Cost Of Borrowing

Lesson B: Cost of Borrowing

What to Consider

When making the decision to borrow money be sure to do the following:
• Identify which sources are available which lend money
• Evaluate loan terms
• Calculate the total cost of the loan
• Know your current debt limit.

Borrowing Sources

There are many available sources from which you can obtain a loan. Banks, savings and loan
companies, credit unions, and credit card companies are some of your options. There are several unscrupulous lenders who have poor lending practices and very high interest rates. The best way to avoid these types of lenders is to know the Loan Terms before you sign the agreement. Below are some of the terms that are commonly used.

Terms of the Loan

Down Payment is the amount of money required up front.

Length Time to Repay is the length of time it will take to repay the loan in full.

Interest Rate (APR) is the cost of borrowing money, expressed as a percentage, usually over a period of one year.

Finance Charge is the cost of the loan represented by a dollar amount.

Cost of Borrowing
The cost of credit varies depending on the lenders method used to calculate the finance charge.
There are four common methods of calculating finance charge:

Average Daily Balance
The balance is totaled for each day in the billing period and any credits (payments) made to the
account are subtracted from your account the same day. The resulting daily balances are added for the billing cycle. The total is then divided by the number of days in the billing period to get the average daily balance.

Adjusted Balance
The balance is determined by subtracting payments or credits received during the current billing period from the balance at the end of the previous billing period.

Previous Balance
The amount owed at the end of the previous billing period. Payments, credits, and new purchases during the current billing period are not included.

Two-Cycle Balance
The interest on your average daily balance is calculated using both the purchases made during the current month and those made the previous month even if those purchases have been paid off.

Types of Interest Rates

Fixed Rates
An interest rate that does not change for the life of the loan

Variable Rates
Some creditors offer variable rate plans. This is particularly popular in mortgages. The interest rate is tied in to an underlying index. Some indexes used are; Prime Rate, Treasury Bill Rate, or Federal Reserve Funds/Discount rate. A common method of calculation is: Index + Margin = Variable
Rate.

Shop Around!
It’s always best to shop for the best deal when considering a credit card account. When shopping compare factors such as Annual Percentage Rate (APR), Grace Period, Fees, and balance computation methods. Be sure to read the agreement carefully and know the total cost of credit. Also, know the features of each account such as credit limit, special services, and how widely the card is accepted.

Predatory Lending
Beware of predatory lenders. These lenders charge very high fees for the credit or services that are provided. Generally, these lenders target consumers with troubled credit histories who may not be eligible for traditional credit. Below are some examples of predatory lenders.

Pawnshops charge very high interest on the value of collateral.

Rent-to-Own Programs offer an opportunity to obtain electronics, furniture, and appliances with a small weekly fee. However, the amount paid for the item usually far exceeds the cost.

Check-cashing Outlets charge high fees (sometimes 2 or 3 percent) just to have a paycheck or government check cashed.

Rapid Refund Services provide “instant refunds” when you pay to have your federal tax return prepared. These refunds come with interest rates as high as 120 percent!

Check-Deferral Services (payday loans) allow consumers to get a cash advance on their next
paycheck. However, these short-term loans are very expensive. A $200 two week advance may cost over $30 (with annual costs exceeding $900). A consumer found out the hard way how expensive payday loans could be. He wrote a check (that was never supposed to be cashed) for $500 to a payday lender. He was to pay off the loan in two weeks and pay a service fee of $3 for each $100 borrowed. When he was unable to repay the loan with interest, the whole procedure was replayed two weeks later, and again, and again. A year later, he owed the lender $3,600 and he was still unable to pay.

Exercise
Review the chart below, calculate the cost of credit for each offer and consider the balance
computation method. Which offer is more favorable?

Offer	Balance Computation Method	Loan Amount	APR	Total Fees
1	Previous Balance	5000	19.99%	Late Fee: $35 Setup Fee: $100
2	Adjusted Balance	5000	5%	Late Fee: $25 Over-Limit Fee: $20
3	Average-Daily Balance	5000	24.99%	Late Fee: $30
4	Two Cycle Balance	5000	9.99%	Setup Fee:$200 Late Fee: $30 Over-limit Fee: $25
5	Average-Daily Balance	5000	11.99%	Late Fee: $35 Over-Limit Fee: $30

Calculating Finance Charge
Loan Amount x APR (will equal the total amount of interest for the year) ÷ 12 (will equal
monthly interest)

Example:
5000 x 19.99% (.1999) = 999.50 (yearly) ÷ 12 = 83.29 (monthly periodic interest)

Fees
Lenders can charge a variety of fees for services provided and penalties for late payments or
exceeding your credit limit. Be sure to include any set up fee amounts when calculating the cost of the loan.

Late and over-limit fees can be avoided and should be. Proper record keeping, money
management and on time bill paying keep you safe from these types of fees.

Of the loan terms listed in above table, which loan would be the most favorable?

Quiz
1. It is a good practice in borrowing to know the terms of the loan agreement.
True False

2. There are several balance computation methods.
True False

3. Predatory lenders target consumers who would not normally qualify for traditional credit offers.
True False

4. The method of finance charge calculation that considers charges from the previous month is Average Daily Balance.
True False

5. You can determine the true cost of credit by calculating finance charge and including any set up fees.
True False

6. Late fees can be avoided.
True False

7. A down payment is a balloon payment required at the end of a loan.
True False

8. Rapid refund services can be an expensive way to borrow money.
True False

9. The two cycle balance method calculates your balance using purchases made in the current month only.
True False

10. Variable interest rates do not change over time.
True False