GB 31303

TUTORIAL SOLUTION
CHAPTER 5 CONSUMER CREDIT

PROBLEMS (p. 179-180)

1. A few years ago, Simon Powell purchased a home for $110,000. Today, the home is
worth $150,000. His remaining mortgage balance is $50,000. Assuming that Simon can
borrow up to 80 percent of the market value, what is the maximum amount he can
borrow? (LO5.2)
Present market value of Simon’s home = $150,000. Simon can borrow up to
80 percent of the market value, or $120,000. Simon still owes $50,000
mortgage on his home. Therefore, he can borrow an additional $70,000
($120,000 - $50,000).

2. Louise McIntyre’s monthly gross income is $2,000. Her employer withholds $400 in
federal, state, and local income taxes and $160 in Social Security taxes per month.
Louise contributes $80 per month for her IRA. Her monthly credit payments for VISA
and MasterCard are $35 and $30, respectively. Her monthly payment on an automobile
loan is $285. What is Louise’s debt payments-to-income ratio? Is Louise living within her
means? (LO5.3)
Louise’s Gross = $2,000
Income
Less: Income taxes = -400

Less: Social Security = -160

Tax
Less: IRA = -80
contribution
Net take-home pay = $1,360

Her monthly payments on VISA, MasterCard, and a car loan add up to $350
per month. Louise’s debt payments to income ratio is 350 to 1,360, or 25.73
percent. This ratio exceeds the recommended 20 percent figure. Therefore,
Louise is overextended. Her maximum monthly loan and credit card payments
should not be over $272 (20 percent of $1,360).

3. Robert Sampson owns a $140,000 townhouse and still has an unpaid mortgage of
$110,000. In addition to his mortgage, he has the following liabilities:
Visa $565
MasterCard 480
Discover card 395
Education loan 920
Personal bank loan 800
Auto loan 4,250

Total $7,410

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Robert’s net worth (not including his home) is about $21,000. This equity is in mutual
funds, an automobile, a coin collection, furniture, and other personal property. What is
Robert’s debt-to-equity ratio? Has he reached the upper limit of debt obligations?
Explain. (LO5.3)
Robert’s total debt (not including mortgage) is $7,410. His net worth (not
including his home) is $21,000. Therefore, his debt-to-equity ratio is $7,410
divided by $21,000, or 0.35. Since this ratio is less than 1, Robert has not
reached the upper limit of debt obligations.

4. Madeline Rollins is trying to decide whether she can afford a loan she needs in order to
go to chiropractic school. Right now Madeline is living at home and works in a shoe
store, earning a gross income of $820 per month. Her employer deducts a total of $145
for taxes from her monthly pay. Madeline also pays $95 on several credit card debts
each month. The loan she needs for physical therapy school will cost an additional $120
per month. Help Madeline make her decision by calculating her debt payments-to-
income ratio with and without the college loan. (Remember the 20 percent rule.) (LO5.3)
Madeline’s debt payments-to-income ratio with the college loan is 31.85
percent; without the college loan it is 14.07 percent. According to the 20
percent rule, she cannot afford the college loan. However, after Madeline pays
off her credit card debts, her debt payments-to-income ratio with the college
loan will be 17.8 percent. Therefore, once she pays off her credit cards, she
will be able to afford the loan. [ANSWER: $820 - $145 = $675; $95 + $120 =
$215; $215 ÷ $675 = 31.85%; $120 ÷ $675 = 17.8%]

5. Joshua borrowed $500 for one year and paid $50 in interest. The bank charged him a $5
service charge. What is the finance charge on this loan? (LO5.4)
$50 (Interest) + 5 (Service Charge) = $55

6. In problem 5, Joshua borrowed $500 on January 1, 2012, and paid it all back at once
on December 31, 2012. What was the APR? (LO5.4)
$55 (finance charge) ÷ 500 (loan total)= 11% APR

7. In problem 5, if Joshua paid the $500 in 12 equal monthly payments, what is the APR?
(LO5.4)
2 12  55 1320
Y 
500(12  1) 6500
= 20.3%

8. Sidney took a $200 cash advance by using checks linked to her credit card account. The
bank charges a 2 percent cash advance fee on the amount borrowed and offers no
grace period on cash advances. Sidney paid the balance in full when the bill arrived.
What was the cash advance fee? What was the interest for one month at an 18 percent
APR? What was the total amount she paid? What if she had made the purchase with
her credit card and paid off her bill in full promptly? (LO5.4)

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- Sidney’s cash advance fee was $4.00.

- At an 18% APR, she paid $3.00 interest for one month.
- She paid a total of $207.
- If Sydney had made the purchase with her credit card and paid off the
bill in full promptly, she would have paid only $200

The answer is true if the card has a grace period, but if there is no grace
period (and some cards don’t offer one), she would have paid the $3 interest
charge regardless and would have saved only on the cash advance of $4.

9. Brooke lacks cash to pay for a $600 washing machine. She could buy it from the store
on credit by making 12 monthly payments of $52.74 each. The total cost would then be
$632.88. Instead, Brooke decides to deposit $50 a month in the bank until she has
saved enough money to pay cash for the washing machine. One year later, she has
saved $642—$600 in deposits plus interest. When she goes back to the store, she finds
that the washing machine now costs $660. Its price has gone up 10 percent—the
current rate of inflation. Was postponing her purchase a good trade-off for Brooke?
(LO5.4)
No, it was not a good trade-off for Brooke to postpone her purchase. By
waiting one year, she had to pay more to buy the washing machine. Now she
had saved $642, but the price of the washing machine has increased from
$600 to $660. If she had used credit to buy the washing machine a year
before, she would have paid only $632.88.
However, it is possible that not incurring a debt and not being responsible for
monthly payments were more important to Brooke than the money she would
have saved if she had used credit.

10. What are the interest cost and the total amount due on a six-month loan of $1,500 at
13.2 percent simple annual interest? (LO5.4)
Using the simple interest formula: I =P×r×T
= $1,500  0.132  1/2 year
Interest = $99.00
Total amount due = $1,500 + $99 = $1,599.

11. After visiting several automobile dealerships, Richard selects the car he wants. He likes
its $10,000 price, but financing through the dealer is no bargain. He has $2,000 cash for
a down payment, so he needs an $8,000 loan. In shopping at several banks for an
installment loan, he learns that interest on most automobile loans is quoted at add-on
rates. That is, during the life of the loan, interest is paid on the full amount borrowed
even though a portion of the principal has been paid back. Richard borrows $8,000 for a
period of four years at an add-on interest rate of 11 percent. (LO5.4)
a. What is the total interest on Richard’s loan?
b. What is the total cost of the car?
c. What is the monthly payment?
d. What is the annual percentage rate (APR)?

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a. What is the total interest on Richard’s loan?

Cash price = $10,000
Down payment = $2,000
Amount of the loan = $8,000
Length of the loan = 4 years or 48 months
Quoted add-on interest = 11 percent
Total interest: I = P  r = $8,000  0.11  4 =
 $3,520

b. What is the total cost of the car?

Total cost = Down payment + total interest + principal
= $2,000 + $3,520 + $8,000 = $13,520
c. What is the monthly payment?
Monthly payment = $3,520 + $8,000 divided by 48 = $240
d. What is the annual percentage rate (APR)?
APR 2 n  I

P (N  1)
2 12  $3,520

$8,000 (48  1)
84,480
  21.55 percent
392 ,000