AFN 221 Personal Finance - Consumer Credit PDF

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WinningIambicPentameter

Uploaded by WinningIambicPentameter

University of Cyprus

2022

Andreas Milidonis

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consumer credit personal finance financial literacy economics

Summary

This document covers consumer credit, discussing its advantages and disadvantages, including concept maps, learning objectives, and a background section on borrowing.

Full Transcript

AFN 221 Personal Finance Lecture Topic: Consumer credit Andreas Milidonis Department of Accounting & Finance University of Cyprus...

AFN 221 Personal Finance Lecture Topic: Consumer credit Andreas Milidonis Department of Accounting & Finance University of Cyprus Email: [email protected] 1 “Concept Map” for the Course Introduction Interest Rates Inflation & Time Money Management Savings Consumer Borrowing (Credit) Review & Midterm Exam Mortgage Insurance & Risk Investing Management Retirement Risk & Return Biases Review & Final Exam 2 2 Chapter 6 Learning Objectives Define consumer credit and analyze its advantages and disadvantages. Assess your credit capacity and build your credit history. 3 3 Background While so much attention has been devoted to wealth and wealth management, most people carry debt. – Need to look at both sides of the balance sheet Consumer borrowing: People increasingly start their working life in debt (student debt, car loans, credit card debt) Debt carries much higher interest rate than assets Opportunities to borrow have grown tremendously and have become very profitable fields At the macro level as well, the financial crisis had to do with debt 4 4 Some facts Student loans have grown to more than $1.5 trillion in the US. – 45% of Americans age 18-34 have student loan debt. Source: 2015 National Financial Capability Study About half of credit card holders carry a balance. FINRA Financial Capability Study (several waves) Borrowing has increased also against retirement accounts. Of each dollar put in, 50 cents leaked out during the financial crisis. Source: Sabelhaus, J. et al. "Changes in U.S. Family Finances from 2007 to 2010: Evidence from the Survey of Consumer Finances." Federal Reserve Bulletin, 2012. In 2013 in Cyprus, many retirement plans were shut down so that people would take their savings out. High-cost methods of borrowing have become common. 5 5 Consumer borrowing / credit There are many reasons why consumers borrow.  To finance an education with a student loan.  To finance consumption with a credit card, home equity line of credit, or a personal loan.  To buy a car with an auto loan.  To fund a business with a credit card, home equity line of credit, or business loan.  To buy a home with a mortgage loan.  To finance home improvements with a home equity loan.  To finance an investment with a margin loan. 6 6 What is Consumer Credit? Define consumer credit and analyze its advantages and disadvantages. – CREDIT is an arrangement to receive cash, goods, or services now and pay for them in the future – CONSUMER CREDIT is the use of credit for personal needs (except a home mortgage) by individuals and families 7 7 Financing Alternatives and Trade-offs – THREE WAYS CONSUMERS CAN FINANCE PURCHASES 2 Draw on savings 1 Use present earnings 3 Borrow against expected future income – TRADE-OFFS WITH EACH ALTERNATIVE Depleting savings reduces emergency funds Spending current income on luxuries will eventually reduce future well-being Spending future income now reduces funds available for future expenses 8 8 Uses and Misuses of Credit – Before you use credit for a major purchase, consider these questions: Do I have the cash for the down payment? Do I want to use my savings for this purchase? Does the purchase fit my budget? Could I use the credit I need in some better way? Can I postpone this purchase? What are the opportunity costs of postponing this purchase? What are the dollar and psychological costs of using credit for this purchase? 9 9 Importance and Advantages of Credit (1 of 2) – CONSUMER CREDIT IMPORTANCE A major force in American economy – ADVANTAGES OF CREDIT Immediate access to goods and services Permits purchase even when funds are low A cushion for financial emergencies Advance notice of sales Easier to return merchandise Convenient when shopping 10 10 Importance and Advantages of Credit (2 of 2) One monthly payment Safer than cash Needed for hotel reservations, car rentals, and shopping by phone Indicates financial stability 11 11 Disadvantages of Credit Temptation to overspend Failure to repay loan may result in loss of income, valuable property, and your good reputation Misuse of credit can create serious long-term financial problems, damage to family relationships, and a slowing of progress toward financial goals It does not increase total purchasing power Credit costs money 12 12 Measuring Your Credit Capacity Assess your credit capacity and build your credit rating. – CAN YOU AFFORD A LOAN? Ask yourself if you can meet all essential expenses and still afford the monthly loan payments Ask yourself what do you plan to give up in order to make the monthly payment? – Are you prepared to make this trade-off ? 13 13 Debt Payments-To-Income Ratio Debt Payments-to-Income Ratio Divide your monthly debt payments by your net monthly income Do not include your house payment in your monthly debt payments total as it is a long-term liability your monthly debt payments net monthly income Consumer credit payments should not exceed a max of 20% of your net (after-tax) income 14 14 Calculating Debt Payments-To-Income Ratio – Example If your monthly net income is $2,136 (gross income less taxes and monthly retirement contribution) and your monthly installment credit payments total $426 (includes credit cards and auto loan), then your debt payments-to-income ratio is 19.94%. $426 / $2,136 = 19.94% 15 15 Debt-To-Equity Ratio Debt To Equity Ratio Divide your total liabilities by your net worth Do not include the value of your home and the amount of its mortgage in total net worth Total Liabilities = Should be < 1 Net Worth 16 16 Cosigning a Loan The creditor will give you a notice that tells you… You are being asked to guarantee the debt, so consider if you can afford it if the borrower defaults If the borrow does not pay, you may have to pay up to the full amount and also any late or collection fees If a payment is missed, the creditor can collect the debt from you without first trying to get it from the borrower Some studies show that three of four cosigners are asked to wholly or partially repay the loan 17 17 If You Do Cosign – If you do cosign, consider... Can you afford to pay the loan? If not, your credit rating could be damaged Liability for this debt may prevent you from getting other credit that you want If you pledge property, you could lose it if the loan goes into default Check your country’s law to learn about cosigner’s rights Request that a copy of overdue-payment notices be sent to you 18 18 Credit History (Rating) – BUILDING AND MAINTAINING YOUR CREDIT HISTORY (RATING) A good credit rating is a valuable asset that should be nurtured and protected Limit your borrowing to your capacity to repay Live up to the terms of contracts In Cyprus the rating only shows if you have an NPL or not. You can request a copy of your own report by writing to ARTEMIS https://www.artemis.com.cy/ 19 19 Building and Maintaining Your Credit – However! – Banks in Cyprus are developing their own credit rating system for their clients based on their own data. – For example, factors that may be included in this credit score are: – Income – Loan balance – Any delays in paying off loan balances – Net worth – Liquidity – etc 20 20 How to Improve Your Credit Score! Get copies of your credit report — review for accuracy Pay your bills on time Understand how your credit score is determined Learn the legal steps to take to improve your credit report Beware of credit-repair scams 21 21 The cost of borrowing The interest rate is the price of money.  When you borrow money today, you must not only return it in the future, but you must also pay interest. Interest is the cost of borrowing. Borrow Today Repay in the Future Repay Dollar Dollar + interest  The higher the interest rate, the higher the cost of borrowing, and the more you will ultimately pay. So pay attention to the interest rate when you borrow. 22 22 Interest and debt growth We learned about interest compounding and saw that debt can grow quickly with a high interest rate. Let’s see how long it takes for debt to double at different interest rates. Time for Debt to Double 40 35.0 Years 35 30 25 20 14.2 Years 15 10 7.3 Years 5.0 Years 3.8 Years 5 3.1 Years 1.7 Years 0 2% 5% 10% 15% 20% 25% 50% Interest Rate 23 23 Interest and debt growth A rule of thumb is the “Rule of 72”. If you divide the number 72 with the interest on a loan (or deposit) you will find the number of years that it approximately takes to double. Time for Debt to Double 40 35.0 Years 35 30 25 20 14.2 Years 15 10 7.3 Years 5.0 Years 3.8 Years 5 3.1 Years 1.7 Years 0 2% 5% 10% 15% 20% 25% 50% Interest Rate 24 24 Installment Loans 25 Installment loans In an installment loan, a borrower must repay the loan in fixed payments according to a set schedule.  An installment loan that requires annual payments for N years will have the following cash flow structure: Borrowed Amount Year 1 Year 2 … Year N-1 Year N Payment Payment … Payment Payment  The payment will be the same each year. After the Nth payment, the loan will be fully repaid.  Mortgages, student loans, auto loans, and personal loans are all common types of installment loans. 26 26 Auto loans Auto loans are a good example of installment loans. Imagine that you borrow $80,000 to buy a fancy car. You take out a 5-year auto loan with an interest rate of 7% that requires annual payments. You must make payments of $19,511 a year for the next 5 years: $80,000 Year 1 Year 2 Year 3 Year 4 Year 5 $19,511 $19,511 $19,511 $19,511 $19,511 Auto loans are collateralized loans – this means if you don’t make your payments, the lender can take your car! 27 27 Interest on installment loans The balance on an installment loan won’t grow over time, but a higher interest rate is still costly: a higher interest rate on an installment loan results in a higher fixed payment. Annual Payment Let’s compare the fixed payment on the 7% $22.2 five-year auto loan with a 12% loan. $19.5 K K A 7% loan requires payments of $19,511. A 12% loan requires payments of $22,193. The 12% loan costs about $2,700 more each year! @ 7% @ 12% 28 28 Interest on installment loans And a higher interest rate and higher fixed payment implies a higher total interest expense over the life of the loan. Let’s compare the total interest expense on a 7% loan to a 12% loan. Interest Expense $31.0 The 7% loan requires total payments of: K 5 ∗ $19,511 = $97,555 $17.6 K $80,000 is the principal. The remaining $17,555 is the interest expense. The interest expense on the 12% loan is $30,965.This is almost twice as much interest! @ 7% @ 12% 29 29 Loan Amortization 30 Loan amortization When a loan is repaid in installments, the loan balance (the amount still owed at a given time, i.e. the principal) is gradually reduced over time.  This is known as amortization.  When a balance is amortized, a portion of each payment is used to repay the interest accrued on the balance between payments.  The remainder is used to reduce the balance.  As the balance shrinks, the interest owed in each subsequent period will decline, and a larger portion of the payment will be used to reduce the principal. 31 31 Loan amortization The following chart shows the principal and interest payments for the 7% auto loan discussed earlier. Loan Amortization Principal Interest $20K $1.3K $3.6K $2.5K $5.6K $4.6K $15K $10K $17.0K $18.2K $14.9K $15.9K $13.9K $5K $0K Year 1 Year 2 Year 3 Year 4 Year 5 The payment is $19.5K each year, but the interest payment declines while the principal payment increases. 32 32 Loan amortization Let’s see how this works.  The beginning balance is $80K and the interest rate is 7%. Therefore, the interest payment for the first year is $5.6K. 0.07 ∗ $80,000 = $5,600  Since the full payment is $19.5K, the principal portion of the payment is $13.9K. $19,511 − $5,600 = $13,911  The balance is reduced by this principal payment and becomes $66.1K. $80,000 − $13,911 = $66,089 33 33 Loan amortization Because the balance is smaller going into the second year, the interest payment will be smaller.  The balance at the beginning of the second year is now $66.1K, and so the interest expense falls to $4.6K. 0.07 ∗ $66,089 = $4,626  The principal portion of the payment increases to $14.9K $19,511 − $4,626 = $14,885  And the balance is reduced to $51,204. This process continues with the interest payment declining each year and the principal payment increasing. In the fifth year, the principal payment completely pays the remaining balance. 34 34 Implications of loan amortization What are the implications?  How much of the loan have you paid back after a few installments?  What happens if T is high, such as 30 years?  Is it always better to have a high T?  Can you borrow the entire amount you need to say buy a car, a house, a household appliance? If yes, which interest rate are you likely to get? 35 35 Student Loans 36 Student loans Over the last two decades, the amount of money students borrow to finance their education has increased. According to data from the 2015 National Financial Capability Study  45% of Americans age 18-34 have student loan debt.  Nearly 1 in 5 of American student loan holders do not know how their monthly payments are determined.  More than half (53%) of American borrowers said that they would make a change if they could go through the process of taking out loans all over again. How expensive is student debt? 37 37 Student loan payments  If you saved $180,000 of the $200,000 needed for your child’s college education, and they have to borrow the remaining $20,000 with a 10-year student loan charging an 8% APR, their monthly payment will be $243.  If you only save half of the $200,000 and they borrow $100,000, their monthly payment will be $1,213.  If they borrow the full $200,000, their monthly payment will be $2,427! Monthly Student Loan Payments $3,000 $2,427 $2,500 $2,000 $1,500 $1,213 $1,000 $500 $243 $0 $20,000 $100,000 $200,000 Borrowed Amount 38 38 Credit Cards 39 Credit Cards: 2015 National Financial Capability Survey (NFCS) In the past 12 months… Total 18-34 35-54 55+ I always paid credit cards in full 52% 54% 44% 59% In some months, I carried over a 47% 46% 56% 40% balance and was charged interest In some months, I paid the 32% 43% 38% 20% minimum payment only In some months, I was charged a fee 14% 21% 15% 6% for late payment In some months, I was charged a fee 8% 14% 8% 3% for exceeding my credit line In some months, I used the cards for 11% 17% 11% 7% a cash advance Source: 2015 NFCS by FINRA Investor Education Foundation 40 40 Credit cards Unlike most consumer loans, a credit card loan is not an installment loan but a revolving loan, or line of credit.  In a revolving loan or line of credit, the borrower does not borrow a fixed amount, but rather has the right to borrow incrementally over time up to some credit limit.  The interest rate is applied to whatever balance is outstanding in a month to find the interest expense due in the following month.  Typically, credit cards and other lines of credit require a minimum monthly payment, and this is often just the interest expense. 41 41 Credit cards (simplified payment) Here’s an example:  Joy has a credit card that carries a 24% APR with a $5,000 credit limit. This month, she has a balance of $2,000 on her card.  Next month, she must pay $40 in interest (a 24% APR corresponds to a 2% monthly interest rate): 0.02*$2,000 = $40.  If she makes a payment of $240, the $40 will pay the interest and the remaining $200 will reduce her balance to $1,800. She will then owe $36 in interest the next month: 0.02*$1,800 = $36.  If Joy then uses her credit card to buy a new $1,000 bike, her balance will increase to $2,800. She will then owe $56 in interest the next month: 0.02*$2,800 = $56.  Joy must pay at least the interest expense each month. She may use her credit card to make purchases as long as her balance does not exceed her credit limit of $5,000. 42 42 Making the minimum payment Let’s figure out how long it takes to pay off a credit card. You have a $10,000 balance on your credit card with a 18% APR. If you make the minimum payment of $150 each month, how long will it take you to pay off your credit card? 43 43 Making the minimum payment With a $10,000 balance on a credit card with a 18% APR (1.5% monthly), the monthly interest expense is $150: 1.5% ∗ $10,000 = $150 If you only pay the $150 minimum, the full $150 will go toward the interest and $0 will be left to amortize the balance. You will be required to pay $150 until you make extra payments to reduce the principal. Over a year, that’s $1,800 in interest. Over 5 years, it’s $9,000, and in 20 it’s $36,000. This is much more than the original borrowed amount $10,000 (which you still have to repay)! Credit Card Interest (18% APR) Principal Interest $50,000 $40,000 $30,000 $36,000 $20,000 $18,000 $9,000 $10,000 $0 44 One year Two years Five years Ten years Twenty years 44 Summary What is consumer borrowing? Advantages and disadvantages of consumer borrowing. Debt to income ratio Debt to equity ratio Cosigning a loan => can you pay it? Credit history is here! It will affect your cost of borrowing. Examples using different types of loans (auto loans, student loans, credit cards). 45 45

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