Consumer Credit

Chapter 5

Objectives

Analyze advantages and disadvantages of using consumer credit.

Assess the types of sources of consumer credit. Determine whether you can afford a loan and how to

apply for credit. Determine the costs of credit by calculating interest

using various interest formulas. Develop a plan to protect your credit and manage

your debts.

Lesson 1

What is consumer credit?

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, except a home mortgage, by individuals and families.

Three ways consumers can finance purchases.– Draw on their savings.– Use present earnings.– Borrow against expected future income.

Trade-offs with each alternative. Consumer credit: Major economic force.

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Use and Misuse of Credit

Before you use credit for a major purchase, ask yourself some questions.– Do I have the cash for the down payment? – Do I want to use my savings for this purchase?– Does this purchase fit my budget?– Could I use the credit I’ll 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?

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Advantages of Credit

Current use of goods and services. Permits purchase even when funds are low. A cushion for financial emergencies. Advance notice of sales. Easier to return merchandise. Convenient when shopping. One monthly payment. Safer than cash. 6-4

Advantages of Credit

Needed for hotel, car reservations and shopping online.

To take advantage of float time/grace period.

May get rebates, airline miles, or other bonuses.

Indicates financial stability.

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(continued)

Disadvantages of Consumer Credit

Temptation to overspend. Can create long-term financial problems, slow

progress toward financial goals. Potential loss of merchandise

due to late or non-payment. Ties up future income. Credit costs money - more costly than paying with

cash.

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Lesson 2

Types of Credit

Types of Credit

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Closed-End Credit.– One-time loans for a specific purpose that you pay back

in a specified period of time, and in payments of equal amounts.

Mortgage, automobile, and installment loans for furniture, appliances and electronics.

Open-End Credit.– Use as needed until reaching line of credit max.

Credit cards, departments store cards, bank credit cards, incidental credit.

– You pay interest and finance charges if you do not pay the bill in full when due.

Lesson 3

Sources of Credit

Sources of Consumer Credit-See Exhibit 5-3

Inexpensive loans.– Parents or family members.– Loans based on assets- using CD as collateral.

Medium-priced loans.– Commercial banks, savings and loan associations, and

credit unions.

Expensive loans.– Finance and check cashing companies .– Retailers such as car or appliance dealers.– Bank credit cards and cash advances.

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Credit Cards

Eight out of ten U.S. households carry one or more credit cards.

One-third are convenience users- pay balances in full each month.

Two-thirds are borrowers, carrying a balance over, paying finance charges.

Some use cards for cash advances - expensive. Co-branding - linking a credit card with a business offering

rebates on products and services. Smart cards have an imbedded computer chip. Debit cards: similar impact as writing a check.

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Choosing and Using a Credit Card

Paying in full each month: cards with no annual fees. Revolving credit: Select a card with a low interest rate,

& a fair method for computing interest. Interest paid on consumer credit is not tax deductible,

and is related to the inflation rate. Avoid the minimum monthly payment trap. Early repayment: The Rule of 78s-favors lenders. Credit insurance: Loan paid off if insured dies or

becomes disabled--Expensive.

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Lesson 4

Applying for Credit

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

payment?

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General Rules of Credit Capacity

*Not including house payment which is a long-term liability

Debt Payments-to-Income Ratio

monthly payments*

net monthly income

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Consumer credit payments should not exceed a max of 20% of your net income.

General Rules of Credit Capacity

Debt To Equity Ratio

total liabilities

net worth*= Should be < 1

*Excluding home value6-14

(Continued)

What Creditors Look For: 5 Cs

Character - Do you pay bills on time? Capacity - Can you repay the loan? Capital - What are your assets

and net worth? Collateral - What property do you have to

pledge that the lender can repossess if you default on the loan?

Conditions - What economic conditions could affect your ability to repay the loan? 6-20

What If You are Denied Credit? Exhibit 5-6

Check your credit file at the credit bureau. If you believe reasons for denial are invalid: file

suit &/or notify federal enforcement agency. Ask the creditor to clarify reason for denial. If you

believe the denial is valid:– 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.

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Build and Maintain Your Credit Rating

Limit your borrowing to your capacity to repay. Live up to the terms of contracts. Check to see what is in your credit report.

– Credit bureaus collect information.– Experian, Trans Union and Equifax.– FTC gets about 12,000 complaints about credit

bureaus each year.– Bureaus get information from banks, finance

companies, credit card companies, merchants, other creditors.

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Lesson 5

The Costs of Credit

The Cost of Credit

Finance charge is the total dollar amount you pay to use credit. It includes interest costs, service charges, credit-related insurance premiums, or appraisal fees.

The annual percentage rate (APR) is the percentage cost of credit on a yearly basis.

APR: True rate of interest so you can compare rates with other sources of credit.

It is important to shop for credit.7-3

Example 1: Calculating Annual Percentage Rate (APR)

P= Principal borrowed, $100 n= number of payments in one year, 1 I= Dollar costs of credit, $8 APR 2 X n X I

P(n+1) APR 2 X 1X $8 $16 .08 or 8%

$100(1 + 1) $200

=

= ==

Example 2 : Calculating Annual Percentage Rate (APR)

APR 2 X n X I

P(n+1)

For 12 equal monthly payments

APR 2 X 12 X $8 $192 .1476 or $100(12 + 1) $1,300 14.76%

= = =

=

Trade-Offs of Financing Choices

Term: Longer loans-lower payments, but more total interest .

Lender risk versus interest rate. Some ways to reduce the lender’s risk and the interest rate:– Accept a variable interest rate.– Provide collateral to secure the loan.– Make a large down payment up front.– Have a shorter loan term.

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Calculating the Cost of Credit

Simple interest.– Computed on principal only and without compounding. The

dollar cost of borrowing.– I = P x R x T

Simple interest on a declining balance.– Interest is paid only on the amount of original principal not yet

repaid. Add-on interest.

– Interest is calculated on the full amount of the original principal, added to the principal, and the total of both is divided by the number of payments to be made.

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Cost of Open-End Credit

Adjusted balance method.– Finance charges are calculated after payments made in

the billing period have been subtracted. Average daily balance method.

– Creditors 1) add your balances for each day in the billing period, then 2) divide this total by the number of days in the billing period, then 3) multiply this average by the monthly interest rate. New purchases may be excluded from the average daily balance calculation, but generally are included if you carry over a balance.

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Cost of Open-End Credit

Two-cycle average daily balance method.– May include or exclude new purchases.– Creditors use average daily balance for two

consecutive billing cycles. Previous balance method.

– Method of computing finance charges that gives no credit for payments made during the billing period. For example...

APR 18%; Monthly rate 11/2%. Previous balance $400; Payments $300 Finance charge $6.00 (11/2% x $400)

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(continued)

Lesson 6

Protecting Your Credit

What if Your Identity is Stolen?

Contact the fraud department of each of the three major credit bureaus; tell them to flag your file with a fraud alert, including a statement that creditors should call you for permission before opening any new accounts in your name.

Contact creditors to check for accounts that have been tampered with or opened fraudulently.

File a police report, keep a copy. Check www.privacyrights.org or call 619-298-3396

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How to Protect Yourself From Identity Theft

Provide SSN only when necessary. Remove your name from junk mail,

telemarketing lists. Protect yourself by shredding old credit slips,

account statements, and credit offers you receive in the mail.

Stop preapproved credit card offers by calling 1-888-567-8688.

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Protecting Yourself Against Credit Card Fraud

Sign new cards when they arrive. Treat cards like money - keep them secure. Shred anything with your account number on it. Don’t give your number over the phone unless you initiate the

call, and don’t put it on postcards. Get card & receipt after every transaction: compare receipts

to bills when they arrive, checking for errors. Notify the card issuer if you don’t get your billing statement,

or if your card is lost or stolen. – If stolen call 1-888-EXPERIAN.

Check credit report.

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When You Make Purchases Online

Use a secure browser. Keep records of online transactions. Review monthly statements-can do so online. Read policies of the websites you visit concerning

refunds, site security, and privacy. Keep personal information private unless you know

who is gathering it and why. Shop at businesses you know and trust. Never give out your password to anyone online. Don’t download files sent by strangers.

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Cosigning a Loan

The creditor will give you a notice that tells you…– You are being asked to guarantee the debt, so

consider if you can afford it if the borrower defaults.– If the borrow does not pay you may have to pay up to

the full amount and also any late or collection fees.– If a payment is missed the creditor can collect the

debt from you without first trying to get it from the borrower.

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Cosigning a Loan

If you do cosign, consider...– Can you afford to pay the loan? If not, your

credit rating could be damaged.– Liability for this debt may prevent you from

getting other credit that you want.– If you put up collateral, you could lose it if the

loan goes into default.– Check your state’s law to learn about cosigner’s

rights.– Request that a copy of overdue payment

notices be sent to you. 6-16

(continued)

Lesson 7

Complaining About Consumer Credit

Complaining About Consumer Credit

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. See the Exhibit 6-11 “Summary of Federal Consumer Credit Laws” in your text.

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Alternative Counseling Services

Universities, local county extension agents, credit unions, military bases, and state and federal housing authorities provide nonprofit counseling services.

You can check with your financial institution or consumer protection office to see if it has a listing of reputable, low-cost financial counseling services. Avoid those with large fees.

www.consumercredit.com is the website of the nonprofit American Consumer Credit Counseling.

Bankruptcy-Last resort.

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Fair Credit Reporting Act

Is your credit report accurate? If denied credit based on your report, you can get a

free copy of your credit report w/i 60 days of your request.

Credit card companies must correct inaccurate or incomplete information.

Only authorized persons have access to your report. Adverse data can be reported for seven years;

bankruptcy for ten years.

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Avoiding and Correcting Credit Mistakes

Notify creditor of error in writing within 60 days. Include your explanation of the error and your

account number to the billing inquiries address. They must respond within 30 days. Credit card company has two billing periods but no

longer than 90 days to correct your account or tell you why they think the bill is correct.

Your credit rating is not affected while item is in dispute.

Fair Credit Billing Act

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Avoiding and Correcting Credit Mistakes

You can withhold payment on damaged or shoddy goods or poor services if you have paid for them with a credit card, if you make a sincere attempt to resolve the problem with your creditor.

Fair Credit Billing Act (continued)

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Truth In Lending Rights

Provides specific cost disclosure requirements for the APR and total finance charges. Regulates disclosure of other terms and conditions. Regulates advertising of credit terms.

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

Fair Debt Collection Practices Act

Can’t be abusive or threaten. Can’t call you at work if you say not to. Can’t tell boss and friends. Can’t call you at odd hours. Must follow set procedures. Act does not apply to creditors attempting

to collect the debt themselves.

Collection agencies...

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Protection Under OtherConsumer Credit Laws

Equal Credit Opportunity Act.– Specifies your rights if you have been refused credit due

to discrimination based on sex, marital status, age, race religion, national origin.

1997 Consumer Credit Reporting Reform Act.– Places burden of proof for reporting on credit issuers.– Sets $8.00 maximum cost for a credit report.– Allows consumers to remove themselves from

prescreened lists.

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Lesson 8

Managing Your Debts

Reasons for Indebtedness

Emotional problems such as the need for instant gratification.

The use of money to punish and get even. The expectation of instant comfort among young

couples who overuse the installment plan. Keeping up with the Joneses. Overindulgence of children. Misunderstanding or lack of communication among

family members. Amount of finance charges makes it difficult to repay.

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Managing Your Debts

Notify creditors if you can’t make a payment. The Fair Debt Collection Practices Act regulates debt

collection agencies.– If a debt collector calls you, within five days they must send you a

written notice of amount owed, the creditors name, and your right to dispute the debt.

– You can dispute the debt or pay it.– You request verification of the debt within 30 days; (See Exhibit 7-

2). If not sent, you can insist communication about the debt cease.

– If verification sent, you may pay the debt or give notice that you will not pay.

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Warning Signs of Debt Problems

Using up your savings. Borrowing money to pay old debts. Not knowing how much you owe. Going over your credit limit on credit cards. Having little or no savings for the unexpected. Being denied credit due to a credit report. Getting a credit card revoked by the issuer. Putting off medical or dental visits because you can’t

afford them now.

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(continued)

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. Intentionally using overdraft protection or taking frequent

cash advances. Using savings to pay routine bills such as food. Getting second or third payment notices. Not talking to your partner about money or talking only

about money. Depending on overtime to meet routine expenses.

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Consumer Credit Counseling Services

If you can’t pay your bills, postpone further credit purchases, talk with your creditors, or seek help from a non-profit credit counseling service.

– CCCS is non-profit and supported by contributions from banks, merchants, etc.

– Provides education about credit and budgeting.– Provides help with spending plan.– Provides debt counseling services for

those with serious financial problems.– Can develop a debt consolidation

plan and negotiate reduced interest rates.

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Declaring Personal Bankruptcy

A record 1.6 million people declared bankrupt in 2004.

Bankruptcy was designed as a last resort but has become an “acceptable” tool of credit management.

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Bankruptcy

Stays on your credit report for 10 years, making it difficult to get credit. Potential employers may look at your credit report.

Chapter 7.– Submit a petition to the court that lists assets and

liabilities, and pay a filing fee.– Many, but not all, debts are forgiven.– Assets are sold to pay creditors.– Can keep some assets. – Fresh start. – Most filed are this type. 7-16

After Chapter 7 You May No Longer Owe...

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

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After Bankruptcy You Still May Owe...

Certain taxes and fines.Child support and alimony.Educational loans.Debts from willful or malicious acts.

Chapter 13 Bankruptcy

A voluntary plan proposed to the bankruptcy court for those to want to pay a portion of their debt over a period up to five years.

– Must have a regular income.– Can’t have more than $250,000 unsecured debt or $750,000

in secured debt.– Payments are made to a trustee.– Trustee distributes money to your creditors.– Court may allow you to keep property & pay less than full

amount of debts. Costs to the debtor include court costs, attorney’s fees

and trustee’s fees and costs.7-18

Credit Card Activity

Go to www.cardratings.com. Compare different cards.

What features are important to you in choosing a credit card?

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