Consumer Credit: Advantages, Disadvantages, Sources, and Costs

Chapter 5

What is Consumer Credit?

Credit: an arrangement to receive cash, goods, or services now and pay for them in the future

Consumer Credit: the use of credit for personal needs (except a home mortgage) by individuals and families

The Importance of Consumer Credit in Our Economy

Consumer credit dates back to colonial times Privilege for the affluent Farmers came to use credit extensively Finance charges were not imposed

Cost of credit added to price of goods Installment credit: debt paid in equal installments

over a specified period of time Exploded with the invention of the automobile in the

early 1900s Credit is a driving force in the U.S. economy

Uses and Misuses of Credit May allow consumers to be more efficient or more

productive Increases the amount of money a person has to spend on

goods and services Questions to ask before making a major purchase:

Do I have the cash I need for the down payment? Do I want to use my savings for this purchase? Does the purchase fit my budget? Could I use the credit I need for this purchase in some

better way? Could I postpone the purchase? What are the opportunity costs of the purchase? What are the dollar costs and psychological costs of using

credit?

Advantages of CreditAllows people to enjoy goods and services

now and pay for them through a payment plan based on future income

Permit purchases even when funds are lowSafe—don’t have to carry a lot of cashConvenient—make hotel reservation, rent a

car, shop by phone or InternetProvides a 50 day “float” before payment is

requiredOffer rewards and privileges

Disadvantages of Credit

Temptation to overspendCan lead to long-term financial problems, loss

of income, court action, and bankruptcyDoes not increase purchasing power—ties up

future incomeCosts money—monthly finance charges can

add up

Types of Credit

Closed-End Credit Pay back one-time loans in a specified period of

time and in payments of equal amounts Used for a specific purpose and involves a

specified amount Mortgage loans, automobile loans, installment loans

Three common types: Installment sales credit Installment cash credit Single lump-sum credit

Types of Credit

Closed-End Credit Installment Sales Credit

Loan that allows you to receive merchandise, usually high priced items (appliances, furniture)

You make a down payment and sign a contract to repay the balance plus interest and service charges

Equal installments over a specified time period

Types of Credit

Closed-End Credit Installment Cash Credit

Direct loan of money for personal purposes, home improvements, or vacations

You make no down payment and make payments in specified amounts over a set period

Single Lump-Sum Credit Loan that must be repaid in total on a specified day,

usually within 30-90 days Generally used to purchase a single item

Types of Credit Open-End Credit

Using a credit card issued by a department store, using a bank credit card

30 day grace period before finance charges or interest are charged

Used to make purchases whenever you wish Line of credit—maximum dollar amount of credit the

lender has made available to you Revolving line of credit—prearranged loan for a

specified dollar amount that you can use by writing a special check

Repayment is made in installments over a set period Finance charges are based on the amount of credit used and

the outstanding balance

Sources of Consumer CreditCredit Source Type of Loan

Commercial Banks Single-payment loanpersonal installment loans

passbook loans check-credit loans

credit cards second mortgages

Consumer Finance Companies Personal installment loanssecond mortgages

Credit Unions Personal installment loansshare-draft credit plans

second mortgages

Life Insurance Companies Single-payment or partial payment loans

Federal Savings Banks (Savings and Loan) Personal installment loansHome improvement loans

Education loansSavings account loans

Second mortgages

Credit Cards

The average cardholder has more than nine credit cards, including: Bank Retail Gasoline Telephone

Convenience User—pays balance in full each month Borrower—does not pay balance in full each month

Credit Cards

Cost of credit depends on type of card you have and the terms set forth by the lender You may have to pay interest or other finance

charges Some companies charge annual fees of $20-$25 Be sure to shop around for the best deal

Other Types of PlasticDebit Cards

Electronically subtracts money directly from your savings or checking account

Smart Cards Equipped with a computer chip that can store 500

times as much data as a normal credit card Combine credit card balances, driver’s license,

health care identification, medical history all in one place

Travel and Entertainment Cards Balance is due in full each month American Express, Diner’s Club

Can You Afford a Loan?Make an accurate and sensible budgetCan you meet all of your expenses and still

afford a monthly loan payment?General Rules of Credit Capacity

Debt Payments-to-Income Ratio Divide monthly debt payments by net monthly income Should be no more than 20% of net income 15% or less is optimal

Debt-to-Equity Ratio Divide total liabilities by net worth Do not include value of home

The Five C’s of CreditCharacter

Will you repay the loan?Capacity

Can you repay the loan?Capital

What are your assets and net worth?Collateral

What if you don’t repay the loan?Conditions

What if your job is insecure?

Other Factors Considered in Determining Creditworthiness

Age If you are old enough to sign a legal contract Cannot be denied a loan because of age

Public Assistance Cannot be denied a loan because you receive

public assistance or social securityHousing Loans

Bans discrimination against you based on the race or nationality of the people in the neighborhood where you live or want to buy your home

Your Credit ReportWhen you apply for a loan, the lender will

review your credit history (credit report, credit file)

Credit Bureau Agency that collects information on how promptly

people and businesses pay their bills Three major credit bureaus:

Experian Trans Union Equifax

Maintain more than 200 million credit files on individuals that they receive from lenders

Your Credit Report What’s in your credit files?

Your employer, position, income Previous address Previous employer Spouse’s name, social security number, employer,

income Whether you rent or own your home Checks returned for insufficient funds Detailed credit information

Account number, date, amount, terms, type of credit for each loan you take out

Updated regularly to show how many payments you’ve made, how many payments were late or missing, and how much you owe

Your Credit Report Fair Credit Reporting

1971 Fair Credit Reporting Act Regulates use of credit reports Requires deletion of out-of-date information Gives individuals access to files as well as ability to change

misinformation Places limits on who can access your credit report

Who Can Obtain a Credit Report? Properly identified persons with approved requests Supplied in response to a court order or at your request Provided for use in connection with a credit

transaction, underwriting of insurance, some legitimate business need

Your Credit ReportTime Limits on Unfavorable Data

May be reported for only seven years Up to 10 years if you have declared personal

bankruptcy Incorrect Information in Your Credit File

Contact bureau to dispute information Credit bureau must check its records and change or

remove incorrect itemsWhat are Your Legal Rights?

Sue a credit bureau or creditor that has caused you harm by not following the rules established by the Fair Credit Reporting Act

The Cost of Credit

Finance Charge and Annual Percentage Rate Finance charge: the total dollar amount you pay

to use credit Includes interest costs and sometimes other costs such

as service charges, credit-related insurance premiums, or appraisal fees

Annual Percentage Rate (APR): percentage cost of credit on a yearly basis

Key to comparing costs, regardless of the amount of credit or how much time you have to repay it

The Cost of Credit

Tackling the Trade-Offs Term versus Interest Cost

Many people choose longer term financing because they want smaller payments

The longer the term of the loan, the greater the amount you must pay in interest charges

Size of down payment makes a difference

The Cost of Credit

Tackling the Trade-Offs Lender Risk versus Interest Rate

Minimize borrowing costs by accepting conditions that reduce the lender’s risk:

`variable interest rate—based on fluctuating rates in the banking industry

Secured loan—pledge property or another asset as collateral Up-front cash—pay cash for a large portion of what you are

financing Shorter term—shorter period of time to repay what you owe

Calculating the Cost of Credit The most common method of calculating interest

is the simple interest formula Simple Interest: interest is computed only on the

principal (the amount you borrow) Based on three factors:

Principal Interest Time

Simple Interest on the Declining Balance: when simple interest is paid back in more than one payment, the method of computing interest is known as the declining balance method

The more payments you make, the lower the interest you will pay

Calculating the Cost of Credit

Add-On Interest Interest is calculated on the full amount of the

original principal, no matter how frequently you make payments

Also known as compound interest The longer you take to repay the loan the more

interest you will pay

Calculating the Cost of Credit

Cost of Open-End Credit Truth in Lending Act

Requires that open-end creditors inform consumers as to how the finance charge and APR will affect their cost

Must explain how finance charges are calculated Must inform you when finance charges on your credit

account begin to accrue, so that you know how much time you have to pay your bills before the finance charge is added

Calculating the Cost of Credit

Cost of Credit and Expected Inflation Inflation reduces buying power of money Each percentage point increase in inflation means

a decrease of about 1% in the quantity of goods and services you can buy with the same amount of money

Lenders incorporate the expected rate of inflation when deciding how much interest to charge

Calculating the Cost of Credit

Avoid the Minimum Monthly Payment Trap Minimum monthly payment is the smallest

amount you can pay and remain in good standing Lenders encourage you to pay the minimum so

that you take longer to pay off your debt The longer it takes to pay off a bill, the more

interest you pay Finance charges could be more than the item was

worth

Protecting Your CreditBilling Errors and Disputes

Fair Credit Billing Act (FCBA) 1975 Sets procedures for promptly correcting billing

mistakes, refusing to make credit card or revolving credit payments on defective goods, and promptly crediting your payments

Protecting your credit rating According to the law, a creditor may not threaten your credit

rating or do anything to damage your credit reputation while you’re negotiating a credit dispute

Defective goods and services You may tell your credit card company to stop payment on

goods and services if you have tried to return defective goods and the store has not accepted the return

Identity Crisis: What to do if Your Identity is Stolen

1. Contact the Credit Bureau2. Contact the Creditors3. File a Police Report Key Websites for Identity Theftwww.consumer.gov/idtheft/indexwww.econsumer.equifax.com

Protecting Your Credit From Theft or Loss

Tear or shred any papers that contain personal information before throwing them out

Close bank accounts immediately Stop payment on checks Cancel debit card and get a new one with a new

PIN number Protecting credit cards:

Be sure cards are returned after a purchase Keep a record of your credit card number Notify the credit card company immediately if your card

is lost or stolen

Protecting Your Credit Information on the Internet

Use a secure browserKeep records of your online transactionsReview monthly bank and credit card

statementsRead the privacy and security policies of the

Web site you visitKeep your personal information privateNever give your password to anyone onlineDon’t download files sent to you by strangers

Cosigning a Loan Cosigning means that you agree to be responsible for

loan payments if the other party fails to make them If you cosign a loan and the borrower does not pay

the debt, you may have to pay up to the full amount of the debt as well as any late fees or collection costs

The creditor can collect the debt from you without first trying to collect it from the borrower

The creditor can use the same collection methods against you that can be used against the borrower

If the debt is not repaid, that fact will appear on your credit report

Complaining About Consumer CreditConsumer Credit Protection Laws

Truth in Lending and Consumer Leasing Acts If a lender does not disclose information as required,

you can sue for any money loss you suffer Equal Credit Opportunity Act

If you can prove that a creditor has discriminated against you, you can sue for actual damages as well as punitive damages, up to $10,000

Fair Credit Billing Act If a creditor fails to follow the rules that apply to

correcting any billing errors, they will be required to give up the amount owed on the item in question as well as any finance charges on it, up to $50

Complaining About Consumer Credit

Consumer Credit Laws Fair Credit Reporting Act

You may sue any credit bureau or creditor that violates the rules regarding access to your credit records, or that fails to correct errors in your credit file

Consumer Credit Reporting Reform Act Places the burden of proof for accurate credit reporting

on the credit bureau rather than you Under this law, the credit bureau must prove that

disputed information is accurate

Your Rights under Consumer Credit Laws

Complain to the creditor Let them know that you are aware of the law

File a complaint with the government Report violations to the appropriate agency

If all else fails, sue the creditor If you win, you can receive actual damages and

punitive damages up to $10,000

Warning Signs of Debt Problems You’re making only the minimum monthly payment on

credit cards You’re having trouble making minimum monthly

payments on credit cards Your total balance on credit cards increases every month You miss loan payments or are often late You use savings to pay for necessities You borrow money to pay off old debts You receive second and third payment due notices from

creditors You exceed credit limits on your credit cards You’ve been denied credit because of a bad credit report

Debt Collection Practices

The Federal Trade Commission enforces the Fair Debt Collection Practices Act Prohibits certain practices by debt collectors Does not eliminate legitimate debts, but it does

control the ways in which debt collection agencies may do business

Financial Counseling Services Consumer Credit Counseling Services

Consumer Credit Counseling Service (CCCS) is a nonprofit organization affiliated with the National Foundation for Consumer Credit (NFCC)

Local branches provide debt counseling for families and individuals with serious financial problems

Counseling is usually free When the organization supervises debt repayment, there is usually

a small charge to cover administrative costs Assist people in managing debt better and set up a realistic

budget Help people prevent indebtedness by teaching them about

budget planning, educating them about pitfalls of unwise credit buying, and encourage credit institutions to withhold credit from people who cannot afford it

Financial Counseling Services

Other Counseling Services Universities Credit unions Military bases State and Federal housing authoritiesSometimes provide nonprofit credit counseling

servicesUsually charge little or nothing for assistance

Declaring Personal Bankruptcy U.S. Bankruptcy Act of 1978

Chapter 7 Bankruptcy An individual is required to draw up a petition listing his or

her assets and liabilities Straight bankruptcy in which many, but not all, debts are

forgiven Most of debtor’s assets are sold to pay off creditors Protected assets: Social Security payments,

unemployment compensation, net value of your home, vehicle, household goods and appliances, tools used in work, and books

Does not affect alimony, child support, certain taxes, fines, certain debts arising from education loans, or debts you fail to disclose properly

Does not affect debts arising from fraud, DWI, or certain other crimes

Declaring Personal Bankruptcy

U.S. Bankruptcy Act of 1978 Chapter 13 Bankruptcy

A debtor with a regular income proposes a plan for using future earnings or assets to eliminate his or her debts over a period of time

The debtor normally keeps all or most of his or her property

During the time when the plan is in effect (can be as long as 5 years), the debtor makes regular payments to a Chapter 13 trustee, or representative, who then distributes the money to the creditors

Declaring Personal Bankruptcy

Effects of Bankruptcy People have varying experiences in obtaining

credit after bankruptcy Obtaining credit may be easier for people who file

Chapter 13 and repay some of their debts than those who file Chapter 7 and make no effort to repay debt

Cannot fine another bankruptcy case for some time