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Chapter

5
Consumer Credit:
Advantages,
Disadvantages,
Sources, and
Costs

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Credit
Chapter Objectives
1. Analyze advantages and disadvantages of
using consumer credit
2. Assess the types and sources of consumer
credit
3. Determine whether you can afford a loan and
how to apply for credit
4. Determine the cost of credit by calculating
interest using various interest formulas
5. Develop a plan to protect your credit and
manage your debts

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Objective 1

Analyze Advantages and


Disadvantages of Using Consumer
Credit
Credit
An arrangement to receive cash, goods or
services now, and pay for them in the future
Based on trust in peoples ability and
willingness to pay bills when due

Consumer credit
Use of credit by individuals for personal
needs, except a home mortgage
A major force in our economy
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Uses and Misuses of Credit


Before you use credit for a major purchase,
consider:

Do I have the cash 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 Ill 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
Provides a record of expenses
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Advantages of Credit
One monthly payment
Safer than carrying cash
Needed for hotel reservations, car
rentals, and shopping online
Take advantage of float time/grace
period
Rebates, airline miles, or other
bonuses
Credit indicates financial stability
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Disadvantages of Consumer
Credit
Temptation to overspend
Can create long-term financial
problems and 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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Objective 2

Assess the Types & Sources of


Consumer Credit
Two Basic Types of Consumer Credit

Closed-End Credit
One-time loans for a specific purpose paid
back in a specified period of time

Open-End Credit
Use as needed until line of credit max
reached

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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
3 most common types of closed-end credit
1.Installment sales credit
2.Installment cash credit
3.Single-lump credit
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Open-End Credit
Use as needed until line of credit max reached
Credit cards
Department store cards
Home equity loans
You pay interest and finance charges if you do
not pay the bill in full when due
Revolving check credit
Bank line of credit

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Sources of Consumer Credit


Loans
Borrowing money with an agreement to repay
along with interest within a certain amount of
time

Inexpensive loans
Parents or family members

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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Sources of Consumer Credit


Home Equity Loans
Loan based on your home equity
Current market value of your home minus the
amount you still owe on the mortgage

Interest is tax deductible


Should only be used for major purchases

Credit Cards
Average cardholder has > 9 credit cards
Convenience users vs. Borrowers
Finance charge = total amount paid to use
credit
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Sources of Consumer Credit


Debit Cards
Debit cards electronically
subtract money from your
savings or checking accounts
Most commonly used at ATMs

Stored Value Cards


Gift cards
Prepaid cards
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Sources of Consumer Credit


Smart Cards
Plastic card equipped with a
computer chip that can store
500 times as much data as
a normal credit card

Travel and Entertainment (T&E) cards


Not really credit cards; balance is due in
full each month
Diners Club; American Express
You dont pay for services or goods at the
time you purchase them
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Objective 3

Determine Whether You Can Afford


a Loan and How to Apply for Credit

Before you take out a loan, ask yourself...


Can you meet all your essential
expenses and still afford the
monthly loan payments ?
What do you plan to give up in order to
make the payment?

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General Rules of Credit


Capacity

Debt Payments-to-Income Ratio


Monthly Debt Payments*
Net Monthly Income

Consumer credit payments should not


exceed a maximum of 20% of your net
income.
*Not including house payment which is a long-term liability
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General Rules of Credit


Capacity
Debt To Equity Ratio
Total Liabilities

= Should be < 1

Net Worth*

*Excluding home value


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The Five Cs of Credit


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

and net worth?


Collateral - What assets do you have to
secure the loan?
Conditions- Lenders will review how general
economic conditions will affect your ability
to repay your loan

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FICO & VantageScore


FICO Credit Score
350 to 850
Higher score = less risk
Available from http://www.myfico.com for a
fee

VantageScore
New scoring technique
Developed collaboratively by 3 credit
agencies
Range = 501 to 990
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Factors of Creditworthiness
ECOA (Equal Credit Opportunity Act)
Gives all applicants the same rights.
Credit providers may not discriminate based on:
Age
Social Security or public assistance
Housing loans (redlining)

If you are denied credit, you have the right


to know the reasons
You can request a copy of your credit report
within 60 days if you are denied credit based
on what is in your files
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Your Credit Report


Credit Reports
Record of your complete credit history
Credit Bureaus
Agencies that collect information on how
promptly people and businesses pay their
bills
Experian, Trans Union and Equifax are
the 3 major credit bureaus
Credit Bureaus obtain information from
banks, finance companies stores, credit
card companies and other lenders
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Your Credit Report


Credit Files
Typically contain detailed credit data
along with considerable personal
information:
Name, address, SSN, DOB (self & spouse)
Employer, position and income (current &
previous, self and spouse)
Home owner or renter

Fair Credit Reporting Act (1971)


Law allows out-of-date information to be
deleted, as well as the right to correct
misinformation
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Your Credit Report


Who can obtain a credit report?
Only authorized persons have access to

your report for approved legitimate business


purposes
Time Limits on Unfavorable Data
Adverse data can be reported for 7 years
Bankruptcy can be reported for 10 years

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Your Credit Report


Incorrect Information in Your File
You may request a copy of your credit
information within 60 days of being denied
credit
You may request a free copy of your credit
report annually
What are Your Legal Rights?
You have the legal right to sue the credit
bureau or the creditor that has caused you
harm
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Objective 4

Determine the Cost of Credit by


Calculating Interest Using
Various Interest Formulas
Finance charge
Total dollar amount you pay to use credit
Includes interest costs and fees, 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 when shopping for rates

It is important to shop for credit


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Tackling the Trade-Offs


Term (length of loan) versus interest
cost
Lender risk versus interest rate
To reduce the lenders risk and thus the
interest rate you can:
Accept a variable interest rate
Provide collateral to secure a loan
Provide up-front cash
Take a shorter term loan
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Calculating the Cost of Credit


Simple interest
Computed on principal only without compounding
The dollar cost of borrowing
Interest = Principal x rate x Time

Simple interest on the declining balance


Interest is paid only on the amount of original
principal not yet repaid

Add-on interest
Interest calculated on full amount of principal
Interest added to original principal
Payment = Total divided by number of payments
to be made
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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 costs

Cost of Credit and Expected Inflation


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

Avoid the Minimum Monthly Payment Trap


The longer you take to pay off the bill, the more
interest you pay
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Objective 5

Develop a Plan to Protect Your


Credit and Manage Your Debts
Fair Credit Billing Act (FCBA, 1975)
Notify creditor of error in writing within 60 days
Pay the portion of the bill not in dispute
Creditor 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
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Protecting Your Credit


Fair Credit Billing Act (FCBA, 1975)
Disputed item wont affect your credit rating
while in dispute
Can withhold payment on damaged or shoddy
goods or poor services if purchased with a
credit card
Must make sincere attempt to resolve problem
with creditor

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What to Do If Your Identity is


Stolen?
Contact the three major credit bureaus
Ask the fraud department to institute a fraud
alert
Request that creditors call you for permission
before opening any new accounts in your name

Contact creditors
Check for any accounts that have been
tampered with or opened fraudulently

File a police report


Keep a copy
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Protecting Your Credit From


Theft or Loss
Shred any papers that contain personal
information
Close your accounts immediately if you
suspect an identity thief has accessed the
account
Be sure your credit card is returned after a
purchase
Keep a record of credit card numbers
Notify your credit card company immediately if
your card is lost or stolen
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Protecting Your Credit


Information on The Internet
Use a secure browser
Keep records of online transactions
Review monthly bank and credit card
statements
Read the privacy and security policies of
websites you visit
Keep personal information private
Never give your password to anyone
Dont download files sent by strangers
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Co-signing a Loan
Co-signing means guaranteeing the debt
Lender would not require a co-signer if
borrower were a good risk
Can you afford it if the borrower defaults?
If borrower doesnt pay, cosigner is liable
for the full amount plus any late or
collection fees
If payment is missed, creditor can collect
from the cosigner first

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Complaining About Consumer


Credit
First: Try to solve the problem
directly with the creditor
If that fails: Use formal complaint
procedures
A variety of Consumer Credit
Protection Laws and Federal
Agencies administer and assist with
complaint procedures

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Consumer Credit Protection


Laws

Truth in Lending and Consumer Leasing Acts


Equal Credit Opportunity Act (ECOA)
Fair Credit Billing Act
Fair Credit Reporting Act
Consumer Credit Reporting Reform Act (1977)
Electronic Funds Transfer Act

Your Rights Under Consumer Credit Laws


Complain to the creditor
File a complaint with the government
If all else fails, sue the creditor
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Managing Your Debts


Warning Signs of Debt Problems
Paying only the minimum balance each month
Trouble even paying the minimum balance
Total balance increases every month
Missing loan payments or paying late
Using savings to pay for necessities
Getting second or third payment notices
Borrowing money to pay old debts
Exceeding the credit limits on your credit cards
Denied credit due to a bad credit report
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Managing Your Debts


Debt Collection Practices
The Federal Trade Commission enforces
the Fair Debt Collection Practices Act
(FDCPA)
Prohibits certain practices by debt
collectors
Does not eliminate legitimate debts

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Managing Your Debts


Consumer Credit Counseling Services
(CCCS)
Non-profit and supported by contributions
from banks, merchants, etc.
Provides education about credit
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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Other Counseling Services


Universities, local county extension
agents, credit unions, military bases,
and state and federal housing
authorities provide nonprofit counseling
services
Check with your financial institution or
consumer protection office for a list of
reputable, low-cost financial counseling
services
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Declaring Personal
Bankruptcy
U.S. Bankruptcy Act of 1978
Chapter 7 = straight bankruptcy
Chapter 13 = wage earner plan
Personal bankruptcy is a procedure to distribute
some or all of your assets among creditors

Bankruptcy should be the last resort, because


of the damage to your credit rating
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Chapter 7 Bankruptcy

Submit a petition to the court that lists


assets and liabilities, and pay a filing fee
Many, but not all, debts are forgiven
Assets sold to pay creditors
Can keep some assets (home, vehicle,..)
Intent = a fresh start
Most filed are this type

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After Chapter 7
You May No Longer Owe:
Retail store charges
Bank credit card charges
Unsecured loans
Unpaid hospital or physician bills

You Still May Owe...

Certain taxes and fines


Child support and alimony
Educational loans
Debts from willful or malicious act
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Bankruptcy Abuse
Prevention and Consumer
Protection Act of 2005

Makes it more difficult for consumers to file a


Chapter 7 bankruptcy
Forces a Chapter 13 repayment plan
Debtors must wait 8 years from their last
bankruptcy to file again
Clamps down on bankruptcy mills that seek to
game the system
Includes provisions for consumer education on
debt management and financial planning

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Chapter 13 Bankruptcy
Debtor with regular income proposes a plan
to eliminate his debts over time
Information provided to the court the same
as under Chapter 7
Plan may last up to five years
Debtor makes payments to a court-appointed
trustee

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Obtaining Credit after


Bankruptcy
May be more difficult
But, creditors may consider the inability to
file bankruptcy again for 8 years
Could be easier for Chapter 13 filers who
have repaid some debt versus Chapter 7
filers who made no effort to repay

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