GE1202

Managing Your
Personal Finance
Lecture 4
Consumer Credits and Loans
What is Consumer Credit?
• Credit is an arrangement to receive cash, goods, or services now and
pay for them in the future
• Consumer credit refers to the use of credit for personal needs (except a
home mortgage) by individuals and families
• It is based on trust in people’s ability and willingness to pay bills when
due
• It works because people by and large are honest and responsible
• The advancement of payment technology has popularized the use of
credit
Two Types of Credit
1. Closed-end credit
• One-time loans that the borrower pays back in a specified period of time and in
payments of equal amounts
• Three most common types of closed-end credit
a. Instalment sales credit
• A loan that allows you to receive merchandise
• Make a down payment and repay the balance (plus interest) in equal instalments over a
specified period
b. Instalment cash credit
• Direct loan of money
• Make no down payment and repay the balance (plus interest) in equal instalments over a
specified period
c. Single lump-sum credit
• A loan that must be repaid in total on a specified day
• Usually 30 – 90 days
Two Types of Credit
2. Open-end credit
• A line of credit in which loans are made on a continuous basis and
the borrower is billed periodically for at least partial payment
• Line of credit
• The maximum dollar amount of credit the lender has made available to you
• You may have to pay interest, a periodic charge, or other finance
charges
• Two common types of open-end credit
• Credit card
• Revolving credit line
Revolving Credit Line
• This is a prearranged loan for a specified amount
• Similar to a cash advance as funds are available up front

• Revolving credit differs from an installment loan

• Installment loan has a fixed number of payments over a set period of time whereas
revolving funds only require payment of interest plus any applicable fees
• new loan application and credit reevaluation does not need to be completed upon
utilizing revolving credit
• Revolving credit is intended for shorter, smaller loans

• Revolving credit differs from credit card

• Revolving credit does not require a specific purchase
• Typically has significantly lower interest rates compared to credit cards
• Example: DBS
Three Types of Revolving Credit
1. Overdraft Protection
• A line of credit linked to a checking account that allows a depositor to overdraw the
account up to a specified amount

2. Unsecured Personal Credit Line

• A line of credit made available to an individual on an as needed basis

3. Home Equity Line of Credit

• A line of credit extended to a homeowner that uses the borrower's home as collateral
• Second mortgage on your home
• It provides access to a lot of relatively inexpensive credit
• You could lose your home
Home Equity Line of Credit
• Example:
• A couple buys a home for $2,850,000
• 10 years later, it’s worth $3,650,000
• The couple now has an asset worth $3,650,000 on which all they owe is the original
mortgage, which may now have a balance of $2,200,000.
• The amount of equity in the house is $3,650,000 – $2,200,000 = $1,450,000
• In order for them to tap that equity without having to sell their home, they can use
the home equity credit line
• 75% loan-to-market-value ratio
• 75% of $3,650,000 = $2,737,500
• $2,737,500-$2,200,000(remaining mortgage) = $537,500
Advantages of Credit
• Using credit increases the amount of money a person can spend to
purchase goods and services now
• Solution to the inconsistence between income and spending

• Advantages:
• Allows us to allocate our financial resources more effectively
• Cushion for financial emergencies
• Grip the chance of low price
• Convenient when shopping
• Can take advantage of grace period
• Indicates financial stability
Uses of Credit
• If you decide to use credit, make sure the benefits of purchasing now
outweigh the costs
• Ask yourself the following questions before you decide how and when to
make a major purchase:
• Do I have the cash I need for the down payment?
• Do I want to use my savings for this purchase?
• Does the purchase fit my budget?
• Could I use the credit I need for this purchase in some better way?
• Could I postpone the purchase?
• What are the OC of postponing the purchase?
• What are the dollar costs and psychological costs of using credit?
Misuses of Credit
• Use your credit card to make everyday purchases
• Using your credit card as a substitute for cash is a habit that can quickly lead to debt

• Make impulse purchases

• Research findings suggest that emotions and feelings play a decisive role in purchasing, triggered
by seeing the product or upon exposure to a well crafted promotional message

• Use your credit card to buy things you cannot afford

• Living a borrowed lifestyle is the quickest way to get into debt.
• If you cannot afford a purchase today, chances are you will not be able to afford it tomorrow, or
even next month

• Get into the habit of making minimum monthly payments

• To pay your debts off quicker and cheaper, you should pay as much as you can on your balance
each month
Avoid the Minimum-Monthly-Payment Trap
• The minimum monthly payment is the smallest amount you can pay and
still be a cardholder in good standing
• It is typically the greater of HK$50 or between 2% or 3% of the balance
Bank Credit Cards
• Line of credit depends on applicant’s financial status and ability to pay
• Cash advances and balance transfers
• A loan that can be obtained by a bank credit cardholder at any participating bank of
financial institution

• You have the option to pay the bill in full within the grace period without
interest charges
• Some creditors allow you a grace period of 20 to 25 days to pay a bill in full

• The outstanding balance will attract interest at a relatively high rate

• Interest rates on credit cards are amongst the highest rates charged on debt
Charges
Comparison
• How high is the finance charge on credit card balance?
• The annualized return on the Dow Jones Index from 1987 to 2012
• 8%

• The annual return of Warren Buffett from 1967 to 2007

• 21.1%
Other Fees
• Annual fees
• Transaction fees
• Late-payment fees
• Over-the-limit fees
• Balance transfer fees
• Foreign transaction fees
Computing Finance Charge
• The Average Daily Balance method (ADB)is a way of calculating interest
by considering the balance owed at the end of each day of the period
rather than the balance owed at the end of the week, month or year.
• If interest compounds monthly, then use the following formula to calculate
interest under the average daily balance method:
 
 

• S = the sum of the daily balances in the billing period

D = number of days in the billing period
i = annual interest rate
P = number of billing periods per year (usually 12)
 Day of Billing Cycle Beginning Balance Charges Payments Ending Balance
1 $ - $ 200.00 $ 200.00
2 $ 200.00 $ 200.00
3 $ 200.00 $ 200.00
4 $ 200.00 $ 350.00 $ 550.00

Example of ADB 5
6
$
$
550.00
550.00
$
$
550.00
550.00
7 $ 550.00 $ 550.00
8 $ 550.00 $ 100.00 $ 650.00
• 9 $ 650.00 -$ 50.00 $ 600.00
Assume
  you have a credit 10 $ 600.00 $ 600.00
card that uses the average daily 11 $ 600.00 $ 400.00 $ 1,000.00
balance method and charges an 12 $ 1,000.00 $ 1,000.00
13 $ 1,000.00 $ 1,000.00
18% annual rate of interest. 14 $ 1,000.00 $ 1,000.00
15 $ 1,000.00 $ 1,000.00
• The table shows the 16 $ 1,000.00 $ 1,000.00
transaction history and the 17 $ 1,000.00 $ 1,000.00
18 $ 1,000.00 $ 1,000.00
balance for the most recent 19 $ 1,000.00 $ 1,000.00
billing period. 20 $ 1,000.00 $ 1,000.00
21 $ 1,000.00 $ 75.00 $ 1,075.00
• S = $25100 22 $ 1,075.00 $ 1,075.00
23 $ 1,075.00 $ 1,075.00
• 24 $ 1,075.00 -$ 100.00 $ 975.00
Interest = 25 $ 975.00 $ 975.00
26 $ 975.00 $ 975.00
= $12.55 27 $ 975.00 $ 200.00 $ 1,175.00
28 $ 1,175.00 $ 1,175.00
29 $ 1,175.00 $ 1,175.00
30 $ 1,175.00 $ 1,175.00
Loan Restructuring
• New loan that replaces the outstanding balance on an older loan
• Paid over a longer period
• Usually with a lower installment amount

• Loans are commonly rescheduled to accommodate a borrower in

financial difficulty and to avoid a default
• Failure to make a payment

• Also called rescheduled loan

Consumer Loans
• Loans made for specific purposes using formally negotiated contracts
that specify the borrowing terms and repayment
• Education loans
• Auto loans
• Personal Loans
• Other durable good loans
• Consolidation loans

• Different from line of credit

• One-time transaction
• No more credit is available once repaid
Consumer Loans
• Single-Payment Loan
• Specified period
• Ranging from 30 days to a year
• Repaid in full with a single payment on a given due date
• Include the principal and all interest charges
• Can be secured or unsecured

• Installment Loan
• Repay debt in a series of equal payments
• Payments includes principal and interest
• Long-term loan
• 6 months to 10years or longer
Important Loan Features
• Loan application
• Information about the purpose of the loan as well as the applicant’s financial condition.

• Total cost of transaction

• Finance Charges
• Sometimes the bank may manipulate both the sticker prices and interest rates, so it is better to compare
monthly payments to get a handle on total cost.

• Collateral
• Properties or other marketable assets that a borrower offers as a way for a lender to secure the loan

• Loan Maturity
• When the original principal amount is due
• The cost of credit increases with the length of the repayment period

• Other consideration
• Banks may charge a prepayment penalty
Computing Finance Charges
1. Single-payment loan
• Simple Interest Method
• Discount Method

2. Installment Loan
• Simple Interest Method
• Add-On Method
Annual Percentage Rate
• Annual Percentage Rate (APR) is a finance charge expressed as an
annual rate
• APR is a true measure of the interest fees charged by credit card
companies & banks.

 
Simple Interest Method (Single-Payment Loan)
 

FC = finance charge; P = Principal loan amount;

i = stated annual interest rate; T = term of loan
• Example
• How much is the finance charge and APR on a $1,000 loan for 2 years at 8% interest
rate (Assume interest is the only finance charge)
Discount Method (Single-Payment Loan)
• Interest (calculated on principal) is subtracted from loan amount and
remainder goes to borrower
• Finance charges paid in advance
• APR will be higher than stated interest rate
• Example
• How much is the finance charge and APR on a $1,000 loan for 2 years at 8% interest
rate (Assume interest is the only finance charge)
Simple Interest Method (Installment Loan )

• Calculated on outstanding balance each period

• The principal balance declines with each payment
• The amount goes to interest decreases while the amount that goes to
principal increases
• Example
• Calculate the finance charges and APR on a $1,000 loan to be repaid in 12 monthly
installments at an annual interest rate of 8%
• Assume interest is the only finance charge
Simple Interest Method (Installment Loan )
• How much is the monthly installment?
 

P = installment; L = Present value of the loan; r=

interest rate per period; n = number of periods
Simple Interest Method (Installment Loan )
•  Total amount paid over 12 months =
• Annual interest paid =
• =
Add-On Method (Installment Loan )
• Finance charges calculated on the original loan balance
• It is then added to principal to determine the total amount to be repaid

 
Add-On Method (Installment Loan )
• Example
• Calculate the finance charges and APR on a $1,000 loan to be repaid in
12 monthly installments at an annual interest rate of 8% (Assume
interest is the only finance charge)
Add-On Method (Installment Loan )
• To find the APR under Add-On Method
 

APR = Approximate APR; n = Number of payment periods in one year

I = Total dollar cost of credit; P = Principal;
N = Total number of payments scheduled to pay off the loan
Establishing Credit
• Open checking and savings accounts
• Get one card and make small purchases
• Use them periodically, even if you prefer paying cash
• Build a record of being a reliable credit customer

• Obtain small loan

Build a Good Credit History
• Not getting overextended
• Fulfilling all credit terms
• Paying on time
• Notifying creditors if unable to pay
• Being truthful
Credit Rating
• When you apply for a loan, the lender will review your credit history
• The record of your complete credit history is called your credit report or
credit file
• Name, address, birth date
• Your employer, position, income, your previous employer, etc

• It is collected and maintained by credit bureaus

• An agency that collects information on how promptly people and business pay their bills

• A credit rating is a measure of a person’s ability and willingness to make

credit payment on time
• Creditors use different combinations of the 5 Cs to reach their decisions
The 5 C’s of Credit
• Character
• Will you repay the loan?
• The borrower’s attitude toward his or her credit obligations

• Capacity
• Can you repay the loan?
• The borrower’s financial ability to meet credit obligations - income

• Collateral
• What if you don’t repay the loan?
• A valuable asset that is pledged to ensure loan payments
The 5 C’s of Credit
• Capital
• What are your assets and net worth?
• Ability to repay a loan if you lost your source of income

• Condition
• What if your job is insecure ?
• General economic conditions that can affect a borrower’s ability to repay a loan
How Much Credit Can You Stand?
 

• Monthly consumer credit payments (excluding mortgage) should not

exceed 20% of monthly net income
• Example:
• If you have $10,000 income, using the 20% ratio, you should have monthly
consumer credit payments of no more than $2,000