Chapter 5

Consumer Credit: Advantages, Disadvantages, Sources, and Costs

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

Consumer Credit

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

Chapter Objectives

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Objective 1Analyze 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 people’s 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 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

• 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 merchandisedue to late or non-payment

• Ties up future income• Credit costs money - more costly

than paying with cash5-7

Objective 2Assess 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 don’t 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

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

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.

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General Rules of Credit Capacity

Debt To Equity Ratio

Total Liabilities

Net Worth*= Should be < 1

*Excluding home value

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The Five C’s 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 4Determine 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 lender’s 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 5Develop 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

• Disputed item won’t 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

Fair Credit Billing Act (FCBA, 1975)

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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• Don’t 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 doesn’t 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

Bankruptcy should be the last resort, because of the damage to your credit rating

Personal bankruptcy is a procedure to distribute some or all of your assets among creditors

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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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