Personal Finance SIXTH EDITION Chapter 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 9.8 Describe how personal loans fit within your financial plan 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 – – – Also known as P2P Conducted through online platforms The most popular at this time are – – – Lending Club Prosper More than $1 billion per year now provided by individual investors via P2P Amounts are typically from $1k to $35k Credit report and FICO score are used 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 Background on Personal Loans (7 of 7) 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 Financial Planning Online (6 of 7) • Go to http://www.edmunds.com and insert the search term “lease versus buy” • This Web site provides a comparison of the cost of leasing versus purchasing a car 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 Down payment $1,000 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 × = $160 Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved 160 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 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 × = $128 Total monthly payments are: Total Monthly Payments = Monthly Payment × Number of Months = $300 × 48 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved $128 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 Financial Planning Online (7 of 7) • Go to http://www.federalreserve.gov and insert the search term “home equity loan” • This Web site provides more information on home equity loans 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 All Rights Reserved How Personal Loans Fit within Your Financial Plan (1 of 3) • Key personal loan decisions for your financial plan are: – How much money can you afford to borrow on a personal loan? – If you obtain a personal loan, should you pay it off early? Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Personal Loans Fit within Your Financial Plan (2 of 3) EXHIBIT 9.7 How Personal Loan Management Fits Within Stephanie Spratt’s Financial Plan GOALS FOR PERSONAL FINANCING Limit the amount of financing to a level and maturity that I can pay back on a timely basis For any personal loan, I will consider paying off the loan balance as soon as possible ANALYSIS Monthly Cash Inflows - Typical Monthly Expenses $2,500 1,400 - Monthly Car Loan Payment 412 = Amount of Funds Available $688 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Personal Loans Fit within Your Financial Plan (3 of 3) EXHIBIT 9.7 How Personal Loan Management Fits Within Stephanie Spratt’s Financial Plan DECISIONS Decision on Affording a Personal Loan: The financing of my new car requires a payment of $412 per month This leaves me with $688 per month after paying typical monthly expenses I can afford to make the payments I will not need additional personal loans for any other purpose Decision on Paying Off Personal Loan Balances: The car loan has an interest rate of 7.6 percent I expect that my stock investment will earn a higher rate of return than this interest rate Once I have accumulated more savings, however, I will seriously consider using my savings and invested funds to pay off the balance of the loan early 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... 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 9.8 Describe how personal loans fit within... 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