Personal Finance SIXTH EDITION Chapter 9 Personal Loans

Personal Finance SIXTH EDITION Chapter 9 Personal Loans Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Chapter Objective (1 of 2) 9. 1 Provide a background on personal loans 9. 2 Outline the types of interest rates that are charged on personal loans 9. 3 Discuss car loans 9. 4 Explain how to decide between financing the purchase of a car and leasing a car Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Chapter Objective (2 of 2) 9. 5 Describe the key features of student loans 9. 6 Describe home equity loans 9. 7 Describe payday loans 9. 8 Describe how personal loans fit within your financial plan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (1 of 7) • Usually obtained to finance a large purchase • Sources of personal loans – Financial institutions § Commercial banks, savings institutions, credit unions and finance companies – Family members or friends § Loan agreement should be in writing and signed by all parties Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (2 of 7) • Peer-to-Peer Lending – Also known as P 2 P – Conducted through online platforms – The 2 most popular at this time are § Lending Club § Prosper – More than $1 billion per year now provided by individual investors via P 2 P – Amounts are typically from $1 k to $35 k – Credit report and FICO score are used Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (3 of 7) • Determining whether a loan is sensible – Periodic payments will be required over time – You are sacrificing future earnings – Avoid a loan if your source of income to repay it is questionable Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (4 of 7) • 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (5 of 7) – 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (6 of 7) – 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 § Unsecured loan: a loan that is not backed by collateral – Cosigning is sometimes required if credit history is weak Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Background on Personal Loans (7 of 7) Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (1 of 7) • Go to www. helpwithmybank. gov • This site provides background information on personal loans. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Interest Rates on Personal Loans (1 of 5) • Annual percentage rate (APR): a rate that measures the finance expenses (including interest and other expenses) on a loan annually – Standard rate required to be disclosed by lenders – Provides comparison between lenders – Result of Truth-in-Lending Act of 1969 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Interest Rates on Personal Loans (2 of 5) • 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 • Add-on interest: a method of determining the monthly payment on a loan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Interest Rates on Personal Loans (3 of 5) EXHIBIT 9. 2 Measurement of the Annual Percentage Rate Interest Expenses Other Finance Expenses Total Finance Expenses Number of Years Average Annual Finance Expenses Annual Percentage Rate (APR)* Bank A $200 0 $200 1 $200/$2, 000 = 10% Bank B 160 $100 260 1 260 $260/$2, 000 = 13% Bank C 120 200 320 1 320 $320/$2, 000 = 16% *The APR is calculated by dividing the average annual finance expenses by the average annual loan balance. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Interest Rates on Personal Loans (4 of 5) EXHIBIT 9. 3 Example of Loan Repayment Schedule: One-Year Loan, 12% Interest Rate (Monthly Payment = $177. 70) Month Interest Payment of Principal Outstanding Loan Balance $2, 000. 00 1 $20. 00 $157. 70 1, 842. 30 2 18. 42 159. 28 1, 683. 02 3 16. 83 160. 87 1, 522. 16 4 15. 22 162. 48 1, 359. 68 5 13. 60 164. 10 1, 195. 58 6 11. 96 165. 74 1, 029. 84 7 10. 30 167. 40 862. 44 8 8. 63 169. 07 693. 37 9 6. 94 170. 76 522. 61 10 5. 23 172. 47 350. 13 11 3. 50 174. 20 175. 94 12 1. 76 175. 94 0 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Interest Rates on Personal Loans (5 of 5) • You can use the phone app “Debts Break” to estimate the time it will take you to pay off your debt using information you provide • Search for “Debts Break” app (by LINKS LTD) on your mobile device Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (1 of 6) • How much money to spend on a car? – Consider how your decision affects your personal budget – Adding credit card debt to car loan debt – The no-debt solution § Only buy what you can pay cash for – The limited-debt solution § Short term loan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (2 of 6) • Selecting the car—things to consider – Personal preferences – Price – Condition – Insurance – Resale value (www. edmunds. com) – Repair expenses – Financing rate – Revised car loan contracts Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (2 of 7) • Go to the autos section of Yahoo. com • This Web site provides estimates of what you should pay for any new car or used car based on the car’s features and options that you specify Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (3 of 7) • Go to http: //www. kbb. com • This Web site (Kelley Blue Book) 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. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (4 of 7) • Go to http: //www. ftc. gov and search for “Are Car Ads Taking You for a Ride? ” • This Web site provides questions you should ask when you are offered unusually low financing rates Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (3 of 6) EXHIBIT 9. 4 Stephanie Spratt’s Car Analysis Car Expected Resale Value After Two Years (as a proportion of original sales price) Repair Expenses and Service Maintenance Insurance A Low Moderate High B Moderate Low C Moderate High D Moderate High Moderate E Moderate Low Moderate Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (4 of 6) • 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (5 of 6) • Financing decisions – Estimate the dollar amount of the monthly payment before you shop – Longer financing periods (up to seven years) provide lower payments – Car may be worthless by the time you pay it off Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (5 of 7) • Go to the finance section of Yahoo. com and insert the search term “car loan rate” • This Web site provides average car loan interest rates across the United States and in various states. • These interest rates can help you estimate what your monthly payments would be if you bought the car Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Car Loans (6 of 6) EXHIBIT 9. 5 Stephanie Spratt’s Possible Monthly Loan Payments (7. 6% interest rate) Loan Amount Loan Maturity $15, 000 $17, 000 36 months (3 years) $467 $530 48 months (4 years) 363 412 60 months (5 years) 301 341 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Purchase versus Lease Decision (1 of 4) • 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 • Decision is highly dependent on the estimated market value of the car at the end of the lease period Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Purchase versus Lease Decision (2 of 4) • Disadvantages of leasing – You build no equity in the car – You are still responsible for maintenance and damages – Additional charges may be imposed § If you drive too many miles § If you end the lease before the specified period Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (6 of 7) • Go to http: //www. edmunds. com and insert the search term “lease versus buy” • This Web site provides a comparison of the cost of leasing versus purchasing a car. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Purchase versus Lease Decision (3 of 4) EXHIBIT 9. 6 Stephanie Spratt’s Comparison of the Cost of Purchasing Versus Leasing Cost of Purchasing the Car Cost 1. Down payment $1, 000 2. Down payment of $1, 000 results in forgone interest income: Forgone Interest Income per Year = Down Payment × Annual Interest Rate = $1, 000 ×. 04 = $40 Forgone Interest over Four Years = $40 × 4 = $160 3. Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months = $412 × 48 = $19, 776 Total Minus: Expected amount to be received when car is sold in four years Total cost Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved $19, 776 $20, 936 10, 000 $10, 936

Purchase versus Lease Decision (4 of 4) EXHIBIT 9. 6 Stephanie Spratt’s Comparison of the Cost of Purchasing Versus Leasing Cost of Leasing the Car for Four Years Cost 1. Security deposit of $800 results in forgone interest income (although she will receive her deposit back in four years): Forgone Interest Income per Year = Down Payment × Annual Interest Rate = $800 ×. 04 = $32 Forgone Interest over Four Years = $32 × 4 = $128 3. Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months = $300 × 48 = $14, 400 Total cost Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 14, 400 $14, 528

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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Home Equity Loan (1 of 3) • 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Home Equity Loan (2 of 3) • Impact of the economy on the credit limit – As economic conditions change, so does the value of a home – Market values of homes may decline substantially, leaving no equity in the home Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Home Equity Loan (3 of 3) • Interest rate – Typically variable – Rate is usually tied to an interest rate index and adjusted periodically • Interest paid on a home equity loan up to $100, 000 is tax-deductible Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Financial Planning Online (7 of 7) • Go to http: //www. federalreserve. gov and insert the search term “home equity loan” • This Web site provides more information on home equity loans. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

Payday Loans • Payday loan: a short-term loan provided in advance of a paycheck • Reasons to avoid payday loans – Using your next paycheck to cover the loan may make you unable to cover your normal purchases – Cost of financing is outrageous – Typically costs several hundred percent a year • Alternatives to payday loans – Friends, family members, credit cards Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

How Personal Loans Fit within Your Financial Plan (1 of 3) • 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? Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

How Personal Loans Fit within Your Financial Plan (2 of 3) EXHIBIT 9. 7 How Personal Loan Management Fits Within Stephanie Spratt’s Financial Plan GOALS FOR PERSONAL FINANCING 1. Limit the amount of financing to a level and maturity that I can pay back on a timely basis. 2. For any personal loan, I will consider paying off the loan balance as soon as possible. ANALYSIS Monthly Cash Inflows - Typical Monthly Expenses $2, 500 1, 400 - Monthly Car Loan Payment 412 = Amount of Funds Available $688 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved

How Personal Loans Fit within Your Financial Plan (3 of 3) EXHIBIT 9. 7 How Personal Loan Management Fits Within Stephanie Spratt’s Financial Plan DECISIONS Decision on Affording a Personal Loan: The financing of my new car requires a payment of $412 per month. This leaves me with $688 per month after paying typical monthly expenses. I can afford to make the payments. I will not need additional personal loans for any other purpose. Decision on Paying Off Personal Loan Balances: The car loan has an interest rate of 7. 6 percent. I expect that my stock investment will earn a higher rate of return than this interest rate. Once I have accumulated more savings, however, I will seriously consider using my savings and invested funds to pay off the balance of the loan early. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved