Consumer Credit

Chapter 6

Section 6.1 – What is Consumer Credit?

• Objectives– Explain the meaning of consumer credit

– Differentiate between close-end credit and open-end credit

What is credit?

• An arrangement to receive cash, goods, or services now and pay later– Credit cards, charge cards, loans

• Consumer credit - specific use of credit for personal needs

• Creditor – A person or institution that lends money

Using Consumer Credit Wisely

• Why is having good credit important?– Receive items now, pay

later – homes, cars, college

– Indicator of consumer spending and demand

– Can be dangerous, so using it wisely is a valuable tool

Different Forms of Credit

• Credit cards

• Charge cards

• Loans

• Cash advances

• Debit cards

• Smart cards

Credit Cards

• Use the card to pay for items and services up to a certain total amount -- your credit limit

• Carrying a balance– The credit card company allows you to pay off what you owe little by

little each month, as long as you pay a minimum amount each time. In exchange, you pay interest on the balance you owe (as high as 29% each year) at the end of each period

• How credit card companies make money. Credit card companies earn high profits in several ways.– High rates of interest -- interest on credit cards accounts for the bulk

of the profits earned by banks that issue credit cards– Annual fees– Late fees, over-the-limit fees, and other miscellaneous charges– Charging merchants and service providers a fee each time a

customer uses the company's credit card in the merchant's establishment

Charge Cards• Charge cards, also called travel and entertainment cards,

are a little different from credit cards because they have no credit limit. You can usually charge as much as you want, but are required to pay off your entire balance when your bill arrives

• You cannot carry a balance. If you don't pay your charge card bill in full, you'll get a one-month grace period without interest charges. After that, you'll be charged interest that can be as high as 30 to 35%. If you don't pay after about three months, your account will be closed and your bill sent to the collections department

• How charge card companies make money. – Charge card companies make their profits by charging high annual

fees -- up to about $90 – Charging merchants relatively high fees each time a customer pays

using the company's charge card. Some merchants don't accept charge cards for this very reason

Loans• Let you borrow money that must be repaid with interest

• You can obtain a loan for a specific purpose, such as financing a new car, paying college tuition and buying or renovating a home. You can get a debt consolidation loan, which combines all current debts from various creditors into a single reduced-interest payment plan

• Loans are generally divided into two types: secured and unsecured– Secured loans are guaranteed by collateral, which is an item of equal or

greater value than the amount of the loan, such as a car, home or cash deposit

– Unsecured loans do not require collateral and are made based on your credit score and ability to repay

• Installment loans are made for a fixed amount at the time of your application and approval. This type of loan is repaid in fixed monthly payments over a specific period of time. The finance charges are included in the payments. Auto loans and mortgages are examples of installment loans.

Cash Advances• Many people use their credit cards to obtain cash advances

• Credit card issuers send cardholders "convenience" checks they can use to pay for goods or services. The amount of the check appears on your credit card statement as a charge, but is generally treated as a cash advance

• Cash advances are more expensive than standard credit card charges and offer more onerous terms for consumers, including:– Transaction fees. Most banks charge a transaction fee of up to 4 to

6% for taking a cash advance– No grace period. Most banks charge interest from the day the cash

advance is posted, even if you pay it back in full as soon as your bill comes

– Higher interest rates. The interest rate is often substantially higher on cash advances that it is on ordinary credit card charges

Credit Uses and Misuses• When is it appropriate to use

credit?– When you can buy something

now for less than it will cost with cash later

• Clearance items, big sales

– When you can afford it• Don’t buy a sports car you can’t

afford – get something cheap and reliable

– Increased credit use decreases how much money you have later

Factors to Consider Before Using Credit

• What should you know before using credit with a major purchase?– Do you have the cash you

need for the down payment?– Do you want to use your

savings instead of credit?– Can you afford the item?– Could you use the credit in

some better way?– Could you put off buying the

item for a while?– What are the costs of using

credit?

Advantages of Credit

• Enjoy things now and pay later

• Can combine several purchases in one monthly payment

• Need one to rent car, make reservations, buy online

• Gives you a record of your expenses

• Safer to carry when shopping or traveling

• Use responsibly and you will get good credit

Disadvantages of Credit

• Temptation to buy more than you can afford

• Bad purchases may cause loss of income and property

• Credit does not give you more money – still have to pay later

• May have trouble paying bills

Types of Credit

• Closed-End Credit– One time loan paid back in specific time period

in payments of equal amounts– Lower interest rates than open-end credit

• Examples: mortgages and car loans

• Open-End Credit– Credit with a limit (line of credit) that you can

use continuously on various items and pay at least a minimum amount per month

• Examples: department store credit cards, Visa, Mastercard

Sources of Consumer Credit

• Commercial Banks

• Consumer Finance Companies

• Credit Unions

• Life Insurance Companies

• Federal Savings Banks

Credit Cards

• Average cardholder has more than nine cards• Those who pay balance off every month are

convenience users, those who carry a balance over every month are borrowers

• Grace period – a time when no interest is added to balance

• Finance Charge – total amount you pay to use • Annual Fee – may have to pay $20 to $50 annual

fee just for having card

Loans

• Inexpensive Loans– Friends or family, little or no interest, potential problems

with these?

• Medium-Priced Loans– From banks, credit unions, may be patient with those late

with payment for good reason

• Expensive Loans– Easiest to get, cash advances (billed to credit cards)

• Home Equity Loans– Based on home equity (difference between the value of

your home and what you owe on it)– For major things such as education, home improvements,

medical bills

Other Forms of Credit Cards• Debit Cards

– Electronically subtract money from savings or checking

– Can be used at most stores, gas stations– Easier than writing a check

• Smart Cards– Contains a computer chip– Example: can be used to track frequent flyer

miles

• Travel and Entertainment Cards– Balance due each month– May be used with business men who travel

Section 6.2 Costs and Methods of Obtaining Credit

Can You Afford a Loan?

• Total income minus monthly expenses– Do you have enough money to pay the monthly loan

payment?

• What types of things can people give up to make room for a needed loan?– Going out to eat– Going to the movies– Smoking/drinking– Shopping– Comparison shop

Debt Payments-to-Income Ratio

• % of debt you have in relation to your net income

• Experts suggest no more than 20% of net income goes to debt

• Formula Monthly Debt Payments = % Monthly Net Income

$180 = .15 or 15%

$1200

The Cost of Credit

• Annual Percentage Rate (APR)– APR is the cost of credit on a yearly basis– APR of 18% mean $18 on every $100 you owe– See chart on Pg. 165– Truth in Lending Act, the creditor must inform

you in writing of the finance charge and APR

Tackling the Trade-Offs

• Term vs. Interest Costs– Longer term (length of time to pay back loan) means

smaller payments– Also means greater amount you will pay in interest

APR Term of Loan

Monthly Payments

Total Finance Charge

Total

Cost

Creditor A 14% 3 years $205.07 $1382.52 $7382.52

Creditor B 14% 4 years $163.96 $1870-08 $7870.08

Lender Risk vs. Interest Rate

• If you were to lend money, what would you worry about and how would you deal with those issues?

• Lender wants to reduce his/her risk, and you want a low interest rate – so what are your choices– Variable Interest Rate - rates rise when overall interest

rates rise, so lender may offer you a lower beginning rate than you would have with a fixed-rate loan

– A Secured Loan – use collateral to guarantee payment – if you don’t pay they take the collateral

– Up-Front Cash – Make a big down payment upfront, so lender thinks that you have a greater chance of repaying

– A Shorter Term – the shorter time to pay it back, the less chance for something to stop you from repaying it

Calculating the Cost of Credit

• Simple Interest

• Simple Interest on the Declining Balance

• Add-On Interest

• Cost of Open-End Credit

• Cost of Credit and Expected Inflation

• The Minimum Monthly Payment Trap

Simple Interest

• Paid back in one payment normally• Interest = Principal x Interest Rate x Amount of

time borrowed for• Principal - original amount of debt or amount

loaned to you before interest is added• Rate - expressed as percentage, the higher the

rate, the less desirable the loan• Time - expressed as a fraction of 1 year, 12

months, 52 weeks, or 360 days6 mo = ½ 90 days = 90/3603 mo = ¼ 4 mo = 1/3

Installment Interest

• The Kramers are buying a new couch. The cash price is $800. Instead they put down $100 and pay the balance in 12 monthly payments of $66.

• What is their finance charge? $100

+ 792 (12 * 66)

$892 total installment price paid

• $892 – 800 = $92 finance charges

Installment Interest Cont.

• APR formula• R = 2*n*I

P(N+1)• R = annual percentage rate• n = # of payment periods in one year• l = total dollar cost of credit (finance charge)• P = principal, or net amount borrowed• N = total number of payments to pay off

amount borrowed

• Using the Kramers example, $800 cash price for couch, put $100 down and pay 12 monthly payments of $66.

• R = 2 * 12 * 92 700 (12 + 1)

• 2,208 = 24.26% 9,100

Simple Interest on Declining Balance• Used for simple interest loan paid back in

more than one payment

• Only pay interest on amount of principal you have not repaid

• More often you make payments, the lower the interest you will pay

• Most credit unions use this

• Good for those who pay off loans early

Add-On Interest

• Interest based on full principal amount, no matter how many payments you make early

• Longer you take to pay the loan the more interest you will pay

• Not good for those who take full term to pay back loan

Cost of Open-End Credit

• Varies with the credit card

• Creditors must inform you of how interest is calculated

• Three method types– Adjusted balance method– Previous balance method– Average daily balance method

Three Finance Charge Methods

Adjusted

Balance Method

Previous Balance Method

Average Daily Balance

Monthly Interest Rate

1.5% 1.5% 1.5%

Previous Balance $400 $400 $400

Payments $300 $300 $300

Interest Charge $1.50

($100 x 1.5%)

$6.00

($400 x 1.5%)

$3.75

(avg. balance of $250 x 1.5%)

Adjusted Balance Method

• Interest applied to the remaining balance AFTER you have made your monthly payment

• If you get a bill for $400, you decide to pay $100, the interest is based on the remaining $300

• If APR is 18%, to get the monthly rate divide 18% by 12 (months) = 1.5%

• So $300 x 1.5% = $1.50 added on for next month’s bill

Previous Balance Method

• Finance charge is applies to entire amount owed from the previous month

• If you get a bill for $400, you decide to pay $100, the interest is still based on the $400

• If APR is 18%, to get the monthly rate divide 18% by 12 (months) = 1.5%

• So $400 x 1.5% = $6.00 added on for next month’s bill

• Worst for the borrower

Average Daily Balance Method

• Most credit cards use this

• Add your balance from each day of the billing cycle together and divide by the number of days in the cycle

Cost of Credit and Expected Inflation

• You may pay a higher interest rate because lenders will figure in the expected inflation rate

Minimum Monthly Payment Trap

• Lenders like you to only pay the minimum amount• The finance charges you pay on an item(s) could

make it more expensive that it is worth• If you buy college books for $500 on a credit card

that charges 19.8% per year– Only make the minimum payment of $21.67– It will take 2 ½ yrs to pay it off and will pay $150 in

interest so a total of $650 dollars for books used 3 months

Five C’s of Credit

• Character: Will You Repay the Loan?

• Capacity: Can You Repay the Loan?

• Capital: What Are Your Assets and Net Worth?

• Collateral: What If You Do Not Repay the Loan?

• Credit History: What Is Your Credit History?

Character: Will You Repay the Loan?

• Are you trustworthy, stable

• May ask for references, check criminal record

• What would you ask someone if you were thinking about lending money to them?

• Have you used credit before?• How long have you lived at your present address?• How long have you held your current job?

Capacity:Can You Repay the Loan?

• How much income do you have coming in?– Job salary– Other income

• Do you already have a lot of debt?

Capital:What Are Your Assets and Net Worth?

• What is your capital?Assets – Liabilities = Capital (Net Worth)

• Assets can be cash, property, investments

• Items of value you can sell to repay the loan

Collateral:What If You Do Not Repay the Loan?

• May be asked to pledge collateral in order to get loan– Car, home,

personal items

Credit History:What Is Your Credit History?

• How have you used credit in the past?

• Do you pay bills on time?

• Have you ever filed for bankruptcy?

How Do Lenders Use the 5 C’s?

• Give a credit rating based on income, debt, character, past repayment history

• Use various rating systems

• May have high standard, may rely on instinct, or may use credit scoring or statistics

Credit Application Information

• Amount needed• Use of loan• Name, birthdate• SS# and driver license• Present and past street

address • Present and previous

employers• Present salary• No. and ages of dependents• Other income

• Have you received credit from us before

• If so, when and which office

• Checking/savings acct. numbers, bank, branch

• Name of nearest relative, address, phone number

• Marital status

Equal Credit Opportunity Act

• Certain factors that lenders cannot consider: race, nationality, age, sex, marital status, religion– Age – if you can legally sign a contract (18 or

21) they cannot turn down due to age– Public Assistance – cannot be denied

because of, but source of income can be considered as to your creditworthiness

– Housing Loans - cannot deny based on your race and the race of neighborhood you want to buy in

What if you are denied?

• Entitled to info in report• No fee if asked for

within 60 days after denial

• Also can ask credit bureau to investigate inaccurate or incomplete information

Credit Bureau• Collect and store credit reports or files

• Three main ones: Experian, TransUnion, Equifax - several thousand smaller ones

• They sell your credit info to

potential creditors

• Where do they get your information?

– Stores, credit card companies, finance companies, banks, court records

Your Credit File

• Employer, position, and income

• Previous address

• Previous employer

• Spouse’s name, SS#, employer, income

• Homeowner or renter status

• Checks returned

• Each time you take out a loan, payments made, missed, how much you owe

Credit File• Detailed credit information:

– Each time you take out a loan they are given your acct. #, date, amount, terms, and types of credit

• Updated frequently– Number of payments made– Number of payments missed or late– Lawsuits or judgments

Who Can Obtain a Credit Report

• May be in response to a court order

• Your own written request

• Provided for a credit transaction

• Friends, neighbors, and others cannot be given access

• Can get free of charge if have been denied

• Law allows each person one free report per year

Time Limits of Data in File• Most is up to 7 years

• 10 years if you declared bankruptcy

• Credit reporting agency cannot disclose information more than 7 or 10 years old unless:– Being reviewed for credit application of

$75,000 or more– Apply to life insurance of $150,000 or more

Section 6.3

Protecting Your Credit

Billing Errors and Disputes

• 1. Notify creditor in writing• 2. Pay portion that is not in question• 3. Creditor must acknowledge within 30

days• 4. Within 2 billing cycles (not more than 90

days) creditor must • Adjust bill• Tell you why it is correct

• 5. If mistake, you pay no finance charges• 6. If no mistake, they send you an explanation and

statement of what you owe

Protecting Credit Rating

• According to law, a creditor may not– Threaten your credit rating– Do anything to damage your credit

reputation when disputing a bill– May not take action to collect the amount

in question until complaint has been answered

Defective Goods and Services

• According to the Fair Credit Billing Act you may tell your credit card to stop payment if you bought a defective item that the store will not return

Identity Theft

• May not know until:– Get bills for cards you never opened– See charges for things you didn’t purchase– See money withdrawn from bank acct.

• You should:– 1. Contact credit bureau – flag acct. and call you for permission to open acct.– 2. Contact creditors for any fraudulent accts. opened– 3. File police report and keep a copy for proof

Protect Yourself from Identity Theft• Shred or tear papers• Close accts. that have been tampered with• Stop payments on stolen checks• Cancel debit card• Credit cards

– Be sure card is returned to you– Keep a record of your numbers– Contact company immediately if stolen or lost– Maximum you pay is $50 for illegal use– No $ payment if you contact them before illegal use

How do thieves steal an identity?• Identity theft starts with the misuse of your personally identifying

information such as your name and Social Security number, credit card numbers, or other financial account information. For identity thieves, this information is as good as gold.

• Dumpster Diving. They rummage through trash looking for bills or other paper with your personal information on it.

• Skimming. They steal credit/debit card numbers by using a special storage device when processing your card.

• Phishing. They pretend to be financial institutions or companies and send spam or pop-up messages to get you to reveal your personal information.

• Changing Your Address. They divert your billing statements to another location by completing a change of address form.

• Old-Fashioned Stealing. They steal wallets and purses; mail, including bank and credit card statements; pre-approved credit offers; and new checks or tax information. They steal personnel records, or bribe employees who have access.

What do thieves do with a stolen identity? Credit card fraud: • They may open new credit card accounts in your name.

When they use the cards and don't pay the bills, the delinquent accounts appear on your credit report.

• They may change the billing address on your credit card so that you no longer receive bills, and then run up charges on your account. Because your bills are now sent to a different address, it may be some time before you realize there's a problem.

Phone or utilities fraud: • They may open a new phone or wireless account in your

name, or run up charges on your existing account. • They may use your name to get utility services like

electricity, heating, or cable TV.

Other fraud:

• They may get a job using your Social Security number.

• They may rent a house or get medical services using your name.

• They may give your personal information to police during an arrest. If they don't show up for their court date, a warrant for arrest is issued in your name.

Bank/finance fraud: • They may create counterfeit checks using your

name or account number. • They may open a bank account in your name and

write bad checks. • They may clone your ATM or debit card and make

electronic withdrawals your name, draining your accounts.

• They may take out a loan in your name. Government documents fraud: • They may get a driver's license or official ID card

issued in your name but with their picture. • They may use your name and Social Security

number to get government benefits. • They may file a fraudulent tax return using your

information.

Protecting Your Credit on Internet• Use a secure browser• Keep records of online transactions• Review monthly statements• Read privacy and security policies of web

site you visit• Keep personal information private• Never give password to anyone• Do not download files sent to you from

strangers

Cosigning a Loan

• You agree to be responsible for the loan payments if they fail to make them

• You may also have to pay late fees or collection costs

• Creditor can collect from you before the borrower

• Will appear on your record if not paid

Your Rights Under Consumer Credit Laws• 1. Complain to creditor and make them

aware you know the laws

• 2. File a complain with the govt.

• 3. Sue creditor. If you win, you can receive

up to $10,000 in actual and punitive

damages, along with attorney’s fees and

court costs

Section 6.4

Managing Your Debts

Warning Signs of Debt Problems

• Only make minimum monthly payment on credit cards

• Having trouble making minimum monthly payments

• Balance on credit cards increases each month• Miss or late loan payments• Use savings for necessities• Receive 2nd or 3rd payment notices• Borrow money to pay debts• Exceed credit limit credit cards• Been denied credit/bad credit report

Debt Collection Practices

• Creditors turn bad debt over to collection agencies

• Federal agency protects legal rights of debtors

• FTC Fair Debt Collection Practices Act prohibits certain practices by debt collectors

Consumer Credit Counseling Service

• Provides debt counseling services for those with financial troubles

• May be small fee for a debt repayment plan• Two part to CCCS

– Aiding families with serious debt by helping manage money and setting up a budget

– Helping people prevent indebtedness by education of budgets and unwise credit purchases

• Many other resources available in other institutions (banks, credit unions, universities)

Declaring Personal Bankruptcy

• Legal process in which some or all of assets of debtor are distributed among creditors b/c debtors cannot pay debts

• May include a plan for debtor to repay creditors on installment basis

• Should be a last resort because it severely damages your credit

Personal Bankruptcy

• Two choices in bankruptcy– Chapter 7 (straight bankruptcy)– Chapter 13 (wage-earner plan bankruptcy)

• Both undesirable

• Neither should be an easy way out of debt

Chapter 7 Bankruptcy

• Draw up petition listing assets and liabilities that could be sold to pay debts

• Pay a filing fee

• Not all debts are forgiven like child support or alimony

• 70% of all filings

Chapter 13 Bankruptcy

• A chapter 13 bankruptcy is also called a wage earner's plan

• Those with regular income develop a plan to repay all or part of debt

• In repayment plan debtors make installment payments to creditors over three to five years

• 29% of all filings

Key Terms• Credit – Arrangement to receive cash, goods, or services

now and pay later• Consumer Credit – Use of credit for personal needs• Creditor – Entity that lends money• Closed-end credit – One time loan that you pay back over

a specified time period in payments of equal amounts• Open-end Credit – A loan with a certain limit on the

amount of money you can borrow for a variety of goods and services

• Line of Credit – Maximum amount of money of a creditor will allow you to borrow

• Finance Charge – Total dollar amount you pay to use credit

• Net Income – The income you receive (take home pay, allowance, gifts, and interest)

• APR (annual percentage rate) – The cost of credit on a yearly basis, expressed as a percentage

• Collateral – A form of security to help guarantee that the creditor will be repaid.

• Simple Interest – The interest computed only on the principal

• Minimum Monthly Payment – The smallest amount you can pay and remain a borrower in good standing

• Credit Rating – A measure of a person’s ability and willingness to make credit payments

• Cosigning – Agreeing to be responsible for the loan payments if another person fails to make them

• Bankruptcy – Legal process in which some or all of the assets of a debtor are distributed among the creditors because the debtor is unable to pay his or her debts