FINC 2400 PERSONAL FINANCE SPRING 2018 CHAPTER 7. Part 1: ABOUT LOANS AND LOAN TYPES

Transcription

1 FINC 2400 PERSONAL FINANCE SPRING 2018 CHAPTER 7 Part 1: ABOUT LOANS AND LOAN TYPES Sven Thommesen

2 THE ESSENCE OF CREDIT The lender provides you with a sum of money today: the loan. You promise to give him back the full amount (the principal) at a later date. Normally, you also need to pay him interest, usually on the unpaid portion of the loan balance. The specific terms of the loan are spelled out in the loan contract. 2

3 SOME ASPECTS OF THE LOAN PROCESS Loans may be secured or un-secured. The difference is what happens if you do not make payments as agreed. With a secured loan, some item or asset has been pledged as security for the loan, and the lender can grab that asset if your loan is in default. (Examples: a car loan, a mortgage.) With an unsecured loan, the lender would have to drag you into bankruptcy court to get money out of you. Since secured loans carry less risk for the lender than an unsecured loan, a secured loan will tend to charge a lower interest rate. When you apply for a loan, the lender initiates an evaluation process called underwriting: the purpose is to assess how risky you are as a borrower. For this they use your credit history, plus other information you give them. The loan you get depends on what they find. If your credit history is good, you will get the best ( prime ) interest rate. If your credit history is not so good, you may get charged a higher ( sub-prime ) interest rate. If your credit history is truly bad, you may be turned down. Interest rates charged on a loan or account may be fixed or variable. If they are fixed, they remain the same for the duration of the loan. If they are variable, they typically vary from month to month tied to a designated market rate (the index rate.) Credit cards fall in-between; they may say fixed but will change if market rates go up or down significantly. 3

4 TYPES OF LOANS NON-INSTALLMENT CREDIT This refers to loans that are short term (30-90 days); interest may or may not be charged. You pay off the loan in full at the end. Treasury bills and commercial paper are examples of non-installment credit. INSTALLMENT CREDIT This refers to longer term loans (up to 30 years for a mortgage). You will need to make regular (monthly) payments to the lender to pay off the loan. You will be charged interest, usually on the unpaid portion of the principal. Interest rates are usually fixed. Each monthly payment will consist of variable portions of interest and reduction of principal. Normally, the loan will be fully paid off when you make the last monthly payment. A. A fully amortized installment loan behaves as described above. You make a specific number of equal-size payments. B. A balloon loan: there will be a large outstanding balance at the end of the loan term, which you have to pay at that time. This payment is referred to as the balloon payment. A balloon loan will have smaller monthly payments than a fully amortized loan of the same size. C. An interest-only loan: your monthly payment is just large enough to pay a month s interest on the amount your borrowed; your balloon payment at the end will be equal to the amount you borrowed. 4

5 REVOLVING OPEN-ENDED CREDIT A revolving credit account (examples: a credit card, a home equity line of credit) is an account where you are given a maximum amount you can borrow (your credit limit), then you decide when and how much you borrow, for example by purchasing something and charging it to your credit card. Each month the outstanding balance (the amount you owe) will increase when you charge new items, and it will increase when the lender adds monthly interest charges. On the other hand, the balance is reduced whenever you make payments to the lender. The lender may require a minimum monthly payment to keep your account in good standing. Interest rates for revolving credit accounts can be (relatively) fixed (some credit cards), or variable (e.g. for home equity lines of credit.) Rates will be relatively low for a secured account (such as a HELOC), but can be high for unsecured accounts such as credit cards, especially if you have a poor credit score. (The penalty rate for credit cards can run 30% or more!) 5

6 TAKING OUT A LOAN 1. Deciding whether it makes sense to take out the loan you are contemplating. Would it be better to save first, then pay cash? Can you afford the resulting loan payments? Budgeting. 2. Shopping for the best terms. For credit cards, a low interest rate and a low or zero annual fees are preferred. For fully amortized loans, look for the lowest APR. 3. Qualifying for the loan a. Your credit score (the higher the better) b. Your income (sufficient to pay off the loan?) c. Your balance sheet: do you have other debt as well? d. Do you have collateral to offer? 4. After getting the loan: budget the required monthly loan payment. Keep up with the monthly statements you get. 6

7 THE COST OF CREDIT: SOME EXAMPLES 7

8 CREDIT CARDS Assume that you have an average balance of $15,000 that you carry from month to month. With an interest rate of 18%, that ll cost you $2,700 in interest per year; With an interest rate of 30%, it will cost you $4,500 in interest per year. Your minimum monthly payment will likely be about 2%, or $300 per month. 8

9 STUDENT LOANS Say you graduate with a student loan balance of $30,000 (about average). You are expected to pay it off over 10 years at 6% interest. Your monthly payment will be $ (If you double the loan your payment doubles as well.) The sum of payments when you are done will be $39, In other words, total interest paid will be $9,

10 CAR LOANS Let us say that you purchase a $40,000 car and finance the full amount. Then we have the following results for the size of the monthly payment and the total sum of interest paid, depending on the interest rate and the length of the loan: 3 years 8% 1, , % 1, , years 8% , % , years 8% , % , Pattern: the longer the loan, the smaller the monthly payment, but the more aggregate interest you pay. As you know, used cars lose value over time due to depreciation. Based on a pace of 20% off-the-lot and 8% per year, the above car would have the following value at the end of the loan: 3 years: $25,600 5 years: $19,200 7 years: $12,800 10

11 HOME MORTGAGES Let us say you purchase a $300,000 home. You finance 95% of it at 4% over 30 years. (Your down payment is 5% or $15,000.) Then: Total amount borrowed = $285,000 Monthly payment = $1, Sum of payments = $489, Total interest paid = $204, (68.3% of price) Total cost of house = $504, NOTE that your monthly payment is likely to be $ higher than the above sum, to pay for property taxes and homeowner s insurance. 11

12 SUB-PRIME LOANS A sub-prime loan is a small and/or short term loan offered to a borrower with poor credit. Such loans carry a high interest rate. An example of such a loan actually offered: You borrow $ You make 12 monthly payments of $ to pay it back. The sum of payments = $1, Total interest paid = $ The resulting APR = 58.04% 12