Personal Finance - Chapter 9: Personal Loans PDF

Personal Finance SIXTH EDITION Chapter 9 Personal Loans Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Chapter Objective (1 of 2) 9.1 Provide a ba...

Personal Finance SIXTH EDITION Chapter 9 Personal Loans Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Chapter Objective (1 of 2) 9.1 Provide a background on personal loans 9.2 Outline the types of interest rates that are charged on personal loans 9.3 Discuss car loans 9.4 Explain how to decide between financing the purchase of a car and leasing a car Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Chapter Objective (2 of 2) 9.5 Describe the key features of student loans 9.6 Describe home equity loans 9.7 Describe payday loans Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (1 of 7) Usually obtained to finance a large purchase Sources of personal loans – Financial institutions ▪ Commercial banks, savings institutions, credit unions and finance companies – Family members or friends ▪ Loan agreement should be in writing and signed by all parties Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (2 of 7) Peer-to-Peer Lending According to data from Khalifa Fund, approximately 50-70% of SMEs applications for funding are declined by traditional banks. Loans to SMEs account for less than 4% of the outstanding bank credit in the UAE, below the Middle East and North Africa (MENA) region average of 9.3%. – Also known as P2P(Beehive is one of the most popular platforms in the country.) – Conducted through online platforms – More than US$35 million in 2017 provided by individual investors via Beehive. – Amounts are typically from AED100K – AED1.5M Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (3 of 7) Determining whether a loan is sensible – Periodic payments will be required over time – You are sacrificing future earnings – Avoid a loan if your source of income to repay it is questionable Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (4 of 7) The personal loan process – Application process ▪ Personal balance sheet ▪ Personal cash flow statement – Loan contract: a contract that specifies the terms of a loan, as agreed to by the borrower and the lender ▪ Amount of the loan ▪ Interest rate Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (5 of 7) – Loan repayment schedule ▪ Amortize: to repay the principal of a loan through a series of equal payments ▪ Each payment includes part of the principal and part of the interest – Maturity: the life or duration of the loan ▪ Longer maturity equals lower payments, but more interest is paid over the life of the loan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Background on Personal Loans (6 of 7) – Collateral: assets of a borrower that back a secured loan in the event that the borrower defaults ▪ Secured loan: a loan that is backed or secured by collateral ▪ Unsecured loan: a loan that is not backed by collateral – Cosigning is sometimes required if credit history is weak Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Interest Rates on Personal Loans (1 of 5) Annual percentage rate (APR): a rate that measures the finance expenses (including interest and other expenses) on a loan annually – Standard rate required to be disclosed by lenders – Provides comparison between lenders Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Interest Rates on Personal Loans (2 of 5) Simple interest: interest on a loan computed as a percentage of the existing loan amount (or principal) – Size of payment depends on size of loan, interest rate and maturity – The higher the interest rate, the higher the payment Add-on interest: a method of determining the monthly payment on a loan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Interest Rates on Personal Loans (3 of 5) EXHIBIT 9.2 Measurement of the Annual Percentage Rate Other Total Annual Interest Finance Finance Number of Average Annual Percentage Expenses Expenses Expenses Years Finance Expenses Rate (APR)* Bank A $200 0 $200 1 $200 $200/$2,000 = 10% Bank B 160 $100 260 1 260 $260/$2,000 = 13% Bank C 120 200 320 1 320 $320/$2,000 = 16% *The APR is calculated by dividing the average annual finance expenses by the average annual loan balance. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Interest Rates on Personal Loans (4 of 5) EXHIBIT 9.3 Example of Loan Repayment Schedule: One-Year Loan, 12% Interest Rate (Monthly Payment = $177.70) Month Interest Payment Payment of Principal Outstanding Loan Balance $2,000.00 1 $20.00 $157.70 1,842.30 2 18.42 159.28 1,683.02 3 16.83 160.87 1,522.16 4 15.22 162.48 1,359.68 5 13.60 164.10 1,195.58 6 11.96 165.74 1,029.84 7 10.30 167.40 862.44 8 8.63 169.07 693.37 9 6.94 170.76 522.61 10 5.23 172.47 350.13 11 3.50 174.20 175.94 12 1.76 175.94 0 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (1 of 6) How much money to spend on a car? – Consider how your decision affects your personal budget – Adding credit card debt to car loan debt – The no-debt solution ▪ Only buy what you can pay cash for – The limited-debt solution ▪ Short term loan Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (2 of 6) Selecting the car—things to consider – Personal preferences – Price – Condition – Insurance – Resale value – Repair expenses – Financing rate – Revised car loan contracts Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (3 of 6) EXHIBIT 9.4 Stephanie Spratt’s Car Analysis Expected Resale Value After Two Years Repair Expenses (as a proportion of and Service Car original sales price) Maintenance Insurance A Low Moderate High B Moderate Low Low C Moderate Moderate High D Moderate High Moderate E Moderate Low Moderate Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (4 of 6) Negotiating the price – Negotiating by phone may be beneficial – Trade-in tactics can be misleading – No-haggle dealers can save time and stress – Information is valuable–shop around – Purchasing a car online is possible, but not yet a streamlined process Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (5 of 6) Financing decisions – Estimate the dollar amount of the monthly payment before you shop – Longer financing periods (up to seven years) provide lower payments – Car may be worthless by the time you pay it off Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Car Loans (6 of 6) EXHIBIT 9.5 Stephanie Spratt’s Possible Monthly Loan Payments (7.6% interest rate) Loan Amount Loan Maturity $15,000 $17,000 36 months (3 years) $467 $530 48 months (4 years) 363 412 60 months (5 years) 301 341 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Purchase versus Lease Decision (1 of 4) Leasing is a popular alternative to buying a car Advantages of leasing – Lower down payment – Just return the car at the end of the lease period Decision is highly dependent on the estimated market value of the car at the end of the lease period Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Purchase versus Lease Decision (2 of 4) Disadvantages of leasing – You build no equity in the car – You are still responsible for maintenance and damages – Additional charges may be imposed ▪ If you drive too many miles ▪ If you end the lease before the specified period Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Purchase versus Lease Decision (3 of 4) EXHIBIT 9.6 Stephanie Spratt’s Comparison of the Cost of Purchasing Versus Leasing Cost of Purchasing the Car Cost 1. Down payment $1,000 2. Down payment of $1,000 results in forgone interest income: Forgone Interest Income per Year = Down Payment × Annual Interest Rate = $1,000 ×.04 = $40 Forgone Interest over Four Years = $40 × 4 = $160 160 3. Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months = $412 × 48 = $19,776 $19,776 Total $20,936 Minus: Expected amount to be received when car is sold in four years 10,000 Total cost $10,936 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Purchase versus Lease Decision (4 of 4) EXHIBIT 9.6 Stephanie Spratt’s Comparison of the Cost of Purchasing Versus Leasing Cost of Leasing the Car for Four Years Cost 1. Security deposit of $800 results in forgone interest income (although she will receive her deposit back in four years): Forgone Interest Income per Year = Down Payment × Annual Interest Rate = $800 ×.04 = $32 Forgone Interest over Four Years = $32 × 4 = $128 $128 3. Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months = $300 × 48 = $14,400 14,400 Total cost $14,528 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Student Loans Student loan: a loan provided to finance part of the expenses a student incurs while pursuing a degree Loan may be provided to either the student or the student’s parents Repayment typically deferred until student is out of school Interest may be tax deductible Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Home Equity Loan (1 of 3) Home equity loan: a loan where the equity in a home serves as collateral for the loan Equity of a home: the market value of a home minus the debt owed on the home Credit limit on a home equity loan – Limit based on equity invested – Financial institutions usually loan up to 80% of the equity in a home Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Home Equity Loan (2 of 3) Impact of the economy on the credit limit – As economic conditions change, so does the value of a home – Market values of homes may decline substantially, leaving no equity in the home Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Home Equity Loan (3 of 3) Interest rate – Typically variable – Rate is usually tied to an interest rate index and adjusted periodically Interest paid on a home equity loan up to $100,000 is tax-deductible Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved  Payday Loans Payday loan: a short-term loan provided in advance of a paycheck Reasons to avoid payday loans – Using your next paycheck to cover the loan may make you unable to cover your normal purchases – Cost of financing is outrageous – Typically costs several hundred percent a year Alternatives to payday loans – Friends, family members, credit cards Copyright © 2017, 2014, 2011 Pearson Education, Inc. 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