Chapter 7
Consumer Loans: Understand the different types of consumer loans available, including their purposes and terms.
Cost of Consumer Loans: Learn how to calculate the total cost of a consumer loan, including interest and fees, and understand the implications of early repayment.
Choosing Loan Sources: Identify the best sources for obtaining consumer loans, considering factors like interest rates and lender reputation.
Debt Management: Develop strategies to control and manage your debt effectively to avoid financial strain.
Student Loans: Recognize the significant impact of student loans on personal finances, noting that student loan debt is second only to housing debt in the U.S.
Statistics on Student Debt: Be aware that 34% of adults aged 18 to 29 have student loan debt, with the average balance for a 35-year-old being $42,000.
Challenges with Student Loans: Understand the difficulties faced by borrowers who do not complete their degrees, leading to challenges in repaying their loans.
Learning Objectives
Consumer Loans: Various types of consumer loans are available, each with different terms and conditions.
Cost of Consumer Loans: Calculating the cost of a consumer loan involves understanding interest rates and repayment terms. Early repayment can affect the total cost.
Choosing Loan Sources: Selecting the right source for a loan is crucial for obtaining the best interest rates and terms.
Debt Control: Managing and controlling debt is essential to avoid financial difficulties.
Student Loans: Student loans are a significant form of debt, second only to housing debt in the U.S. Many borrowers struggle with repayment, especially if they do not complete their degrees.
Statistics on Student Debt: In 2021, 34% of adults aged 18 to 29 had student loan debt, with the average balance for a 35-year-old being $42,000. This debt can be burdensome, particularly for those who do not finish their education.
Consumer Loans—Your Choices
Consumer loans are more formal and structured than credit cards and open credit, involving formal contracts specifying the loan amount and repayment terms.
Purpose: Consumer loans are typically used for larger purchases, allowing you to borrow more and repay over a longer period compared to open credit.
Repayment: These loans require a set repayment schedule, which necessitates planning both the purchase and the repayment.
Financial obligation: While consumer loans enable immediate consumption, they create a future financial burden.
Types of consumer loans:
Unsecured loans: Do not require collateral.
Fixed-rate loans: Have a constant interest rate throughout the loan term.
Single-payment loans: Require the entire loan amount to be repaid in one lump sum.
Secured loans: Require collateral to back the loan.
Variable-rate loans: Have an interest rate that can change over time.
Installment loans: Require regular payments over the loan term.
First Decision: Single-Payment Versus Installment Loans
Consumer loans can be either single-payment loans or installment loans.
Single-payment (balloon) loans:
Paid back in a single lump-sum payment at maturity.
Maturity is usually less than 1 year.
Used as bridge or interim loans for short-term funding.
Example: Financing the building of a house until a mortgage loan is secured.
Installment loans:
Repayment of both interest and principal at regular intervals.
Monthly payments are structured so the loan expires at a preset date.
Initial payments have a higher interest component, which decreases over time.
Principal payments start small and increase over time.
This repayment process is known as loan amortization.
Commonly used to finance cars, appliances, and other big-ticket items.
Second Decision: Secured Versus Unsecured Loans
Secured loans are guaranteed by a specific asset, which can be seized and sold if you fail to make payments.
The asset purchased with the loan funds often serves as collateral (e.g., a car for a car loan).
If the collateral is repossessed, it may not cover the full amount owed, potentially leaving you with remaining debt.
Common assets used as collateral include certificates of deposit (CDs), stocks, jewelry, land, and bank accounts.
Secured loans typically have lower interest rates due to reduced lender risk.
Unsecured loans do not require collateral and are generally given to borrowers with excellent credit histories.
The primary security for an unsecured loan is the borrower’s promise to pay.
Unsecured loans are more expensive due to the higher risk for lenders.
Third Decision: Variable-Rate Versus Fixed-Rate
Fixed-interest-rate loans maintain a single interest rate for the entire loan duration, unaffected by market interest rate changes.
Variable- or adjustable-interest-rate loans are tied to a market interest rate, such as the prime rate or the 6-month Treasury bill rate, causing the interest rate you pay to vary with market rate changes.
The prime rate is the interest rate banks charge their most creditworthy customers, and consumer loans are typically set above this rate.
Example: If your loan is set at 4% over prime and the prime rate is 3.5%, your loan rate is 7.5%. If the prime rate increases to 7%, your loan rate becomes 11%.
Variable-rate loans can adjust at different intervals, such as monthly or yearly. Less frequent adjustments mean less concern about rate changes.
The volatility of the interest rate to which the loan is pegged is important. Short-term market rates, like the 6-month Treasury bill rate, tend to change more frequently than long-term rates, like the 20-year Treasury bond rate, exposing you to more risk.
Facts of Life
Variable-rate loans have rate caps to limit interest rate fluctuations:
Periodic cap: Limits the maximum interest rate increase during one adjustment period.
Lifetime cap: Limits the total interest rate increase over the life of the loan.
Risk and return: Variable-rate loans involve the borrower bearing the risk of rising interest rates, while fixed-rate loans involve the lender bearing the risk of rising interest rates.
Fixed-rate loans generally cost more than variable-rate loans because the lender bears more risk.
Convertible loans are variable-rate loans that can be converted to fixed-rate loans at specified future dates, combining the lower initial cost of variable-rate loans with the option to lock in a fixed rate.
Fourth Decision: The Loan’s Maturity—Shorter- Versus Longer-Term Loans
With a shorter-term loan, monthly payments are larger because you pay off more of the borrowed amount each month.
For example, borrowing $10,000 at 8 percent interest results in monthly payments of $313 for a 3-year loan, but only $121 for a 10-year loan.
Although monthly payments are smaller with a longer-term loan, the total interest paid over the life of the loan is higher.
Shorter-term loans often have lower interest rates because lenders perceive a lower risk of financial disaster (e.g., job loss or medical emergency) over a shorter period.
Understand the Terms of the Loan: The Loan Contract
A loan contract details all conditions of the loan, including a security agreement if the item purchased is collateral.
The security agreement specifies whether the lender or borrower retains control over the collateral.
The note outlines the payment schedule and rights of both parties in case of default.
Common clauses in loan contracts include:
Insurance Agreement Clause: Requires purchasing credit life insurance to pay off the loan in case of death.
Acceleration Clause: States that missing one payment makes the entire loan due immediately, potentially leading to repossession.
Deficiency Payment Clause: If the collateral sale doesn't cover the owed amount, the borrower is billed for the difference and additional costs.
Recourse Clause: Defines actions a lender can take to claim money, such as wage attachment.
An installment purchase contract includes:
Itemization Amount Financed: Fees and insurance charges added to the unpaid balance.
Annual Percentage Rate (APR): The cost of the loan expressed annually.
Number and Amount of Payments: Total number of payments and each monthly payment amount.
Late Charge: Additional fee for missed payments.
Total of Payments: Total amount paid, excluding down payment.
Cosigner: Required if the borrower has poor credit; the cosigner becomes liable if the borrower defaults.
Example contract details:
Buyer Information: Names, addresses, and signatures.
Insurance Statement: Options for credit life, accident, and health insurance.
Description of Goods: Details of the purchased items and their costs.
Itemization of Amount Financed: Breakdown of costs, including insurance and finance charges.
Payment Schedule: Number, amount, and due dates of payments.
Security Interest: Lender's interest in the purchased goods if applicable.
Prepayment: Potential refund of part of the finance charge if paid off early.
Buyer Acknowledgment: Signatures confirming agreement to the contract terms.
Special Types of Consumer Loans
Home Equity Loans: These are secured loans using your home's equity as collateral. You can borrow 50-85% of your equity.
Example: For a home valued at $200,000 with an $80,000 mortgage, you can borrow $60,000 to $102,000.
Advantages of Home Equity Loans:
Tax Deductible Interest: Interest is generally tax-deductible up to $750,000, reducing your taxable income. Example: In a 25% tax bracket, $1 of interest saves 25¢ in taxes, making the after-tax cost 75¢. Formula: * Example Calculation: For a 9% interest rate and 25% tax bracket, the after-tax cost is 6.75% ().
Lower Interest Rates: Home equity loans typically have lower interest rates than other consumer loans due to being secured.
Disadvantages and Dangers of Home Equity Loans:
Risk to Home: Your home is at risk if you default.
Debt Management: Ensure you can support the debt to avoid financial strain.
Limited Financing Flexibility: Only one home equity loan can be outstanding at a time.
Market Risks: Housing prices can drop, reducing the value of your home equity.
Historical Context: Before the 1980s, these were called second mortgages and were less popular. Their rebranding increased their appeal, leading to higher usage and risks during housing market downturns.
Automobile Loans: These are secured loans for purchasing cars, using the car as collateral.
Loan Terms: Typically short-term (24-48 months), but can extend to 5-6 years.
Marketing Tool: Auto loans are used to sell cars, sometimes offering very low or 0% interest rates. * Example: In 2021, GM and Mazda offered 0.0% rates while the national average was 4.21%.
Cost and Early Payment of Consumer Loans
Cost of a consumer loan: Understand the total finance charges and the annual percentage rate (APR) before borrowing.
Truth in Lending Act: Requires lenders to provide written information on total finance charges and APR before signing a loan agreement.
Finance charges: Include all costs associated with the loan, such as interest payments, loan-processing fees, credit check fees, and required insurance fees.
Annual Percentage Rate (APR): Represents the simple percentage cost of all finance charges over the life of the loan on an annual basis, including noninterest finance charges.
Types of consumer loans:
Single-payment or balloon loans
Installment loans
Cost of Single-Payment Loans
Truth in Lending Act: Requires lenders to provide finance charges and APR associated with a loan.
Loan Disclosure Statement: Includes key information such as:
Annual Percentage Rate (APR): True simple interest rate paid over the life of the loan, calculated by dividing the average annual finance charge by the average loan balance outstanding.
Finance Charge: Includes all costs associated with the loan (interest payments, loan-processing fees, credit check fees, insurance fees).
Amount Financed: The principal amount borrowed.
Total of Payments: Sum of the finance charge and the amount borrowed.
Variable Rate Loans: Interest rate may increase based on the WSJ Prime Rate, affecting the number of payments and payment amounts.
Example: A $10,000 loan for 144 months at 12% interest increasing to 12.5% results in a $7.30 increase in the 61st payment.
Simple Interest Method: Interest is calculated as:
Example: Borrowing $10,000 for 6 months at 12% annual rate results in $600 interest:
Single-Payment Loans: Both interest and principal are due at maturity. The stated interest rate and APR are the same if there are no noninterest finance charges.
Example: For a $10,000 loan with $600 interest over 6 months, the APR is calculated as:
Annual finance charges are the total finance charges divided by the number of periods the loan continues. For a 6-month loan with $600 interest, the annual finance charges would be $1,200.
Facts of Life
The average educational debt for law school graduates is approximately $160,000, while for medical school graduates, it is around $216,000.
Discount Method for Single-Payment Loans:
The interest charge is subtracted from the loan principal before you receive the money.
At maturity, you repay the full principal amount.
Example: Borrowing $10,000 for 1 year at an 11% interest rate results in a finance charge of $1,100 ($10,000 \times 0.11).
You receive $8,900 ($10,000 - $1,100) and repay $10,000 after 1 year.
The effective loan amount is $8,900, as the interest is prepaid.
The APR (Annual Percentage Rate) is calculated as follows: For a 1-year loan: For a 6-month loan at 12% interest:
The APR is higher with the discount method compared to the simple interest method because the interest is deducted upfront, resulting in a lower effective loan amount.
Facts of Life
Sandra Harris, an accounting technician from Wilmington, North Carolina, faced financial difficulties after her husband lost his job.
To pay her car insurance, she took a $200 payday loan from Payday Loans Direct, paying a $50 fee.
Initially planning to repay the loan, she ended up renewing it multiple times and taking out additional payday loans.
Over six months, she paid over $600 per month in fees, totaling $8,000 in fees for six payday loans.
The fees did not reduce her debt, leading to her eviction and car repossession.
Payday Loans—A Dangerous Kind of Single-Payment Loan
Payday loans are short-term, high-interest loans typically ranging from $100 to $500, aimed at individuals needing quick cash until their next paycheck.
These loans are often used by vulnerable borrowers, including young adults and those without access to traditional banking services.
The cost of payday loans is extremely high, with fees ranging from $15 to $30 for a 1- or 2-week loan, leading to annual interest rates of 400% to 800%.
Borrowers often fall into a cycle of debt, repeatedly renewing loans and incurring additional fees.
Despite legislative efforts to regulate payday loans, such as the 2006 Congressional act protecting military families and various state laws, payday lenders often find ways to circumvent these regulations, including operating online and partnering with American Indian tribes.
Online payday loans can have APRs ranging from 350% to 699%, with borrowers potentially paying thousands of dollars in interest and fees.
Title loans, similar to payday loans, allow borrowers to use their car as collateral, with interest rates over 300% and a significant risk of losing the vehicle if the loan is not repaid.
Both payday and title loans are highly detrimental to borrowers and should be avoided due to their predatory nature and the financial traps they create.
Cost of Installment Loans
Installment loans require regular repayment of both interest and principal, with payments set to ensure the loan expires on a preset date.
Simple Interest Method: The most common method for calculating payments on an installment loan.
Monthly payments remain the same, but the interest portion decreases each month while the principal portion increases.
Interest is paid only on the unpaid balance, which decreases over time.
Monthly payment calculation can be done using a financial calculator or financial tables.
To calculate the monthly payment, convert the annual interest rate to a monthly rate by dividing by 12.
Example: For a 12-month installment loan of $5,000 at 14% annual interest:
Convert the annual interest rate to a monthly rate: per month.
Calculator Clues
For a loan with 12 monthly payments, is 12, and is the annual interest rate divided by 12.
The monthly payment (PMT) for a $5,000 loan at 14% interest is $448.94.
Using installment loan tables, the monthly payment for a $1,000 loan at 14% interest for 12 months is $89.79. For a $5,000 loan, multiply $89.79 by 5 to get $448.95.
Loan payments remain constant, but as you pay off the loan, interest expenses decline, and principal payments increase.
Example of monthly payments for a $5,000 loan at 14% interest:
Month 1: Interest = $58.33, Principal = $390.61, Ending Balance = $4,609.39
Month 12: Interest = $5.18, Principal = $443.76, Ending Balance = $0.00
Add-on interest method calculates interest on the original balance, resulting in higher costs.
For a $5,000 loan at 14% interest using the add-on method, total interest is $700, making monthly payments $475.
The APR for this add-on loan is approximately 24.91%, calculated using the N-ratio method:
The Truth in Lending Act requires lenders to disclose the APR, providing a more accurate cost of the loan.
Early Payment of an Add-On Loan
Installment Loan Early Payoff: To pay off an installment loan early, you need to determine the remaining principal. Under the simple interest method, interest is paid only on the remaining balance, making it straightforward to calculate the remaining principal.
Add-On Interest Installment Loan: For add-on interest loans, early repayment calculations are more complex. The loan contract typically includes a method for calculating the unpaid principal and the interest saved by early repayment.
Rule of 78s: This method is commonly used to determine the proportion of each payment that goes toward the principal. More interest is paid in the early periods because the principal is higher.
Example Calculation:
Step 1: Sum the months' digits using the formula . For a 12-month loan, .
Step 2: Sum the remaining months' digits. For the remaining 6 months: .
Step 3: Determine the portion of interest avoided by dividing the result from Step 2 by the result from Step 1: .
Step 4: Calculate the dollar interest charge avoided. Multiply the result from Step 3 by the total dollar interest charge: .
Step 5: Calculate the payoff amount. Subtract the interest charges avoided from the total amount due for the remaining payments. For 6 payments of $475: . Subtracting $188.46 from $2850 gives .
Stop & Think
In ancient India and Nepal, creditors would fast at the debtor's front door until the debt was paid.
If the creditor died from starvation, the debtor would be dragged out and beaten to death by locals.
Add-on loans are very expensive and should be avoided if possible.
Paying off an add-on loan early may incur a penalty, often 20% of prepaid interest.
Most add-on loans of a year or less do not offer a rebate of prepaid interest if paid off early.
Getting the Best Rate on Your Consumer Loans
Shop around for the best loan deal: Treat applying for a consumer loan like any other purchase. Compare different lenders and negotiate terms.
Commercial banks:
Types of Loans: Home mortgage, home improvement, education, personal, auto, mobile home.
Advantages: Widely available, may offer financial counseling.
Limitations: Generally competitive, do not take credit risks, primarily offer larger loans.
Savings and loan associations:
Types of Loans: Home mortgage, home improvement, education, personal, auto, mobile home.
Advantages: Low costs, may provide financial counseling.
Limitations: Selective in lending, only lend to good risks.
Credit unions:
Types of Loans: Home mortgage, home improvement, education, personal, auto, mobile home.
Advantages: Easy to arrange for members in good standing, lowest rates, excellent service.
Limitations: Lend to members only.
Sales financing companies:
Types of Loans: Auto, appliance, major, boat, mobile home.
Advantages: Very convenient, good terms during special promotions, easy to get, processed quickly.
Limitations: High rates, defaulting can mean loss of item and payments already made.
Small loan companies:
Types of Loans: Auto, personal.
Advantages: Easy to get, good credit rating not required, processed quickly.
Limitations: High rates, cosigner often required, maximum size limited by law.
Insurance companies:
Types of Loans: General-purpose loans.
Advantages: Easy to arrange, low rates, can borrow up to 95% of a life insurance policy’s surrender value, no obligation to repay.
Limitations: Outstanding loan and accumulated interest reduce payment to survivors, policy ownership required.
Brokerage firms:
Types of Loans: Margin account, general-purpose loans using investments as security.
Advantages: Easy to arrange, little delay in getting money, flexible repayment.
Limitations: Changing value of investments can require payment of additional security, margin requirements can change.
Inexpensive Sources
Family loans are typically the least expensive source of funds because you don't pay the market rate; instead, you may pay what your family members would have earned in a savings account.
Downside of family loans: If you can't repay, your family suffers, and many people feel uncomfortable borrowing from family.
Home equity loans and secured loans are relatively inexpensive because the lending agency has an asset to claim if you default.
Downside of secured loans: Assets are tied up as collateral, limiting financing flexibility, and you risk losing your assets if you can't make payments.
Sources for home equity loans: Almost all lending agencies offer them.
Insurance companies offer low rates on loans against the cash value of life insurance policies because they are not taking on significant risk.
Stop & Think
When borrowing isn't tax deductible, the cost of borrowing is higher than it appears.
Mortgage or home equity loan interest is deductible up to $750,000 of qualified loans; beyond this, the interest is not deductible.
For someone in the 32% marginal tax bracket, to pay $68 of interest, they must earn $100 because $32 goes to taxes, leaving $68 for the interest payment.
More Expensive Sources
Credit unions, savings and loan associations, and commercial banks are good sources of funds.
The cost of borrowing depends on:
Whether the loan is secured or unsecured.
The length of the loan.
Whether the loan has a variable or fixed interest rate.
Interest rates can vary significantly between lenders for the same loan.
It is important to shop around for the best loan terms.
Credit unions generally offer the most favorable loan terms compared to other sources.
Most Expensive Sources
Financing from retail stores is generally very expensive.
Borrowing from finance companies or small loan companies is also extremely costly.
To borrow from other sources, a solid credit rating is usually required.
Those in the most desperate financial situations often have to pay the highest costs for credit, perpetuating their financial difficulties.
Keys to Getting the Best Rate
Strong credit rating: The primary key to securing a favorable interest rate on a loan is maintaining a strong credit rating.
Variable-rate loan: Opting for a variable-rate loan can reduce the lender's risk, as the interest rate adjusts with market rates, potentially resulting in a lower initial rate. However, this means you bear the risk if interest rates rise.
Short loan term: Keeping the loan term short decreases the interest rate because it reduces the lender's risk of default. Shorter terms mean a lower probability of financial disaster before the loan is paid off.
Collateral: Providing collateral for the loan makes it less risky for the lender, as they have an asset to claim in case of default.
Large down payment: Making a large down payment reduces the amount you need to borrow and increases your ownership stake in the financed asset, which is viewed favorably by lenders as it indicates a higher commitment to repaying the loan.
Should You Borrow or Pay Cash?
Control and planning are essential in debt decisions: Set a budget, live within it, and understand the consequences of your actions.
Debt is expensive: Interest on loans increases the cost of purchases and reduces future financial flexibility.
Evaluate necessity before borrowing: Determine if the purchase fits into your financial plan. If not, avoid borrowing.
Consider liquidity: Ensure using cash doesn't affect your ability to handle financial emergencies.
Compare borrowing costs to savings earnings:
If borrowing costs are lower than savings earnings, borrowing may be advantageous.
Example: Borrow at 0.05% if savings earn 0.5%.
If borrowing costs are higher than savings earnings, use savings instead.
Example: Use savings if borrowing at 5% and savings earn 0.5%.
Borrowing makes sense if benefits outweigh costs.
Controlling Your Use of Debt
Control your debt by determining how much debt you can comfortably handle.
Debt levels change through different stages of the financial life cycle:
Early stages: Higher debt due to housing and family demands, coupled with lower income.
Later stages: Debt as a portion of income tends to decline as income rises.
Use common sense in analyzing your financial commitments.
Measures to control debt include:
Debt limit ratio: A measure to help manage debt levels.
Debt resolution rule: Another guideline to control debt commitments.
Debt Limit Ratio
The debt limit ratio measures the percentage of your take-home pay used for nonmortgage debt payments.
The formula for the debt limit ratio is:
Consumer debt and mortgage debt are the two main types of debt, but only consumer debt is included in the debt limit ratio.
Ideal debt limit ratio: Keep it below 15% to maintain financial flexibility and a borrowing reserve for emergencies.
Critical threshold: At 20%, financial planners advise limiting additional consumer debt to avoid reduced access to emergency funds.
28/36 rule: Lenders use this to evaluate mortgage applicants:
Total monthly mortgage payment (including insurance and taxes) should be less than 28% of gross monthly income.
Total monthly debt payments (including mortgage and consumer debt) should be less than 36% of gross monthly income.
Failing to meet the 28/36 rule may result in the need for a larger down payment or rejection of the mortgage application.
Debt Resolution Rule
The debt resolution rule helps control debt obligations by requiring repayment of all outstanding debts every four years.
This rule excludes borrowing for education and home financing.
The rationale is that consumer credit should be short-term; if it exceeds four years, it is not considered short-term.
Consumer credit should not be relied upon as a long-term funding source due to its relative costs.
Controlling Consumer Debt
Controlling consumer debt is essential to align with your financial goals and budget.
Financial control is crucial in personal finance to avoid costly and painful consequences.
Accumulating consumer debt during college can limit future financial flexibility.
Recognize signs of financial trouble by referring to indicators and checklists, such as Checklist 7.1.
What to Do If You Can’t Pay Your Bills
Budgeting: Create a budget that ensures your income exceeds your expenses.
Self-Control: Exercise self-control in the use of credit to avoid further debt.
Contact Creditors: If you can't pay a bill, contact your creditor first. They may be willing to restructure your loan.
Credit Counselors: If creditors can't help, seek assistance from a credit or debt counselor. They can help you organize your finances and develop a debt repayment plan.
Choosing a Counselor: Be cautious when selecting a credit counselor. Reliable options include the Consumer Credit Counseling Service, affiliated with the National Foundation for Consumer Credit.
Verification: Check the counselor's qualifications and any complaints with the Better Business Bureau and state Consumer Protection Office.
Other Options: Consider borrowing as inexpensively as possible and avoid high-interest small loan companies.
Facts of Life
Payday Loan Shops: There are over 23,000 payday loan shops in the U.S.
Using Savings to Pay Off Debt: Consider using savings to pay off high-interest consumer debt, but only as an emergency measure and not regularly.
Debt Consolidation Loans: These loans combine multiple debts into one with a lower interest rate, but they do not eliminate debt problems, only restructure payments.
Bankruptcy as a Last Resort: Personal bankruptcy should be considered only in extreme cases. It does not eliminate all obligations but can relieve financial pressure.
Leading Causes of Bankruptcy:
Major illness
Easy availability of credit
Divorce
Job loss
Types of Bankruptcy:
Chapter 13 (Wage Earner’s Plan): Requires regular income, secured debts under $1,257,850, and unsecured debts under $419,275. Allows for a repayment plan to cover most debts while maintaining normal living expenses. * You keep your assets and follow a court-supervised repayment schedule.
Chapter 7 (Straight Bankruptcy): * Most debts are discharged, providing relief from debt obligations.
Facts of Life
Bankruptcies have increased significantly in the last century due to longer lifespans and medical expenses.
Bankruptcy can provide a fresh start for individuals in severe financial distress, including notable figures like Dave Ramsey and 50 Cent.
Chapter 7 Bankruptcy:
Known as straight bankruptcy, it is a severe form of bankruptcy for those unable to repay debts.
To qualify, you must pass a "means test" showing your disposable income is lower than your qualified monthly expenses and own minimal property.
The means test checks if you can repay at least some debt; if not, you may qualify for Chapter 7 instead of Chapter 13.
Requirements include: Completing a credit counseling course within 6 months before filing. Taking a personal financial management course before debts are discharged.
Most debts are eliminated, but some, like child support, alimony, student loans, and taxes, remain.
A trustee sells your nonexempt property to pay creditors.
Chapter 7 is a drastic measure and should be considered with professional advice.
Student Loans and Paying for College
Understanding the alternatives for financing college education:
Choice of school and major: The school and major you choose can significantly impact your future financial situation.
Costs and borrowing: Be aware of all costs, including tuition and living expenses, and aim to borrow less and more wisely.
Money management: Manage your finances well while on campus to minimize debt.
Loan repayment: Plan to repay your loans without compromising your financial goals.
Importance of college education:
College can be a good investment, but it is not always the case. Graduates earn more due to productivity, ambition, and in-demand skills.
Some successful individuals did not complete college, indicating that success can also come from other paths.
Economic data on education:
Unemployment rates (2019): Doctoral degree: 1.1% Professional degree: 1.6% Master’s degree: 2.0% Bachelor’s degree: 2.2% Associate’s degree: 2.7% Some college, no degree: 3.3% High school diploma: 3.7% Less than a high school diploma: 5.4% * All workers: 3.0%
Median weekly earnings (2019): Doctoral degree: $1,883 Professional degree: $1,861 Master’s degree: $1,497 Bachelor’s degree: $1,248 Associate’s degree: $887 Some college, no degree: $833 High school diploma: $746 Less than a high school diploma: $592 * All workers: $969
So Many Choices—Schools and Majors
College costs vary significantly: In 2021, the average annual cost for a public 4-year university was $25,396 for in-state students, $42,514 for out-of-state students, and $53,102 for private universities. Some schools, like New York University, can cost around $78,742 per year.
Choose your college carefully: Consider both educational and financial factors to avoid unaffordable costs. In-state schools and community colleges are generally less expensive than out-of-state schools.
Future income considerations: Your potential starting salary should influence how much you borrow for college. Different career paths offer varying starting salaries, which will affect your ability to manage student loan payments.
Impact of college major on earnings: Your choice of major significantly affects your future earnings. A study from the University of Texas System found that the difference in earnings between majors can be as much as $40,000 per year.
Evaluate career prospects: Understand the positive and negative aspects of careers related to your major, including status, earning potential, industry stability, and job requirements like travel or relocation.
Earning potential of majors: The earning potential of different majors varies greatly. The highest-earning major can earn 314% more than the lowest-earning major.
Borrowing Less and Borrowing Smarter
Compare financial aid packages and college costs: Use the U.S. Department of Education's College Scorecard to compare graduation rates, salaries, costs, and other important metrics.
Apply for financial aid: Fill out the FAFSA starting October 1 for the upcoming academic year, using tax returns from two years prior. This determines your eligibility for grants, loans, and work-study funding.
Review your Student Aid Report (SAR): After submitting the FAFSA, check your SAR for accuracy and report any special circumstances that might affect your aid.
Understand your award letter: Differentiate between grants (which do not need to be repaid) and loans (which must be repaid). Consider the total cost of attendance, including tuition, fees, and living expenses.
Reapply for aid annually: Complete the FAFSA every year to continue receiving student loans and other aid. Apply early to maximize your potential aid.
Explore additional funding sources: Look into state and local grants, scholarships, GI Bill benefits, military tuition assistance, and federal tax credits like the American Opportunity Credit and Lifetime Learning Credit.
Tax benefits: Claim up to $2,500/year with the American Opportunity Credit or $2,000/year with the Lifetime Learning Credit. Deduct up to $2,500 of student loan interest from your taxable income.
Be aware of front-loading of grants: Grants may be more generous in your freshman year compared to subsequent years.
Consider the long-term impact of loans: Understand that loans will need to be repaid, often over a decade or more. The average student debt is over $29,000, with total student loan debt in the U.S. exceeding $1.68 trillion.
Borrowing options: If additional funds are needed beyond grants and work-study, consider the implications of taking out loans and the long-term repayment responsibilities.
Paying for Your College Education
Saving for College:
Prioritize paying down debt and maximizing retirement contributions before saving for a child's college.
529 Plans: Tax-advantaged savings plans for future college costs. Two types: prepaid tuition plans and college savings plans. Prepaid tuition plans allow purchasing units or credits at participating colleges for future tuition. College savings plans allow setting up an account for future eligible college expenses. Tax advantages: earnings grow tax-deferred, and withdrawals are tax-free for qualified education expenses. Can be used for private, public, or religious school tuition (up to $10,000 per year) and vocational school expenses. * Can also be used to pay off a portion of student loan debt.
Coverdell Education Savings Account (ESA): Allows annual nondeductible contributions up to $2,000 per year per person. Tax-free growth and withdrawals for education expenses. * Contributions stop at age 18, and funds must be used by age 30.
Borrowing Money:
Federal Student Loans: Funded by the government with fixed interest rates. Four types of Direct Loans: Direct Subsidized Loans: For undergraduates with financial need; government pays interest while in school and during the grace period. Direct Unsubsidized Loans: For undergraduate, graduate, and professional students; interest accumulates if not paid during school. Direct PLUS Loans: For graduate/professional students and parents of dependent undergraduates; requires a credit check, interest accrues immediately. Direct Consolidation Loans: Combine all eligible federal student loans into one loan.
Parent PLUS Loans: Loans for parents of dependent undergraduate students. Interest begins accruing immediately, and payments are deferred for 6 months. * Can lead to significant debt for parents, with potential garnishment of Social Security checks for defaults.
Facts of Life
Parent PLUS loans have significantly increased, making up over 25% of undergraduate loans by 2021, with parents owing around $100 billion.
Federal loan interest rates are fixed for the life of the loan but change annually on July 1 for new loans, based on the 10-year Treasury note rate plus an add-on.
For the 2020-2021 loan year:
Direct subsidized and unsubsidized undergraduate loans:
Direct unsubsidized graduate loans:
Direct PLUS loans:
Interest rates on new loans change annually, but rates on existing loans remain fixed.
There are caps on federal loan interest rates:
Direct subsidized and unsubsidized undergraduate loans: 8.25%
Direct unsubsidized graduate loans: 9.50%
Direct PLUS loans: 10.50%
Private student loans should be considered only after exhausting federal financial aid options. They often have variable interest rates and can be more expensive, sometimes reaching up to 13%.
Private loans typically do not offer options to reduce or postpone payments, unlike federal loans.
If additional funds are needed after federal aid, consult your school's financial aid office for guidance and certification of need.
Most private loans require a cosigner, with nearly 94% requiring one in 2016. Look for loans offering a cosigner release after a certain number of on-time payments.
Facts of Life
A study from the University of North Carolina at Greensboro found that each additional $10,000 in student debt decreases the borrower's long-term probability of marriage by 7 percentage points.
When comparing financial aid and college costs, use the U.S. Department of Education’s Financial Aid Shopping Sheet if available, as it provides a standardized format for easier comparison.
If the Financial Aid Shopping Sheet is not available, use the Consumer Financial Protection Bureau's website to compare college costs and financial aid offers.
The financial aid office at each institution is a valuable resource for information and assistance.
Manage Your Money Responsibly
Setting up a bank account: Ensure you have a bank account to receive any loan money via direct deposit, which is faster and may help avoid certain bank fees.
Student loan refund: After tuition is paid, the remaining loan money is refunded to you for other student expenses like books, a computer, and food.
Choices for handling the refund:
Return the money: If possible, return the refund to avoid additional debt. A part-time job (less than 10 hours per week) can help cover expenses and may improve your GPA.
Use the money wisely: If you keep the refund, use it strictly for necessary college expenses. This requires discipline to avoid spending it on non-essential items or helping family and friends.
Avoid frivolous spending: Do not treat the refund as free money to spend on luxuries, as this will lead to financial consequences later.
Repaying Your Loans
Repayment Plans:
Standard Repayment: 10-year term, lowest interest paid, automatic unless another plan is chosen.
Extended Repayment: 10- to 30-year term, more payments, more interest.
Income-Based Repayment: Based on discretionary income, low monthly payments, more interest, 25-year term before forgiveness.
Graduated Repayment: Starts low, increases every 2 years, low initial payments, more interest, 25- to 30-year term before forgiveness.
Deferment:
Postpone payments for up to 3 years if enrolled at least half-time, unemployed, or meet hardship standards.
Interest does not accrue on subsidized loans during deferment.
Forbearance:
Temporarily stop payments for qualified reasons like illness or financial hardship.
Interest continues to accrue during nonpayment.
Loan Servicer:
Assigned by the U.S. Department of Education to help manage repayment for free.
Keep all paperwork and contact information for your servicer.
Update your servicer with current contact information.
Use the servicer’s messaging system for a paper trail of communications.
Resources:
U.S. Department of Education websites and your school’s financial aid office are valuable resources for information and assistance.
Repaying Your Loans
It's important to plan for student loan repayment before graduation to avoid being overwhelmed later.
Contact your loan provider to determine your total balance at graduation and the monthly payment under the standard 10-year repayment plan.
Aim to pay off your student loans within 10 years to improve your financial situation sooner.
Minimize student loan borrowing by working part-time during college.
For unsubsidized loans, unpaid interest during deferment and grace periods will be added to the principal, increasing your loan balance.
Prioritize your student loan payments by making them the first expense you cover each month.
Love & Money
Student debt impacts romantic relationships: 27% of millennials consider a partner's student loan debt before entering a long-term relationship.
Gender differences: Men are more likely than women to consider a partner's student debt before dating.
Divorce and student debt: 13% of divorced borrowers blame student loan debt for their divorce.
Average student debt: The average U.S. household with student debt owes about $47,671.
Reasons for concern: The impact of student debt on relationships depends on whether the debt was part of a bigger plan or due to poor financial habits.
Key questions: Important considerations include whether there is a plan to pay off the loan, if extra money is used to pay the loan, and if bad financial habits are in the past.
Other types of debt: Auto loan debt (38%) and medical debt (27%) are also common among millennials entering new relationships.
Communication and planning: Openness and honesty about debt are crucial. Couples should discuss their financial situations and create a plan to manage debt and align financial goals.
Behavioral Insights
Endowment Effect: People value items they own more than items they do not own. This effect is exploited by marketers through trial periods and money-back guarantees, making it harder for you to return items once they are in your home.
Marketing Tactics: Marketers use the endowment effect to increase sales. For example, eBay sellers start bidding at low prices to increase the number of bidders, making you feel like the item is already yours and increasing its value to you.
Behavioral Finance: Understanding how marketers influence your spending can help you control it. Recognize when your emotions are being manipulated, such as during "try it at home" offers or online bidding.
Choice Overload: Too many choices, especially in the context of student loans, can be overwhelming and lead to poor decision-making. This often results in taking on more debt than necessary.
Expert Guidance: Seeking help from financial aid experts can simplify choices and lead to more responsible borrowing, avoiding unnecessary debt.
Action Plan
Mind your loans: Know the details of your student loans, including the lender, balance, and repayment status. Keep organized records for each loan.
Watch your grace period: Understand when you need to start repaying your loan. For direct loans, the grace period is 6 months. Set up automatic payments to avoid missing the first payment.
Keep connected: Inform your lender or loan servicer of any changes in your contact information. Read all communications from them.
Know your repayment choices: The standard repayment plan is 10 years, but other options exist. Prioritize paying off debt with the highest interest rate first.
Deal with problems promptly: If you face financial difficulties, explore options like federal loan deferments and forbearance. Avoid defaulting on your loans, as it has severe consequences.
Prioritize high-interest loans: Pay off loans with the highest interest rates first, typically private student loans.
Consider loan consolidation: Consolidating loans can simplify payments but does not reduce interest rates. Never consolidate federal loans into a private loan to retain repayment options and benefits.
Seek loan forgiveness: If you work in public service, you may qualify for loan forgiveness programs. Research public service loan forgiveness for more information.
Chapter Summaries
Consumer Loans:
Single-Payment Loan: Paid back in a single lump-sum at maturity.
Installment Loan: Repaid with regular payments of interest and principal until a preset date.
Secured Loan: Guaranteed by a specific asset.
Unsecured Loan: No collateral required.
Fixed-Interest-Rate Loan: Interest rate remains fixed for the loan's duration.
Variable-Interest-Rate Loan: Interest rate adjusts based on market rates.
Home Equity Loan: Uses home equity as collateral.
Key Terms:
Consumer Loan: Formal contract detailing borrowing and repayment terms.
Single-Payment or Balloon Loan: Lump-sum repayment at maturity.
Bridge or Interim Loan: Short-term funding until longer-term financing is secured.
Installment Loan: Regular payments of interest and principal.
Loan Amortization: Equal monthly payments covering principal and interest.
Secured Loan: Guaranteed by a specific asset.
Unsecured Loan: Not guaranteed by a specific asset.
Fixed-Interest-Rate Loan: Fixed interest rate.
Variable-Interest-Rate Loan: Interest rate varies with market rates.
Prime Rate: Interest rate for the most creditworthy customers.
Convertible Loan: Variable-rate loan convertible to fixed-rate.
Security Agreement: Identifies control over the purchased item.
Default: Failure to make scheduled payments.
Note: Legal obligations of lender and borrower.
Insurance Agreement Clause: Requires credit life insurance.
Acceleration Clause: Entire loan due if one payment is missed.
Deficiency Payments Clause: Borrower billed for the difference if collateral sale doesn't cover the loan.
Recourse Clause: Defines lender's actions in case of default.
Home Equity Loan: Uses home equity as collateral.
Automobile Loan: Uses the automobile as collateral.
Cost of a Consumer Loan:
Finance Charges: Include interest payments, loan-processing fees, credit check fees, and insurance fees.
APR (Annual Percentage Rate): Simple percentage cost of credit over the loan's life.
Loan Disclosure Statement: Provides APR and interest charges.
N-Ratio Method: Approximates the APR.
Rule of 78s: Determines the proportion of each payment towards interest and principal.
Sources of Consumer Loans:
Sources: Family, insurance companies, credit unions, savings and loan associations, commercial banks, small loan companies, retail stores, and credit cards.
Factors for Favorable Rates: Strong credit rating, variable-rate loan, short loan term, collateral, and large down payment.
Controlling Debt:
Financial Planning: Ensure borrowing fits within your financial plan and budget.
Debt Affordability: Analyze debt commitments using common sense and specific ratios.
Key Terms: Credit or Debt Counselor: Helps develop budgets and debt repayment programs. Debt Consolidation Loan: Pays off current debts. * Bankruptcy: Inability to pay off debts.
Financing College Education:
Key Considerations: School and major importance, cost management, and loan repayment.
Savings Plans: 529 plans and Coverdell ESAs.
Federal Student Loans: Generally better choice.
Key Terms: Student Loan: Low, federally subsidized interest rate based on financial need. 529 Plan: Tax-advantaged savings for college costs. Prepaid Tuition Plan: Purchase future tuition units or credits. College Savings Plan: Establish account for future college expenses. Coverdell ESA: Annual nondeductible contribution for education savings. Federal Student Loans: Funded by the federal government. Direct Subsidized Loans: For undergraduates with financial need. Direct Unsubsidized Loans: For undergraduate, graduate, and professional students. Direct PLUS Loans: For graduate or professional students. Direct PLUSParent Loans: For parents of dependent undergraduates. Direct Consolidation Loans: Combine eligible federal student loans. Private Student Loans: Offered by commercial banks and credit unions. Deferment: Postpone payments for up to 3 years. Forbearance: Temporarily stop payments for qualified reasons.
Problems and Activities
Interest Calculation Methods:
For a bank loan with a 1-year repayment period and 13% interest, calculate monthly payments and total cost.
For a store loan using the add-on method with a 1-year repayment period and 11% interest, calculate monthly payments and total cost.
The bank loan results in lower payments and total cost despite a higher stated interest rate due to different interest calculation methods.
Interest Savings on Early Repayment:
Calculate the interest saved or rebated if the loans from Problem 1 are repaid after 6 months.
Single-Payment vs. Installment Loan:
Compare the total interest charge for borrowing $1,430 to be repaid in 12 months as a single-payment loan versus a 12-month installment loan at 11% simple interest.
Factors Affecting Loan Availability and Cost:
A consumer’s financial life cycle stage, income, net worth, and credit score can impact the availability and cost of loans.
Secured vs. Unsecured Loans:
Advantages of secured loans: lower interest rates, higher borrowing limits.
Disadvantages of secured loans: risk of asset loss, more complex application process.
Variable-Interest-Rate Loan:
Calculate the new interest rate on a consumer loan set at 3% over prime, which increases to 4% over prime after 1 year, with Treasury bills currently paying 2%.
Financing Decision for Golf Clubs:
Compare the cost of in-store financing at 2.43% versus not renewing a $600 CD with a 2.77% renewal rate, considering tax implications on CD interest earnings.
Debt Limit Ratio for Car Purchase:
Calculate the debt limit ratio for Reza and Abeni with current payments totaling $398 out of $2,820 monthly take-home pay.
Determine affordable car payments assuming a 15% and then a 20% debt limit.
Car Loan Term Comparison:
Calculate the difference in monthly payments for a $10,775 car loan at 5% interest over 48 months versus 60 months.
Total Repayment for Student Loan:
Calculate the total amount to be repaid for a $25,225 student loan at 4% interest over 10 years.
Compare this to the total amount if the $25,225 was a grant.
Educational Tax Credits:
Determine the maximum amount of educational tax credits claimable for 4 years of school, referencing the American Opportunity Credit and the Lifetime Learning Credit.
Early Repayment of Student Loans:
Calculate monthly payments for $28,617 in student loan debt repaid over 10 years at 6%.
Evaluate whether to use an emergency fund earning 3% to repay the student loans early.
Comparison of Private vs. Federal Student Loans:
Calculate the difference in total payments over 10 years for $20,000 in private student loans at 16% APR versus federal student loans at 4.66% APR.
Discussion Case 1
Karou is evaluating financing options for a $12,000 car purchase.
The lowest car loan rate available from local banks is 7% for a 48-month term.
Her home equity line of credit has an interest rate of 8.5%.
Karou's federal tax bracket is 25%.
Her state tax bracket is 5.75%.
Questions
Calculate Karou’s monthly car payment for both the 48-month car loan and the home equity line of credit using the simple interest method.
Compare the payment amounts for both loans.
Determine Karou’s income tax savings over the life of the loan if she uses her home equity line of credit.
Identify which loan offers the lower payment and which has the lower after-tax cost to decide the best option for Karou.
Calculate the monthly payments and final payment for Karou’s father’s $2,000 loan using the add-on method with a 5% interest rate, repaid in 9 months.
Determine the interest saved using the rule of 78s for the add-on method loan.
Calculate the payments and final payment for Karou’s father’s $2,000 loan using the simple interest method with a 5% interest rate, repaid in 9 months.
Compare the interest saved between the add-on method and the simple interest method.
Calculate the difference in finance charges for both methods if neither loan was paid off early.
Consider factors to reduce the lender’s risk and obtain a lower-cost loan if Karou did not have access to a home equity line, such as Principle 8: Risk and Return Go Hand in Hand.
Identify the collateral for each loan Karou is considering and determine if she would still have to repay the loan if the bank repossessed her car.
Discussion Case 2
Mary Lou Hennings, a junior, needs to apply for a loan due to her mother's job loss.
She has a part-time job with a take-home pay of $450 per month.
She expects her annual net earnings to be approximately $35,000 after graduation.
She plans to live at home for another year or two.
Her parents have offered up to $10,000 from their home equity line of credit, but she is hesitant to use it.
She has no debt except for 3 more years of monthly auto payments of $194.
She is concerned about managing an additional loan while still in school, though her mother is optimistic about finding a new job soon.
Questions
Direct Subsidized Loan vs. Direct Unsubsidized Loan: Direct subsidized loans are need-based, and the government pays the interest while you are in school. Direct unsubsidized loans are not need-based, and interest accrues while you are in school.
Types of Student Loans and Lending Limits: Mary Lou can access federal student loans, including direct subsidized and unsubsidized loans, with specific annual and aggregate limits. Repayment typically begins six months after graduation or dropping below half-time enrollment.
Monthly Payments Calculation: For a $6,000 loan with a 6% interest rate over 10 years, the monthly payment is calculated using the formula for an installment loan. Similarly, for a home equity line with a 9.75% interest rate over 10 years, the monthly payment is calculated using the same formula.
Tax Consequences: Interest on student loans may be tax-deductible for Mary Lou, reducing her taxable income. Her parents' home equity loan interest may also be deductible, but the tax benefit depends on their higher tax bracket.
Debt Limit Ratio Calculation: Calculate the debt limit ratio by dividing total monthly debt payments by monthly income. This ratio should be calculated for both her current income and projected post-graduation income to assess affordability.
Loan Consolidation: Advantages include simplified payments and potentially lower interest rates. Disadvantages may include loss of borrower benefits and potentially higher overall interest costs. Mary Lou should consider her current interest rates, repayment terms, and any borrower benefits before consolidating.
Bankruptcy and Student Loans: Student loan debt is generally not dischargeable in bankruptcy unless undue hardship is proven, which is difficult to establish.
Loan Recommendation: Suggest the loan with the lowest interest rate and most favorable terms. Consider other financing options like scholarships, grants, or work-study programs to minimize loan dependency.