Borrowing

What Is Credit?

In a very fundamental sense, credit represents value earned that has not been used or trust that another person places in you based on your reputation. We could think in basic terms of credit as extra credit earned on homework assignments. This is credit that has not been used but is available for use against future assignment or test grades. We can also think of credit as borrowing your sibling’s car or driving your parents’ car. A certain amount of trust is placed in you to return the car in the same condition as it was before you drove it. For purposes of this lesson, we are focused credit as trust in your reputation and ability to fulfill your promises.

We can understand damaged credit as broken trust. When you borrow your sibling’s car, if you are careless and forget to put it in park or leave the keys in the ignition with the doors unlocked, you are responsible for damage or loss. The next time you request to borrow your sibling’s vehicle, your sibling may be hesitant to agree.

What Is A Loan?

Like borrowing your sibling’s car, a loan is borrowing money from someone else, usually a bank or financial institution, and agreeing to pay it back over time. When the bank lends you money, they become known as a lender, and you become known as the borrower. Credit is important in loans because your credit is an assessment of your ability to repay the loan. If you would like to be in good standing with the bank in the event you need a loan, then maintaining your credit responsibly is important.

Loans are useful to accomplish key goals and meet needs in your life. For example, you may borrow money to purchase a house or a vehicle. You may not have enough money on hand to afford a house with a purchase price of $150,000, so a loan can help you make the purchase and repay it over time. For a vehicle, you may have a few thousand dollars available that you could use to purchase the vehicle, however, doing this would leave you with only a small amount of money in savings or to meet basic needs. In that case, while a loan may not be necessary, it can help you accomplish other goals.

Loans may not make as much sense when it comes to buying groceries and daily necessities.

There are two main types of loans, and then several forms of loans under each type. The first type of loan is an unsecured loan. Unsecured means that you do not put up anything to secure your promise to repay the money borrowed. The loan is documented by an agreement or contract known as a promissory note. The basic elements of the promissory note include the names of the borrower and lender, the amount borrowed, where payments are to be made, and the cost of the loan. Forms of unsecured loans include:

  • Credit cards
  • Personal loans from a bank
  • Student loans to pay for attending college

The other type of loan is a secured loan. Security for loans, also known as collateral, is an asset which you pledge to stand in your place if you cannot repay the loan. The collateral should have a value equal to or greater than the amount of the loan, and the promissory note includes a pledge to allow the lender to take the asset, sell it and apply the sale proceeds to the loan. Collateral is intended to ensure that the lender will be repaid no matter what happens. Examples of secured loans include:

  • A home mortgage
  • Car loan
  • Title loan

Included in the promissory note documenting the loan will be the terms of repayment. Many loans require repayment to begin the month after borrowing the money, although other loans have delayed repayment, such as student loans. Most loans also require payments to be made each month once repayment begins. This is known as amortizing the loan over time, which breaks up the loan over a period of time to make it easier for you to repay the amount borrowed.

When the lender extends credit to you, as a borrower, it is important that you make every effort to repay the amount borrowed. Repayment terms in unsecured loans may be more open-ended, in the sense that there may not be a fixed amount of monthly payments or a deadline by which the loan must be repaid. The main expectation is that you repay any amounts borrowed. An example of this is a credit card. Although they are very flexible in that you can borrow any amount up to the borrowing limit, that does not mean you should borrow the entire amount or that doing so is wise. Failing to repay the amount borrowed or failing to make payments on time are likely to cause damage to your credit. The lender may set a minimum amount to be repaid each month

Secured loans generally have fixed repayment terms with set amounts of the monthly payments and a date by which the loan is to be repaid. Failing to make the monthly payments on time can trigger a sale of the collateral by the bank in a process known as foreclosure. Of course, missing payments or being late on payments are likely to reflect negatively on your credit, as will failing to pay the loan as required.

The Costs of Borrowing

The lender may charge a variety of fees and costs when making a loan. There may be an application fee, an origination fee to cover the cost of documents, late payment fees if you are late on a monthly payment, and interest. Collectively, these costs are commonly referred to as finance charges. Lenders make their money on finance charges associated with loans.

Best practices when borrowing money are to investigate and compare the finance charges on various types of loans and by various lenders. The finances charges imposed by payday lenders and title loan lenders are often very high, which makes these types of loans cost-prohibitive for many people, even though they are often easy loans to get.

Interest is a percentage of the amount borrowed which is charged over time for the duration of the loan. Interest represents the time value of money. The time value of money is a method of assigning value to money given a specified duration at a given rate of interest. In the same way that the bank may pay you interest for depositing money into a savings account, the lender will charge you interest for borrowing money.

When evaluating finance charges on a loan, it is important to consider both the rate of interest and the amount of time interest will be charged on the loan.

Interest is charged in two forms on loans. Simple interest is calculated only on the amount borrowed over the duration of the loan, but interest is not added to the amount borrowed, which is known as principal. The rate of interest is expressed as a percentage which represents the annual percentage rate. For example, a $1,000 loan with 10% interest which is to be repaid in a lump sum in 12 months will cost $100 in interest.

Activity

George is evaluating two different loans. Neither loan will require any monthly payments, and the entire loan will be due in a lump sum at the end of the loan duration. How much simple interest will George pay on each loan?

Loan 1Loan 2
Loan Amount$25,000Loan Amount$50,000
Duration12 monthsDuration12 months
Interest Rate (annual)15%Interest Rate (annual)3%
Total InterestTotal Interest

When calculating simple interest, the rate of interest can be divided by 365 days or 12 months to arrive at the amount of interest for a loan with a duration for less than or more than a year. For example, interest on a loan with a simple interest rate of 12% and a duration of 90 days can be calculated by dividing 12% by 365, and then multiplying the result by 90 days.

0.12/365 = 0.00033
0.00033 x 90 = 0.03 (or 3%)

Compound interest is charged over time and added to principal. Many compound loans calculate interest daily as opposed to annually or monthly. The timing of compound interest will be one of the terms in the promissory note. A daily compounding rate means that the interest calculated today will be added to principal, and the sum of the two amounts will be used to calculate interest tomorrow. Where simple interest only charges interest on the principal, compound interest charges interest on both interest and principal.

Calculating compound interest over time, especially where payments are being made each month, is complex without the assistance of a computer spreadsheet or financial calculator. Here is an example of the formula to calculate compound interest over two years if there are no payments required:

$1,000 principal amount of loan

8% interest compounding

$1,000 x (1.08 x 1.08) = $1,166

When a loan has compound interest, paying additional principal and paying the loan off early will result in a savings on interest.

Alternative Financing Arrangements

As with alternatives to banking, there are alternatives to borrowing money. A few of these alternatives will be discussed here.

  • Rent-to-Own – Renting to own items such as furniture involve signing an agreement at a store to purchase an item and to pay for it over time. If you decide not to complete the purchase or if you do not fulfill your agreement to pay, the store takes the furniture back. Renting to own is not actually a loan. Instead, the store typically owns the item, and the agreement is simply for payment of rent until the total rent paid is equal to the purchase price. Generally, the cost of the item will be higher than if the same or similar item was purchased outright at a traditional store.
  • Payday Loan – Payday loans were discussed briefly in the first lesson. Very simply, the lender agrees to make a loan and to accept your paycheck as payment in full. The amount the loan will be less than the amount of your paycheck, even though your entire paycheck is expected in repayment. The difference represents the finance charges on the loan. An obvious problem is that in taking a payday loan you are receiving less than the full amount of your paycheck. Once a person utilizes a payday loan, it can be very hard to get out of the cycle of borrowing.
  • Tax Refund Anticipation Loan – These are special types of loans similar to payday loans which can be available when filing your annual income tax return. If a person is scheduled to receive a refund on their income tax return, the refund can take several weeks or even several months to be processed. The tax return preparer may offer a refund anticipation loan by advancing a portion of the tax refund. Once the tax refund is actually paid, the lender receives payment on the loan. As with payday loans, the difference between the amount of the loan and the amount of the loan repayment represents the finance charges.

Alternative financing arrangements can appear to be inexpensive because finance charges are built into the cost of the item or are paid from the source of funds designated for repayment (i.e., paycheck or tax refund). Because there is a promise of quick money today, the cost of borrowing may be ignored. However, alternative financing arrangements often carry far higher finance charges than would normally be found on traditional loans through a reputable lender.

Activity

George takes his tax information to ABC Tax Co. who will prepare his income tax return. The tax refund will be $1,000. ABC Tax Co. offers George $800 today if he signs the refund anticipation loan documents. By signing the documents, George agrees to give the entire $1,000 to ABC Tax Co. The tax refund will be received in 90 days. Assuming simple interest, how much will George pay in finance charges?

Predatory Lending

It is important to be aware of the finance charges and to read the documents you will be asked to sign for the loan. Lenders may engage in fraudulent activity by promising a loan on a fixed interest rate but actually have you sign documents for a variable interest rate, or a rate which can change over time at specified intervals. Other lenders may disguise finance charges as transaction fees to keep from having to comply with regulations. Interest rates should be reasonable, and armed with the information and activities in this lesson, you can calculate the finance charges on your own.

Predatory lending may be subject to state or local law enforcement, so be aware that you can and should refuse to sign documents if they are inaccurate.


Before moving onto the graded assignment, it is recommended that you watch the short video on interest. This video will provide some additional explanation that will be useful on the graded assignment.