Personal Finance: A Gospel Perspective

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Personal FinanceA Gospel Perspective

• Understanding Consumer and Other Loans

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Objectives

• A. Understand how consumer loans can keep you
  from your goals
• B. Understand the types of consumer loans, their
  characteristics, and how to calculate the costs
• Know the least expensive types of loans and how
  to reduce the cost of consumer loans

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Your Personal Financial Plan

• Section VII Student/Consumer Loans and Debt
  Reduction
• Consumer and Student Loans outstanding?
• What are your interest rates, costs, and other
  fees?
• Current Debt Situation.
• What rates are you paying? Costs, fees, etc.?
• What is your debt reduction strategy?
• What are your views on future debt?

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Understand how Consumer Loans can Keep you from
your Goals?

• Consumer loans
• Encourage consumption now, rather than saving for
  the future
• Dont borrow for it, save for it
• Are very expensive, and reduce what you might
  otherwise have saved for your goals
• Earn interest, dont pay it
• Are generally unnecessary
• Other than for education and a home (what the
  prophet has stated), they generally are not
  necessary!

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How Consumer Loans Keep You From Your Goals
(continued)

• Key questions to ask when you are thinking of
  borrowing for consumer loans?
• 1. Do you really need to make this purchase?
• Is it a need or a want? Separate them!
• 2. Can you pay for it without borrowing?
• What is the after-tax cost of borrowing versus
  the after-tax lost return from using savings?
  Compare!
• 3. Is it in your budget/financial plan?
• Should you save for it instead of borrow for it?
  Save!

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Key Questions (continued)

• 4. What is the all-in cost of this loan,
  including its impact on your other goals?
• Can you maintain sufficient liquidity and still
  achieve your other goals? Choose wisely!
• 5. Will this purchase bring you closer or take
  you farther away from your personal goals?
• If it brings you closer to your goals, including
  your goal of obedience to the Lords
  commandments, do it. If it takes you farther
  away, dont!

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Questions

• Any questions on how consumer loans keep you from
  your goals?

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B. Understand Consumer LoanTypes,
Characteristics, and Costs

• Types of Consumer Loans
• General consumer loans
• Single payment loans
• Installment loans
• Special consumer loans
• Auto loans
• Home equity loans
• Student loans
• Payday loans
• Mortgage loans

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Characteristics of Consumer Loans

• Consumer Loan Characteristics
• Secured versus Unsecured Loans
• Secured loans are guaranteed by a specific asset,
  i.e. a home or a car, and typically have lower
  rates
• Unsecured loans require no collateral, are
  generally offered to only borrowers with
  excellent credit histories, and have higher rates
  of interest 12 to 28 (and higher) annually

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Consumer Loan Characteristics (continued)

• Fixed-rate loans
• Have the same interest rate for the duration of
  the loan.
• Normally have a higher initial interest rate as
  the lender could lose money if overall interest
  rates increase

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Consumer Loan Characteristics (continued)

• Variable-rate loans
• Have an interest rate that is tied to a specific
  index (e.g., prime rate, 6-month Treasury bill
  rate) plus some margin or spread, i.e. 9)
• Can adjust on different intervals such as
  monthly, semi-annually, or annually, with a
  lifetime adjustment cap.
• Normally have a lower initial interest rate
  because the lender wont lose money if overall
  interest rates increase

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Consumer Loan Characteristics (continued)

• Convertible loans
• Begin as a variable rate loan and can be locked
  into the current rate a some predetermined time
  in the future at a specific cost
• Balloon loans
• Loans which payments including interest and
  principle are not sufficient to pay off the loan
  at the end of the loan period, but require a
  large balloon payment at some point in the
  future. This type of loan is not recommended.

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Costs of Consumer Loans

• What are the costs of consumer loans?
• Consumer loans are required by Regulation Z of
  the Truth in Lending Act to state the loan APR in
  bold on the loan documents
• The APR is the simple interest rate paid over the
  life of the loan.
• It takes into account all costs, including
  interest rate, cost of credit reports, and costs
  of all possible fees

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Single Payment Loans

• What are single payment (or balloon) loans?
• A loan that is repaid in only one payment,
  including interest.
• Characteristics of Single Payment loans
• Short-term lending of one year or less, sometimes
  called bridge or interim loans, often used until
  permanent financing can be arranged
• May be secured or unsecured

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Single Payment Loans (continued)

• Costs of single payment loans
• Generally it is simple interest, or interest rate
  times the loan amount times the period covered
• The simple interest method
• Both principal and interest are due at maturity
• Interest principal x interest rate x time
• With not costs and fees, APR and simple interest
  are the same

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Cost of Consumer Loans (continued)

• What is the cost of a 1,000 single payment loan
  for 1 year at an interest rate of 12. By the
  way, there is a 20 loan processing fee, 20
  credit check fee, and 60 insurance fee. What is
  your APR for the 1 year loan? What is the APR if
  this was a 2 year loan with principle paid only
  at maturity?
• The formula is (interest fees) / amount
  borrowed. Your interest is principle x
  interest rate x time.
• The APR for the 1 year loan is
• (120 100) / 1,000 22.0
• The APR for the 2 year loan is
• (240 100) / 2 / 1,000 17.0

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Single Payment Loans (continued)

• The Discount Method (never borrow using this
  method of calculating your costs)
• Subtracts the entire interest charge from the
  loan principal before you receive the loan, so
  you are paying interest on money you have not
  received.
• You prepay the interest, so it inflates the rate
  of interest because the amount received is less
  than the amount borrowed.
• The APR will be much higher than the discount
  method rate

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Single Payment Loans (continued)

• What is the cost of the same 1,000 loan at 12
  interest for 2 years using the discount rate
  method? What is the APR for this loan?
• The discount method is principle x interest
  rate x time interest. Subtract interest from
  the loan and divide the remainder by the number
  of payment periods (for more than one period)
• The cost of the loan is
• 1,000 (1,000 x 12 x 2) 760 actually
  received
• The APR is
• ( 240 / 2 ) / 760 15.8

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Installment Loans

• What are installment loans?
• Installment loans are loans which are repaid at
  regular intervals and where payment includes both
  principal and interest.
• Installment Loan characteristics
• Normally used to finance houses, cars,
  appliances, and other expensive items
• Loans are amortized, which is the process of the
  payment going more toward principal and less
  toward interest each subsequent month
• May be secured or unsecured loans, variable-rate
  or fixed-rate loans

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Installment Loans (continued)

• Costs of Installment loans
• Costs of installment loans are based on a
  simple-interest calculation (using your
  calculator)
• Repayment is simply the outstanding balance (each
  month the interest portion of the payment
  decreases and the principal portion increases)

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Installment Loans (continued)

• What is the cost of the same 1,000 loan at 12
  interest for 2 years using the simple interest
  method and monthly payments?
• The simple interest method for installment loans
  is simple loan amortization with your calculator
  
• PV -1,000 , I 12, P/Y 12, N 24, PMT?
• PMT 47.074
• Total Interest Paid 47.074 x 24 1,000
  129.76
• APR (interest fees) / 2 / average amount
  borrowed (which changes each year as you pay it
  down)
• (129.76 / 2) / 540.68 12

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Installment Loans (continued)

• The add-on method
• Never borrow using this method of calculating
  your costs
• Adds the total interest payment to the principal
  of the loan, and is much more costly than the
  simple-interest method.
• It can double the stated APR rate as you are
  paying interest on money you have not received

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Installment Loans (continued)

• What is the cost of the earlier 1,000
  installment loan at 12 interest for 2 years
  using the add on method? What is the APR?
• The add on method is amount borrowed plus
  Principle x interest rate x time divided by
  periods
• The cost of the loan is
• 1,000 (1,000 x 12 x 2) 1, 240 / 24 months
  51.66 payment per month
• The APR is determined using your calculator
• 51.66 PMT, -1,000 PV, 24 N, I/Y 21.6

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Home Equity Loans

• What are home equity loans
• Home equity loans are basically second mortgages
  which use the equity in your home to secure your
  loan. Normally can borrow up to 80 of your
  equity in your home
• Characteristics of home equity loans
• Interest payments may be tax-deductible
• Lower rates of interest than other consumer loans

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Home Equity Loans (continued)

• Costs of home equity loans
• Home equity loans are generally either single
  payment or installment loans. The benefit of
  these loans is that the interest may be tax
  deductible, reducing the cost of borrowing
• Keep people from making the hard financial
  choices to curb their spending
• Sacrifices future financial flexibility
• Can put your home at risk if you default

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Student Loans

• Student Loans
• Loans with low, federally subsidized interest
  rates used for higher education. Examples
  include Federal Direct (S) and PLUS Direct (P)
  available through the school Stafford (S) and
  PLUS loans (P) available through lenders.
• Student Loan Characteristics
• Some are tax-advantaged and have lower than
  market rates.
• Payment on Federal Direct and Stafford loans
  deferred for 6 months after graduation.

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Student Loans (continued)

• Costs of Student loans
• Student loans are installment loans, with either
  fixed or variable rates, and are repaid in
  installments.
• Reduces future flexibility

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Auto Loans

• Automobile Loans
• Auto loans are consumer loans that are secured
  with an automobile.
• Auto loan characteristics
• Has a lower interest rate than an unsecured loan
  or credit card.
• Normally has a maturity length of 2 to 6 years.
• You will often be left with a vehicle that is
  worth less than what you owe on it

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Auto Loans (continued)

• Costs of Auto Loans
• You are looking to finance a used car for 9,000
  for three years at 12 interest. What are your
  monthly payments and how much will you pay in
  interest?
• Answer
• Set your PV -9,000, I 12, N36, PMT?
• Your payment is 298.93 per month 36 months
  10,671.48 9,000 borrowed 1,671.93 in
  interest or 20 of the value of the car.

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Payday Loans

• Payday Loans
• Short-term loan of 1-2 weeks secured with a
  post-dated check which is held by the lender
  and then cashed later
• Have very high interest rates and fees, APR gt
  450
• Typical users are those with jobs and checking
  accounts but who have been unable to manage their
  finances effectively
• How is it calculated?
• Take the APR of the loan in decimal form, divide
  it by the number of compounding periods, add 1,
  and take it to the power of the number of
  periods, and subtract 1.

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Payday Loans (continued)

• Cost of Payday Loans
• Very high interest rates gt 500 APR
• Used by those who cannot get credit any other way
• Sacrifices future flexibility

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Payday Loans (continued)

• Jeremy is short on cash for date this weekend.
  He finds that he can give a post-dated check to a
  Payday lender who will give him 100 now for a
  115 check which the lender can cash in 2 weeks.
  What is the APR and effective annual interest
  rate on this loan?
• The APR is the total fees divided by amount
  borrowed. The effective rate (1
  APR/periods)periods -1
• APR (15 26 two-week periods)/100 390
• The effective annual interest rate is
• (1 3.90/26 periods)26 periods 1 3,686
• This is a very expensive loan

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Mortgage Loans

• Mortgage Loans
• Fixed rate loans
• Installment loans with a fixed rate of interest
• Variable rate loans
• Installment loans with a rate of interest that is
  pegged to a specific index plus a margin that
  changes periodically

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Mortgage Loans (continued)

• NegAm or Negative Amortization loans
• Loans in which scheduled monthly payments are
  insufficient to amortize, or pay off the loan.
  Interest expense that has been incurred, but not
  paid is added to the principal amount, which
  increases the amount of the debt.
• Balloon mortgages
• Mortgages whose interest and principal payment
  wont result in the loan being paid in full at
  the end of the term. The final payment, or
  balloon, is significantly larger. These are
  often used when the debtor expects to refinance
  the loan closer to maturity

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Mortgage Loans (continued)

• Reverse mortgages
• Mortgages whose proceeds are made available
  against the homeowners equity. These are
  typically used by cash-poor but home-rich
  homeowners to need to access the equity in their
  homes to supplement their monthly income at
  retirement
• Interest only loans
• Loans in which payments cover the interest costs
  only and do not cover repayment of principle.
  Often debtors will take out an interest only loan
  to free up principal to pay down other more
  expensive debt

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Mortgage Loans (continued)

• Interest only loans
• Benefits
• Lower monthly payments and greater flexibility
• Helpful if have better use for money elsewhere
• Borrowers can afford more house, and may move
  before the payments increase
• Negatives
• Major rise in payments when the interest-only
  period ends
• No amortization of principlemust assume
  appreciation on the house to make money
• Many do not have the discipline to invest savings
  from principle elsewhere (they spend it)

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Mortgage Loans (continued)

• Interest only loans
• What is the monthly mortgage cost of a 6.0 30
  year amortizing loan versus a 7.0 30 year 10
  year interest only home mortgage of 300,000?
  What is the interest payment beginning in year 11
• The amortizing is PV -300,000, I 6.0, P/Y
  12, n 360, PMT ? 1,798.65
• The interest only payment would be 300,000
  7.0 / 12 1,750.00
• One you pay off in 30 years, the other you never
  pay off
• After 10 years, your payment is PV -300,000, I
  7.0, P/Y 12, N 240, PMT ?
• 2,325.89, a 33 increase

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The Consumer Loan Contract

• Key clauses for Consumer and Mortgage Loansnone
  are in your favor!
• Note that all clauses are in the lenders favor,
  and very few, if any, are in the borrowers favor.
• You are putting your future in someone elses
  hands when you borrow!
• You are committing future earnings to todays
  consumption!
• Know what your are doing before you do it!!!!!
• Read the documents very carefully and understand
  them before you sign!!!

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The Consumer Loan Contract (continued)

• Insurance agreement clause
• Requires you to purchase life insurance that will
  payoff your loan after your death
• Benefits only the lender, and Increases your
  total loan cost
• Acceleration clause
• Requires the entire loan to be paid-in-full if
  you miss just one payment
• Normally (but not always) not invoked if you make
  a good faith effort to pay

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The Consumer Loan Contract (continued)

• Deficiency payments clause
• Requires any amount in excess to be paid if the
  collateral's value does not satisfy the loan.
• Borrower must also pay any outstanding charges
  incurred by the lender associated with the
  disposal of the collateral
• Recourse clause
• Defines the lenders ability to collect any
  outstanding balance via wage attachments and
  garnishments
• Can also include liens on other borrowers
  property

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C. How to Reduce your Borrowing Costs

• Key Relationships on Borrowing
• The total interest cost of your loan is directly
  related to the interest rate.
• Keep your interest rate as low as possible
• The total interest cost of your loan is inversely
  related to the maturity length.
• Keep your loan maturity short
• Your periodic payment is directly related to both
  the maturity and interest rate
• Keep both short
• Parents are cheaper than banks

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Reducing Borrowing Costs (continued)

• Least expensive
• Borrowing from parents and family
• Home equity loans
• Other secured loans
• More expensive
• Credit unions
• Savings and loans
• Commercial banks

• Most expensive
• Retail stores
• Finance companies
• Isnt it interesting that those who are in the
  worst financial situation have to pay the most
  for credit.

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Reducing Borrowing Costs (continued)

• 1. Dont get into debt in the first place!
• Follow the prophetrather than your wants!
• Distinguish between true needs and wants
• Remember your goals
• Remember ignorance, carelessness, compulsiveness,
  pride, and necessity are offset by knowledge,
  exactness, discipline, humility, and self
  reliance
• Stick to your budget
• If you need it, plan and save for it

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Reducing Borrowing Costs (continued)

• 2. Compare the after-tax cost of borrowing with
  the after-tax lost return from using savings
• It makes little sense to borrow at a high
  interest rate when you have savings earning a
  lower rate. The formula is
• After-tax lost return nominal interest rate
  (1 tax rate)
• Tax rate Federal State Local marginal tax
  rate

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Reducing Borrowing Costs (continued)

• 3. Maintain a strong credit rating
• Increase your FICO score
• Make sure your credit reports have no mistakes
• Pay all your bills on-time
• Keep balances low, particularly on revolving debt
• Keep your oldest accounts, but not too many
• Dont apply for too many new cards
• Dont have too many of the same type of cards

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Reducing Borrowing Costs (continued)

• 4. Reduce the lenders risk
• a. Use a variable rate loan
• b. Keep the loan term as short as possible
• c. Provide collateral for the loan
• d. Pay a large down payment on the item to be
  purchased with financing

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Review of Objectives

• A. Do you understand how consumer loans can keep
  you from your goals?
• B. Are you aware of the characteristics of
  consumer loans and how to calculate costs?
• C. Do you know the least expensive types of
  loans and how to reduce the cost of those loans?