USING CONSUMER LOANS - University of Phoenix

6

USING CONSUMER LOANS

The Wise Use of Debt

Starting Point

Go to college/bajtelsmit to assess your knowledge of using consumer loans. Determine where you need to concentrate your effort.

What You'll Learn in This Chapter

Types and sources of consumer loans Warning signs of too much debt Bankruptcy and its alternatives

After Studying This Chapter, You'll Be Able To

Compare types of consumer loans and lenders Assess the characteristics of different types of loans Manage your debts wisely Establish a plan for managing your consumer credit and reducing

outstanding balances

Copyright ? 2012 John Wiley & Sons, Inc.

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INTRODUCTION

The most common types of consumer loans are home equity loans, student loans, and automobile loans. Consumer loan contract terms vary, depending on the lender and type, so you must be informed to make the best choices. As with credit cards, lenders offer better loan terms to more creditworthy borrowers. In this chapter, you'll learn how to challenge your credit information if it's incorrect and how to reduce your debt and get it under control before you get into financial trouble.

6.1 Characteristics of Consumer Loans

Consumer loans vary in the interest rates charged, payment arrangements, and collateral required. Typically, a lender charges lower interest rates if you meet contract terms that reduce the risk of your defaulting on the loan. In this section, you'll read about your options.

6.1.1 Interest Rates

Interest rates on consumer loans can be either fixed or variable. With a fixedrate loan, the same interest rate applies throughout the life of the loan. With a variable-rate loan, the periodic rate fluctuates along with a predetermined measure, such as the prime rate or the Treasury bill (T-bill) rate. The prime rate is the rate banks charge to their most preferred customers, and it is commonly used as a base rate for variable-rate loans.

For example, suppose you took out a loan in February 2004, when the prime rate was 4 percent, and agreed to pay the prime rate plus 2 percentage points in interest. The interest rate on your loan would have started out at 6 percent, but you took the risk of unexpected increases in future payments. For example, by October 2006, the prime rate had more than doubled, to 8.25 percent, so your loan rate increased to 10.25 percent, resulting in a substantial increase in your monthly payment. In periods when interest rates are rising, especially when they rise rapidly, a variable-rate loan can subject you to unexpected increases in required payments. However, variable-rate loans generally carry lower initial interest rates than fixed-rate loans because the lender isn't facing the risk of having the interest rate fall behind market rates on comparable loans. Therefore, if the introductory rate is low enough, or if you don't expect to borrow the money for a long period of time, you might find it worthwhile to take out a variablerate loan, despite the risk of increased payments.

Certain types of loans are more likely than others to have fixed rates. It's relatively common for rates on automobile loans to be fixed, whereas rates on home equity loans can be either fixed or variable. The interest rates on credit cards, discussed in Chapter 5, can be either fixed or variable. In practice, revolving credit

Copyright ? 2012 John Wiley & Sons, Inc.

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agreements are most often classified as variable-rate loans because the issuer generally retains the right to change the rate at any time in the future.

6.1.2 Payment Arrangements

Loan agreements may be single-payment or, more commonly, installment arrangements. A single-payment loan requires that the balance be paid in full at some point in the future, including the principal--the original borrowed amount--and the interest owed on the borrowed funds. For example, many tax preparation firms offer to lend their customers money on the condition that it be repaid in full when the customers receive their income tax refunds.

An installment loan allows the borrower to repay over time, usually in monthly installments that include both principal and interest. An installment loan is said to be in default when a required payment is overdue. Loan agreements specify the consequences of defaulting, which may include late fees or even cancellation of the loan. Some loans include an acceleration clause that makes the entire balance due and payable in the event that the borrower falls behind in payments. A prepayment penalty--a fee charged for early repayment--can apply to certain loans.

6.1.3 Secured and Unsecured Loans

A secured loan gives the lender the right to take certain assets or property in the event that the loan is not repaid according to its terms. The pledged property-- which can be any valuable asset, such as an automobile, a home, or business

FOR EXAMPLE

Comparing Interest Rates

There is often a large difference between the average rates on credit cards, which are unsecured, and the rates on automobile loans, which give the lender rights to your automobile if you don't pay the loan. The difference is often 10 percentage points or more. If you don't make your credit card payments, the lender has few options for recovering your bad debt, but if you don't make your automobile loan payments, the lender can repossess, or take back, your automobile, sell it, and keep the proceeds. If you don't make your automobile loan payments, the lender hires a repo firm to take your automobile back, usually by towing it away. The automobile is then sold at a wholesale auction to pay back your loan. Some loan agreements even include a deficiency judgment clause, giving lenders the right to bill you for the difference between what you owed and the value of the repossessed collateral.

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property--is called the collateral for the loan. The right to take the collateral reduces the potential cost of default to the lender; thus, lenders usually charge lower rates of interest on secured loans than on unsecured loans.

When real property (i.e., land and anything attached to it, such as a home or commercial building) is used as collateral, as in the case of a home mortgage, the lender records a lien against the property at the county courthouse, putting the public on notice of its potential right to the property. This ensures that if you sell the home, the loan must be repaid before you can take any of the proceeds from the sale.

SELF-CHECK

1. Define collateral, variable-rate loan, and lien. 2. What types of loan payment arrangements are available?

6.2 Types of Consumer Loans

Although you can obtain a consumer loan for almost any consumer purchase, subject to your creditworthiness, certain very common consumer loans are designed to be used for specified purposes. Examples include home equity loans, automobile loans, and student loans.

6.2.1 Home Equity Loans

If you're like the majority of households, your family home is your most valuable asset. As your property value increases and your mortgage is repaid over time, you gradually build up home equity. Home equity is the difference between the market value of your home and the remaining balance on your mortgage loan (discussed in more detail in Section 7.5).

A home equity loan allows you to borrow against this valuable asset. Like your primary mortgage loan, a home equity loan is secured by your home. The lender's right to the home is secondary to that of the primary mortgage lender, however, so these loans are also referred to as second mortgages. In the event of default, the first mortgage must be repaid from the proceeds of the sale of the home before the second mortgage lender gets anything.

Depending on the lender, you may be able to borrow as much as 100 percent of your home equity, although most lenders limit your total mortgage debt to 80 to 90 percent of the market value of your home.

Suppose you own a home worth $150,000, and your mortgage balance is $100,000. Your home equity is $50,000 $150,000 $100,000. If you're

Copyright ? 2012 John Wiley & Sons, Inc.

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approved for a home equity loan in the amount of $20,000, your total debt on the home is $120,000, which amounts to 80 percent of the market value. Home equity lenders commonly have maximum loan-to-value ratios of between 75 and 90 percent. This means that they do not allow your total debt on the home, including the first mortgage and the home equity loan, to exceed that percentage of the current market value of the home.

Home equity loans are usually installment loans payable over 5 to 15 years, in equal monthly payments. They are often established as lines of credit that you can access as needed. Generally, home equity loan proceeds can be used for any purpose. An important feature of home equity loans is that the interest is tax deductible up to a maximum of $100,000.

The tax benefits of home equity loans, particularly for households in higher tax brackets, can make this type of borrowing significantly less costly than other credit choices. If your marginal tax rate is 30 percent (including federal and state taxes), and the interest rate on your home equity loan is 6 percent, you are effectively paying only 70 percent of that amount in interest after your tax deduction, or 4.2 percent.

Recently, some lenders have begun offering loans that combine the characteristics of low-risk secured loans with those of high-risk unsecured credit. These types of loans, although they're called home equity loans, are more similar to credit cards and carry much higher rates of interest than typical secured loans. The rates are generally comparable to those of unsecured consumer loans and revolving credit accounts. This type of product is like a home equity loan and credit card in one, but you risk your house in the process of acquiring this type of loan because you are borrowing more than the value of your home. If you default, the lender can take your house and you may still owe money.

FOR EXAMPLE

Tax Benefits of Home Equity Borrowing

Suppose that your taxable income is $46,200 and your marginal tax rate is 30 percent. If you take out a home equity loan of $20,000 at 6 percent interest, the total interest for one year is $1,200 6% $20,000. If you can deduct this interest on your taxes, you lower your taxable income by $1,200--to $45,000 instead of $46,200. At the 30 percent tax rate, this saves you $360 $1,200 30%. Because you don't have to pay that tax, the actual cost of the loan is the $1,200 in interest less the $360 in tax savings, for a net marginal cost of $840. The effective after-tax cost of the loan is therefore $840 / $20,000, or 4.2 percent.

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6.2.2 Automobile Loans

An automobile loan is a secured loan made specifically for the purpose of buying an automobile. Lenders typically limit the amount of an automobile loan to some percentage of the current market value of the automobile being purchased, and they require that the borrower pledge the automobile as collateral for the loan. In addition, the borrower must list the lender as an insured party on his or her auto collision insurance. See Chapter 8 for more details.

Because of the relatively short economic life of a car, automobile loan maturities are typically from two to six years. Both new car prices and rates on automobile loans have been unusually low in the past few years due to competition among auto dealers and generally low market interest rates. As a result, consumers have taken on significant automobile loan debt and monthly payments.

It's worth noting that getting a below-market interest rate from an auto dealer doesn't necessarily mean you've come out ahead. As discussed in Section 7.2, dealers generally make up the difference in higher prices and fees. Average automobile loan rates are lower than home equity loan rates, but home equity loan interest is tax deductible, and automobile loan interest is not. The after-tax cost of home equity loans is actually comparable to that of auto loans, although the difference depends on your marginal tax rate.

6.2.3 Student Loans

As with all types of borrowing, you shouldn't borrow money to finance education costs without considering other less expensive alternatives for achieving your family's education goals. Even if you don't have enough savings, you should investigate eligibility for scholarships and grants because these do not have to be repaid.

In addition to funding education costs through savings, scholarships, and grants, many people do borrow to cover some or all of the costs of higher education. A student loan is a loan made for the purpose of paying college or graduate school expenses. Because they are available at low interest rates, student loans are generally preferable to other forms of consumer financing.

The costs of both public and private higher education continue to rise at a faster rate than inflation, so student loan debt is also on the increase. The average graduate in 2009 had $24,000 in student loan debt, up 6 percent from the prior year. Because your education is an investment you hope will pay off later in the form of increased income, borrowing for this purpose may make good financial sense. However, students often underestimate how hard it will be to repay these loans, particularly if they do not complete the degree program in which they are enrolled. A simple rule of thumb for someone who does not have other unusually high expenses is that total borrowing should not exceed expected first-year salary after graduation. The For Example feature "Student Loan Costs

Copyright ? 2012 John Wiley & Sons, Inc.

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Figure 6.1

Student Aid on the Web: The Department of Education's portal offers a one-stop shop for information on federal grants and loans for postsecondary education. Studentaid.

After Graduation" shows how you can estimate how much it will cost you after graduation on a monthly basis.

Eligibility The Health Care and Reconciliation Act of 2010 simplified the student loan application, borrowing, and repayment process. Instead of acting as a middleman by subsidizing loans made by other financial institution, the federal government became the direct lender. The U.S. Department of Education now provides more than $150 billion in new aid to nearly 14 million postsecondary students and their families each year. Its well-designed and informational website studentaid. is a one-stop shop for information on student grants and loans.

To be eligible for a federal student loan, you must:

? Be a U.S. citizen with a valid Social Security number and a high-school diploma or the equivalent.

? Be taking courses to fulfill requirements for a degree or certificate.

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FOR EXAMPLE

Student Loan Costs After Graduation

Karina is a recent university graduate. She financed her education costs as follows:

Employment during school and vacations: Parents savings Scholarships Grants Student Loans TOTAL COSTS

$ 5,000 10,000 5,000 16,000 24,000

$60,000

Assuming that her student loans must be repaid over a 10-year period at an interest rate of 6.8 percent (the 2012 fixed rate for federal direct loans), how much will she pay per month?

SOLUTION

Karina is fortunate that she received so much support from scholarships and grants because these forms of financial aid do not have to be repaid. Therefore, the only debt she must pay back is the $24,000 in student loans. You can use Self-calculating Worksheet 2.x or a financial calculator to estimate the monthly payment for this loan. Enter the information you know (N = 10 12 = 120; I = 6.8/12 = 0.5667; PV = 24000) and solve for PMT = $276 per month. This is a significant burden on an entry-level salary, but will be manageable if Karina is successful in gaining post-graduation employment and she keeps her budget under control. If she has difficulty repaying the loan, she may be eligible for a program that will allow her to make lower payments and/or extend her payment period, as discussed in a later section.

? Meet satisfactory progress standards set by your school. ? Certify that you will use the funds only for educational purposes. ? Certify that you are not in default on any other federal student loan. ? Comply with Selective Service registration, if you're a male aged 18

through 25.

Application Process 1. Complete the FAFSA. Most student aid requires that you first submit the Free Application for Federal Student Aid (FAFSA), available at fafsa.. Although there are firms that specialize in helping students through this process for a fee, you can complete and submit

Copyright ? 2012 John Wiley & Sons, Inc.

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