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Consumer Loans

Consumer Loans

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Author: Sophia Tutorial
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Recognize the high costs of consumer loans and how to avoid them.

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Tutorial

what's covered
In this lesson, you will learn how to identify high-cost consumer loans and how to avoid them. You will consider how strong problem solving skills can help you make wise decisions. You will understand you may need to use your agility skill to make sure you have enough for an emergency. Specifically, this lesson will cover:
  1. Alternative Financial System Loans
    1. Payday Loans
    2. How to Calculate the APR of a Loan
    3. Pawn Shops and Title Loans
  2. Pros and Cons of Alternative Loans
    1. Fewer Protections for the Consumer
    2. Best Low-Cost Alternative Loan Options
  3. How to Avoid Expensive Loans

before you start

Are you interested in a video preview of this lesson? Click play to learn about the risks associated with high-cost consumer loans. When you’re through, move on to section 1.

1. Alternative Financial System Loans

When dealing with lenders, you have many choices. Lenders can be generally classified into two different categories, as shown in the following table.

  1. Members of the mainstream financial system, which include banks and credit unions. These institutions offer lower interest rates, are more heavily regulated by state and federal government agencies, offer what are considered traditional loan products, and rely heavily on each borrower’s credit report and credit score when deciding whether to approve a loan.
  2. Members of the alternative financial system, such as check cashers, money order providers, pawn shops, payday lenders, auto title loan lenders, and rent-to-own retailers. These types of lenders typically don’t rely on an individual’s credit report when making a loan decision. Instead, these firms focus on making loans that are collateralized either with an asset or access to a borrower’s bank account. In this way, if a borrower makes a late payment or fails to pay, the lender can seize the borrower’s assets and enforce payment through other legal means.

Mainstream Lenders Alternative Lenders
Banks Check cashers
Credit unions Payday lenders
Auto manufacturer financing Title loans
Credit card issuers Pawn shops
Merchant credit cards Seller-financed used car loans

big idea
When given a choice, most consumer advocates recommend using products and services provided by mainstream financial service providers.


1a. Payday Loans
The most popular alternative loan is a payday loan, which is a short-term loan designed to be repaid within a few weeks when the borrower receives a paycheck. Here’s how a typical payday loan transaction occurs.


IN CONTEXT

Consider Tisha who works full-time and goes to school. Her car just broke down, which is a real problem because she needs it to get to her job and classes. Her mechanic told her that it would cost $500 to repair it, which is more than she currently has in her savings account. Because Tisha doesn’t have the cash or a credit card to pay for the repair, she panics and visits a payday lender, who agrees to lend Tisha $500.
  1. The payday lender charges a $75 fee for a 2-week loan, but rather than demand the fee today, the payday lender simply adds it to the amount Tisha will owe later. (The APR of this payday loan is 391%! We discuss how to calculate the APR in the next section.)
  2. As collateral, Tisha writes a check in the amount of $575 and hands it to the payday lender employee.
  3. When the 2 weeks are up, Tisha needs to return and “buy back” her check for $575 in cash.


The process is shown in this illustration.

an infographic with two steps: (step 1) after her car breaks down, a woman gives a check for 575 dollars to a quick loan shop and receives a 500-dollar cash loan; (step 2) two weeks later, the woman gives 575 dollars in cash to the quick loan shop and her original check is returned to her uncashed

If Tisha doesn’t pay back the loan in 2 weeks, the lender will attempt to cash the check. If Tisha has insufficient funds in her account, she’ll pay a bank fee and owe the payday lender even more money. Rather than have this happen, Tisha and many payday loan users often roll over one loan into another every few weeks by extending the terms of the original loan. They then get caught in the unfortunate trap of incurring a new fee each time a loan is rolled over.


Problem Solving: Skill Reflect
What if Tisha had been more knowledge about how payday loans work before she chose to utilize one? Could she have used her problem solving skills to consider alternatives that may have been a better choice? Knowledge is power. The more you know before a problem occurs, the better use you can make of your problem solving skill.

term to know

Payday Loan
A short-term loan designed to be repaid within a few weeks when the borrower receives a paycheck.

1b. How to Calculate the APR of a Loan
To calculate the approximate annual percentage rate (APR) on a payday or alternative loan that is based on fees rather than a stated interest rate, you’ll need to perform a few simple math calculations. In Tisha’s case, she obtained a 2-week (14 days) loan for $500 with a $75 loan fee. The illustration below shows how to calculate the APR of this loan.

an APR calculation with four steps: (step 1) 75 dollars divided by 500 dollars equals 15 percent; (step 2) 365 divided by 14 days equals 26 point zero 7; (step 3) zero point one five, times 26 point zero 7, equals 3 point nine one; (step 4) 3 point nine one, times one hundred equals 391 percent

Take a breath. Yes, that is an APR of 391%! This is the APR if no other fees are charged and assuming Tisha pays off the loan on time.


1c. Pawn Shops and Title Loans
Pawn shops and title loans work the same way as payday lenders.
  • Pawn shops and title loan companies base their loan on the value of collateral—something you give the lender that they can later sell if you don’t repay the loan in a timely manner.
  • Pawn shops typically provide a longer period to pay back a loan, but they give less of a loan compared to the value of the collateral.
  • For example, if you pawn a $1,000 diamond ring, you may receive a 3-month $400 loan. At the end of the loan period, you could owe the pawn shop anywhere from $450 to $500 to get back the diamond ring.

Although these companies offer services valued by their customers, the fees and implicit interest rates for these types of loans and services are very high, ranging up to an APR of 400%. The interest rate charged by alternative financial lenders is much higher than the credit-riskiness of their customers might indicate. However, many consumers believe that the convenience and transparency of the alternative financial system (i.e., a clearly stated fee for any service) is worth the higher costs when compared to the mainstream financial system.


did you know
A high credit card APR is 26%, much less than the APR of most alternative loans (up to 400%).


2. Pros and Cons of Alternative Loans

Strong problem solving skills allow you to choose the best loan product for your needs. Part of that process is looking at benefits and risks associated with each.

2a. Fewer Protections for the Consumer
The world of alternative lending is not highly regulated.
  • Some states have stepped in and passed legislation to cap the amount of interest consumers pay.
  • Other states have placed limits on fees and the number of times one person can obtain a loan in any given year.
  • In general, borrowers need to know that there is less protection, compared with mainstream lenders, in case something goes wrong.

The good news is that protections are in place for military service members and their dependents.


2b. Best Low-Cost Alternative Loan Options
Alternative financial service providers seek to provide a high level of social interaction and inclusion for their clients, making customers feel more welcome compared with mainstream institutions. In addition, alternative lenders are quick to point out that fees, such as overdraft charges on checking accounts, late fees on credit card payments, and overdraft expenses on debit and ATM cards, may be higher at a bank than what it costs to borrow a similar amount of money from a payday lender. In general, however, the best approach is to rely on low-cost borrowing options from mainstream financial service providers if possible. Some of these low-cost borrowing options, many of which we’ll discuss in later topics, are shown in the following table.

Table: Borrowing Options and Alternatives

Product Good Credit Score Required Additional Application Requirements Example Finance Charge: $300 for 3 Months*
Parents or family No None. Likely 0% APR, $0
Subsidized student loan No FAFSA form. No credit check required. 5% APR, deferred interest, $0**
Auto loan at bank Yes Must own the car and have equity in it. Complete loan application at bank. 6% APR, $4.52
Personal loan at bank Yes Complete loan application at bank. 10% APR, $7.56
Credit card Yes Complete a loan application. 12% APR, $9.09
Credit offered by service provider Yes Service providers often offer loans to customers to pay for services. The loan is generally made by a national lender partnering with the local business. Complete application at store. 29.99% APR, $23.06
Pawn shop No Something of significant value to give to the pawn shop as collateral. If the loan is repaid, the item can be reclaimed; if not, the item is sold. 200% to 400% APR; $176.39 (at 200% APR)
Title loan No Must own the car without any other loans against the car. No credit check required. 300% APR, $285.94
Payday loan No Must write a personal check for the loan amount plus a fee, usually $15 per $100 borrowed. In 2 weeks, must repay the loan or renew the loan with an additional fee. No credit check required. 390% APR, $393.92
* The finance charge assumes the entire $300 balance is carried for 3 months then paid in full. If monthly payments are made, the finance charges will be less.
** A subsidized loan means the federal government pays interest on the loan while the student is enrolled in school.


3. How to Avoid Expensive Loans

Many Americans fail to set money aside for emergencies. This creates tremendous vulnerabilities for themselves and their families. Ask yourself this: Would you be able to come up with the money if faced with a $2,000 unexpected expense in the next month?

Agility: Skill Tip
You may need to be agile and adjust your monthly spending to make sure you have an emergency fund with at least $2,000.

When asked this question in a survey, approximately half of all American consumers said that they could probably not or certainly not be able to come up with $2,000 in an emergency. Although $2,000 is a significant amount of money, it does not require too much imagination to identify possible things that could go wrong to create a bill for this amount. How long would it take to save $2,000 in an emergency fund?

  • The answer is easy to calculate because you should assume that you will earn a low yield on any emergency savings.
  • If you could save $25 per month (that is less than $1 per day), it would take you nearly 7 years to accumulate $2,000.
  • If you could find and save about $1.50 per day, it would take you about 3½ years to reach your goal.
hint
For the price of a daily soda and candy bar, you could accumulate a nice emergency fund in just a few years.

summary
In this lesson, you learned the pros and cons of alternative loans. Some people turn to these high-cost consumer loans during financial emergencies. However, obtaining loans such as payday loans, title loans, and borrowing from pawn shops is often not a good idea. These systems offer fewer protections for the consumer and can result in outrageous interest rates and exorbitant fees. (See for yourself by calculating the APR for these loans.) Strong problem solving skills can help you determine if one is right for you.

For the best low-cost alternative loan options, look to more mainstream financial sources, such as parents and family, banks, and low-interest credit card options. You can also avoid expensive loans by investing in your own emergency fund. Find ways to be agile and build your emergency fund each month by raising your income and lowering your expenses.

Source: THIS WORK IS ADAPTED FROM CHAPTER 6.1 OF JOHN WILEY & SONS, INC. EBOOK, “INTRODUCTION TO PERSONAL FINANCE: BEGINNING YOUR FINANCIAL JOURNEY” BY JOHN E. GRABLE PHD, CFP AND LANCE PALMER PHD, CPA, CFP.

Terms to Know
Payday Loan

A short-term loan designed to be repaid within a few weeks when the borrower receives a paycheck.