Personal Finance:
A Gospel Perspective
Understanding Consumer
and Other Loans
Objectives
A. Understand how consumer loans can keep you
from your goals
B. Understand the types of consumer loans, their
characteristics, and how to calculate the
costs
C. Know the least expensive types of loans and
how to reduce the cost of consumer loans
Your Personal Financial Plan
 Section VII: Student/Consumer Loans and Debt
Reduction
• Consumer and Student Loans outstanding?
• What are your interest rates, costs, and other
fees?
• Current Debt Situation.
• What rates are you paying? Costs, fees, etc.?
• What is your debt reduction strategy?
• What are your views on future debt?
A.
Understand how Consumer Loans can
Keep you from your Goals?
 Consumer loans:
• Encourage consumption now, rather than saving for
the future
• Don’t borrow for it, save for it
• Are very expensive, and reduce what you might
otherwise have saved for your goals
• Earn interest, don’t pay it
• Are generally unnecessary
• Other than for education and a home (what the
prophet has stated), they generally are not
necessary!
How Consumer Loans Keep You From Your
Goals (continued)
 Key questions to ask when you are thinking of
borrowing for consumer loans?
• 1. Do you really need to make this purchase?
• Is it a need or a want? Separate them!
• 2. Can you pay for it without borrowing?
• What is the after-tax cost of borrowing
versus the after-tax lost return from using
savings? Compare!
• 3. Is it in your budget/financial plan?
• Should you save for it instead of borrow for
it? Save!
Key Questions (continued)
 4. What is the all-in cost of this loan, including
its impact on your other goals?
• Can you maintain sufficient liquidity and still
achieve your other goals? Choose wisely!
 5. Will this purchase bring you closer or take
you farther away from your personal goals?
• If it brings you closer to your goals, including your
goal of obedience to the Lord’s commandments, do
it. If it takes you farther away, don’t!
Questions
Any questions on how consumer loans
keep you from your goals?
B. Understand Consumer Loan
Types, Characteristics, and Costs
 Types of Consumer Loans
• General consumer loans
• Single payment loans
• Installment loans
• Special consumer loans
• Auto loans
• Home equity loans
• Student loans
• Payday loans
• Mortgage loans
Characteristics of Consumer Loans
 Consumer Loan Characteristics
• Secured versus Unsecured Loans
• Secured loans are guaranteed by a specific asset,
i.e. a home or a car, and typically have lower
rates
• Unsecured loans require no collateral, are
generally offered to only borrowers with
excellent credit histories, and have higher rates
of interest – 12% to 28% (and higher) annually
Consumer Loan Characteristics (continued)
Fixed-rate loans
• Have the same interest rate for the duration
of the loan.
• Normally have a higher initial interest
rate as the lender could lose money if
overall interest rates increase
Consumer Loan Characteristics (continued)
 Variable-rate loans
• Have an interest rate that is tied to a specific index
(e.g., prime rate, 6-month Treasury bill rate) plus
some margin or spread, i.e. 9%)
• Can adjust on different intervals such as
monthly, semi-annually, or annually, with a
lifetime adjustment cap.
• Normally have a lower initial interest rate
because the lender won’t lose money if overall
interest rates increase
Consumer Loan Characteristics (continued)
 Convertible loans
• Begin as a variable rate loan and can be locked into
the current rate a some predetermined time in the
future at a specific cost
 Balloon loans
• Loans which payments including interest and
principle are not sufficient to pay off the loan at the
end of the loan period, but require a large “balloon”
payment at some point in the future. This type of
loan is not recommended.
Costs of Consumer Loans
 What are the costs of consumer loans?
• Consumer loans are required by Regulation Z of the
Truth in Lending Act to state the loan APR in bold
on the loan documents
• The APR is the simple interest rate paid over the
life of the loan.
• It takes into account all costs, including interest
rate, cost of credit reports, and costs of all
possible fees
Single Payment Loans
 What are single payment (or balloon) loans?
• A loan that is repaid in only one payment,
including interest.
 Characteristics of Single Payment loans
• Short-term lending of one year or less, sometimes
called bridge or interim loans, often used until
permanent financing can be arranged
• May be secured or unsecured
Single Payment Loans (continued)
 Costs of single payment loans
• Generally it is simple interest, or interest
rate times the loan amount times the period
covered
 The simple interest method
•
•
•
Both principal and interest are due at maturity
Interest = principal x interest rate x time
With not costs and fees, APR and simple interest
are the same
Cost of Consumer Loans (continued)
 What is the cost of a $1,000 single payment loan for 1
year at an interest rate of 12%. By the way, there is a
$20 loan processing fee, $20 credit check fee, and $60
insurance fee. What is your APR for the 1 year loan?
What is the APR if this was a 2 year loan with
principle paid only at maturity?
• The formula is (interest + fees) / amount borrowed.
Your interest is: principle x interest rate x time.
• The APR for the 1 year loan is:
• (120 + 100) / 1,000 = 22.0%
• The APR for the 2 year loan is:
• [(240 + 100) / 2] / 1,000 = 17.0%
Single Payment Loans
(continued)
 The Discount Method (never borrow using
this method of calculating your costs)
• Subtracts the entire interest charge from the loan
principal before you receive the loan, so you are
paying interest on money you have not received.
• You prepay the interest, so it inflates the rate of
interest because the amount received is less
than the amount borrowed.
• The APR will be much higher than the discount
method rate
Single Payment Loans (continued)
 What is the cost of the same $1,000 loan at 12%
interest for 2 years using the discount rate method?
What is the APR for this loan?
• The discount method is: principle x interest rate x
time = interest. Subtract interest from the loan and
divide the remainder by the number of payment
periods (for more than one period)
• The cost of the loan is:
• $1,000 – ($1,000 x 12% x 2) = $760
actually received
• The APR is:
• ( 240 / 2 ) / 760 = 15.8%
Installment Loans
 What are installment loans?
Installment loans are loans which are repaid at
regular intervals and where payment includes both
principal and interest.
Installment Loan characteristics
• Normally used to finance houses, cars, appliances,
and other expensive items
• Loans are amortized, which is the process of the
payment going more toward principal and less
toward interest each subsequent month
• May be secured or unsecured loans, variable-rate or
fixed-rate loans
•

Installment Loans (continued)
 Costs of Installment loans
• Costs of installment loans are based on a simpleinterest calculation (using your calculator)
• Repayment is simply the outstanding balance (each
month the interest portion of the payment decreases
and the principal portion increases)
Installment Loans
(continued)
 What is the cost of the same $1,000 loan at 12% interest
for 2 years using the simple interest method and monthly
payments?
• The simple interest method for installment loans is
simple loan amortization with your calculator:
• PV = -1,000 , I = 12%, P/Y = 12, N = 24, PMT=?
• PMT = $47.074
• Total Interest Paid = 47.074 x 24 – 1,000 =
$129.76
• APR = [(interest + fees) / 2] / average amount
borrowed (which changes each year as you pay it
down)
• ($129.76 / 2) / $540.68 = 12%
Installment Loans
(continued)
 The add-on method
• Never borrow using this method of calculating
your costs
• Adds the total interest payment to the principal
of the loan, and is much more costly than the
simple-interest method.
• It can double the stated APR rate as you are paying
interest on money you have not received
Installment Loans (continued)
 What is the cost of the earlier $1,000 installment loan
at 12% interest for 2 years using the add on method?
What is the APR?
• The add on method is amount borrowed plus
Principle x interest rate x time divided by periods
• The cost of the loan is:
• 1,000 + ($1,000 x 12% x 2) = $1, 240 / 24
months = $51.66 payment per month
• The APR is determined using your calculator:
• 51.66 PMT, -1,000 PV, 24 N, I/Y = 21.6%
Home Equity Loans
 What are home equity loans
• Home equity loans are basically second mortgages
which use the equity in your home to secure your
loan. Normally can borrow up to 80% of your
equity in your home
 Characteristics of home equity loans
• Interest payments may be tax-deductible
• Lower rates of interest than other consumer loans
Home Equity Loans (continued)
 Costs of home equity loans
• Home equity loans are generally either single
payment or installment loans. The benefit of these
loans is that the interest may be tax deductible,
reducing the cost of borrowing
• Keep people from making the hard financial
choices to curb their spending
• Sacrifices future financial flexibility
• Can put your home at risk if you default
Student Loans
Student Loans
• Loans with low, federally subsidized interest rates
used for higher education. Examples include
Federal Direct (S) and PLUS Direct (P) available
through the school; Stafford (S) and PLUS loans
(P) available through lenders.
• Student Loan Characteristics
• Some are tax-advantaged and have lower than
market rates.
• Payment on Federal Direct and Stafford loans
deferred for 6 months after graduation.
Student Loans (continued)
Costs of Student loans
• Student loans are installment loans, with
either fixed or variable rates, and are repaid
in installments.
• Reduces future flexibility
Auto Loans
Automobile Loans
• Auto loans are consumer loans that are
secured with an automobile.
• Auto loan characteristics
• Has a lower interest rate than an
unsecured loan or credit card.
• Normally has a maturity length of 2 to 6
years.
• You will often be left with a vehicle that
is worth less than what you owe on it
Auto Loans (continued)
 Costs of Auto Loans:
• You are looking to finance a used car for $9,000 for
three years at 12% interest. What are your monthly
payments and how much will you pay in interest?
 Answer:
• Set your PV= -9,000, I = 12, N=36, PMT=?
• Your payment is $298.93 per month * 36 months =
$10,671.48 – $9,000 borrowed = $1,671.93 in interest
or 20% of the value of the car.
Payday Loans
 Payday Loans
• Short-term loan of 1-2 weeks secured with a postdated check which is “held” by the lender and then
cashed later
• Have very high interest rates and fees, APR > 450%
• Typical users are those with jobs and checking
accounts but who have been unable to manage their
finances effectively
 How is it calculated?
• Take the APR of the loan in decimal form, divide it
by the number of compounding periods, add 1, and
take it to the power of the number of periods, and
subtract 1.
Payday Loans (continued)
Cost of Payday Loans
• Very high interest rates > 500% APR
• Used by those who cannot get credit any other
way
• Sacrifices future flexibility
Payday Loans (continued)
 Jeremy is short on cash for date this weekend. He
finds that he can give a post-dated check to a Payday
lender who will give him $100 now for a $115 check
which the lender can cash in 2 weeks. What is the
APR and effective annual interest rate on this loan?
• The APR is the total fees divided by amount
borrowed. The effective rate = (1 +
APR/periods)periods -1
• APR = ($15 * 26 two-week periods)/$100 =
390%
• The effective annual interest rate is
• (1 +[ 3.90/26 periods])26 periods – 1 = 3,686%
• This is a very expensive loan
Mortgage Loans
Mortgage Loans
• Fixed rate loans
• Installment loans with a fixed rate of
interest
• Variable rate loans
• Installment loans with a rate of interest
that is pegged to a specific index plus a
margin that changes periodically
Mortgage Loans (continued)
 NegAm or Negative Amortization loans
• Loans in which scheduled monthly payments are
insufficient to amortize, or pay off the loan. Interest
expense that has been incurred, but not paid is added to
the principal amount, which increases the amount of the
debt.
 Balloon mortgages
• Mortgages whose interest and principal payment won’t
result in the loan being paid in full at the end of the term.
The final payment, or balloon, is significantly larger.
These are often used when the debtor expects to refinance
the loan closer to maturity
Mortgage Loans (continued)
 Reverse mortgages
• Mortgages whose proceeds are made available against
the homeowners equity. These are typically used by
cash-poor but home-rich homeowners to need to access
the equity in their homes to supplement their monthly
income at retirement
 Interest only loans
• Loans in which payments cover the interest costs only
and do not cover repayment of principle. Often debtors
will take out an interest only loan to free up principal to
pay down other more expensive debt
Mortgage Loans (continued)
 Interest only loans
• Benefits
• Lower monthly payments and greater flexibility
• Helpful if have better use for money elsewhere
• Borrowers can afford more house, and may
move before the payments increase
• Negatives
• Major rise in payments when the interest-only
period ends
• No amortization of principle—must assume
appreciation on the house to make money
• Many do not have the discipline to invest
savings from principle elsewhere (they spend it)
Mortgage Loans (continued)
• Interest only loans
• What is the monthly mortgage cost of a 6.0% 30
year amortizing loan versus a 7.0% 30 year 10 year
interest only home mortgage of $300,000? What is
the interest payment beginning in year 11
• The amortizing is PV = -300,000, I = 6.0%, P/Y
= 12, n = 360, PMT = ? = $1,798.65
• The interest only payment would be $300,000 *
7.0% / 12 = $1,750.00
• One you pay off in 30 years, the other you never
pay off
• After 10 years, your payment is PV = -300,000,
I = 7.0%, P/Y = 12, N= 240, PMT = ?
• $2,325.89, a 33% increase
The Consumer Loan Contract
 Key clauses for Consumer and Mortgage
Loans—none are in your favor!
• Note that all clauses are in the lenders favor, and
very few, if any, are in the borrowers favor.
• You are putting your future in someone else’s
hands when you borrow!
• You are committing future earnings to today’s
consumption!
• Know what your are doing before you do it!!!!!
• Read the documents very carefully and
understand them before you sign!!!
The Consumer Loan Contract (continued)
 Insurance agreement clause
• Requires you to purchase life insurance that will
payoff your loan after your death
• Benefits only the lender, and Increases your
total loan cost
 Acceleration clause
• Requires the entire loan to be paid-in-full if you
miss just one payment
• Normally (but not always) not invoked if you
make a good faith effort to pay
The Consumer Loan Contract (continued)
 Deficiency payments clause
• Requires any amount in excess to be paid if the
collateral's value does not satisfy the loan.
• Borrower must also pay any outstanding
charges incurred by the lender associated with
the disposal of the collateral
 Recourse clause
• Defines the lender’s ability to collect any
outstanding balance via wage attachments and
garnishments
• Can also include liens on other borrower’s
property
C. How to Reduce your Borrowing Costs
 Key Relationships on Borrowing:
• The total interest cost of your loan is directly
related to the interest rate.
• Keep your interest rate as low as possible
• The total interest cost of your loan is inversely
related to the maturity length.
• Keep your loan maturity short
• Your periodic payment is directly related to both
the maturity and interest rate
• Keep both short
• Parents are cheaper than banks
Reducing Borrowing Costs (continued)
 Least expensive
• Borrowing from
parents and family
• Home equity loans
• Other secured loans
 More expensive
• Credit unions
• Savings and loans
• Commercial banks
 Most expensive
• Retail stores
• Finance companies
 Isn’t it interesting that
those who are in the
worst financial situation
have to pay the most for
credit.
Reducing Borrowing Costs (continued)
 1. Don’t get into debt in the first place!
• Follow the prophet—rather than your wants!
• Distinguish between true needs and wants
• Remember your goals
• Remember ignorance, carelessness,
compulsiveness, pride, and necessity are offset
by knowledge, exactness, discipline, humility,
and self reliance
• Stick to your budget
• If you need it, plan and save for it
Reducing Borrowing Costs (continued)
 2. Compare the after-tax cost of borrowing
with the after-tax lost return from using
savings
• It makes little sense to borrow at a high interest
rate when you have savings earning a lower rate.
The formula is:
• After-tax lost return = nominal interest rate *
(1 – tax rate)
• Tax rate = Federal + State + Local marginal tax
rate
Reducing Borrowing Costs (continued)
 3. Maintain a strong credit rating
• Increase your FICO score
• Make sure your credit reports have no mistakes
• Pay all your bills on-time
• Keep balances low, particularly on revolving
debt
• Keep your oldest accounts, but not too many
• Don’t apply for too many new cards
• Don’t have too many of the same type of cards
Reducing Borrowing Costs (continued)
 4. Reduce the lender’s risk
•
•
•
•
a. Use a variable rate loan
b. Keep the loan term as short as possible
c. Provide collateral for the loan
d. Pay a large down payment on the item to be
purchased with financing
Review of Objectives
A. Do you understand how consumer loans can
keep you from your goals?
B. Are you aware of the characteristics of
consumer loans and how to calculate costs?
C. Do you know the least expensive types of
loans and how to reduce the cost of those
loans?