6 USING CONSUMER LOANS 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 balances 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 (FAFSA). 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 are: 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 obligations. 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 building. 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 graduation. Unsubsidized loans Student loans that accrue interest from the time they are awarded, although it is sometimes possible to defer the repayment until after graduation. 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 loans? 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, http://money.cnn.com/2005/08/18/real_estate/helocs_0509/index.htm 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 1. http://www.ftc.gov/bcp/conline/edcams/credit/coninfo_reports.htm 2. www.salliemae.com 3. http://www.nelliemae.org/ 4. For articles on consumer loans, The Wall Street Journal 5. Money Magazine 6. Kiplingers 7. http://www.moneyinstructor.com/creditcards.asp Answers to Self-check Questions 6.1 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 arrangements. 6.2 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. 6.3 1. List two types of companies that finance higher risk customers. Consumer and sales finance companies 2. Name two advantages of nonbank loans. Access and speed. 6.4 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 target. 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. 6.5 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 false? 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. $118.95 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.