Copyright ©2004 Pearson Education, Inc. All rights reserved.8-1 What Is Consumer Borrowing?...

Copyright ©2004 Pearson Education, Inc. All rights reserved. 8-1

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.


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.


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.


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



• 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



– 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



– 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


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?


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.


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.


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.


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.



• 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


Methods of Computing Interest

• Simple interest method– single payment loan

– installment loan

• Discount method

• Add-on method


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


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


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


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


Car Loans

• Selecting the car — things to consider– Personal preferences

– Price

– Insurance

– Resale value

– Repair expenses

– Financing rate


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


Car Loans

– Financing decisions• Estimate dollar amount of monthly payment you

can afford before shopping


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 student’s parents

• Repayment typically deferred until student is out of school

• Interest may be tax deductible

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