978-0357033616 Chapter 7 Part 2

subject Type Homework Help
subject Pages 9
subject Words 5343
subject Textbook PFIN 7th Edition
subject Authors Lawrence J. Gitman, Michael D. Joehnk, Randall Billingsley

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Test Yourself Questions
7-1 List and briefly discuss the five major reasons for borrowing money through a
consumer loan.
3. Education loans: These loans can be used to finance either undergraduate or graduate
studies, and special government-subsidized loan programs are available to students and parents.
4. Personal loans: These loans are typically used for nondurable expenditures, such as an
expensive European vacation or to cover temporary cash shortfalls. Many personal loans are
unsecured.
7-2 Identify several different types of federally sponsored student loan programs.
The federal government (and some state governments) have available several different types of
subsidized educational loan programs. The federally sponsored programs are:
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7-3 As a college student, what aspects of these student loan programs appeal to you the
most?
Most students will prefer subsidized loans with low rates and interest deferred until student leave
7-4 Explain some strategies for reducing the cost of student loans.
It’s important to borrow as little as possible to cover college costs. This common-sense goal can
7-5 Define and differentiate between (a) fixed- and variable-rate loans and (b) a single
payment loan and an installment loan.
7-6 Compare the consumer lending activities of (a) consumer finance companies and (b)
sales finance companies. Describe a captive finance company.
Consumer finance companies make secured and unsecured (signature) loans to qualified
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7-7 Discuss the role in consumer lending of (a) credit unions and (b) savings and loan
associations. Point out any similarities or differences in their lending activities. How do
they compare with commercial banks?
A credit union is a cooperative financial institution that is owned and controlled by the people
(“members”) who use its services. Only the members can obtain installment loans and other
7-8 What two questions should be answered before taking out a consumer loan? Explain.
From a financial planning perspective, you should ask yourself two questions when considering
the use of a consumer loan:
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7-9 List and briefly discuss the different factors to consider when shopping for a loan. How
would you determine the total cost of the transaction?
The major factors are:
Finance Charges--What’s it going to cost me? That’s appropriate, because borrowers should know what
they’ll have to pay to get the money The rate of interest, known as the APR (annual percentage rate), includes
not only the basic cost of money but also any additional fees that might be required on the loan.
Collateral--Make sure you know up front what collateral (if any) you’ll have to pledge on the loan and what
you stand to lose if you default on your payments. Using collateral often makes sense--it may result in lower
finance charges, perhaps half a percentage point or so.
7-10 What is a lien, and when is it part of a consumer loan?
7-11 When might you request a loan rollover?
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7-12 Describe the two methods used to calculate the finance charges on a single payment
loan. As a borrower, which method would you prefer? Explain.
7-13 Briefly describe the basic features of an installment loan.
Installment loans differ from single-payment loans in that they require the borrower to repay the
debt in a series of installment payments (usually monthly) over the life of the loan. Installment
7-14 What is a home equity loan, and what are its major advantages and disadvantages?
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7-15 Explain why a borrower is often required to purchase credit life and disability
insurance as a condition of receiving an installment loan.
Sometimes, as a condition of receiving an installment loan, a borrower is required to buy credit
7-16 Define simple interest as it relates to an installment loan. Are you better off with add-
on interest? Explain.
When simple interest is used with installment loans, interest is charged only on the outstanding
7-17 When does it make more sense to pay cash for a big-ticket item than to borrow the
money to finance the purchase?
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Critical Thinking Cases
7.1 Financing Zoe’s Education
At age 19, Zoe Trainor is in the middle of her second year of studies at a community college
in Charlotte. She has done well in her course work; majoring in pre-business studies, she
currently has a 3.75 grade point average. Zoe lives at home and works part-time as a filing
clerk for a nearby electronics distributor. Her parents can’t afford to pay any of her tuition
and college expenses, so she’s virtually on her own as far as college goes. Zoe plans to
transfer to the University of Tennessee [Go Vols!] next year. (She has already been
accepted.) After talking with her counselor, Zoe feels she won’t be able to hold down a
part-time job and still manage to complete her bachelor’s degree program at UT in two
years. Knowing that on her 22nd birthday, she will receive approximately $35,000 from a
trust fund left her by her grandmother, Zoe has decided to borrow against the trust fund to
support herself during the next two years. She estimates that she’ll need $25,000 to cover
tuition, room and board, books and supplies, travel, personal expenditures, and so on
during that period. Unable to qualify for any special loan programs, Zoe has found two
sources of single-payment loans, each requiring a security interest in the trust proceeds as
collateral. The terms required by each potential lender are as follows:
a. Tennessee State Bank will lend $30,000 at 6 percent discount interest. The loan principal
would be due at the end of two years.
b. National Bank of Knoxville will lend $25,000 under a two-year note. The note would
carry a 7 percent simple interest rate and would also be due in a single payment at the end
of two years.
Critical Thinking Questions
1. How much would Zoe (a) receive in initial loan proceeds and (b) be required to repay at
maturity under the Tennessee State Bank loan?
2. Compute (a) the finance charges and (b) the APR on the loan offered by Tennessee State
Bank.
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3. Compute (a) the finance charges and (b) the APR on the loan offered by the National
Bank of Knoxville. How big a loan payment would be due at the end of two years?
4. Compare your findings in Questions 2 and 3, and recommend one of the loans to Zoe.
Explain your recommendation.
5. What other recommendations might you offer Zoe regarding disposition of the loan
proceeds?
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7.2 Grant Gets His Outback
Grant Tyson, a 27-year-old bachelor living in Arlington, Virginia, has been a high-school
teacher for five years. For the past four months, he’s been thinking about buying a Subaru
Outback, but he feels that he can’t afford a brand-new one. Recently, however, his friend
Martin Grubbs has offered to sell Grant his fully loaded Subaru Outback 3.6R. Martin
wants $26,900 for his Outback, which has been driven only 8,000 miles and is in very good
condition. Grant is eager to buy the vehicle but has only $10,000 in his savings account at
Central Bank. He expects to net $8,000 from the sale of his Chevrolet Malibu, but this will
still leave him about $8,900 short. He has two alternatives for obtaining the money:
a. Borrow $8,900 from the First National Bank of Arlington at a fixed rate of 6 percent per
annum, simple interest. The loan would be repaid in equal monthly installments over a
three-year (36-month) period.
b. Obtain a $8,900 installment loan requiring 36 monthly payments from the Arlington
Teacher’s Credit Union at a 4.5 percent stated rate of interest. The add-on method would
be used to calculate the finance charges on this loan.
Critical Thinking Questions
1. Using Exhibit 7.6 or a financial calculator, determine the required monthly payments if
the loan is taken out at First National Bank of Arlington.
2. Compute (a) the finance charges and (b) the APR on the loan offered by First National
Bank of Arlington.
3. Determine the size of the monthly payment required on the loan from the Arlington
Teacher’s Credit Union.
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4. Compute (a) the finance charges and (b) the APR on the loan offered by the Arlington
Teacher’s Credit Union.
As a rule of thumb, the add-on method of computing finance charges will be about twice the
simple interest rate. Here the simple interest rate is 4.5% times 2 = 9%.
5. Compare the two loans and recommend one of them to Grant. Explain your
recommendation.
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Terms Found in the Chapter
529 college savings
plan
A government-sponsored investment vehicle that allows earnings to
grow free from federal taxes, so long as they are used to meet college
education expenses.
add-on method
A method of calculating interest by computing finance charges on the
original loan balance and then adding the interest to that balance.
cash value (of life
insurance)
An accumulation of savings in an insurance policy that can be used as a
source of loan collateral.
captive finance
company
A sales finance company that is owned by a manufacturer of big-ticket
merchandise. GMAC is a captive finance company.
chattel mortgage
A mortgage on personal property given as security for the payment of
an obligation.
collateral
An item of value used to secure the principal portion of a loan.
collateral note
A legal note giving the lender the right to sell collateral if the borrower
defaults on the obligation.
consumer finance
company
A firm that makes secured and unsecured personal loans to qualified
individuals; also called a small loan company.
consumer loans
Loans made for specific purposes using formally negotiated contracts
that specify the borrowing terms and repayment.
credit life (or
disability)
insurance
A type of life (or disability) insurance in which the coverage decreases
at the same rate as the loan balance.
discount method
A method of calculating finance charges in which interest is computed
and then subtracted from the principal, with the remainder being
disbursed to the borrower.
installment loan
A loan that is repaid in a series of fixed, scheduled payments rather
than a lump sum.
interim financing
The use of a single payment loan to finance a purchase or pay bills in
situations where the funds to be used for repayment are known to be
forthcoming in the near future.
lien
A legal claim permitting the lender, in case the borrower defaults, to
liquidate the items serving as collateral to satisfy the obligation.
loan application
An application that gives a lender information about the purpose of the
loan as well as the applicant’s financial condition.
loan disclosure
statement
A document, which lenders are required to supply borrowers, that
states both the dollar amount of finance charges and the APR
applicable to a loan.
loan rollover
The process of paying off a loan by taking out another loan.
Rule of 78s (sum-of
the-digits method)
A method of calculating interest that has extra-heavy interest charges
in the early months of the loan.
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sales finance
company
A firm that purchases notes drawn up by sellers of certain types of
merchandise, typically big-ticket items.
simple interest
method
A method of computing finance charges in which interest is charged on
the actual loan balance outstanding.
single-payment
loan
A loan made for a specified period, at the end of which payment is due
in full.
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Using Consumer Loans
Chapter Outline
Learning Objectives
I. Basic Features of Consumer Loans
A. Using Consumer Loans
B. Different Types of Loans
1. Common loans
a. Auto loans
b. Loans for other durable goods
c. Education loans
d. Personal loans
2. Single-Payment or Installment Loans
3. Student loans
a. Government loans v normal consumer loans
b. Type of government loans See Exhibit7.1
c. Obtaining a student loan
d. Are student loans programs “too big to fail”
e. Strategies for reducing student loan costs
C. Where Can You Get Consumer Loans?
1. Commercial Banks
2. Consumer Finance Companies
3. Credit Unions
4. S&L Associations
5. Sales Finance Companies
6. Life Insurance Companies
7. Friends and Relatives
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II. Managing Your Credit
A. Shopping for Loans
1. Finance Charges
2. Loan Maturity
3. Total Cost of the Transaction
4. Collateral
5. Other Loan Considerations
B. Keeping Track of Your Consumer Debt
III. Single-Payment Loans
A. Important Loan Features
1. Loan Collateral
2. Loan Maturity
3. Loan Repayment
B. Finance Charges and the Annual Percentage Rate
1. Simple Interest Method
2. Discount Method
IV. Installment Loans
A. A Real Consumer Credit Workhorse
B. Finance Charges, Monthly Payments, and the APR
1. Using Simple Interest
2. Add-on Method
3. Prepayment Penalties
C. Buy on Time or Pay Cash?

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