PERSONAL FINANCIAL MANAGEMENT

CHOOSING A SOURCE OF CREDIT: THE COSTS OF CREDIT ALTERNATIVES

SOURCES OF CONSUMER CREDIT
Credit costs money. It is important to know the source of credit and its costs in
order for you to reduce your finance charges. Reconsider your decision to borrow
money; do I need a loan? can I afford a loan? can I qualify for a loan? Credit
should be avoided in two situations:
one in which you do not need or really want a product that will require
financing,
one in which you can afford to pay cash but consider the trade-off and
opportunity costs involved.
What Kind of Loan Should You Seek?
The sources of credit come in all shapes and sizes. Two types of credit exist
namely closed-end and open-end credit. Since credit costs money, we first
classified the credit sources according to their costs:

Inexpensive Loans: Parents or family members however, it can complicate

family relationship. All loans between family members should preferably be in
writing stating the interest, repayment schedule and final payment date.
Relatively inexpensive loan is money borrowed on financial assets held by a
lending institution i.e. loan with secured collateral.

Medium-Priced Loans: Loans from commercial banks and credit unions. New
car loans may cost 6 to 8 percent; used car loans and home improvement
loans may cost slightly more.

Expensive Loans: The most expensive loans are available from finance
companies, retailers, and banks through credit cards. Finance companies
often lend to those who cannot obtain credit from banks or credit unions. The
interest ranges from 8% to 20%. Other expensive loans include cheque
cashers, payday loans, cash advance loans, cheque advance loans, postdated
cheque loans, tax refund loan or deferred deposit cheque loans. Loans
secured to a personal cheque are extremely expensive. Borrowing from car
dealers, appliance stores, department stores and other retailers is also
relatively expensive.
Cash advance is a loan billed to your credit card. Most credit cards charge a
special fee when cash advance is taken out usually 2 3% of the amount
borrowed but some charge a fixed fee. The interest is charge immediately on
daily basis and is higher than interest on credit purchases. For example, a
cash advance of $200 may costs $7 or 3.5%.
Cash advance fee = $4 (2% x $200)
Interest for one month = $3 (1.5% APR on $200)
compared to $0 on a purchase of $200 paid in full using the allowed grace
period.
Exhibit below summarizes the sources of consumer credit, type of loan and
the lending policies:

THE COST OF CREDIT

Creditors are required to state the cost of borrowing as a dollar amount so that
consumer would know exactly what the credit charges were and thus could
compare credit costs and shop for credit.
Two key concept which must be make known in the cost of credit is the finance
charge and the annual percentage rate (APR).
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Finance Charge and Annual Percentage Rate (APR)

All creditors must state the cost of their credit in terms of the finance charge and
the APR. The finance charge is the total dollar amount paid to use credit. It
includes interest costs, service charges, credit-related insurance premiums, and
appraisal fees. For example, borrowing $100 for a year might cost you $10 or
10% in interest, and $1 in service charge. Total finance charge will be $11.
The annual percentage rate (APR) is the percentage cost (or relative cost) of
credit on a yearly basis. The APR is the key to comparing credit costs.
APR can be calculated using an APR formula:
where,

r=2xnxl
P(N + 1)

r = approximate APR
n = number of payment periods in one year (12 for monthly; 52 for

weekly)
I = total dollar cost of credit
P = Principal, or net amount of loan
N = Total number of payments scheduled to pay off the loan
What is the APR for a $100 loan where payment is made in one lump sum at the
end of the year and if it is paid off in 12 equal monthly payments. The interest
rate is 10%. Note that total dollar cost of credit is $10 (10% x $100).
The APR for the lump sum = 2 x 1 x $10 = $20
= 0.10 = 10%
$100 (1 + 1) $100(2)
The APR for the 12 monthly payments = 2 x 12 x $10
= $240
= 0.1846 = 18.46%
$100(12 + 1)
$1,300

$240

$100(13)

Tackling the Trade-offs

When choosing your financing, there are trade-off between the features
preferred such as term, size of payments, fixed or variable interest or payment
plan and the cost of the loan.

Term versus interest costs: the longer the term for a loan at a given
interest rate (hence smaller monthly payment), the greater the amount
that must be paid in interest charges,

Lender risk versus interest rate: the greater the risk for the lender, the
higher the cost of credit. This is financing that require low fixed payments
with a large final payment or only a minimum of up-front cash.

Variable interest rate, a secured loan, a large down payment, and a

shorter-term loan are less expensive.
- variable interest rate is based on the fluctuating rates in the banking
system e.g. prime rate. With this type of loan, you share the interest rate
risks with the lender, hence lender may give you lower interest rate
compared with a fixed-rate loan.
- a secured loan is where you pledge property or assets as collateral.
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- up-front cash is making a large cash payment up-front and followed by

lower monthly payment.
- a shorter term of the loan lower the risk to the lender hence lower
interest rate.
Calculating the Cost of Credit
The two most common methods of calculating interest are compound interest
and simple interest formulas. Simple interest can also be calculated on
declining balance, add-on interest, bank discount while compound interest are
variations of simple interest.
Simple interest is the interest computed on principal only and without
compounding; it is the dollar cost of borrowing money.
The simple interest formula is: I = P r T.
where, I = the interest; P = principal; r = interest rate; T = time
For example, you borrow $1,000 for one year at 5%. What is the interest
charged and the APR?
Interest = $1,000 x 0.05 x 1 = $50
$100
= 0.05 = 5%

APR = 2 x n x 1 = 2 x 1 x 50
P(N + 1)

$1,000(1 + 1)

$2,000
Note that the stated rate, 5% is also the APR
Simple interest on the declining balance is when more than one payment is
made on a simple interest loan, the method of computing interest is known as
the declining balance method.
For example, you borrow $1,000 for one year at 5% interest rate. You make two
payments, one at the end of first half-year and another at the end of the secondhalf year. What is the interest charged and the APR?
First payment, P x r x T = I
$1,000 x 0.05 x = $25 interest plus $500 or
$525
Second payment, P x r x T = I $500 x 0.05 x = $12.50 interest plus the
balance $500 = $512.50
Total payment $1,037.50 and total interest $37.50 ($1,037.50 - $1,000.00)
APR = = 2 x n x 1 = 2 x 2 x $37.50
P(N + 1)
$1,000(2 + 1)

$150
$3,000

= 0.05 = 5%

Note that the stated rate, 5% is also the APR. The more frequent the
payments, the lower the interest you will pay.
Add-on interest is when interest is calculated on the full amount of the original
principal. The interest amount is immediately added to the original principal, and
payments are determined by dividing principal plus interest by the number of
payments to be made.

For example, you borrow $1,000 for one year at 5% interest rate or $50. You
make two payment of $525 for each half of the year. What is the interest charged
and the APR?
Using the add-on interest method means regardless of how many payments,
the interest charged will be $50 as interest is calculated upfront and added to
the principal i.e. $1,000 + $50 = $1,050
APR = = 2 x n x 1 = 2 x 2 x $50
P(N + 1)
$1,000(2 + 1)

$200
$3,000

= 0.066 = 6.6%

As the number of payments increases your APR also increase.

Cost of Open-end Credit

Open-end credit includes credit card, department store charge cards and
overdraft accounts. You can write cheques over and over again as long as you do
not exceed your line of credit. Creditors use various systems to calculate the
balance on which they assess finance charges. Creditors must therefore inform
borrowers on two important factors; (1) how they calculate the finance charges
and(2) when finance charges on your credit account begin so that borrowers
know how much time borrowers have to pay their bills before a finance charges
is added. Some of the method to calculate the cost of open-end credit are:

The adjusted balance method, where finance charges are added after
subtracting payments made during the billing period. For example,
Monthly rate is 1.5%, APR 18%, previous balance $400, payments $300.
What is the finance charge?
Adjusted balance = previous balance payment = $400 - $300 = $100.
Finance charges for the month = 1.5% x $100 = $1.50

The previous balance method, where creditors give no credit for

payments made during the billing period. For example,

Monthly rate is 1.5%, APR 18%, previous balance $400, payments $300.
What is the finance charge?
Previous balance method calculate the finance charge on the previous
balance ($400) that is, it does not take into account any payment during
the month.
Finance charges = 1.5% x $400 = $6.00

The average daily balance method, where creditors add your balances
for each day in the billing period and then divide by the number of days in
the period. Two methods, either including new purchases or excluding new
purchases. For example,
Monthly rate 1.5%, APR 18%, previous balance $400, new purchases on
18th day $50, payments on 15th day $300.
Average daily balance including new purchase:
Day 1 Day 15, $400; Day 16 Day 18, $400 - $300 = $100; Day 19
Day 30, $100 + $50 = $150
[($400 x 15) + ($100 x 3) + (150 x 12)]/30 days = $270
Finance charges = 1.5% x $270 = $4.05
Average daily balance excluding new purchases:
Day 1 Day 15, $400; Day 16 Day 30 = $400 - $300 = $100
[($400 x 15) + ($100 x 15)]/30 days = $250
finance charges = 1.5% x $250 = $3.75

Cost of Credit and Expected Inflation

Borrowers and lenders are more concern about purchasing power of money.
Inflation erodes the purchasing power of money. Each percentage point
increase in inflation means a decrease of approximately one percent in the
purchasing power of money. Lenders, seeking to protect their purchasing
power, add the expected rate of inflation to the interest they charge.

Avoid the Minimum Monthly Payment Trap

The minimum monthly payment is the smallest amount you can pay and still be
a borrower in good standing. Paying only the minimum payment will make you
repay the whole loan in a longer period and at much higher interest sum.
When the Payment is Early: The Rule of 78s
The rule of 78s or the sum of the digits, is to determine how much interest you
have paid at any point in a loan. The formula favors lenders and dictates that
you pay more interest at the beginning of a loan, when you have the use of more
of the money, and pay less and less interest as the debt reduced. Because all the
payments are the same size, the part going to pay back the amount borrowed
increases as the part representing interest decreases.
How to Use The Rule of 78s
The first step is to add up all the digits for the number of payment scheduled. For
example, for a 12-installment loan add the numbers 1 through 12 and for a 15installment loan add the number from 1 through 15:
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12+ 13 + 14 + 15 = 120
This can be done by using formula,
installments.

N/2 x (N + 1) where N = number of

For 12-installment loan, 12/2 x (12 + 1) = 6 x 13 = 78

For 15-installment loan, 15/2 x (15 + 1) = 7.5 x 16 = 120
This can be said that the total interest is divided into 78 parts or 120 parts for
payment over the term of the loan.
In the first month, before making any payments, you have the use of the whole
amount borrowed and therefore you pay 12/78 or 15/120 of the total interest in
the first payment. On the second month, you still have the use of 11 parts or 14
parts of the loan and pay 11/78 or 14/120 of the interest and so on down to the
final installment.
For example,
CIMB approved your personal loan of RM2,000 to purchase a mountain bike. The
interest rate is 5% per year. The loan is to be paid in 15 equal instalments. Using

the rule 78s , prepare the payment schedule for each instalment that represents
the interest and the reduction of debt.

Total loan sum

: RM 2,000
Interest rate
: 5% per year
No. of loan instalment : 15
Total interest charged : RM 2,000 x 5% x 15 = RM 125
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Total payable (principal + interest) = RM 2,000 + RM 125 = RM 2,125
Monthly instalment

: RM 2,125/15 = RM 141.66

Interest payment formula: Total Interest

x Parts of the Total Interest
The Sum of the Digits
Sum of the Digits for 15 nos instalment = 15 + 14 + 13 + 12 + 11 + 10 + 9 + 8 + 7
+ 6 + 5 + 4 + 3 + 2 + 1= 120

Payme
nt
No.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Interes
t

Princip
al

Total
Payme
nt

15.62

126.04

141.66

14.58

127.08

141.66

13.54

128.12

141.66

12.50

129.16

141.66

11.46

130.20

141.66

10.42

131.24

141.66

9.37

132.29

141.66

8.33

133.33

141.66

7.29

134.37

141.66

6.25

135.41

141.66

5.21

136.45

141.66

4.17

137.49

141.66
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3.12

138.54

141.66

2.08

139.58

141.66

1.06

140.70

141.76

125.00

2,000.0
0

2,125.0
0

Other Methods of Determining the Cost of Credit

Bank Discount Method interest is calculated on the amount to be paid back and
you receive the difference between the amount to be paid back and the interest
amount. For example, if you borrow $1,000, it will be less $50 (5% interest), you
receive $950.
APR = 2 x 1 x $50 = $100 = 0.05263 = 5.263%
$950(1 + 1) $1,900
Compound Interest interest paid on the original principal plus the accumulated
interest. With interest compounding, the greater the number of periods of which
interest is calculated, the more rapidly the amount of interest on interest and
interest on principal builds.
The formula for compound interest is F = P (1 + r) T
where, F = future value; P = principal; r = interest rate; T = time

Credit Insurance
Credit insurance ensures the repayment of your loan in the event of death,
disability or loss of property. The lender is named the beneficiary and directly
receives any payments made on submitted claims.
The most commonly purchased type of credit insurance is credit life insurance,
which provides the repayment of the loan if the borrower dies. Credit accident
and health insurance or credit disability insurance, repays your loan in the event
of a loss of income due to illness or injury. Credit property insurance provides
coverage for personal property purchased with a loan. It may also insure
collateral property however, payment for such coverage are quite high.
MANAGING YOUR DEBT
If you cannot make your payments, contact creditors at once and try to work out
a modified payment plan with them. Do not wait until your account is turned over
to a debt collector which means the creditor has given up on you.
There are companies that offer to assist you in solving your debt problem by
offering debt consolidation loans, debt counselling and debt reorganization plan
that will stop creditors collection effort. Investigate them, be sure you know the
terms of services provided before engaging them.
Debt Collection Practices
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There normally will be an Act which regulates and prohibits certain practices by
agencies that collect debt for creditors.
Warning Signs of Debt Problem
The following are the frequent reasons for indebtedness:

Emotional problem such as the need for instant gratification,

The use of money to punish,
The expectation of instant comfort such as getting all the good living in a
short time,
Keeping up with the neighbours, friends etc
Overindulgence of children
Misunderstanding or lack of communication
The amount of finance charges.

Reasons for default on loan include excessive use of credit, unemployment or

reduced income, poor money management, divorce or separation, medical
expenses etc.
Excessive indebtedness may result in heavy drinking, a neglect of children,
marital difficulties, and drug abuse. But help is available to those who seek it.
Summarised in the exhibit below are danger signals of potential debt problems.

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CONSUMER CREDIT COUNSELLING SERVICES

In The United States, a Consumer Credit Counselling Services (CCCS) is a local,
non-profit organization affiliated with the National Foundation for Consumer
Credit. It provides debt counseling services for families and individuals with
serious financial problems. It aids families with serious debt problems by helping
them manage their money better, and through education. Anyone overburdened
by credit obligations can phone, write, or visit a CCCS office. The CCCS requires
that an application for credit counseling be filled, and then an appointment is
arranged for a personal interview with the applicant.
Counseling services are also available from universities, military bases, credit
unions, local county extension agents, and state and federal housing authorities.
In Malaysia, it is Agensi Kaunseling dan Pengurusan Kredit (AKPK). AKPK is a
counselling and credit management agency that provides financial education,
financial counselling and debt management.

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DECLARING PERSONAL BANKRUPTCY

Debtors who suffer extreme financial woes can opt for bankruptcy as a relief.
Bankruptcy is a legal process in which some or all of the assets of a debtor are
distributed among creditors because the debtor is unable to pay his debts.
Bankruptcy may also include a plan for the debtor to pay creditors on an
installment basis. Declaring bankruptcy is the last resort because it severely
damages your credit rating.
Bankruptcy is supposed to be the relief of last resort. However, this relief was
widely used in the United States to resolve financial indebtedness. The
Bankruptcy Recovery Act of 1978, which made personal bankruptcy easier, is
also considered an important cause of the increase in personal bankruptcies. The
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it more
difficult to file for bankruptcy under Chapter 7, Bankruptcy and most likely to go
for Chapter 13, Bankruptcy.
Chapter 7 Bankruptcy
In a Chapter 7 bankruptcy, a debtor is required to draw up a petition listing his or
her assets and liabilities. Chapter 7 bankruptcy grants a debtor a chance to make
a fresh start in life. It is a straight bankruptcy in which many, but not all, debts
are forgiven. Most of the debtors assets are sold to pay off creditors. However,
certain assets of the debtors are protected to some extent.
Chapter 13 Bankruptcy
In Chapter 13 bankruptcy, a debtor with a regular income proposes to a
bankruptcy court a plan for extinguishing his or her debts from future earnings or
other property over a period of time. In such a bankruptcy, the debtors normally
keep all or most of the property. During the period the plan is in effect, the
debtors make regular payment to a Chapter 13 trustee. The trustee distributes
the money to the creditors.
Notation: In Malaysia, there is no such relief such as in United States. This is
especially sad as there are no discharge from bankruptcy even after many years
in Malaysia and for just RM30,000 , one can be made a bankrupt for that small
matter
Effect of Bankruptcy on Your Job and Your Future Credit
Different people have different experiences in obtaining credit after they file a
bankruptcy case. Some find obtaining credit more difficult. Obtaining credit
maybe easier for people who file a Chapter 13 bankruptcy and repay some of
their debts compared to those who file under Chapter 7 bankruptcy and make no
effort to repay.
The bankruptcy law prohibits your employer from discharging you simply
because you have filed a bankruptcy case.
Should a Lawyer Represent You in a Bankruptcy Cases
In filing bankruptcy cases, it is strongly recommended that an attorney be
engaged for proper procedures and submission of forms. The monetary costs to
debtors include court costs, attorneys costs and trustees fees and costs. There
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are also intangible costs to bankruptcy such as the difficulty of getting future
loans since the bankruptcy report is kept by credit bureau for 10 years. Hence,
declaring bankruptcy should be taken as a last resort when no other option is
available.

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