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Borrowing

There will be times when we need or want to spend or invest more cash than we have at the moment. However, many of us have the financial capability to borrow at this time knowing we will repay the loan at a later time. This page introduces basic concepts related to borrowing.

 

 

Occasionally we are short on cash; we borrow to pay bills or other financial obligations.  We then pay these debts in the future when our cash income exceeds our expenses and we have cash with which to pay those obligations.

 

A loan is a contract between the lender and borrower.  If borrowing from a bank, the contract is usually referred to as the loan agreement or note.  If arranging to borrow from a credit card company, the loan agreement is the extensive document that accompanies the application for the card or the receipt of the card.

 

Credit cards -- unsecured debt, creditor cannot seize your property if you cannot pay your debt, the creditor will charge a higher interest rate to offset the risk that the creditor might not be repaid the loan.

 

Some terminology/concepts

Principal – amount borrowed or still owed.

 

Interest expense – amount paid to lender on a regular basis to compensate the lender for the use of the lender’s funds.  The amount of interest is calculated as principal x interest rate x time period for which the interest is being calculated (e.g., monthly, annually, quarterly)

 

Interest rate – the amount lender requires borrower to pay for the use of the lender’s funds.  Interest rate is usually expressed on an annual basis, such as “the interest expense for using my funds will be 5.25% of the principal amount you owe throughout the year.

 

Relationship between risk and interest rate – the great the perceived risk, the higher the interest rate the lender will expect.

 

Interest rate on credit card is usually high because the debt is unsecured (unsecured and secured debt are mentioned subsequently).  Credit cards are not a good source for long-term credit; may be an excellent way to manage cash flow if you have the finance capacity and the discipline to pay the full amount each month.  Could be a source of short-term, emergency capital/credit – but use that credit wisely.

 

Credit score as a measure of how risky it is for others to loan you credit

 

Interest rate/APR – amount borrower must pay creditor for the use of the creditor’s capital; interest rate is usually expressed on an annual basis even if the debt requires more frequent payments, such as monthly payment.  Federal law requires creditor to indicate an annual percentage rate (APR) because there often are additional costs associated with the loan that effectively raise the interest rate.  For example, see https://www.bankofamerica.com/home-loans/mortgage/finding-the-right-loan/apr-vs-interest-rate.go

 

Fixed or variable interest rate – will the interest rate remain unchanged for the duration of the loan, or will the interest rate adjust upward or downward as the market rate of interest fluctuates?

 

Monthly payment on credit card debt – The credit card company specifies a minimum monthly payment but WATCH OUT; that amount is only enough to cover the interest and a little principal.  Making minimum payments will require long time to repay debt. 

 

Long term debt – used to buy higher-cost items, such as vehicle or a house.  The borrower will make payments (usually monthly payments) for several years to pay off the relatively large amount of debt.  Hopefully, interest rates will be more reasonable (lower) because the creditor is secured with a mortgage against the house or have a security interest in the vehicle.

 

Mortgage – creditor’s right to seize your land if you are unable to pay your debt according to the agreed upon payment schedule.

Security interest – creditor’s right to seize your personal property if you are unable to pay your debt according to the agreed upon payment schedule.

 

Additional Terminology

  • Amortization -- the process of calculating a series of payments; each payment pays the interest and some of the principal.  The first payments in a series of payments pays very little principal; it is mostly interest. – provide an example???

Loan amount

$1,200.00



No. of quarterly payments

10

(total of 2.5 years)

Annual interest rate

6

percent


Amount of quarterly payment

$130.12










Amount owed at beginning of quarter

Quarterly payment at end of quarter

Quarterly interest expense

Amount paid on principal

Amount owed at end of quarter

1

$1,200.00

$130.12

$18.00

$112.12

$1,087.88

2

1,087.88

130.12

$16.32

113.80

974.08

3

974.08

130.12

$14.61

115.51

858.57

4

858.57

130.12

$12.88

117.24

741.33

5

741.33

130.12

11.12

119.00

622.33

6

622.33

130.12

9.33

120.79

501.54

7

501.54

130.12

7.52

122.60

378.95

8

378.95

130.12

5.68

124.44

254.51

9

254.51

130.12

3.82

126.30

128.21

10

128.21

130.12

1.92

128.20

0.01

 

  • Balloon payment – A point in time specified in the loan agreement when the remaining principal becomes due; the challenge for the borrower may be having enough cash to make the large payment at that point in time.

 

  • Prepayment penalty -- An extra amount the borrower needs to pay if the borrower wants to pay principal before the scheduled date; NEVER accept a loan that includes a prepayment penalty.

 

Wage garnishment – a creditor’s right (often granted by a court) to direct an employer to pay a portion of an employee’s wages to the creditor rather than to the employee.  Garnishment is a way for creditors to collect an amount they are owed but are not being paid by the borrower.

 

This document does not address bankruptcy or other legal proceedings used to resolve debt if the borrower is unable to make payments according to the schedule agreed to by the lender and borrower.

 

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