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1. To examine and apply contract terminology in an appropriate

way.

2. To interpret rate definitions and structures.

3. To illustrate the structure of credit card contracts.

4. To compare and contrast the various types of loans.

5. To demonstrate knowledge of legal and regulatory

compliance of financial contracts.

6. To evaluate the costs associated with the use of credit.

7. To build and interpret an amortization schedule.

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• In general are agreements between two or more individuals (entities) that are enforceable by law

• Include a financial obligation between two or more individuals (entities) that  are enforceable by financial contracts laws

• Usually between an individual (entity) and a financial institution 

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• Can include:

– consumer banking centers

– investment banking centers

– credit unions

– savings associations

– credit card companies

– mortgage companies

• Can include:

– credit cards

– loans

– checking accounts

– investment banking

– payroll cash advances

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• Represent a relationship between an individual or business and a financial institution

– individual or business is the debtor

– financial institution is the creditor

•  Are an open line of credit to spend on consumer goods 

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• Represent a relationship between an individual or business and a financial institution– Individual or business is the debtor– financial institution is the creditor

• Are a closed line of credit to spend on consumer goods or intangible goods– such as franchise startup costs, debt

consolidation, tax expenses, etc.

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• Represent a relationship between an individual or business and a financial institution

– individual or business is the creditor

– financial institution is the debtor

• Allows individual to deposit money in an institution with the right to withdrawal on demand

• Are insured deposits up to $100,000 through the Federal Deposit Insurance Corporation (FDIC)

• Collect deposits and use them to make loans to other individuals and businesses

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Federal Deposit Insurance Corporation: a government agency charged with oversight of consumer banks and savings associations.

• Represents a relationship between an individual or business and a financial institution

– individual or business is the creditor

– financial institution is the debtor

• Enables an individual to invest money with an investment banker who will make a (profitable) return on the investment

• Involves some risk10

• Represent a relationship between an individual and their employer

– individual is the debtor

– employer is the creditor

• Enables an individual to borrow money from employer before a scheduled pay date

• Reduces the amount of next paycheck11

1. Financial contracts involve a relationship between a

__________ and ____________.  

2. You are represented as a creditor in which type(s) of

contracts?

a. loans

b. checking accounts

c. investment banking

d. a and c

e. b and c

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3. Which of the following financial contracts do NOT have a low risk related to them?  

a. checking accounts

b. payroll advances

c. investment banking

d. b and c

e. a and c

4. Who insures that your checking deposits will be available for withdrawal?

a. bankerb. President of the United Statesc. Federal Reserve Boardd. Federal Deposit Insurance Company 13

5. Payroll advances represent the

relationship between an ___________

and their __________________.

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• Creditors can be sneaky about hiding some terms of agreement

• Fine print maintains important information• By not reading the terms of agreement you could

jeopardize your credit situation• Terms of agreement vary for different lines of credit

• some cards include an application fee• different loans calculate interest rates in

different ways

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• Understand the various terms you will find in “terms of agreement” and “note disclosures ”

• Understand how the definitions of various components of credit terms of agreement apply to your specific situation – credit card – loan– mortgage  

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Terms of agreement: a list of rules you agree to follow; also lists consequences you agree to accept for not following the rules

Note disclosures: terms of agreement for a loan

• Are mandated  by the Consumer Credit Protection Act

• Require creditors to state the terms of agreement briefly 

• Allow debtors (applicants) to compare different lines of credit and choose the correct one for their needs

• Vary among different types of credit, for example:

– loans: flood determination, truth-in-lending, HMDA, etc.

– credit cards: rate calculation, repayment, late payment, etc.

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• Entails the method in which the line of credit (i.e., credit card or loan) is priced

• Calculates the rate of interest  • Varies between purchases, balance

transfers, cash advances, and default

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Interest: the amount of money you are charged for borrowing credit; creditors profit off interest

• Represents an individual’s primary APR Rate

• Usually lowest APR compared to balance transfers, cash advances and default APRs

• Can be fixed or variable

– fixed: usually an introductory offer, for instance the first six billing cycles may have an APR of zero percent interest

– variable: an individual’s credit is evaluated every three to six months, and based on the credit score the rate can increase or decrease

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• Moves an unpaid debt from one creditor to another creditor

• Usually second lowest APR compared to cash advances and default

• Can be fixed or variable

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• Allows an individual to collect cash from a creditor  

• Infers a higher convenience than simply purchasing an item

– therefore has a higher APR than purchases

• Rank third in terms of repayment 

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• Substitutes an individual’s purchase APR

– in some situations it can substitute balance transfer and cash advance APRs in addition to the purchase APR

• Punishes an individual for failing to abide by the terms of agreement

– did not pay on time

– did not meet your minimum monthly payment

– overdrawn - went over your credit line

• finance charges are considered part of your credit line

• Usually calculated at the highest interest rate allowed by current legislation

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Finance Charges: the interest rate accrued to your outstanding balance

• Indicates the time an individual has to pay a purchase without

accruing interest

– for instance, you open an Macy’s credit account to obtain

a 10 percent discount on purchases

– the grace period is 30 days, therefore you have 30 days to

pay the amount of that purchase without accruing interest

– if you make payment past 30 days, you must pay the

balance of that purchase PLUS interest

• Lasts for 20 to 30 days normally

• Are only available to those who pay the balance in full each

month

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• Around a tiered system

– payment is allocated to purchases first

– payment is allocated to balance transfers second

– payment is allocated to cash advances last

• To benefit creditors

– interest accrues on the higher APR category (cash advances) until an individual pays the purchases and balance transfer balances

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• Calculate the amount owed to a creditor for providing a service (i.e., a line of credit; borrowing services)

• Involves complex calculations and various methods

• Can be calculated using several methods– Average Daily Balance (most common)– Adjusted Balance– Previous Balance (least used)– Double Billing (least used)

• Include fees26

• Measures interest paid to a creditor through a variety of ways• Determines Average Daily Balance (ADB) based on a specific

plan– could include cash advances– may include new purchases

• Generally ADB is measured the following way: – Beginning Balance + New Purchases + Cash Advances  –

Credits (Payments, Refunds)• Days in the Billing Cycle (28, 30, 31) 

– ADB is then multiplied by: APR• Number of Months in a Year (12) • Divide APR by 12 because charges are billed monthly NOT

annually. Dividing by 12 months in a year gives you the monthly rate. 27

• Represents the least expensive method

– advantageous from the debtors perspective

• Does not include purchases made during the billing

cycle

• Calculates the balance by:

• Beginning Balance – Credits

• Days in Billing Cycle 

– adjusted balance is then multiplied by: APR

• Number of Months in a Year (12)

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• Is not commonly used in the industry, but does exist

• Bases finance charges on the amount owed at the end of the previous billing period

• Does not include credits and new purchases made during the current billing period

• Modify the Adjusted Daily Balance formula • Beginning Balance • Days in the Billing Cycle (28, 30, 31)  

– New balance is then multiplied by: APR• Number of Months in a Year (12)

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• Represents the most expensive method for calculating finance charges

• Seems to be popular among high end department stores

• Utilizes the account activity for the last two months to calculate finance charges

• Modify the Adjusted Daily Balance formula

• Previous 2 Month Purchases + New Purchases + Cash Advances  – Credits (Payments, Refunds)

• Days in the Billing Cycle (28, 30, 31)

– ADB is then multiplied by: APR

• Number of Months in a Year (12)30

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Method Balance Calculation Characteristic

Average Daily Balance

Beginning Balance + New Purchases + Cash Advances

Most commonly used

Adjusted Balance Beginning Balance - Credits

Least expensive to the debtor

Previous Balance Beginning Balance Only

Rarely used

Double Balance Previous 2 Month Purchases + New Purchases + Cash

Advances

Most expensive to the debtor

• Facts:– APR: 19.99 percent– previous billing balance: $2,000– purchase total for the past two months: $2,300– new purchases: $500– cash advance: $100– last month’s payment: $40– terms of agreement include cash advance in the

calculation of Average Daily Balance– 31 days in the billing cycle

• Steps– calculate Average Daily Balance– multiply APR

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• Step One: Calculate Average Daily Balance• Beginning Balance + New Purchases + Cash Advances  –

Credits (Payments, Refunds)• days in the billing cycle (28, 30, 31)• beginning balance: $ 2,000• add: new purchases 500• add: cash advances 100• deduct: credits <40>• divide: days in a month 31 Days• Average Daily Balance $82.58• Assuming the plan stipulates these items are involved in

the calculation

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• Step Two: Multiply APR – remember the A in APR stands for ANNUAL– 12 Months = Annual– therefore divide the APR by 12 months  

• APR 19.99 =1.67 percent• Number of Months in a Year (12) 12 • 1.67 percent * $82.58 = $1.38 or

.0167 * $82.58 = $1.38• Finance charges from purchases and cash

advances: $1.38

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Average Daily

BalanceAdjusted Balance

Previous Balance

Double Balance

Beginning Balance

  $2,000 $2,000 $2,000 $2,000

Add: Average Daily Balance from last billing cycle

      $80

Add: New Purchases

$500     $500

Add: Cash Advances

$100     $100

Deduct: Credits ($40) ($40)   ($40)Divide: Days in a

Month 31 Days 31 Days 31 Days 31 Days

Average Daily Balance

  $82.58 $63.23 $64.52 $85.16

• Also include:

– annual fee: some cards have a fee for service; this fee is distributed throughout the year (fee ÷ 12) 

– initial fee: there may be a one time application fee that is charged during the first billing cycle

– over the limit fee: if an individual goes over the credit line they may be charged a set fee

– late payment fee

• May include minimums, for example:

– if the finance charge calculates to 30 cents and the terms state a minimum finance charge of $1.00, an individual will pay $1.00 instead of 30 cents

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1. The Credit Consumer Protection Act requires creditors to disclose the ____________ ___________ ____________.

2. Annual Percentage Rate calculates

a. debt-to-income ratio

b. interest rate

c. periodic rate

d. debtor income

3. Janet has an introductory APR for the first six months, after that her rate increases to a variable 13.99 percent. Janet purchased the card in January, how would you define her rate in October?

a. variable

b. fixed

c. mixed

d. elastic

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4. Creditors make the most money off which tiered APR?

a. purchases

b. installments

c. balance transfers

d. cash advances 

5. Nikita opens a department card on black Friday (November 24) with Best Buy to purchase a new plasma television for $1,000. Her grace period is 25 days. Her introductory APR is 9.99 percent for six months. She waits until she receives her statement on December 28 to make payment. There were 30 days in her last billing cycle. What is her average daily balance?

a. $0

b. $3.33

c. $99.90

d. $33.33

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6. Refer to the previous facts in question five. What is her minimum finance charge?

a. 0

b. $3.33

c. $99.90

d. $33.33

7. Why do you divide APR by 12 when calculating finance charges?

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8. Which finance charge calculation method is the least advantageous

to the debtor?

a. double balance

b. adjusted balance

c. average daily balance

d. previous balance

9. Which finance charge calculation method is the least advantageous

to the creditor?

a. double balance

b. adjusted balance

c. average daily balance

d. previous balance

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10. Put the following repayment tier in order. Place a one next to the tier that is paid first, a two next to the repayment tier paid second and three next to the repayment tier that is paid last.

a. _______ Cash Advances

b. _______ Purchases

c. _______ Balance Transfers

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• Vary by type

– secured: pledging collateral  in the event an individual is unable to repay the loan

– unsecured: does not require collateral; trusts that an individual will repay the loan

– student: to assist in paying for college

• two types:

– federal process is similar to that of a credit card

– private process is similar to that of a loan  

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Collateral: a valuable item such as a car, boat, house or certificate of deposit

• Debt-to-income ratio assists in determining if a loan is affordable

• In general when debt-to-income

– exceeds 40 percent, the debtor cannot afford the debt

– falls below 40 percent, the debtor can afford the debt 

• Debt-to-income ratio= total monthly payments ÷ gross monthly income

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• Details repayment information over the course of the debt

• Forces the big picture to be seen

– for instance, an individual will be able to see how much interest has been paid to the creditor for loaning you money

– will be able to see, for example, that a $30,000 loan may cost $8,000 in interest

• Allows an individual to develop a long term financial plan

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• Five Columns

• Principal Paid: Given• Interest Expense: Carrying Balance x Interest

Rate ÷ Number of Payments• Amortization Amount: Principal Paid – Interest

Expense• Carrying Balance: Previous Carrying Balance –

Amortization Amount

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PaymentPrincipal

PaidInterest

ExpenseAmortization

AmountCarrying Balance

• Consider the cost of a one year, $30,000 loan with a 10 percent interest rate

• The loan cost you $1,649.70 and the additional fees you had to pay to receive the loan (e.g., application fee, title fee, appraisal fee)

• If this loan was an eight year loan your interest expense would have been $13,701.59

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Payment Principal PaidInterest

ExpenseAmortization

AmountCarrying Balance

       $30,000.00

Month 1 $2,637.48 $250.00 $2,387.48 $27,612.52

Month 2 $2,637.48 $230.10 $2,407.37 $25,205.15

Month 3 $2,637.48 $210.04 $2,427.43 $22,777.72

Month 4 $2,637.48 $189.81 $2,447.66 $20,330.06

Month 5 $2,637.48 $169.42 $2,468.06 $17,862.00

Month 6 $2,637.48 $148.85 $2,488.63 $15,373.37

Month 7 $2,637.48 $128.11 $2,509.37 $12,864.00

Month 8 $2,637.48 $107.20 $2,530.28 $10,333.73

Month 9 $2,637.48 $86.11 $2,551.36 $7,782.36

Month 10 $2,637.48 $64.85 $2,572.62 $5,209.74

Month 11 $2,637.48 $43.41 $2,594.06 $2,615.68

Month 12 $2,637.48 $21.80 $2,615.68 $0.00

Total Cost of Loan: $31,649.76

Total Interest Expense: $1,649.70

Principal of Loan: $30,000.00

• Can improve an individual’s credit score

– demonstrate credit responsibility

– create a successful history of repayment

– established credit relationships

• Will destroy a credit score if payments are late

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• In the case of a credit card– does not mature but

rather ends– can end when the

individual decides– can end if the creditor

no longer wishes to provide their services (negative effect on a credit score)

• In the case of a loan– maturity is a set

date – the individual has

an option to renew the loan locking in at a new or lower rate

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• Renegotiates the terms listed within a financial contract

• Usually involves borrowing from a different lender

• Process is similar to the original process

 

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• Application fee: covers the new lenders expenses for evaluating and providing refinancing services

• Title search fee: covers the lenders expense to search for the title and determine if an individual is indeed the owner

• Title insurance fee: covers legal expenses for the lender, in the event there is a discrepancy within the title

• Appraisal fee: covers the expenses to have the property appraised

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• Benefits include:

– lower interest rate

– faster payoff

– ability to save money

• Consequences include:

– tax penalties

– paying over a longer period than originally financed for

• why a problem? You are paying unnecessary interest

– coerced into a variable APR that will cost you more in the end

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1. What is the difference between a secured loan and an unsecured loan?

2. Discuss the positive benefits and negative consequences of financial contract maturity.

3. Cost of refinancing includes all of the following except

a. title insurance fee

b. application fee

c. title recall fee

d. appraisal fee

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Use the following information to answer questions four and

five. Consider the cost of a 12 year, $150,000 loan with a 12

percent interest rate. Given: Principal payment required at the

end of each month $13,327.32 

4.What is the total cost of the loan at the end of the third year?

(Hint: Construct an amortization schedule for the first three

years)

a. $13,327.33

b. $114,162.04

c. $39,981.96

d. $4,144.00

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5. What is the interest expense at the end of the third year?

a. $2,881.73

b. $114,162.04

c. $39,981.96

d. $4,144.00

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• Support the legality of a contract• Must be met in order for a court to recognize

and enforce the terms of a contract• Include

– offer– acceptance– genuine agreement– consideration– capacity – legality

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• A proposal the creditor extends to the debtor indicating a willingness to exchange borrowing services

• Credit card offers

– are promptly accompanied with application via phone or the Internet

– are usually represented through signature of the application

– are often predetermined through the terms offered in the advertisement

• Loan offers

– are discussed in a note (terms of agreement)

– can take three or more weeks following the credit application

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• Bound agreement between the two parties• Credit card acceptance

– approval of the application – issuance of the card– telephone verification

• Loan acceptance– signature of the note

• May require multiple parties such as a lender, notary, applicant or guarantor   

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Guarantor: a person who agrees to co-sign a debt

• Represents having good faith in individuals

• May be destroyed by:

– fraud

– misrepresentation

– mistake

– duress 

• Supports the offer and acceptance as legitimate elements

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Duress: forced into making the contract

• Represents the transaction, in other words consideration is the exchange of services

• Credit card consideration– issuance of the card from the creditor– activation of the card from the debtor

• Loan consideration– issuance of cash from creditor– signature of note from the debtor,

pledging collateral (if secured)

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• Ensures that the parties involved are of legal consent – minors usually do not have the authority to sign

financial contracts– unusual circumstances may permit a minor to sign

a financial contract with a legal guardian acting as a guarantor

• Maintains that parties are of mental stability– sober– competent– manic (people near death tend to sign contracts

they normally would not)

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• Establishes that the contract was conducted in legal compliance

• Links genuine agreement and capacity

• Ensures that the contract is not of an illegal nature

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1. Credit card offers take longer than loan offers.

a. true

b. false

2. A person has been advised that they are terminally ill. They have always had a dream of visiting the world before they died. To help finance this adventure they enter into a loan agreement. What is the legal element that makes this financial contract (loan agreement) null and void?

a. mental distress

b. misrepresentation

c. genuine agreement

d. capacity 

3. Consideration is an exchange of ___________.65

4. Jacqueline acquires a loan to purchase a car that she

knows has been stolen. Is this financial contract

enforceable? Discuss why or why not this contract is

enforceable.  

5. Genuine agreement supports which element(s)?

a. legality

b. consideration

c. capacity

d. offer and acceptance

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Garner, Bryan (2004) Black’s Law Dictionary. New York, NY: Thompson

West. 

Hempel, George & Simonson, Donald (1999) Bank Management Text and

Cases. Hoboken, NJ: John Wiley & Sons, Inc. 

(n.d.). Retrieved March 16, 2009, from Census Bureau Home Page: http://www.census.gov/

(2009). Retrieved March 16, 2009, from Board of Governors of the Federal Reserve System: http://www.federalreserve.gov/

Compare Mortgage Rates. (2009). Retrieved March 16, 2009, from Bankrate.com: http://www.bankrate.com/brm/news/debt/debt_manage_2004/gooddebt-baddebt.asp 

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