Chapter 7 Choosing a Source of Credit; The Costs of Credit Alternatives
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Transcript of Chapter 7 Choosing a Source of Credit; The Costs of Credit Alternatives
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CANIAFFORDALOANAND REPAYITONTIME?
Ifyouarethinkingoftakingoutaloanorapplyingforac
redit
card,yourfirststepshouldbetofigureouthow muchthel
oan
will costyou andwhetheryou can afford it.Thenyou sh
ould
shopforthebestcreditterms. Butwhat ifyouarehavingtrouble
payingyourbillsandneedhelp?Doyouknow your options?Themain focusistokeepthecost
ofcreditlow,andavoidthe warningsigns ofdebtproblems
.
Foreachofthe followingstatements, selectyes,no,oru
ncertaintoindicateyourpersonal
responseregarding these situations.
1. IfI needtoborrowmoney,myparentsor familymembers
are often
the source of theleastexpensiveloans
Yes No Uncertain
2. Iamaware ofthetwo mostcommonmethodsofcalculatin
ginterest. Yes No Uncertain
3. Ifmyhouseholdisexperiencingproblems in payingbills,it
istimeto
examinethe family budget forways toreduceexpenses.
Yes No Uncertain
4. I amawarethat everyone whoisoverburdenedwith credit o
bligations
canphone,write,orvisittheConsumerCredit CounselingService.
Yes No Uncertain
5. I realize thattheBankruptcyAbuse Prevention and Consum
er
Protection Actof2005madeitmoredifficultforconsumersto
file
aChapter7bankruptcy.Yes No Uncertain
Asyoustudythischapter,youwillencounterMyLife box
eswithadditionalinformationand
resourcesrelatedtotheseitems.
MyLif
7Choosing a Source ofCredit: The Costs ofCredit Alternatives
1. Analyze the major sources of consumercredit.
2. Determine the cost of credit by calculatinginterest using various interest formulas.
3. Develop a plan to manage your debts.
4. Evaluate various private and governmentalsources that assist consumers with debtproblems.
5. Assess the choices in declaring personalbankruptcy.
Objeives
Like everything else you buy, credit has a
price tag and it pays to comparison shop.
Understanding the cost involved in obtaining
credit will give you the tools to acquire the
best source of credit. If you experience the
warning signs of debt problems, there are
several options available to manage your
finances.
Wha wil tis men for me?
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 213
Sources of Consumer CreditCredit costs got you down? Well, you are not alone. Credit costs money; therefore,
always weigh the benefits of buying an item on credit now versus waiting until you
have saved enough money to pay cash. We can all get into credit difficulties if we do not
understand how and when to use credit.
Financial and other institutions, the sources of credit, come in all shapes and sizes.
They play an important role in our economy, and they offer a broad range of financialservices. By evaluating your credit options, you can reduce your finance charges. You
can reconsider your decision to borrow money, discover a less expensive type of loan,
or find a lender that charges a lower interest rate.
Before deciding whether to borrow money, ask yourself these
three questions: Do I need a loan? Can I afford a loan? Can I
qualify for a loan? We discussed the affordability of loans and
the qualifications required to obtain loans in the last chapter.
Here we wrestle with the first question.
You should avoid credit in two situations. The first situation is
one in which you do not need or really want a product that will
require financing. Easy access to installment loans or possession
of credit cards sometimes encourages consumers to make expen-
sive purchases they later regret. The solution to this problem is
simple: After you have selected a product, resist any sales pres-
sure to buy immediately and take a day to think it over.
The second situation is one in which you can afford to pay
cash. Consider the trade-offs and opportunity costs involved.
Paying cash is almost always cheaper than using credit. In fact,
some stores even offer a discount for payment in cash.
WHAT KIND OF LOAN SHOULD YOU SEEK?
As discussed in the last chapter, two types of credit exist: closed-end and open-end
credit. Because installment loans may carry a lower interest rate, they are the less
expensive credit option for loans that are repaid over a period of many months or years.However, because credit cards usually provide a float perioda certain number of days
during which no interest is chargedthey represent the cheaper way to make credit
purchases that are paid off in a month or two. Also, once you have a credit card, using
it is always easier than taking out an installment loan. An
alternative to a credit card is a travel and entertainment
(T&E) card, such as an American Express or Diners Club
card. A T&E card requires full payment of the balance due
each month but does not impose a finance charge. Annual
fees, however, can be high.
In seeking an installment loan, you may think first of
borrowing from a bank or a credit union. However, less
expensive credit sources are available.
INEXPENSIVE LOANS Parents or family mem-bers are often the source of the least expensive loans. They
may charge you only the interest they would have earned
had they not made the loanas little as the 2 percent they
would have earned on a passbook account. Such loans, however, can complicate family
relationships. All loans to or from family members should be in writing and state the
interest rate, if any, repayment schedule, and the final payment date.
Also relatively inexpensive is money borrowed on financial assets held by a lending
institution, for example, a bank certificate of deposit or the cash value of a whole life
Objective 1
Analyze the major sources
of consumer credit.
If I need to borrow money, my parents orfamily members are often the source of theleast expensive loans.
Borrowing from relatives and friends is usu-ally the least expensive, but make sure theloan agreement is in writing. It should statethe interest rate, repayment schedule, andthe final payment date. Information on vari-ous sources of loans and costs is available atwww.consumerworld.org and www.ftc.gov/credit.
My Lif 1
Parents may often loan their
children money. If you are the
recepient of such a loan, make
sure to come to an agreement
regarding repayment.
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214
insurance policy. The interest rate on such loans typically ranges from 5 to 7 percent.
But the trade-off is that your assets are tied up until you have repaid the loan.
MEDIUM-PRICED LOANS Often you can obtain medium-priced loans fromcommercial banks, federal savings banks (savings and loan associations), and credit
unions. New-car loans, for example, may cost 6 to 8 percent; used-car loans and home
improvement loans may cost slightly more.
Borrowing from credit unions has several advantages. These institutions provide
free credit life insurance, are generally sympathetic to borrowers with legitimate pay-ment problems, and provide personalized service. Credit unions can now offer the same
range of consumer loans that banks and other financial institutions do. Over 89 million
Americans belong to credit unions, and the number of credit union members has been
growing steadily. About 7,800 credit unions exist in the United States today.1
EXPENSIVE LOANS Though convenient to obtain, the most expensive loansavailable are from finance companies, retailers, and banks through credit cards. Finance
companies often lend to people who cannot obtain credit from banks or credit unions. Typ-
ically, the interest ranges from 8 to 20 percent. If you are denied credit by a bank or a credit
union, you should question your ability to afford the higher rate a loan company charges.
Check cashers, finance companies, and others make small, short-term, high-rate
loans called payday loans, cash advance loans, check advance loans, postdated check
loans, or deferred deposit check loans. Such loans secured by a personal check areextremely expensive. Suppose you write a personal check for $115 to borrow $100 for
14 days. The lender agrees to hold the check until your next payday, when you redeem
the check by paying the $115 in cash. Your cost of this loan is a $15 finance charge that
amounts to a whopping 391 percent annual percentage rate (APR).
Another expensive way to borrow money is a tax refund loan. This type of credit lets
you get an advance on a tax refund. APRs as high as 774 percent have been reported. If
you are short of cash, avoid these loans by asking for more time to pay a bill or seek a
traditional loan. Even a cash advance on your credit card may cost less.
A cash advance is a loan billed to your credit card. Youcan obtain a cash advance with your credit card at abank or an automated teller machine (ATM) or by using
checks linked to your credit card account.Most cards charge a special fee when a cash advanceis taken out. The fee is based on a percentage of theamount borrowed, usually about 2 or 3 percent.
Some credit cards charge a minimum cash advancefee, as high as $5. You could get $20 in cash and becharged $5, a fee equal to 25 percent of the amountyou borrowed.
Most cards do not have a grace period on cashadvances. This means you pay interest every day untilyou repay the cash advance, even if you do not have anoutstanding balance from the previous statement.
On some cards, the interest rate on cash advances ishigher than the rate on purchases. Be sure you check
the details on the contract sent to you by the card issuer.
Here is an example of charges that could be imposedfor a $200 cash advance that you pay off when the billarrives:
Cash advance fee = $4 (2% of $200)
Interest for one month = $3 (1.5% APR on $200)
Total cost for one month= $7 ($4 + $3)
In comparison, a $200 purchase on a card with a graceperiod could cost $0 if paid off promptly in full.
The bottom line: It is usually much more expensiveto take out a cash advance than to charge a purchaseto your credit card. Use cash advances only for realemergencies.
Source: A pamphlet provided by the office of Public Responsibility,American Express Company and Consumer Action, San Francisco,
CA 94105. (n.p; n.d.)
Financial Planning Calculations
CASH ADVANCES
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 215
Borrowing from car dealers, appliance stores, department stores, and other retail-
ers is also relatively expensive. The interest rates retailers charge are usually similar to
those charged by finance companies, frequently 15 percent or more.
Banks lend funds not only through installment loans but also through cash advances
on MasterCard or Visa cards. (See the Financial Planning Calculations box on page 214.)
According to Stephen Brobeck, executive director of the Consumer Federation of
America in Washington, DC, the average household has more than 9 credit cards and
owes $7,400 on them. Credit card cobranding has become increasingly popular withbanks and industries. Cobranded credit cards, such as the Yahoo! Visa card will make
shopping over the Internet easier and faster. Yahoo! will designate Visa as its pre-
ferred card and will promote Visa throughout its Web sites and to online merchants
worldwide.
One type of loan from finance companies is currently less expensive than most other
credit. Loans of this kind, which often can be obtained at a rate of under 4 percent, are
available from the finance companies of major automakersGeneral Motors Accep-
tance Corporation, Ford Motor Credit Corporation, and others. In early 2010, Toyota
was offering zero percent financing for up to 6 years. But a car dealer that offers you
such a rate may be less willing to discount the price of the car or throw in free options.
Exhibit 7-1 on page 216 summarizes the major sources of consumer credit: com-
mercial banks, consumer finance companies, credit unions, life insurance companies,
and savings and loan associations. This exhibit attempts to generalize the informationand give an average picture of each source regarding the type of credit available, lend-
ing policies, and customer services. Due to the dramatic fluctuations in interest rates in
recent years, it is no longer possible to provide a common range of annual percentage
rates for each source of credit. Check with your local lender for current interest rates.
Study and compare the differences to determine which source can best meet your needs
and requirements.
STUDENT LOANS: IMPACT OF THE
FINANCIAL CRISIS
The current financial crisis has caused many challenges for families with college-bound
students. As the overall credit market has suffered, college loans have dropped sharply.Borrowing by parents, especially through home equity lines of credit, has diminished as
house prices have dropped in most regions of the United States. Middle-income fami-
lies, those with yearly incomes between $50,000 and $100,000, rely on loans for a
larger share of the college costs than higher or lower-income families.
Inexpensive loans to finance education beyond high school are available from the
U.S. Department of Education. The interest you pay is lower than commercial rates
because the federal government subsidizes the rate. Moreover, you dont have to begin
to repay your Perkins or Stafford Loans until you leave college. Exhibit 7-2 on page 217
presents a summary of various loan programs and their important features.
Student loans, unlike grants and work-study, are borrowed money that must
be repaid, with interest, just like loans and mortgages. You cannot have these loans
canceled because you didnt like the education you received, didnt get a job in your
field of study, or because youre having financial difficulty. Loans are legal obligations,so before you take out a student loan, think about the amount youll have to repay over
the years.
In addition to federal loans, private lenders such as banks, credit unions, savings and
loan associations, and others provide educational loans. There are over 2,000 lenders,
although most of the loans come from the top 50 lenders. The top 50 include most of
the big banks and several nonprofit organizations. Parents can get educational loans for
their dependent children through the Parent Loan for Undergraduate Students (PLUS)
program.
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216 Part 2 MANAGING YOUR PERSONAL FINANCES
Exhibit 7-1 Sources of consumer credit
Credit Source Type of Loan Lending Policies
Commercial banks Single-payment loans
Personal installment loans
Passbook loans
Check-credit loans
Credit card loans
Second mortgages
Seek customers with established credit history.
Often require collateral or security.
Prefer to deal in large loans, such as vehicle, home
improvement, and home modernization, with theexception of credit card and check-credit plans.
Determine repayment schedules according to the pur-pose of the loan.
Vary credit rates according to the type of credit, timeperiod, customers credit history, and the securityoffered.
May require several days to process a new creditapplication.
Consumer financecompanies
Personal installment loans
Second mortgages
Often lend to consumers without established credithistory.
Often make unsecured loans.
Often vary rates according to the size of the loanbalance.
Offer a variety of repayment schedules.
Make a higher percentage of small loans than otherlenders.
Maximum loan size limited by law.
Process applications quickly, frequently on the same daythe application is made.
Credit unions Personal installment loans
Share draftcredit plans
Credit card loans
Second mortgages
Lend to members only.
Make unsecured loans.
May require collateral or cosigner for loans over a speci-fied amount.
May require payroll deductions to pay off loan.
May submit large loan applications to a committee ofmembers for approval.
Offer a variety of repayment schedules.
Life insurancecompanies
Single-payment or partial-payment loans
Lend on cash value of life insurance policy.
No date or penalty on repayment.
Deduct amount owed from the value of policy benefit ifdeath or other maturity occurs before repayment.
Federal savingsbanks (savingsand loan
associations)
Personal installment loans(generally permitted bystate-chartered savings
associations)
Home improvement loans
Education loans
Savings account loans
Second mortgages
Will lend to all creditworthy individuals.
Often require collateral.
Loan rates vary depending on size of loan, length ofpayment, and security involved.
Consumer credit is available from several types of sources.Which sources seem to offer the widest variety ofloans?
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 219
you should shop for the best terms. Two key concepts that you should remember are the
finance charge and the annual percentage rate.
FINANCE CHARGE AND ANNUAL
PERCENTAGE RATE (APR)
Credit costs vary. If you know the finance charge and the annual percentage rate (APR),
you can compare credit prices from different sources. Under the Truth in Lending law,
the creditor must inform you, in writing and before you sign any agreement, of the
finance charge and the APR.
The finance charge is the total dollar amount you
pay to use credit. It includes interest costs and some-
times other costs such as service charges, credit-related
insurance premiums, or appraisal fees. For example,
borrowing $100 for a year might cost you $10 in inter-
est. If there is also a service charge of $1, the finance
charge will be $11.
The annual percentage rate (APR) is the percent-
age cost (or relative cost) of credit on a yearly basis. The
APR is your key to comparing costs, regardless of theamount of credit or how much time you have to repay it. Suppose you borrow $100 for
one year and pay a finance charge of $10. If you can keep the entire $100 for the whole
year and then pay it all back at once, you are paying an APR of 10 percent:
Truth in Lending law Afederal law that requirescreditors to disclose theannual percentage rate(APR) and the financecharge as a dollar amount.
AmountBorrowed
MonthNumber
PaymentMade
LoanBalance
$100 1 $0 $100
2 0 100
3 0 100
. . .
. . .
. . .
. . .
12 100 0
(plus $10 interest)
On average, you had full use of $100 throughout the year. To calculate the average
use, add the loan balance during the first and last month, then divide by 2:
Average balance=$100+ $100____________
2 = $100
But if you repay the $100 in 12 equal monthly payments, you dont get use of the
$100 for the whole year. In fact, as shown next, you get use of less and less of that $100
each month. In this case, the $10 charge for credit amounts to an APR of 18.5 percent.
Note that you are paying 10 percent interest on $100 even though you had use of only
$91.67 during the second month, not $100. During the last month, you owed only $8.37
D I D Y O U K N O W ?
Every time you use a credit card in a foreigncountry, Visa or MasterCard charges a 1%fee for converting the purchase or cashadvance into U.S. dollars.
finance charge The totaldollar amount paid to usecredit.
annual percentage rate(APR) The percentage cost(or relative cost) of crediton a yearly basis. The APRyields a true rate of inter-est for comparison withother sources of credit.
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222 Part 2 MANAGING YOUR PERSONAL FINANCES
A Shorter Term As you have learned, the shorter the periodof time for which you borrow, the smaller the chance that some-
thing will prevent you from repaying and the lower the risk to
the lender. Therefore, you may be able to borrow at a lower
interest rate if you accept a shorter-term loan, but your payments
will be higher.
In the next section, you will see how the above-mentioned
trade-offs can affect the cost of closed-end and open-endcredit.
CALCULATING THE COST OF
CREDIT
The two most common methods of calculating interest are com-
pound and simple interest formulas. Perhaps the most basic
method is the simple interest calculation. Simple interest on the declining balance,
add-on interest, bank discount, and compound interest are variations of simple
interest.
SIMPLE INTEREST Simple interest is the interest computed on principal onlyand without compounding; it is the dollar cost of borrowing money. This cost is basedon three elements: the amount borrowed, which is called the principal; the rate of inter-
est; and the amount of time for which the principal is borrowed.
You can use the following formula to find simple interest:
Interest= Principal Rate of interest Time
or
I=PrT
simple interest Inter-est computed on prin-cipal only and withoutcompounding.
EXAMPLE 1: Using the Simple Interest Formula
Suppose you have persuaded a relative to lend you $1,000 to purchase a lap-top computer. Your relative agreed to charge only 5 percent interest, and youagreed to repay the loan at the end of one year. Using the simple interestformula, the interest will be 5 percent of $1,000 for one year, or $50, since youhave the use of $1,000 for the entire year:
I= $1,000 0.05 1
=$50Using the APR formula discussed earlier,
APR =2 nI_________P(N+ 1)
=2 1 $50_____________
$1,000(1+ 1)=
$100_______$2,000
= 0.05, or 5 percent
Note that the stated rate, 5 percent, is also the annual percentage rate.
I am aware of the two most commonmethods of calculating interest.
The two most common methods of calculat-
ing interest are compound and simple inter-est formulas. For examples of calculatinginterest, be sure to read the Financial Plan-ning Calculations boxes in this chapter.
My Lif 2
SIMPLE INTEREST ON THE DECLINING BALANCE When morethan one payment is made on a simple interest loan, the method of computing interest
is known as the declining balance method. Since you pay interest only on the amount
of the original principal that you have not yet repaid, the more frequent the payments,
the lower the interest you will pay. Most credit unions use this method for their loans.
declining balance methodA method of computinginterest when more thanone payment is made on asimple interest loan.
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 223
Note that using simple interest under the declining balance method, the stated rate,
5 percent, is also the annual percentage rate. The add-on interest, bank discount, and
compound interest calculation methods differ from the simple interest method as to
when, how, and on what balance interest is paid. For these methods, the real annual rate,
or the annual percentage rate, differs from the stated rate.
ADD-ON INTEREST With the add-on interest method, interest is calculatedon the full amount of the original principal. The interest amount is immediately added
to the original principal, and payments are determined by dividing principal plus inter-
est by the number of payments to be made. When only one payment is required, this
method produces the same APR as the simple interest method. However, when two or
more payments are to be made, the add-on method results in an effective rate of interest
that is higher than the stated rate.
add-on interest methodA method of computinginterest in which interestis calculated on the fullamount of the originalprincipal.
EXAMPLE 2: Using the Simple Interest Formula on the DecliningBalance
Using simple interest on the declining balance to compute interest charges, theinterest on a 5 percent, $1,000 loan repaid in two payments, one at the endof the first half-year and another at the end of the second half-year, would be$37.50, as follows:
First payment:
I=PrT
= $1,000 0.05
= $25 interest plus $500, or $525
Second payment:
I=PrT
= $500 0.05
= $12.50 interest plus the remaining balance of $500, or $512.50
Total payment on the loan:
$525 + $512.50= $1,037.50
Using the APR formula,
APR =2 nI_________P(N+ 1)
=2 2 $37.50_______________$1,000(2+ 1)
=$150_______
$3,000= 0.05, or 5 percent
EXAMPLE 3: Using the Add-on Method
Consider again the two-payment loan in Example 2. Using the add-on method,interest of $50 (5 percent of $1,000 for one year) is added to the $1,000 bor-
rowed, giving $1,050 to be repaidhalf (or $525) at the end of the first half-year and the other half at the end of the second half-year.
Even though your relatives stated interest rate is 5 percent, the real interest rate is
APR =2 nI_________P(N+ 1)
=2 2 $50_____________
$1,000(2+ 1)=
$200_______$3,000
= 0.066, or 6.6 percent
Note that using the add-on interest method means that no matter how many payments
you are to make, the interest will always be $50. As the number of payments increases,
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224 Part 2 MANAGING YOUR PERSONAL FINANCES
you have use of less and less credit over the year. For example, if you make four quar-
terly payments of $262.50, you have use of $1,000 during the first quarter, about $750
during the second quarter, about $500 during the third quarter, and about $250 during
the fourth and final quarter. Therefore, as the number of payments increases, the true
interest rate, or APR, also increases.
COST OF OPEN-END CREDIT As discussed earlier, open-end credit includescredit cards, department store charge cards, and check overdraft accounts that allow you
to write checks for more than your actual balance. You can use open-end credit again and
again until you reach a prearranged borrowing limit. The Truth in Lending law requires that
open-end creditors let you know how the finance charge and the APR will affect your costs.
First, creditors must tell you how they calculate the finance charge. Creditors use various
systems to calculate the balance on which they assess finance charges. Some creditors add
finance charges after subtracting payments made during the billing period; this is called the
adjusted balance method. Other creditors give you no credit for payments made during
the billing period; this is called the previous balance method. Under the thirdand the
fairestmethod, the average daily balance method, creditors add your balances for each
day in the billing period and then divide by the number of days in the period. The average
daily balance may include or exclude new purchases during the billing period.
Here is how some different methods of calculating finance charges affect the cost of
credit:
adjusted balancemethod The assessmentof finance charges afterpayments made duringthe billing period havebeen subtracted.
previous balancemethod A methodof computing financecharges that gives nocredit for payments madeduring the billing period.
average daily balancemethod A methodof computing financecharges that uses aweighted average of theaccount balance through-out the current billing
period.
Average Daily Balance(includingnew purchases)
Average Daily Balance(excludingnew purchases)
Monthly rate 1% 1%
APR 18% 18%
Previous balance $400 $400
New purchases $50 on 18th day $50 on 18th day
Payments $300 on 15th day (new
balance=
$100)
$300 on 15th day (new
balance=
$100)Average daily balance $270* $250**
Finance charge $4.05 (1% $270) $3.75 (1% $250)
*To figure average daily balance (including new purchases):[($400 15 days )+($100 3 days )+($150 12 days )] 30 days =
($6,000+ $300 + $1,800) 30= $8,100 30 days= $270**To figure average daily balance (excluding new purchases):
[($400 15 days )+($100 15 days )] 30 days = ($6,000+ $1,500) 30= $7,500 30 days= $250
Adjusted Balance Previous Balance
Monthly rate 1% 1%
APR 18% 18%
Previous balance $400 $400
Payments $300 $300
Average daily balance N/A N/A
Finance charge $1.50 (1% $100) $6.00 (1% $400)
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229
HOW TO USE THE RULE OF 78sThe first step is to add up all the digits for the numberof payments scheduled. For a 12-installment loan, add
the numbers 1 through 12:
1 + 2 + 3 + 4 + 5 + 6 + 7+ 8 + 9 + 10 + 11 + 12 = 78
The answerthe sum of the digitsexplains howthe rule was named. One might say that the total inter-est is divided into 78 parts for payment over the term ofthe loan.
In the first month, before making any payments,you have the use of the whole amount borrowed, andtherefore you pay 12/78 of the total interest in the firstpayment, in the second month, you still have the useof 11 parts of the loan and pay 11/78 of the interest;in the third, 10/78; and so on down to the final install-
ment, 1/78.Adding all the numbers in a series of payments is
rather tedious. We can arrive at the answer quickly byusing this formula:
N__2 (N+ 1)
N is the number of payments. For a 12-month loan, itlooks like this:
12___2 (12 + 1) = 6 13 = 78
A LOAN FOR KAREN AND MIKELet us suppose that Karen and Mike borrow $3,000 from
the National Bank to redecorate their home. Interestcomes to $225, and the total of $3,225 is to be paid in 15equal installments of $215.
Using the rule of 78s, we can determine how muchof each installment represents interest. We add all thenumbers from 1 through 15:
15___2 (15 + 1) = 7.5 16 = 120
Total interest is divided into 120 parts. The first paymentwill include 15 parts of the total interest, or 15/120
($225_____120 15 = $28.13 )the second, 14/120
($225_____120 14 = $26.25 )and so on.
Notice in the following table that the interestdecreases with each payment and the repayment of theamount borrowed increases with each payment:
PaymentNumber Interest
Reductionof Debt
TotalPayment
1 $28.13 $186.87 $215.00
2 26.25 188.75 215.00
3 24.37 190.63 215.00
4 22.50 192.50 215.00
5 20.63 194.37 215.00
6 18.75 196.25 215.00
7 16.87 198.13 215.00
8 15.00 200.00 215.00
9 13.13 201.87 215.00
10 11.25 203.75 215.00
11 9.37 205.63 215.00
12 7.50 207.50 215.00
13 5.63 209.37 215.00
14 3.75 211.25 215.00
15 1.87 213.13 215.00
$225.00 $3,000.00 $3,225.00
HOW MUCH IS THE REBATE?Now lets assume Karen and Mike want to pay off theloan with the fifth payment. We know the total interestis divided into 120 parts. To find out how many partswill be rebated, we add up the numbers for the remain-ing 10 installments, which will be prepaid:
10___2 (10 + 1) = 5 11 = 55
Now we know that 55/120 of the interest will bededucted as a rebate; it amounts to $103.12:
55____120
$225 =$12,375________
120 = $103.12
We see that Karen and Mike do not save two-thirdsof the interest (which would be $150) by paying off theloan in one-third of the scheduled time. But the earlierthey repay the loan the higher the portion of interestthey do save. The rule of 78s favors lenders.
Source: The Rule of 78s (Philadelphia: Federal Reserve Bank ofPhiladelphia).
Financial Planning Calculations
THE RULE OF 78s
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 231
CREDIT INSURANCE
Credit insurance ensures the repayment of your loan in the event of death, disability,
or loss of property. The lender is named the beneficiary and directly receives any pay-
ments made on submitted claims.
There are three types of credit insurance: credit life, credit accident and health, and
credit property. The most commonly purchased type of credit insurance is credit life
insurance, which provides for the repayment of the loan if the borrower dies. Accord-
ing to the Consumer Federation of America and the National Insurance Consumer
Organization, most borrowers dont need credit life insurance. Those who dont have
life insurance can buy term life insurance for less. Term life insurance is discussed in
Chapter 12.
Credit accident and health insurance, also called credit disability insurance, repays
your loan in the event of a loss of income due to illness or injury. Credit property insur-
ance provides coverage for personal property purchased with a loan. It may also insure
collateral property, such as a car or furniture. However, premiums for such coverages
are quite high.
COST OF CREDIT AND THE CREDIT CARD
ACCOUNTABILITY, RESPONSIBILITY, ANDDISCLOSURE ACT OF 2009 (THE CREDIT
CARD ACT)
The Credit CARD Act has a sweeping effect on annual percentage rates, fees, and dis-
closures. The law:
Limits card issuers ability to increase the APR on transferred balances duringthe first year that the account is opened.
Restricts card issuers from applying new (higher) interest rates to the existingcard balances.
Requires companies to inform consumers of rate increases or other significant
changes at least 45 days in advance.
States that teaser rates must stay in effect for at least 6 months.
Requires issuers to mail monthly statements at least 21 days before paymentis due.
Makes new disclosure statements clear and more timely.
Mandates that monthly credit card statements must prominently display the duedate and potential late fees, as well as the interest you have paid during the cur-
rent year, the monthly payment required to pay off the existing balance, and warn
consumers about the costs of making only the minimum payments.
Requires credit card issuers to post their standard card agreements on the
Internet.
Sets a consistent due date for card payments each month. If the due date falls ona holiday or weekend, the deadline is considered the next business day.
Restricts the penalties that card issuers can charge for going over the creditlimit.
Prohibits cards issuers from issuing cards to consumers under 21 unless theyhave a co-signer or can demonstrate that they have independent means to repay
the card debt.
credit insurance Any typeof insurance that ensuresrepayment of a loan inthe event the borrower isunable to repay it.
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Chapter 7 Choosing a Source of Credit: The Costs of Credit Alternatives 241
Saturday sessions to handle the overflow. This drastic increase in
personal bankruptcy filing led to the Bankruptcy Abuse Preven-
tion and Consumer Protection Act of 2005.
THE BANKRUPTCY ABUSE
PREVENTION AND CONSUMER
PROTECTION ACT OF 2005
On April 20, 2005, President Bush signed the Bankruptcy Abuse
Prevention and Consumer Protection Act, which is perhaps the
largest overhaul of the Bankruptcy Code since it was enacted in
1978. Signing the bill, the president declared, Bankruptcy should
always be the last resort in our legal system. In recent years too
many people have abused the bankruptcy laws. Under the new
law, Americans who have the ability to pay will be required to
pay back at least a portion of their debts. The law will help make
credit more affordable, because when bankruptcy is less com-
mon, credit can be extended to more people at better rates. Debt-
ors seeking to erase all debts will now have to wait eight years
from their last bankruptcy before they can file again. The law will
also allow us to clamp down on bankruptcy mills that make their
money by advising abusers on how to game the system.
Among other provisions, the law requires that:
The director of the Executive Office for U.S. Trusteesdevelop a financial management training curriculum to
educate individual debtors on how to better manage their
finances; and test, evaluate, and report to Congress on the
curriculums effectiveness.
Debtors complete an approved instructional course in personal financial management.
The clerk of each bankruptcy district maintains a list of credit counseling agen-cies and instructional courses on personal financial management.
Furthermore, the law may require that states should develop personal finance cur-ricula designed for use in elementary and secondary schools.
Exhibit 7-7
U.S. ConsumerBankruptcy Filings(19802009)
Source: Administrative Office of the U.S. Courts, uscourts.gov/bankruptcystats/bankrupt_fztable_dec2006.x/s, accessed January 22, 2009.
250
0
500
750
1,000
1,250
1,500
1,750
2000'90'80'701961
2,250
2,000
Thousands
Total Personal Bankruptcies
2009
I understand how the Bankruptcy AbusePrevention and Consumer Protection Act of2005 made it more difficult for consumers to
file a Chapter 7 bankruptcy.The filing process is now more difficult fordebtors:
Debtors must file more documents,including itemized statements ofmonthly net income, proof of income(pay stubs) for the last 60 days, and taxreturns for the preceding year (fouryears for Chapter 13).
Debtors must take a prefiling creditcounseling and postfiling educationcourse to have debts discharged.
Debtors face increased filing fees, plusfees for credit counseling/education.
The bankruptcy petition and process aremore complicated, so its very difficult tofile without an attorney.
My Lif 5
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247
Page Topic Formula
221 Calculating annual
percentage rate (APR)APR=
2 Number of payment periods in one year Dollar cost of credit_______________________________________________________Loan amount (Total number of payments to pay off the loan + 1)
=2nI_________P(N+ 1)
Example:
P= Principal borrowed, $100
n= number of payments in one year, 1
I= Dollar cost of credit, $8
APR=2 1 $8___________$100(1+ 1)
=$16_____
$200= 0.08, or 8 percent
For 12 equal monthly payments,
APR=2 12 $8____________$100(12 + 1)
=$192______
$1,300= 0.1476, or 14.76 percent
222 Calculating simple
interestInterest (in dollars) = Principal borrowed Interest rate Length of loan in years
I=Pr T
Example:
From above: P= $100; r= 0.08; T= 1
I= $100 0.08 1= $8
230 Calculating compound
interestTotal future value of a loan= Principal (1+ Rate of interest) Time in years
F=P(1+r)TExample:
From above: P= $100; r= 0.08; T= 1
F= $100(1+ 0.08)1= $100(1.08)= $108
KEY FORMULAS
SELF-TEST PROBLEMS
1. Your bankcard has an APR of 18 percent and there is a 2 percent fee for cash advances. The bank starts charging you interest on
cash advances immediately. You get a cash advance of $600 on the first day of the month. You get your credit card bill at the end
of the month. What is the total finance charge you will pay on this cash advance for the month?
2. You borrowed $1,000 at the stated interest rate of 8 percent. You pay off the loan in one lump sum at the end of the year. What is
the approximate annual percentage rate?
Solutions
1. Cash advance fee = 2 percent of $600= $12
Interest for one month = $600 .18 1= $108 12= $9
(UsingI=PrTformula)
Total cost for one month= $12+ $9= $21
2. Using the formula, the APR for the lump-sum loan is
r=2 n 1_________p (N+ 1)
=2 1 $8____________
$1,000(1+ 1)=
$16______$2,000
= .008 or 8 percent
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