Personal Finance Chapter 6 Notes

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University of Guelph
Marketing and Consumer Studies
MCS 2100
Rosemary Vanderhoeven

Chapter 6: Choosing A Source Of Credit: The Costs of Credit Alternatives Beware of teaser rates! - Credit card marketers may advertise a low annual percentage rate (APR), but this rate often jumps substantially after three to nine months - Students are often the targets of this kind of marketing scheme - Late fees can be as high as $30, and some cards impose a fee of up to 4% on cash advances THE MORAL: DON’T ASK FOR EXTRA CREDIT! - Get a card with a restrictive credit line instead, OR get a secured credit line - Don’t put purchases on your credit card that you can pay for with cash o Only exception: buying things you can pay for immediately so as to build a good credit rating Sources of Consumer Credit - Weigh the pros/cons of buying now with credit vs waiting until you have the money saved - Evaluate the pros and cons of various credit sources to see what works for you best Before deciding whether to borrow, ask yourself: - Do I need a loan? - Can I afford a loan? - Can I qualify for a loan? Avoid credit in these situations: - When you don’t need or really want a product that requires financing o Quick sale incentives like easy access to instalment loans or possessing credit cards often make consumers buy things they later regret o Solution: take a day to consider, don’t give in to sales pressure! - When you can afford to pay cash o Almost always cheaper to pay cash than with credit (some places give discounts for cash payments) What Kind Of Loan? - Instalment loans usually have lower interest rates but credit cards usually have a float period (a certain number of days when no interest is charged) that makes it easier to pay for things on credit that can be paid off in a few months Inexpensive Loans - Parents / relatives: often charge little to no interest, only full repayment of money loaned o Downfall: can strain family relationships o Try to get documentation of the loan in writing (interest rate, repayment schedule, final payment date, etc) - Money borrowed on financial assets held by a lending institution (eg. Guaranteed Investment Certificate [GIC]) or the cash value of a whole life insurance policy o Interest rates are usually 7-10%, but assets are tied up until you repay the loan Medium Amount Loans - Banks, trust companies, credit unions o Advantages:  Provide credit life insurance  Provide personalized service  Credit unions can offer the same range of consumer loans as banks/etc  Generally sympathetic to borrowers with legitimate payment problems Expensive Loans - Finance companies, retailers, banks- through credit cards o Usually 12-25% interest rate - Some provide cheque cashing/ etc @ 1% per week - No lender in Canada can charge higher than 60% rate per year - If you are denied a loan by a bank/credit union, question your ability to afford the higher rates offered by others - Borrowing from car dealerships, retailers, appliance stores, etc., are usually very expensive Student Loans - Used to finance post-secondary education, available through Government Of Canada o Lower than commercial rates because it is subsidized by the federal government o Don’t have to repay until you complete /end your education o Repaid with interest, unlike grants and work-study and scholarships o You can’t get out of paying because you didn’t finish the education, or get a job in your field, or if you’re in financial difficulty  Moral: choose your field of study wisely before borrowing! 2 Types of Government Loans - Federal: Canada Student Loans Program (CSLP) – full and part time students can apply for this - Provincial: ON, NF, NB, SK have integrated federal and provincial systems o Student only has to apply at provincial level for the loans and repay the loans together in integrated systems, but non-integrated provinces require the student to manage federal + provincial loans separately - There is also the Canada Student Grants Program (CSGP), which offers assistance to those in greater need (grants don’t need to be paid back remember!) o Federal Government of Canada will pay up to 60% of the assessed need (up to $210 in loans per week of study)  40% left can be paid by provincial / territorial loans Annual Percentage Rate (APR) - The yearly interest rate quoted by a financial institution on a loan. The APR may be compounded more frequently than once a year o The effective annual rate on the loan will be higher than the APR - Effective annual interest rate (EAR) charged on a loan depends on the quoted APR, how frequently interest is compounded, whether interest is charged up front (on a discounted basis), and whether any other charges are incurred (eg. service charges) - Financial insitutions are obligated to disclose both APR and EAR to the borrower at the time the loan contract is signed EAR Calculation EAR = (1+APR/m) – 1 Where m is the number of times a year the interest is compounded - Interest that is prepaid increases the effective annual cost of the loan Tradeoffs to Consider - Long term plans to pay smaller monthly payments o The longer the term, the greater is the amount you pay in interest charges - Choose a term/rate depending on your need and what you can afford, what you’re willing to give up Scenario: Buying a used car at $7500, and you put down $1500, needing to borrow $6000. APR Term Of Monthly Total Total Compounded Loan Payment Amount Interest Monthly Repaid Cost Creditor A 14% 36 Months $205.07 $7382.52 $1382.52 Creditor B 14% 48 Months $163.96 $7870.08 $1870.08 Creditor C 15% 48 Months $166.98 $8015.04 $2015.04 The monthly payments for shorter terms are higher, but you are not paying as much interest. Conversely, you will have to pay for more interest in a longer term, but you will pay smaller monthly payments. Lender Risk Vs. Interest Rate - You may want low fixed payments with a large final payment or only a minimum of upfront cash o These requirements can increase your cost of borrowing because they create more risk for lender  Minimize lender risk if possible to get the best deal Variable Interest Rate - Based on fluctuating rates in the banking system (eg. the prime rate) o You share the interest rate risks with lender here o May entice lender to give a lower initial interest rate than they would with a fixed-rate loan Secured Loan - If you pledge property or other assets as collateral, you’ll probably receive a lower interest rate on your loan Upfront Cash - May give you a better chance at negotiating other terms of your loan (eg. term length, etc) - Creditor like when you pay cash upfront Shorter Term - The shorter the period of time for which you borrow, the less chance of something happening to prevent you from paying your loan back (lower risk for lender) - Might get lower rate for shorter time (payments will still be higher though!) Calculating Loan Payments -fixed rate instalment loans - floating rate personal line of credit Fixed-Rate -formula for calculating an instalment loan payment: 1- [1/(1+i) ] PMT= PV / i Where: PMT = monthly payment PV= loan amount i = monthly interest n= term of loan in months - At the beginning of the loan repayment, more of the payment is used to pay the interest, but as the amount you have to pay back decreases, the less interest (in $$) there is to be paid back - Higher payments but fixed time period - Each payment is a blend of interest and principal of loan repayment o The interest is paid first from the payment and the rest goes towards repaying the principal Floating (Variable) Rate - Interest is usually compounded daily - There is usually a variable interest rate tied to the lender’s prime rate What you need to know to calculate the total payment for each month: - Beginning loan amount - The prime interest rate your financial institution is charging + the variable interest rate they are charging you (“prime + variable”) - Minimum amount/percentage to be paid back on outstanding loan balance each month - Assumption of days in a month (usually 30, but sometimes 31 days) To calculate the daily interest: Your interest rate (Prime + Variable) / 365 days To calculate the interest charge amount per month: Beginning loan balance for month x daily interest x 30 days To calculate total payment: Beginning Min payment % of X loan balance + Interest charge outstanding loan for month for month - Variable rates give you smaller payments but take much longer to fully pay off loan (especially if you only pay minimum payment) - By using a variable rate, you are taking a chance with fluctuating rates (will they go higher or lower?) o Exception: if you’re able to lock in the current rate Cost Of Carrying Credit Card Balances - Revolving credit includes: personal line of credit, credit cards, store credit cards, and overdraft protection Adjusted balance method: the assessment of finance charges after payments made during the billing period have been subtracted Previous balance method: a method of computing finance charges that gives no credit for payments made during the billing period Average daily balance method: a method of computing finance charges that uses a weighted average of the account balance throughout the current billing period How to calculate the Average Daily Balance (including new purchases): # of days from 1 # of days from New balance ( Previous x of month to next) + ( New balance as x # of days unt) + ( purchase date x after payment ) balance payment on loan of most recent purchase is to next balance and purchase(s) payment made change (usually 15 days) ______________________________________________________________________ Billing period (usually 30 days) (If you can’t see this equation see Appendix A at the end of these notes). The values for each part of this equation can be different depending on when you make payments, when and how much you are buying in the month. Average Daily Balance without new purchases: # of days until Previous New balance # of days left payment after p
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