WK 4 - borrowing money

What is credit?

The ability to borrow money from a lender with the promise to repay it later

What is a loan?

enables a borrower to recieve a fixed amount of money and agree to repay it over time according to a schedule, usually with interest

What is debt?

the total amount of money a person/organisation owes to others

What can debt result from?

loans, credit cards, unpaid bills or other borrowing arrangements

What is interest?

the cost of borrowing money. The amount a borrower pays to the lender for the use of the borrowed funds

What type of debt is student loan?

Income-contingent: income is low, you repay nothing. Income rises, you pay more

APRA has told banks to include HECS-HELP (student loan) debt when estimating

customers total debt

Payment to HECS: $0 - 67,000

nothing

Payment to HECS: $67,0001 - 125,000

15c for each $1 over $67,000

Payment to HECS: $125,001 - 179,285

$8,700 plus 17c for each $1 over $125,000

Payment to HECS: $179,286 and over

10% of your total repayment income

consumption smoothing

an economic concept that describes how people balance their spending and saving to keep their standard of living steady over time

Debt is your bargain with yourself that:

• Value of the debt today > value of the future payment

• Your future self has to pay more to the lender

At early stage in life borrowing is…

useful as long as you use the money to improve your human capital

Debt level quote textbook

• "when you are young, have few financial resources and are investing time to develop and improve your human capital, spending more than you earn is rational" (Milevsky, 2010)

Secured loans

• security offered by borrower

• lender taking less risk

• eg: home mortgage

interest rate on secured loans?

lower

Secured loans: If borrower gails to pay…

lender can sell secured asset & return any remaining cash, net of costs, to borrower

Unsecured loans

• no asset is pledged

• Generally small amounts, higher interest rates than secured loans

• Lender taking more risk

examples of unsecured loans

credit card, BNPL, payday loans, personal loans

payday loans

• lets you borrow up to $2000. You have between 16 days and one year to pay it back

  • Payday loan has a lot of fees

  • Eg: to pay back a $2000 loan over one year, your total repayments will be about $3360

Credit providers must:

• Make reasonable inquiries about your financial situation, requirements and objectives

• Take reasonable steps to verify your financial situation

• Decide whether the credit contract you are asking for is not suitable for you

As consumers we need to be aware:

• Lenders are doing business so they have incentive to maximise their own benefit so they may avoid these checks may encourage you to borrow

• Lenders aren’t necessarily considering your best interest

Credit providers must have a ______ but

license, some who “provide” credit are exempt

Get a credit guide

license number, contact details, fees/charges, details of your right to complain

• Credit contract must be in writing

• Common fees and charges

• Monthly fee for having an account

• Late payment fees

• Missed payment fees

• Fees for going over your credit limit

• Establishment fee

Co-borrowers

Both responsible for the joint debt (common with home mortgages where the house is owned jointly)

Guarantor

must pay if the borrower does not pay as they are guaranteeing the loan (encouraged with a wide variety of loans)

Loan size is a TVM question

present value = future value t / (1 + discount rate) t

nominal rate equation

interest per period x number of periods in year

Effective rate equation

(1 + interest per period) number of periods in year

Effective rate is higher than nominal rate because

compounding

Reducing balance (Amortized) loan

Interest is charged only on what you still owe. As the loan balance falls, the interest rate falls too, so more of each repayment goes toward paying off the loan itself

Reduce balance loan is one of the most…

common types of loan in modern financial systems

How does Afterpay make money if the organisation charges no interest?

$7 late fee added 7 days after payment is due. Orders about $272 late fee of $68 may be applied. If you don’t pay they “can collect any amounts owing to us”

Costly behaviour: debt diversification

• Can be costly because:

  • Interest rates vary across debt providers

  • Transaction costs, fees, penalties also vary

  • Some costs are fixed costs, not percentage

Why is debt diversification a costly behaviour?

• Your time is valuable and more effort required for multiple debts

Refinance debt

• renogiate single debt

  • Eg: ask your bank to change terms on home loan or change to a bank with a better home loan

Consolidate debt

• multiple debts into one

  • Payout credit card, card loan, mortgage with new single loan

We describe amount of debt as

leverage because debt magnifies effect