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Using Consumer Loans
Chapter 7
How Will This Affect Me?
Consumer loan sources abound, and their terms vary significantly. The primary types are single-
payment and installment consumer loans. It’s important to understand when to use each credit
source, to be able to calculate and compare their costs, and to determine the circumstances in
which it is best to take out a loan or pay cash. Practical examples considered in this chapter
include taking out a car loan and borrowing to pay for a college education. The chapter provides
you with an applied framework for evaluating the best ways to choose among and obtain
consumer loans.
One of the most important topics in the chapter is the computation of the annual percentage rate,
the APR. The APR is the primary way to compare alternative loans, that is, same type of loans
from two different sources. The nominal rate is not so useful.
Learning Goals
LG1 Know when to use consumer loans, and be able to differentiate between the major types.
It is important to point out that the ability to get a loan does not mean that you need to get the
loan. Loans are useful to help purchase high cost items, but should be used only when you can
afford the item being purchased and the related payoff of the loan.
LG2 Identify the various sources of consumer loans.
Section 7-1b has a list of common types of consumer loans. The power point slides has these
loans listed and will be sufficient to discuss the various types. It may prove useful to ask
students if they have one of the loans. You could ask a couple of students why they have that
type of loan.
LG3 Choose the best loans by comparing finance charges, maturity, collateral and other loan
terms.
Here is the key point of the chapter. Worksheet 7.1, “An Inventory of consumer Debt”, organizes
the various loans you may have and is very useful to see the impact of adding an additional loan.
The debt safety ratio is a statistic that will help judge your ability to manage another loan. That
ratio should be less than 20 to comfortably be able to pay off the debt. The ratio was discussed
in section 6-1d. It will be useful to review the ratio—it is important.
LG4 Describe the features of, and calculate the finance charges on, single payment loans.
Computation of the APR is the key point here. Go over the example in the chapter. The discount
method will need to be explained; the students’ previous exposure most likely has been limited to
simple interest loans.
LG5 Evaluate the benefits of an installment loan.
Installment loans are the most common consumer loans. The simple interest method of
computing finance charges should be compared to the add-on method using the APR. Simple
interest method APR is always the face rate. The add-on method will most likely be higher than
the alternative simple interest. But an add-on loan may be the only one available to the
consumer.
LG6 Determine the costs of installment loans, and analyze whether it is better to pay cash or take
out a loan.
Worksheet 7.2 organizes the comparison of pay cash or borrow. The key point is the rate of
return on the cash available. It you can earn more than the interest cost, borrow.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre-test questions” to get their attention.
• Buying a new car is the major reason that people borrow money through consumer loans.
Fact: Buying a new car accounts for about 35 percent of all consumer loans outstanding, which
is the single most common reason for taking out a consumer loan.
• Consumer loans can be set up with fixed rates of interest or with variable loan rates.
Fact: While fixed-rate loans still dominate the consumer loan market, variable-rate loans are
becoming more common, particularly with longer-term debt.
• An S&L is the only type of financial institution that is prohibited from making consumer loans.
Fantasy: Financial deregulation opened up the consumer loan market to S&Ls and they are an
important source of such credit.
• Single-payment loans are often secured with some type of collateral and are usually relatively
short-term in duration (maturities of one year or less).
Fact: Because these loans require only one payment at maturity, banks and other lenders
generally keep them fairly short-term and often require some type of collateral.
• Using the discount method to figure interest is one way of lowering the effective cost of a
consumer loan.
Fantasy: Because the interest is paid in advance on discount loans, the net effect is to
substantially raise the cost of borrowing. Specifically, a discount loan results in a true interest
rate (APR) that is much higher than the stated rate.
• The Rule of 78 is a regulation that grew out of the Consumer Credit Enhancement Act of 1978
and mandates how installment loans will be set up.
Fantasy: The Rule of 78s is a procedure that is used to find the monthly finance charges on add-
on loans.
Financial Facts or Fantasies?
These true/false questions may be used as quizzes or as pretest to get the students’ attention.
1. True False Buying a new car is the major reason that people borrow money through
consumer loans.
2. True False Consumer loans can be set up with fixed rates of interest or with variable
loan rates.
3. True False An S&L is the only type of financial institution that is prohibited from
making consumer loans.
4. True False Single-payment loans are often secured with some type of collateral and
are usually relatively short-term in duration (maturities of one year
or less).
5. True False Using the discount method to figure interest is one way of lowering the
effective cost of a consumer loan.
6. True False The Rule of 78 is a regulation that grew out of the Consumer Credit
Enhancement Act of 1978 and mandates how installment loans will
be set up.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
Current Auto Loan Rates
If you’re considering buying a car, you need to know current auto loan rates
to estimate prospective monthly payments and what price you can afford to
pay for an auto. Up-to-date market rates are available at
http://www.bankrate.com. You’ll see how much higher used auto loan
rates are than new auto loan rates. And you’ll get a sense of the trade-off
between auto loan rates and maturity, e.g., between 48 and 60 month loan
rates. Getting familiar with auto loan rates will help you be a more informed
shopper – you can do it now.
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss
the choices being made.
John and Mary Calculate their Auto Loan Backwards
John and Mary budget and spend their money carefully. Their Honda CRV has
over 150,000 miles and needs to be replaced. Because they drive their cars
so long, John and Mary have decided to buy a new car and have saved a
$5,000 down payment. They are willing to make a monthly car payment of
about $350 while 48 month loans are at 3 percent. Before they choose a new
car, they want to determine how much they can afford to spend.
John and Mary do their auto loan calculations backwards to figure out the
size of the auto loan implied by a 48 month maturity and 3 percent interest.
Using a calculator and the approach explained in this chapter, that loan
amount is about $15,813. Thus, given their down payment of $5,000, John
and Mary can afford a car selling for about $21,813 net of tax, title and
licensing fees. They are indeed careful, if not “backward,” car shoppers who
explore the angles.
Making the Payments!
For many of us, new cars can be so appealing! We get bitten by the “new car bug” and think how
great it would be to have a new car. Then we tell ourselves that we really need a new car because
our old one is just a piece of junk waiting to fall apart in the middle of the road. Of course, we
don’t have the money to purchase a new car outright, so we’ll have to get a loan. That means car
payments. The trouble is, car payments often turn out to be a lot less affordable after we actually
get the loan than we thought they would be before we signed on the dotted line. And they last
way beyond the time the new car aura wears off. This project will help you understand how loan
payments are determined, as well as the obligation that they place on you as the borrower. Let’s
assume for this project that your parents have promised to make the down payment on a new car
once you have your degree in hand. They have agreed to pay 30 percent of the cost of any car
you choose, so long as you are able to obtain a loan and make the payments on the remainder.
Find the price of the vehicle you would like by visiting a car dealership or pulling up a Web site
such as http://www.edmunds.com. Add another 4 percent to the price for tax, title, license, and
so on (or ask a dealer to estimate these costs for you). Take 70 percent of the total to determine
how much you’ll have to finance from your car loan. Then find out what the going rate is for car
loans in your area by calling or visiting your bank or by consulting a Web site such as
http://www.bankrate.com. Calculate what your monthly payments would be at this rate if you
financed the loan for three, five, and six years. How well do you think these car payments would
fit into your budget? What kind of income would you have to make to afford such payments
comfortably? If the payments are more than you thought they would be, what can you do to bring
them down?
Test Yourself Questions
7-1 List and briefly discuss the five major reasons for borrowing money through a
consumer loan.
1. Auto loans: The loan is secured with the auto, meaning that the vehicle serves as collateral
2. Loans for other durable goods: Consumer loans can also be used to finance other kinds of
3. Education loans: These loans can be used to finance either undergraduate or graduate
4. Personal loans: These loans are typically used for nondurable expenditures, such as an
5. Consolidation loans: This type of loan is used to straighten out an unhealthy credit situation.
When consumers overuse credit cards, credit lines, or consumer loans and can no longer
promptly service their debt, a consolidation loan may help control this deteriorating credit
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:
• Stafford loans (Direct and Federal Family Education Loans—FFELs)
• Perkins loans
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
school [only Stafford and Perkins loans allow deferral]. To help you service the debt, if you have
several student loans outstanding, then you can consolidate the loans, at a single blended rate,
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
be quantified by borrowing in light of the student’s expected future salary. Before borrowing, it
makes sense to explore all possibly available grants and scholarships and to apply for federal
7-5 Define and differentiate between (a) fixed- and variable-rate loans and (b) a single
payment loan and an installment loan.
Single-payment loans are made for a specified period of time, at the end of which payment in
Installment loans, in contrast, are repaid in a series of fixed, scheduled payments rather than in
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
individuals. These companies do not accept deposits but obtain funds from their stockholders and
through open market borrowing. Because they don’t have the inexpensive sources of funds that
banks and other deposit-type institutions do, their interest rates are generally quite high.
Businesses that sell relatively expensive items—such as automobiles, furniture, and appliances—
often provide installment financing to their customers. Because dealers can’t afford to tie up their
The largest sales finance organizations are the captive finance companies owned by the
manufacturers of big-ticket items—automobiles and appliances. General Motors Acceptance
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
types of credit from these institutions, but credit unions can offer membership to just about
S&L associations (as well as savings banks) primarily make mortgage loans. They aren’t major
players in the consumer loan field, but they do make loans for consumer durables and for home
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:
(1) does making this purchase fit into your financial plans; and
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,
Loan Maturity--Make sure that the size and number of payments will 3t comfortably
into your spending and savings plans. As a rule, the cost of credit increases with the length
Total Cost of the Transaction--When comparison shopping for credit, always
look at the total cost of both the price of the item purchased and the price of the credit.
Collateral--Make sure you know up front what collateral (if any) you’ll have to pledge on
Other Loan Considerations
In addition to following the guidelines just described, here are some questions that you
should also ask. Can you choose a payment date that will be compatible with your spending
patterns? Can you obtain the loan promptly and conveniently? What are the charges for late
7-10 What is a lien, and when is it part of a consumer loan?
Most single-payment loans are secured by certain specified assets. For collateral, lenders
prefer items they feel are readily marketable at a price that’s high enough to cover the
principal portion of the loan. The lenders don’t take physical possession of the collateral but
7-11 When might you request a loan rollover?
An individual will borrow money using a single-payment loan and then discover that he or
she is short of money when the loan comes due—after all, making one big loan payment can
cause a real strain on one’s cash ?ow. Should this happen to you, don’t just let the payment
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.
The two basic procedures used to calculate the finance charges on single-payment loans are the
Interest is charged only on the actual loan balance outstanding in the simple interest method.
The discount method calculates total finance charges on the full principal amount of the loan,
which is then subtracted from the amount of the loan. The difference between the amount of the
Because the interest is paid in advance on discount loans, the net effect is to substantially raise
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
loans have long been one of the most popular forms of consumer credit. As a financing vehicle,
there are few things that installment loans can’t do—which explains, in large part, why this form
7-14 What is a home equity loan, and what are its major advantages and disadvantages?
An installment loans secured by second mortgages typically on personal residence is referred to
as home equity loans. The major advantage of home equity loans is the tax deductibility of the
interest. The loan may be used for any purpose, but for the interest to be deductible, the principal
must be no more than the lesser of the fair market value of the home less the first mortgage or
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
life insurance and possibly credit disability insurance. Credit life (and disability) insurance is
tied to a particular installment loan and provides insurance that the loan will be paid off if the
borrower dies (or becomes disabled) before the loan matures. These policies essentially insure
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
Some installment loans, particularly those obtained directly from retail merchants or made at
finance companies and the like, are made using the add-on method. Add-on loans are very
expensive. Indeed, they generally rank as one of the most costly forms of consumer credit, with
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?
Essentially, it all boils down to this: If it costs more to borrow the money than you can earn in
