Chapter 8

Personal Loans

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What Is Consumer Borrowing?

Obtaining funds from a lender under
specific loan provisions.
Called Consumer Loans.
Made for a specified purpose.
Must be repaid according to a specified
schedule.

Consumer loans are necessary

because few people can pay cash for
big-ticket items.
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Advantages of Consumer Loans

Permits buying expensive items.
Permits you to use the item while
paying for it.
Provides financial flexibility--spread
payments over long period of time.
To cover unexpected expenses and
emergencies.
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Disadvantages of Consumer Loans

You must pay interest on the loan.
Must provide collateral or security for
the loan.
If overused, may be unable to repay
your debts.

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Chapter 8
Personal Loans

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Chapter Objectives
Provide a background on personal
loans
Outline the types of interest rates that
are charged on personal loans
Describe home equity loans
Discuss car loans
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Chapter Objectives
Explain how to decide between
financing the purchase of a car and
leasing a car
Describe the key features of student
loans

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Background on Personal Loans

Usually obtained to finance a large
purchase
Has a specific repayment schedule
Sources of loans
Commercial banks, savings institutions,
finance companies, credit unions, some
automobile manufacturers, friends, or family
members
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Background on Personal Loans

The personal loan process
Application process
Personal balance sheet
Personal cash flow statement

Loan contract: a contract that specifies the

terms of a loan, as agreed to by the borrower
and the lender
Amount of the loan
Interest rate

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Background on Personal Loans

Loan repayment schedule
Amortize: to repay the principal of a loan
through a series of equal payments
Each payment includes part of the principal and
part of the interest

Maturity: the life or duration of the loan

Longer maturity equals lower payments, but
more interest is paid over the life of the loan
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Background on Personal Loans

Collateral: assets of a borrower that back a
secured loan in the event that the borrower
defaults
Secured loan: a loan that is backed or secured by
collateral which could be repossessed if the lender
defaulted on the loan
Unsecured loan: a loan that is not backed
by collateral

Cosigning is sometimes required if credit

history is weak
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Background on Personal Loans

Exhibit 8.1:
An Example of a Loan Application

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Five Cs of Consumer Borrowing

Character - refers to the integrity of
the prospective borrower.
Have you met your previous obligations?

Capital - refers to the net worth

position of the applicant.
Have you sufficient financial assets?

Capacity - refers to the ability of the

borrower to repay borrowed amounts.
Can you meet your future obligations?
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Five Cs of Consumer Borrowing

Collateral - consists of items of value
that may be pledged to secure the loan.
Conditions - refers to general economic
conditions.

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Managing Debt
To determine how much you can borrow,
debt payments should be compared to
disposable income, and the amount
borrowed should be compared to net
worth.

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Amount of Debt
Ratio of debt payment to disposable
income (should not exceed 20%)
measures you ability to make your non-mortgage debt
payments from current disposable income.
Is a flow measure--matches cash inflow with cash
outflows.
A low ratio (<10%) indicates you can borrow more.
Ratios over 20% indicates too much has been
borrowed.

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Amount of debt (continued)

Ratio of debt to net worth.
Excludes mortgage debt and the value of
your home.
stock measure - relates debt to
accumulated net worth.
A ratio of more than 100% indicates no
additional debt should be undertaken.
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Financial Planning Online:

Loan Request Online
Go to: http://www.lendingtree.com
This Web site provides a set of
questions that you can answer to
specify the type of loan that you desire.
You will then receive up to four loan
offers from various financial institutions
within the next business day.
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Background on Personal Loans

Focus on Ethics: Predatory Lending
Beware of illegal lending practices
Lender charging high loan fees
Lender provides home equity loan with the
expectation of default so he can take ownership
Lender ties other products to loan approval
Lender includes balloon payment at end of loan
Loan agreement includes confusing information

Shop around for best loan terms

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Methods of Computing Interest

Simple interest method
single payment loan
installment loan

Discount method
Add-on method

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Simple Interest Method

Single payment loan
interest is charged on amount owed.
interest is charged only once.

Installment loan
interest is calculated on outstanding balance.
installment payments are equal.
amount applied to principal increases with
each payment.
amount applied to interest decreases with
each payment.

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Discount Method
Finance charges are calculated based
upon the loan principal, and then
deducted from the principal, with the
borrower receiving the net amount.
3000 x 10% = 300 interest
3000 - 300 = 2700 amount received

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Add-on Method
Finance charges are calculated based on
the loan principal, then the finance
charges are added back to the
principal. Loan payments are based
upon the sum of these 2 values.
3000 + 300 -:- 12 = 275
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Interest Rates on Personal Loans

Annual percentage rate (APR): a rate
that measures the finance expenses
(including interest and other expenses)
on a loan on an annualized basis
Add-on interest method: a method of
determining the monthly payment on a
loan
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Interest on Personal Loans

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Interest Rates on Personal Loans

Simple interest: interest on a loan
computed as a percentage of the existing
loan amount (or principal)
Size of payment depends on size of loan,
interest rate and maturity
The higher the interest rate, the higher the
payment
The longer the maturity, the lower the payment
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Interest Rates on Personal Loans

Exhibit 8.3: Example of a Loan Repayment Schedule

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Home Equity Loan

Home equity loan: a loan where the equity in
a home serves as collateral for the loan
Equity of a home: the market value of a home
minus the debt owed on the home
Credit limit on a home equity loan
Limit based on equity invested
Financial institutions usually loan up to 80% of the
equity in a home
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Home Equity Loan

Interest rate is typically variable
Rate is usually tied to an interest rate index
and adjusted periodically
Interest on most home equity loans is tax
deductible

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Financial Planning Online:

Applying for a Home Equity Loan
Go to: http://www.bloomberg.com
Click on: Mortgage Calculator, then
Online Home Equity
This Web site provides access to home
equity loan applications.

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Car Loans
Selecting the car things to consider
Personal preferences
Price
Insurance
Resale value
Repair expenses
Financing rate
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Car Loans
Negotiating the price
Negotiating by phone may be beneficial
Trade-in tactics can be misleading
No-haggle dealers can save time and stress
Information is valuable shop around
Purchasing a car online is possible, but not
yet a streamlined process
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Car Loans
Financing decisions
Estimate dollar amount of monthly payment
you can afford before shopping

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Financial Planning Online:

Prices of New Cars
Go to: http://autos.yahoo.com/
Click on: New Car Guide under New
Cars heading
This Web site provides estimates of
what you should pay for any new car,
based on the cars features and options
that you specify.
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Car Loans

Exhibit 8.4: Stephanie Spratts Car Analysis

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Car Loans

Exhibit 8.5: Stephanies Possible Monthly Loan Payments

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Financial Planning Online: Trade-In

and Retail Value of Used Cars
Go to: http://www.kbb.com
This Web site provides trade-in and
retail values for a used car, based on
the condition of the car, its age, and
other characteristics that you specify.

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Financial Planning Online:

Car Loan Interest Rate Quotation
Go to: http://autos.yahoo.com/buy.html
Click on: Car Financing, then Get An
Auto Loan
This Web site provides a car loan
interest rate quotation based on your
desired car, the amount you need to
borrow, and the term of the loan.
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Financial Planning Online:

Prevailing Car Loan Interest Rates
Go to: http://biz.yahoo.com/b/r/a.html
This Web site provides average car
loan interest rates across the United
States and in various states, which
provide a useful benchmark for you to
consider before obtaining a car loan.

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Financial Planning Online:

What Is the Optimal Loan Maturity?
Go to: http://www.financenter.com
/products/sellingtools/calculators
Click on: Auto, then What term of
loan should I choose?
This Web site provides a comparison of
what your car loan payments will be
based on loan maturity.
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Purchase versus Lease Decision

Leasing is a popular alternative to
buying a car
Advantages of leasing
Lower down payment
Just return the car at the end of the lease
period

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Purchase versus Lease Decision

Disadvantages of leasing
You build no equity in the car
You are still responsible for maintenance
and damages
Additional charges may be imposed
Too many miles
Ending the lease before the specified period
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Financial Planning Online:

Should You Lease or Buy?
Go to: http://www.bloomberg.com
Click on: Tools, then Lease/Buy
calculator
This Web site provides a comparison of
the cost of leasing versus purchasing a
car.

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Purchase versus Lease Decision

Exhibit 8.6: Stephanies Comparison of the Cost of Purchasing versus Leasing

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Purchase versus Lease Decision

Exhibit 8.6: Stephanies Comparison of the Cost of Purchasing versus Leasing

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Student Loans
Student loan: a loan provided to finance
part of the expenses a student incurs while
pursuing a degree
Loan may be provided to either the student
or the students parents
Repayment typically deferred until student
is out of school
Interest may be tax deductible
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How Personal Loans Fit

within Your Financial Plan
Key personal loan decisions for your
financial plan are:
How much money can you afford to borrow
on a personal loan?
If you obtain a personal loan, should you
pay it off early?

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Integrating the Key Concepts

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Integrating the Key Concepts

Part 1: Financial Planning Tools
Part 2: Liquidity Management
Part 3: Financing
In Chapter 8 we learned about personal loans
Chapter 9 teaches about purchasing and financing
a home

Part 4: Protecting Your Wealth

Part 5: Investing
Part 6: Retirement and Estate Planning
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