Question

TYPE ANSWERS

1.

• Be able to identify your responsibilities as a debtor, as well as creditors’ responsibilities to you

• Be able to identify methods to increase your credit score

• Differentiate between simple and compound interest; know how to calculate each (debtor perspective)

• Understand what Annual Percentage Rate (APR) is, and how it is calculated

Answer 1

Responsibility of a Debtor

Debtor is the one who has borrowed or availed a credit from a Creditor or a Lender. So, the debtor has certain responsibilities towards the creditor:

(i) Debtors are legally responsible for paying the dues they owe and must promptly pay the dues (interest payment or principal repayment or both) as when required to do so

(ii) Should maintain complete transparency about their financial condition to the creditor, in fact they must periodically inform the creditor regarding the same

(iii) Must promptly contact the creditor if facing financial difficulties, and try to work out an alternative repayment plan

(iv) Debtor must not sell the assets which have been pledged as collateral with the creditor

(v) Debtor must not claim that the same asset has been used as collateral to obtain several other loans

(vi) Debtor must not look for securing additional borrowing without the consent of the present creditor

(vii) Debtor must insure and maintain the assets used as collateral to obtain the loan

(viii) Debtor must utilize the credit amount only for the purpose he has stated it to be used for while obtaining the loan; if he uses it for other purposes without the consent of the creditor, it will be deemed as diversion of funds, which is an act of fraud

(ix) Debtor must always comply with the applicable laws and regulations of the land

Responsibility of Creditor

(i) Creditors must be flexible, fair, and realistic in debt collection. Sometimes a debtor may default due to genuine reasons which are beyond his control, such as unemployment, illness, downturn in the economy, etc. In such cases, the creditor must take a flexible approach, and arrange for suitable alternatives for debt collection.

(ii) Creditor must never resort to collection methods which are illegal, or humiliating for the debtor, which infringe upon the right of the debtor to lead a life with honor

(iii) Creditor must not disclose the identity of the debtor

(iv) Creditor must not share the financial or other data related to the debtor with any third party, at least not without the consent of the debtor

(v) Creditor must not contact the debtor for unreasonable & unnecessary purposes, and the contact must be within the reasonable hours

(vi) Creditor must periodically convey information about the account of the debtor to him

(vii) Any query, by the debtor regarding his debt, must be satisfied by the creditor in an amicable and clear manner

(viii) Creditor must keep accurate, complete, and up to date records of all the payments made by the debtor, and also of all the correspondence & communication with the debtor

(ix) Creditor must, on the request of the debtor, provide him with the documents which he is entitled to have

Methods to Increase Credit Score

(i) Any amount which is due to be paid must be paid in time by the debtor. Overdue amounts are bad for credit scores.

(ii) Outstanding amount in credit cards, or cash credit accounts, or in any kind of revolving credit accounts must be kept within reasonable limits

(iii) Timing loan applications is important because each time one applies for a loan, an inquiry is made on the credit report of the applicant. Such an inquiry can lower the credit score in the short term, thus, only when credit is really needed it must be applied for.

(iv) Bill payments must be made regularly and promptly, because the past payment performance is considered a good predictor of the future performance by the lenders.

(v) Unused credit cards must not be closed down unless these cost the debtor in terms of annual fees, because these enhance the credit utilization rate.

Difference between Simple & Compound Interest

Interest is the cost of borrowing money. Simple Interest is calculated only on the principal amount which has been borrowed, whereas Compound Interest is calculated on the principal amount as well as the interest which is accumulated on that principal amount in each of the period.

Simple Interest is calculated using the formula:

SI = P * r * n

where;

P = Principal Amount

r = Annual Interest Rate

n = Term of loan, or, No. of Time Periods

Compound Interest is calculated using the formula:

CI = P * (1 + r)^t  - P

where;

P = Principal Amount

r = Annual Interest Rate

t = Term of loan

Annual Percentage Rate (APR)

APR is the percentage rate of interest which is charged for borrowing an amount, or which is earned through an investment.

APR can either be Nominal APR, which is the simple interest rate for the year; or it can be Effective APR, which represents the actual yearly cost of funds, and includes any fees or additional costs (like closing fee, origination fee, broker fee, insurance fee etc.) associated with the loan.

Annual Percentage Rate is calculated as:

APR = [(Fee + Interest)/Principal] * (365/n) * 100

Here,

n = No. of days in the term of the loan

Here, basically we are calculating that (Fee + Interest) is what percentage of the Principal Amount. This part is represented by [(Fee + Interest)/Principal] * 100.

Dividing it by n gives the daily rate, and then multiplying it by 365 gives the annualized rate.