Managing Personal Finance Lecture 4 PDF

GE1202 Managing Your Personal Finance Lecture 4 Consumer Credits and Loans What is Consumer Credit? Credit is an arrangement to receive cash, goods, or services now and pay for them in the future Consumer credit refers to the use of credit for personal needs (except a home mortgage)...

GE1202 Managing Your Personal Finance Lecture 4 Consumer Credits and Loans What is Consumer Credit? Credit is an arrangement to receive cash, goods, or services now and pay for them in the future Consumer credit refers to the use of credit for personal needs (except a home mortgage) by individuals and families It is based on trust in people’s ability and willingness to pay bills when due It works because people by and large are honest and responsible The advancement of payment technology has popularized the use of credit Two Types of Credit 1. Closed-end credit One-time loans that the borrower pays back in a specified period of time and in payments of equal amounts Three most common types of closed-end credit a. Instalment sales credit A loan that allows you to receive merchandise Make a down payment and repay the balance (plus interest) in equal instalments over a specified period b. Instalment cash credit Direct loan of money Make no down payment and repay the balance (plus interest) in equal instalments over a specified period c. Single lump-sum credit A loan that must be repaid in total on a specified day Usually 30 – 90 days Two Types of Credit 2. Open-end credit A line of credit in which loans are made on a continuous basis and the borrower is billed periodically for at least partial payment Line of credit The maximum dollar amount of credit the lender has made available to you You may have to pay interest, a periodic charge, or other finance charges Two common types of open-end credit Credit card Revolving credit line Revolving Credit Line This is a prearranged loan for a specified amount Similar to a cash advance as funds are available up front Revolving credit differs from an installment loan Installment loan has a fixed number of payments over a set period of time whereas revolving funds only require payment of interest plus any applicable fees new loan application and credit reevaluation does not need to be completed upon utilizing revolving credit Revolving credit is intended for shorter, smaller loans Revolving credit differs from credit card Revolving credit does not require a specific purchase Typically has significantly lower interest rates compared to credit cards Example: DBS Three Types of Revolving Credit 1. Overdraft Protection A line of credit linked to a checking account that allows a depositor to overdraw the account up to a specified amount 2. Unsecured Personal Credit Line A line of credit made available to an individual on an as needed basis 3. Home Equity Line of Credit A line of credit extended to a homeowner that uses the borrower's home as collateral Second mortgage on your home It provides access to a lot of relatively inexpensive credit You could lose your home Home Equity Line of Credit Example: A couple buys a home for $2,850,000 10 years later, it’s worth $3,650,000 The couple now has an asset worth $3,650,000 on which all they owe is the original mortgage, which may now have a balance of $2,200,000. The amount of equity in the house is $3,650,000 – $2,200,000 = $1,450,000 In order for them to tap that equity without having to sell their home, they can use the home equity credit line 75% loan-to-market-value ratio 75% of $3,650,000 = $2,737,500 $2,737,500-$2,200,000(remaining mortgage) = $537,500 Advantages of Credit Using credit increases the amount of money a person can spend to purchase goods and services now Solution to the inconsistence between income and spending Advantages: Allows us to allocate our financial resources more effectively Cushion for financial emergencies Grip the chance of low price Convenient when shopping Can take advantage of grace period Indicates financial stability Uses of Credit If you decide to use credit, make sure the benefits of purchasing now outweigh the costs Ask yourself the following questions before you decide how and when to make a major purchase: Do I have the cash I need 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 for this purchase in some better way? Could I postpone the purchase? What are the OC of postponing the purchase? What are the dollar costs and psychological costs of using credit? Misuses of Credit Use your credit card to make everyday purchases Using your credit card as a substitute for cash is a habit that can quickly lead to debt Make impulse purchases Research findings suggest that emotions and feelings play a decisive role in purchasing, triggered by seeing the product or upon exposure to a well crafted promotional message Use your credit card to buy things you cannot afford Living a borrowed lifestyle is the quickest way to get into debt. If you cannot afford a purchase today, chances are you will not be able to afford it tomorrow, or even next month Get into the habit of making minimum monthly payments To pay your debts off quicker and cheaper, you should pay as much as you can on your balance each month Avoid the Minimum-Monthly-Payment Trap The minimum monthly payment is the smallest amount you can pay and still be a cardholder in good standing It is typically the greater of HK$50 or between 2% or 3% of the balance Bank Credit Cards Line of credit depends on applicant’s financial status and ability to pay Cash advances and balance transfers A loan that can be obtained by a bank credit cardholder at any participating bank of financial institution You have the option to pay the bill in full within the grace period without interest charges Some creditors allow you a grace period of 20 to 25 days to pay a bill in full The outstanding balance will attract interest at a relatively high rate Interest rates on credit cards are amongst the highest rates charged on debt Charges Comparison How high is the finance charge on credit card balance? The annualized return on the Dow Jones Index from 1987 to 2012 8% The annual return of Warren Buffett from 1967 to 2007 21.1% Other Fees Annual fees Transaction fees Late-payment fees Over-the-limit fees Balance transfer fees Foreign transaction fees Computing Finance Charge The Average Daily Balance method (ADB)is a way of calculating interest by considering the balance owed at the end of each day of the period rather than the balance owed at the end of the week, month or year. If interest compounds monthly, then use the following formula to calculate interest under the average daily balance method: S 𝑖 Interest = × D 𝑃 S = the sum of the daily balances in the billing period D = number of days in the billing period i = annual interest rate P = number of billing periods per year (usually 12)  Day of Billing Cycle Beginning Balance Charges Payments Ending Balance 1 $ - $ 200.00 $ 200.00 2 $ 200.00 $ 200.00 3 $ 200.00 $ 200.00 4 $ 200.00 $ 350.00 $ 550.00 Example of ADB 5 6 $ $ 550.00 550.00 $ $ 550.00 550.00 7 $ 550.00 $ 550.00 8 $ 550.00 $ 100.00 $ 650.00 Assume you have a credit 9 $ 650.00 -$ 50.00 $ 600.00 card that uses the average 10 $ 600.00 $ 600.00 daily balance method and 11 $ 600.00 $ 400.00 $ 1,000.00 charges an 18% annual rate 12 $ 1,000.00 $ 1,000.00 of interest. 13 $ 1,000.00 $ 1,000.00 14 $ 1,000.00 $ 1,000.00 The table shows the 15 $ 1,000.00 $ 1,000.00 transaction history and the 16 $ 1,000.00 $ 1,000.00 balance for the most recent 17 18 $ $ 1,000.00 1,000.00 $ $ 1,000.00 1,000.00 billing period. 19 $ 1,000.00 $ 1,000.00 20 $ 1,000.00 $ 1,000.00 S = $25100 21 $ 1,000.00 $ 75.00 $ 1,075.00 25100 0.18 22 $ 1,075.00 $ 1,075.00 Interest = × 23 $ 1,075.00 $ 1,075.00 30 12 24 $ 1,075.00 -$ 100.00 $ 975.00 = $12.55 25 26 $ $ 975.00 975.00 $ $ 975.00 975.00 27 $ 975.00 $ 200.00 $ 1,175.00 28 $ 1,175.00 $ 1,175.00 29 $ 1,175.00 $ 1,175.00 30 $ 1,175.00 $ 1,175.00 Loan Restructuring New loan that replaces the outstanding balance on an older loan Paid over a longer period Usually with a lower installment amount Loans are commonly rescheduled to accommodate a borrower in financial difficulty and to avoid a default Failure to make a payment Also called rescheduled loan Consumer Loans Loans made for specific purposes using formally negotiated contracts that specify the borrowing terms and repayment Education loans Auto loans Personal Loans Other durable good loans Consolidation loans Different from line of credit One-time transaction No more credit is available once repaid Consumer Loans Single-Payment Loan Specified period Ranging from 30 days to a year Repaid in full with a single payment on a given due date Include the principal and all interest charges Can be secured or unsecured Installment Loan Repay debt in a series of equal payments Payments includes principal and interest Long-term loan 6 months to 10years or longer Important Loan Features Loan application Information about the purpose of the loan as well as the applicant’s financial condition. Total cost of transaction Finance Charges Sometimes the bank may manipulate both the sticker prices and interest rates, so it is better to compare monthly payments to get a handle on total cost. Collateral Properties or other marketable assets that a borrower offers as a way for a lender to secure the loan Loan Maturity When the original principal amount is due The cost of credit increases with the length of the repayment period Other consideration Banks may charge a prepayment penalty Computing Finance Charges 1. Single-payment loan Simple Interest Method Discount Method 2. Installment Loan Simple Interest Method Add-On Method Annual Percentage Rate Annual Percentage Rate (APR) is a finance charge expressed as an annual rate APR is a true measure of the interest fees charged by credit card companies & banks. Average annual finance charges APR = × 100% Average amount of credit used in the life of the loan Simple Interest Method (Single-Payment Loan) FC=P × 𝑖 × 𝑇 FC = finance charge; P = Principal loan amount; i = stated annual interest rate; T = term of loan Example How much is the finance charge and APR on a $1,000 loan for 2 years at 8% interest rate (Assume interest is the only finance charge) FC = $1,000 x 8% x 2 = $160 APR on a simple interest loan will always be APR = ($160/2)/$1000 = 8% equal to the stated annual interest rate Receive full loan amount ($1,000) but pay back $1,160 (loan amount + finance charge) Discount Method (Single-Payment Loan) Interest (calculated on principal) is subtracted from loan amount and remainder goes to borrower Finance charges paid in advance APR will be higher than stated interest rate Example How much is the finance charge and APR on a $1,000 loan for 2 years at 8% interest rate (Assume interest is the only finance charge) FC = $1,000 x 8% x 2 = $160 Borrower receives $840 now, pays back $1,000 APR = $80/$840 = 9.52% Simple Interest Method (Installment Loan ) Calculated on outstanding balance each period The principal balance declines with each payment The amount goes to interest decreases while the amount that goes to principal increases Example Calculate the finance charges and APR on a $1,000 loan to be repaid in 12 monthly installments at an annual interest rate of 8% Assume interest is the only finance charge Simple Interest Method (Installment Loan ) How much is the monthly installment? r(L) P= 1 − (1 + r)−𝑛 P = installment; L = Present value of the loan; r = interest rate per period; n = number of periods 8% ($1000) $86.99= 12 8% −12 1 − (1 + ) 12 Simple Interest Method (Installment Loan ) Total amount paid over 12 months = $86.99 x 12 = $1043.88 Annual interest paid = $1043.88 – $1000 = $43.88 Average amount of credit used in the life of the loan = $6582/12 = $548.5 $43.88 APR = × 100% = 8% $548.5 APR on a simple interest loan will always be equal to the stated annual interest rate Add-On Method (Installment Loan ) Finance charges calculated on the original loan balance It is then added to principal to determine the total amount to be repaid Monthly Payment (Amount of Loan + Finance Charges) = Number of payments Add-On Method (Installment Loan ) Example Calculate the finance charges and APR on a $1,000 loan to be repaid in 12 monthly installments at an annual interest rate of 8% (Assume interest is the only finance charge) Finance charges on the original loan amount $1,000 x 8% x 1 = $80 Higher interest is charged than under Simple Interest Method Add these charges to principal $80 + $1,000 = $1,080 Divide this amount by the number of periods to arrive at payment $1,080/12 = $90.00 Add-On Method (Installment Loan ) To find the APR under Add-On Method 2×n×I APR= P(N + 1) APR = Approximate APR; n = Number of payment periods in one year I = Total dollar cost of credit; P = Principal; N = Total number of payments scheduled to pay off the loan 2 × 12 × $80 14.77%= $1000(12 + 1) Establishing Credit Open checking and savings accounts Get one card and make small purchases Use them periodically, even if you prefer paying cash Build a record of being a reliable credit customer Obtain small loan Build a Good Credit History Not getting overextended Fulfilling all credit terms Paying on time Notifying creditors if unable to pay Being truthful Credit Rating When you apply for a loan, the lender will review your credit history The record of your complete credit history is called your credit report or credit file Name, address, birth date Your employer, position, income, your previous employer, etc It is collected and maintained by credit bureaus An agency that collects information on how promptly people and business pay their bills A credit rating is a measure of a person’s ability and willingness to make credit payment on time Creditors use different combinations of the 5 Cs to reach their decisions The 5 C’s of Credit Character Will you repay the loan? The borrower’s attitude toward his or her credit obligations Capacity Can you repay the loan? The borrower’s financial ability to meet credit obligations - income Collateral What if you don’t repay the loan? A valuable asset that is pledged to ensure loan payments The 5 C’s of Credit Capital What are your assets and net worth? Ability to repay a loan if you lost your source of income Condition What if your job is insecure ? General economic conditions that can affect a borrower’s ability to repay a loan How Much Credit Can You Stand? Debt Payment Ratio Monthly consumer credit payments = Monthly take−home pay Monthly consumer credit payments (excluding mortgage) should not exceed 20% of monthly net income Example: If you have $10,000 income, using the 20% ratio, you should have monthly consumer credit payments of no more than $2,000