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CHAPTER 5Consumer Credit

“Borrowing money is like wetting your bed in the middle of the night. At first all you feel is warmth and release. But very, very

quickly comes the awful, cold discomfort of reality.”– Elizabeth Gilbert

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What is Consumer Credit? Credit is an arrangement to receive cash, goods or

services now, and pay for them in the future Consumer credit is the use of credit for personal

needs (excludes home loans, home improvement loans and higher education loans) It is a major force in the American economy

There are three ways consumers can finance current purchases Take money from savings Use present earnings Borrow against future income

Trade-offs are involved in using credit

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Which Is It?

Does consumer credit increase or decrease your purchasing power?

A. Consumer credit increases your purchasing power

B. Consumer credit decreases your purchasing power

C. Consumer credit has no effect on your purchasing power

The correct answer is (B). Sounds like a test question, huh?

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The Cost of Credit The finance charge is the total dollar amount

you pay for the loan Includes interest and fees, such as service

charges or credit-related insurance The annual percentage rate (APR) is the

percentage cost of credit on a yearly basis The APR provides the true rate of interest for

comparison with other sources of credit This rate lets you compare “like with like” when

shopping for rates Mandated by the Truth in Lending Act

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Truth In Lending Act

The Truth In Lending Act requires creditors to provide you with accurate and complete credit costs, terms, and APR

Creditors must disclose credit terms and information... In a clear and conspicuous manner In a form you can keep

But often in a font you can not possibly read

And that is where they put all the information they do not want you to read such as what happens if you miss a single payment – Your interest rate goes up to 1000% and they come and take your house and your first born and you will be in debt to them for the rest of your life which will not be that long since you will work yourself to death trying to pay the interest but they do not care because they will have made enough money off you to buy one or maybe even two yachts and brand new gas bar-b-q and a trip around the world and …

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Calculating the Cost of Credit Simple interest

Computed on principal only and without compounding – The dollar cost of borrowing Interest = Principal x Rate x Time

Note: Time needs to be expressed in years Used for most installment loans (closed-end loans)

Average daily balance method Most credit cards use this method Uses a weighted average of the account balance

throughout the current billing period If you carried over a balance, new purchases will

be included in your average daily balance calculation So you do not get to take advantage of the “float”

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Calculating the Cost of Credit Adjusted balance method

New purchases are not taken into account and all payments are deducted from your previous balance before interest is added

This is the most favorable to credit card holders But – Surprise! – is the least common method

Previous balance method More costly than average balance method, less

costly than adjusted balance method Two cycle average daily balance method

The worst method for card holders Luckily, not very common

(continued)

http://www.asapcreditcard.com/articles/interest-calculation-methods.html

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Remember Our $299 Stereo? It cost us almost two times more than $299

because of the taxes What if we had purchased it with a credit card

and only paid the minimum payments? 19.9% APR 2.2% minimum

That is right – The Price Just Doubled Again! It will cost us twice as much if we purchase it on

credit and only make the minimum payments And since those are all after-tax dollars, the true

cost of the $299 stereo is almost $1,200

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When to Use Personal Credit?

Home PurchaseHigher Education or

Career-Related EducationHome Improvement

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When to Use Consumer Credit?

NEVER!Well, all right. In case of emergency…

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Try Our Easy Payment Plan!

100% Down!No Monthly Payments!

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Before you use credit for a major purchase, ask yourself some questions: Could I pay cash or make a down payment? Do I want to use savings for this purchase? Does purchase fit with my goals and budget? Could I use the credit I will need in some better

way? Can I postpone this purchase? What are the opportunity costs of postponing this

purchase? What are the dollar and psychological costs of

using credit for this purchase?

Credit Considerations

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Advantages of Consumer Credit

Current use of goods and services Permit purchase even when funds are low Convenient when shopping Safer than cash Can take advantage of float time May get rebates, airline miles or other

bonuses Demonstrates financial stability Use For Financial Emergencies

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Disadvantages of Consumer Credit

Purchases are more expensiveTemptation to overspendTies up future incomePossible financial difficultiesPotential loss of merchandise due

to late payment or non-payment (Unlikely in case of credit cards)

Gotta’ love this one!

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Types of Credit Closed-End Credit

For a specific purpose and amountMortgage loansAutomobile loans Installment loans

Open-End Credit – a.k.a. line of credit Used as needed until limit of credit is reached You pay interest and finance charges if you do

not pay the bill in full when due Revolving credit – prearranged loan Credit cards / Home equity loans

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Credit Cards Nearly eight out of ten American

households carry one or more credit cards One-third are convenience users

They pay their balance off in full each month Often to take advantage of points, miles, etc.

The other two-thirds are borrowers Co-branding – GM, Shell, etc.

Linking a credit card with a business offering rebates on products and services

“The bubonic plague of personal finance” – Jonathan Clements

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Credit Cards Debit Cards versus Credit Cards

They are not the same Laws and regulations differ

Credit Card Fraud $50 limit on credit card fraud

Debit Card Fraud $50 limit if reported within 2 days $500 limit if reported within 6 months Unlimited loss after 6 months!

Most banks and credit unions will waive the above limits

(continued)

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Credit CardsWhat is the Cost of Convenience?

“But aren’t credit cards a good way to save money? As long as you pay the total amount each month, you are essentially getting a free loan. Plus they are so convenient,” said Cathy. “Not so fast,” said Roy. “By taking advantage of the ‘float’ as it is called, you may save a few dollars a year. But the pennies you save each year are swamped by the hundreds or even thousands of dollars you spend because of the very same convenience you speak so highly of. How many times have you rationalized the purchase of items simply because you told yourself you wouldn’t have to pay for it until next month? And then when the bill came the next month, you ask yourself, ‘How did I spend $500!?’ The cost of that convenience is very high.”

(continued)

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True Confessions!

How Many Credit Cards Do You Have?A. Zero, zilch, nada, no way. Forget it.

They ain’t gettin’ their hooks in me!B. Only one! I swear it! I only use it to

buy gas.C. Okay. I have two. I use one to pay off

the other …D. More than two and I lost count a long

time ago. Plus I would not tell you even if I did know!

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True Confessions, Continued

And How Much Do You Owe?

A. Nothing! I am serious! I do not owe a cent!

B. Less than $1,000C. Between $1,000 and $5,000D. More than $5,000 (You can lie if you do

not want us to know…)

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Credit Cards

Use your credit card like a debit card If you can not pay off the balance at

the end of the month, Do Not Use It! If you find that you abuse your credit

card, Cut The Damned Thing Up!

Notice that I use the singular instead of the plural? Do not have more than one credit card!

There simply is not any valid reason to have more than one.(Well, actually, there might be one or two.)

(continued)

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Home Equity Loans Based on the current market value of your

home less the amount still owed on the mortgage (asset – liability = equity)

a.k.a. 2nd mortgage, 2nd trust deed, HELOC Will be much cheaper than a credit card Interest is normally tax-deductible (Schedule A) Danger! ¡Peligro!

Do not pay your credit cards and you can destroy your credit rating – bad, but not a big deal

Do not pay your home equity loan and you can lose your home – Big Deal!

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Home Equity Loans Example:

Home currently worth $200,000 Still owe $150,000 on the mortgage Home Equity = $50,000 ($200,000 – $150,000)

A reputable lender would let you borrow up to 75% or 80% or even maybe 90% of the current value of your home 80% of $200,000 = $160,000 $160,000 – $150,000 mortgage = $10,000 You would be eligible for a $10,000 home equity

line of credit

(continued)

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Home Equity LoansBut some unscrupulous lenders will let

you borrow more than the available equity in your home!

Have you heard or seen the ads?“Get a 125% Home Equity Loan!”“Consolidate your car loans and credit card bills into one easy monthly payment!”

(continued)

“Run up your credit card bills all over again!”“Lose your house to us when we foreclose!”

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Home Equity Loans Same example – 125% home equity loan:

Home currently worth $200,000 Still owe $150,000 on the mortgage Home Equity = $50,000 ($200,000 – $150,000) 125% of $200,000 = $250,000 $250,000 – $150,000 mortgage = $100,000 If you used over $50,000 of your available

credit – only ½ of your line of credit – you would owe more than the house is worth!

If you got into financial trouble, you would be tempted to simply walk away from your home

(continued)

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Inexpensive loans Parents and family members

Do Not Even Think About It! (Except for down payment on a home – more in chapter 7)

Loans based on assets, such as a savings acct A secured loan should have a lower interest rate

than an unsecured loan (all other things equal)

Medium-priced loans Commercial banks and credit unions

Expensive loans Retailers such as car or appliance dealers Credit cards and cash advances

Sources of Consumer Credit

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Secured Credit – Loans based on assets called “collateral” Auto Loans Home Loans

Unsecured Credit Credit cards Most all other forms of consumer credit

“Secured” vs “Unsecured” Credit

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An excellent way to begin building your credit is to obtain a “secured credit card” Deposit $500 in a savings account Receive a credit card with a limit of $500 Use the credit card …

Remembering to pay off the balance each month! Make sure the issuer reports your credit usage!

After a year or less, you will have built up enough of a credit history to get an “unsecured credit card” You can then close account & get your $500 back

A “Secured” Credit Card

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Measuring Your Credit Capacity

Before you take out a loan, ask yourself... Can you afford the loan? What do you plan to give up in order to make

the payments? Look closely at your…

Debt Payments-to-Income Ratio and Debt-to-Equity Ratio

Or better yet, “Make Love, Not Loans!”

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Credit Capacity Indicators

*Not including housing

Debt Payments-to-Income Ratio

monthly payments*

monthly after tax income

Da’ Book sez, “Should be less than 20%.” I think that is obscenely high!

31 Example: Debt Payments-to-Income Ratio (page 149)

Monthly Gross Income $1,500

Less:

All Taxes 270

Social Security / Medicare 112

Monthly IRA Contribution 50

Monthly Net Income $1,068

Monthly Installment Debt Payments

Squeezya $25

MonsterCard 20

Disaster Card 15

Auto Loan 153

Total Monthly Debt Payments $213

Debt Payments-to-Income Ratio ($213 / $1,068) 19.94%

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Credit Capacity Indicators

Debt-to-Equity Ratio

total liabilities*

net worth= Should be < 100%

*Excluding home valueand mortgage

Again, this is far too high!Businesses try to keep it

down to between 30% and 50%

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Example: Debt-to-Equity Ratio

Assets (a.k.a. Equity, excluding value of home)

Automobile $8,000

Furniture 1,200

Computer 400

Miscellaneous 2,400

Total Assets (a.k.a. Equity, excluding home) $12,000

Liabilities (a.k.a. Debts, excluding home mortgage)

Auto Loan $6,500

MonsterCard 4,300

Disaster Card 1,400

American Excuse 800

Total Liabilities (a.k.a. Debts, excluding home) $13,000

Debt-to-Equity Ratio ($13,000 / $12,000) 108.3%

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“Would You Co-sign For Me?” Before co-signing a loan consider...

If the person does not pay, you will have to Can you afford to pay if the person does not? It will affect your credit report as well as theirs Request that a copy of overdue payment notices

be sent to you

Surprise – Three out of four co-signers end up paying!

The correct answer, by the way, to the above question is “No.”

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Your Credit Report Credit bureaus collect information

Experian, Trans Union, and Equifax 888-567-8688 / 888-5OPT-OUT

“Get me off your mailing list!” Number of mix-ups and errors in credit reports

have declined recently but it is still very high Bureaus get information from banks, finance and

credit card companies, merchants, and others Each year, you can get a free credit report from

each of the three major credit bureaus Use the “Central Source” to get all three at once http://www.annualcreditreport.com 877-FACT-ACT (877-322-8228)

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Your “FICO” Credit Score Your credit score is generated by a company

called Fair Isaac Corporation using the data from Experian, Trans Union, and Equifax

FICO scores range from upper-300’s to mid-800’s

Generally, anything over 700 is excellent Computer will automatically approve you

At around 600, your credit application is supposed to be manually reviewed Does not always happen (more later)

Mid-500’s or lower, you are considered a high risk

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Your “FICO” Credit Score What makes up your FICO score?

Past payment history (35%) Amounts owed (30%)

Are you “maxed out?” Rule of thumb: Never pass 75% of your credit

capacity Length of credit history (15%) Amount of new credit (10%)

Can be a “red flag” if you open too many accounts in a short period of time

Types of credit (10%) No more “Authorized User”

(continued)

Psst! Do not tell anyone about this info on this

slide. It is a secret!

http://finance.yahoo.com/news/pf_article_109347.html

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Fair Credit Reporting Act Is your credit report accurate? You can get a free copy of your report if you are

denied credit In addition to the free annual copy of your credit

report from each of the three credit bureaus Inaccurate information must be corrected within

30 days Only authorized persons have access to your

report Ha! Ha! Ha! Ha! Ha! This is a good one! Anyone can access your credit report!

Adverse data can be reported for seven years and bankruptcy for ten years

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Protect yourself by shredding old credit slips, account statements, and credit offers you receive in the mail Shredders are cheap; get a decent one

Spend about $30 to $50 You may not know your identity has been

stolen until you receive a bill with charges that are not yours Over 23 million thefts in 2013, $1,070 per victim!

That is $24.7 billion – www.IdTheftCenter.org

Identity Theft

Finding good statistics on identity theft is not easy. Anyone want to validate my numbers?

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Take three actions once you know Contact the fraud departments of each of the three

major credit bureaus Contact the creditors for any accounts that have

been tampered with or opened illegally File a police report

Identity Theft Resource Center http://www.idtheftcenter.org/

Identity Theft(continued)

Why should you bother filing a police report?

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Sources of identity theft 30% – Security breaches at businesses 30% – Consumer’s lost and stolen wallets,

checkbooks, etc. 15% – “Friends” and family members 9% – Stolen mail 9% – Attacks and scams targeting home computers

Credit protection businesses $10 - $30 per month to protect & insure your

identity Virtually all of the services can be done by you for

free

Identity Theft(continued)

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Freezing your credit Blocks new lines of credit being open Free in California if you have been already targeted Otherwise, $10 per credit bureau (3 x $10 = $30)

Fraud alerts A fraud alert notifies lenders that you have or you

believe you have been targeted (no charge) Time limit – 90 days up to 7 years

Other innovative protection methods Counter-intelligence! Analyzing transaction data

Identity Theft(continued)

Many companies will do some or all of these services for a fee.

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An entire industry is springing up TrustedID – specializes in credit freezes ($15/mo) LifeLock – specializes in fraud alerts ($10/mo)

Now have LifeLock Ultimate! (only $25/mo!) IdentifySecure –$17.99/month

Now with Registered Sex Offender Tracker! IdentitySweep – $14.95/mo

Now have IdentitySweep 360-Plus! (only $30/mo!) IdentityForce – $17.95/month MyPublicInfo – $69.95/year

Identity Theft(continued)

Hmm. Paying for protection. Makes you feel as though you are dealing with organized crime!

http://www.consumerreports.org/cro/2012/02/debunking-the-hype-over-id-theft/index.htm

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What Creditors Look For: 5 C’s

Character – Do you pay bills on time? Capacity – Can you repay the loan? Capital – What are your assets and net worth? Collateral – What do you have of value that the

lender can take if you do not repay? Conditions – What economic conditions could

affect your repayment of the loan?

Discussion: Who gets credit? Who doesn’t?

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What If You Are Denied Credit? Ask the creditor to clarify the specific reason for

denial of credit Check your credit report file (It is free, remember?) Apply to another creditor with different

standards Take steps to improve your creditworthiness You have the right to provide a 100-word

explanation in your file For example, you could explain if you were out of

work due to an extended illness and were therefore late paying bills for a time

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What If You Are Denied Credit? The majority of credit applications are now

electronically pre-screened If your FICO score is below approximately 600, the

application is supposed to be reviewed by a human In practice, the credit company often simply

rejects the application entirely Or automatically sends the application to their “sub-

prime” department Unfortunately, one account in default can put

your score in the low-500’s The moral? Check your credit files before you

apply for credit. Get rid of erroneous data.

(continued)

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What If You Are Denied Credit?

Do Not Fall For…

“We Will Repair Your Credit –

100% Satisfaction Guaranteed!”

(continued)

Anything legitimate that these people can do for you, you can do for yourself for free!

Anything illegitimate they suggest is either illegal or simply will not work

Let’s look at some credit card applications…

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How Long Will It Take?

How long can adverse credit data (late payments, charge offs, etc.) be reported on your credit report?

A.3 years

B.5 years

C.7 years

D.10 years

The correct answer is (C).

Once Again,

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How Long Will It Take?

How long can a bankruptcy be reported on your credit report?

A.3 years

B.5 years

C.7 years

D.10 years

The correct answer is (D). Now, do not forget these two numbers, 7 & 10.

Once Again,

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Avoiding & Correcting Credit Mistakes

Notify creditor of error in writing within 60 days Send it to the correct address They must respond within 30 days Credit card company has 90 days to resolve

the problem or tell you why they think the bill is correct

Will not affect your credit rating while in dispute You can withhold payment on shoddy goods if

you have paid for them with a credit card

Fair Credit Billing Act

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What’s the Significance?

7years

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And This One?

10

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First try to solve the problem directly with the creditor

If that does not work, there are more formal complaint procedures

There are a variety of consumer credit protection laws and federal agencies who administer and assist with complaint procedures

www.ftc.gov/credit

Complaining about Consumer Credit

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Equal Credit Opportunity Act

You know what this one is supposed to do “Some of us are more equal than others” Don’t Give Up! Never Give Up!

Someone out there wants to lend to you!

And after you have established yourself as a good credit risk, the others will come calling…

You can then tell ‘em to “Kiss Off!”

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Notify creditors if you can not make a payment

Debt collection practices require… If a debt collector calls you, within five days

they must send you a written notice of amount owed

You can dispute the debt The debt collector has 30 days to verify the

debt Send the collector a letter stating that all further

contact should be via the U. S. Postal Service

Managing Your Debts

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Statute of Limitations Every state has a statute of limitations on how long

a person can be sued for debt In California, the statute of limitations is 4 years

Note: The debt is not erased The collector simply can not sue you in court for the debt

However, debt collectors will still try It is up to you to tell the court that the statute of limitations

has passed – The debt becomes “time-barred” If you pay any part of the debt, no matter how small,

or acknowledge that the debt is yours, The statute of limitations clock can start all over again

This has nothing to do with credit reporting And the 7-year adverse data and 10-year bankruptcy times

http://www.creditcards.com/credit-card-news/credit-card-state-statute-limitations-1282.php

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Fair Debt Collection Practices Act

Can not be abusive or threaten Can not call you at work if you say not to Can not tell boss and friends Can not call you at odd hours Must follow set procedures The act does not apply to creditors that try

and collect the debt themselves

Collection agencies...

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Consumer Credit Counseling Service

One option for those in credit trouble is to seek help from a non-profit credit counseling service National Foundation for Consumer Credit, Consumer Credit Counseling Service, American Debt Counseling, etc.

Credit card companies pay for their operationProvide education about creditProvide help with spending planProvide debt counseling services for those with

serious financial problems

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Warning Signs of Debt Problems

Paying only the minimum balance each month Increasing the total balance due each month Missing or alternating payments or paying late Getting second or third payment notices Borrowing money to pay debt payments Not knowing how much you owe Going over your credit limit on credit cards Not talking to your partner about money

Or talking only to your partner about money

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Declaring Personal Bankruptcy Bankruptcy was designed as a last resort but

has become an “acceptable” tool of credit management Many (especially the credit card companies)

complained that bankruptcy was being abused They pushed through legislation in 2005 that

made it harder to declare bankruptcy The resulting backlash led to some of the recent

consumer-friendly changes in the industry

“Bankruptcy is a legal proceeding in which you put your money in your pants pocket and give your coat to your creditors” –

Joey Adams

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Bankruptcy: The Last Resort

Chapter 13 Plan to pay a portion of your debt Trustee distributes money to your creditors Can keep most of your property Must have a regular income

Chapter 7 Submit a petition and pay the fee yourself, or … Lawyers charge >$500, including court costs Can keep some property Idea is a “fresh start”

But the person may still wind up being hounded by debt collectors anyway!

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After Bankruptcy You No Longer Owe...

Retail store charges Bank credit card charges Unsecured loans Unpaid hospital or physician bills

After Bankruptcy You May Still Owe... Taxes & fines Child support & Alimony College loans & Co-signer obligations Debts arising from illegal activities (ex: DUIs)

63 Bankruptcy:Should You Consult a Lawyer?

Only if you believe it is okay not to consult a doctor and instead decide to take out your appendix by yourself

Find a good lawyer, by the way.

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“Uh, Oh!”On your tenth wedding anniversary, you splurge on

a $5,000 second honeymoon, which you charge to your credit card. With an interest rate of 15.9%, how long will it take you to pay back the debt if you make only the 2.2% minimum payment each month?

A.13 years

B.19 years

C.28 years

D.It will be paid off out of your estate when you die

The correct answer is (C).

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“Uh, Oh!”And how much of a finance charge will you

pay in those 28 years?

A.$2,976

B.$4,820

C.$7,129

D.$15,281

The correct answer is (C).

(continued)

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“Uh, Oh!”Under the new law, the

credit card companies now must disclose how long it

will take you pay the balance and how much you will

actually pay if you only make the minimum payments. The hope is that people who have

not taken BUS-121 will be motivated to pay off their balance quicker. But, of course, all of you already

knew this, right?(Nod your heads, “Yes.”

Thank you very much.)

(continued)

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The Bottom Line on Credit

Make Love, Not Loan$!

“All the perplexities, confusion and distress in America arise not from the defects of the Constitution, not from want of honor or virtue, so much as from downright ignorance of the nature of coin, credit and

circulation.” – John Adams, from a letter to Thomas Jefferson in 1787