-.25) = 6.38 percent. You’ll probably pay that back
    over a longer period, reducing your monthly payments but increasing total interest paid.
    The disadvantage of the home equity loan is that it ties up home equity you may need in
    the future.

 2. Al and Janet Fernandez have two alternatives for financing their son Joel’s college costs—an
    unsubsidized student loan with a variable rate that is currently at 6 percent or a fixed-rate
    home equity loan at 7 percent. Assume that both loans will have 10-year terms for repayment.
    What factors should they consider in deciding between these two alternatives?

   Unsubsidized Student Loan Now 6%, Variable
    Accrues interest from date of award
    Repayment deferred until six months after graduation
    Helps student liquidity while in college
    Tax deductible interest starting with loan repayment
    Possibility of rising rates in the future?
    Owed by student

   Home Equity Loan, Fixed at 7%
    Payments start now
    Tax deductible interest starting now
    Possibility of falling rates in the future?
    Reduces parents current liquidity
    Increases parents debt ratio
    Owed by parents

 3. Use Figure 6-2 to estimate the monthly payments necessary to reduce the debt to zero by the
    end of the time specified, assuming simple interest. For a $1,000 debt, 15 percent interest, 2
    years $48.49
 4. Use Figure 6-2 to estimate the payments for a $5,000 debt, at 15 percent interest, 5 years.
 5. Why is it insufficient to simply make the minimum monthly payments required by your
    lender? ? Because the minimum payment will be primarily the interest owed on your
    monthly balance and will not include much toward paying down the principal. It will
    take a very long time to pay off the loan that way and that assumes that you do not
    continue to borrow more on your card.
 6. After his online gambling debts had gotten out of control, Trevor went to an agency that
    advertises it will help people get out of debt. He has $15,000 in credit card debt and is unable
    to make his minimum payments. The agency agrees to help Trevor take out another loan at 13
    percent interest, for a $200 fee. Because he’s now paying rates of 18 percent, this sounds like
     a good deal. Explain the pros and cons of Trevor’s decision. Trevor may receive a lower
     rate of interest, but an agency that charges fees, when non-profit counseling is available,
     is probably not a good place to go. He shouldn’t have to pay a $200 fee for advice. He
     may be able to obtain better loan terms, as well. However, the annual interest savings the
     first year will be 5% of $15,000 or $750.

Answers to “You Try It!” Questions
A Home Equity Loan to Consolidate Debt
Jasmine currently has three credit cards with outstanding balances that total $15,000. Her minimum
monthly payments on these cards total $350. Her home is currently worth $120,000 and she has a
mortgage of $80,000. How much can she borrow on her home if the lender allows a maximum 80
percent loan-to-value? How much will the monthly payment be on a home equity loan at 6 percent
interest-only. If Jasmine decides to take a home equity loan, explain why she should make larger
payments, paying both interest and principal.

Jasmine’s home equity is $120,000 - $80,000 = $40,000. With an 80 percent loan to value
requirement, the maximum total debt on her property is $120,000 x .8 = $96,000. Assuming
that she can qualify, she could get a home equity line of credit for $16,000. At interest only, she
will have to pay 6%/12 =0.5% per month. The interest payment will be .005 x $16,000 = $80
per month. She should make large payments so that she can gradually pay back the loan. As
she pays it back, the interest payment will be lower as well.

The Effects of Debt on Your Financial Plan
Suppose you’re currently saving $300 per month, in an account earning 5 percent interest, so that you
can attend graduate school six years from now. You decide to buy a car and take out a six-year loan
with payments of $150 per month. This decision means that you will have to reduce your monthly
graduate-school savings contributions by $150 a month. At the end of the six years, how much money
would you have been able to save (not counting the interest you would have made on the money had
you deposited it in the account)?
Instead of saving $300 per month, you are only saving $150,
for a net reduction of $150. After 6 years, you will have
contributed $150 x 72 = $10,800 as compared to $21,600 if you
had not bought the car. In addition, you have lost all the
compound interest on those contributions. However, at the
end of the car loan, you will presumably own a car that is
worth something, so your net loss is somewhat lower.

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