Cost of CreditCh. 7.4Banking Services

U.S. Economy Runs on Credit

Credit is the foundation of banking income.

U.S. Economy Runs on Credit

Credit is the engine that makes possible growth & development through the economy.

Ex) Septic Tank installation at center

Credit can be Dangerous if MisusedRevolving Credit – a line of

credit that has a maximum limit. It can be used on an ongoing basis until that limit is reached.

Ex) Credit cards, & lines of credit

Dangers of CreditEasy access to credit

allowed many consumers to accumulate more debt than they can manage.

Whenever in a financial pinch, they add more debt to cover the shortfall.

Eventually leading to disaster!

Informed ConsumersIt is the bank’s best interest &

the consumer’s best interest if the consumer is informed about the cost of using credit, and the dangers involved.

Banks want to lend money to make money, but . . .

The bank doesn’t want to struggle to collect money owed to them.

Annual Percentage Rate (APR)

The amount of interest charged on the loan principal expressed as a yearly figure.

Does not include:◦Annual fees◦Transaction fees◦Penalties◦Loan origination fees◦Etc.

Different Ways Interest is ChargedSum-of-Digits MethodPrevious Balance MethodAdjusted Balance MethodAverage Daily Balance Method

Sum-of-Digits MethodInterest gets paid firstPaying ahead doesn’t save you

any $Has built in prepayment

penalties, which may be fixed charges or may be based on the Sum-of-Digits Methods

Sum-of-Digits MethodSum-of-Digits Method –

method of calculating finance charges that takes the total finance charge, divides it by the number of months in the loan term, and assigns a higher ratio of interest to the early payments.

Example of Sum-of-Digits Method

Consider a 12 month loan.Add 12 + 11 + 10 + so onThe sum of the digits 1 through 12 = 781st month of the loan, 12/78ths of the

payment goes towards interest2nd month of the loan, 11/78ths of the

payment goes towards interestAlthough the total cost to the consumer

is the same, there is no advantage to paying early, because the interest is front-loaded.

Example of Sum-of-Digits paymentsLook at example on page 208Read paragraphs explaining savings

differences

House Payment ExampleMortgage payment history

“Rule of 78”A method of

calculating payments

The name derives from how the denominator sums for a 1-year period

Sum-of-Digits MethodCan work for loans of any durationThe denominator used is always

the sum of the total monthsEx) a 15-month loan would have a

denominator of 120.

Previous Balance Method

The amount owed at the beginning of the billing cycle with calculated interest on that figure, regardless of payments or charges

Used with open-ended credit

Adjusted Balance Method

Payments made are subtracted during the billing cycle, however new purchases are not included.

Used with open-ended credit

Average Daily Balance MethodMost common methodThe balances for each day of the

billing cycle are added and then divided by the number of days in the billing cycle to yield an average figure on which the finance charge is calculated.

Minimum PaymentsMost credit cards require a

minimum payment of about 4% of the unpaid balance every month

Used to be only 2% but that only paid the interest, and the credit card companies could keep indebted to them forever

TermTerm – the length of the loan (ex:

60 months, 48 months, etc)The length of the term affects the

finance chargeThe longer the term, the more $

paid backSee example on page 210

OverextensionHappens when you take on more

debt than you can affordSome consumers mistakenly

believe that just because someone approves them for credit, that must mean they can afford it.

Ex) they take on 3, 4, or 5 credit cards, but then they can only afford to make minimum payments

Overextension can be Disastrous!If you’re overextended, and an

emergency arises, or a situation changes, such as a job loss, you are in major trouble!

A snowball effect may occur as late charges, penalty interest rates, & other fees apply

Consequences of overextension

Ruined credit ratingMissed opportunities on great

deals Important things may have to be

passed over (orthodontics for kids, etc)

If all your money is already going out to make debt payments, when gas prices go up, your entire budget may collapse!

The Role of Banks Regarding CreditPredatory Lending – occurs when

lenders create problems for consumers by making credit too easily available without regard to the borrower’s ability to pay.

Not really in the bank’s best interestBanks need creditworthy customersCollecting debt is expensive, & almost

impossible on loans in default

Credit CounselingCounseling agencies (some are for-

profit, some are non-profit)Help you reorganize your debts &

sometime negotiate termsBanks will often accept such

arrangements rather than lose their money altogether.

Be Careful with Credit Counseling

Some credit-counseling companies are simply looking for ways to offer more subprime loans or to make a profit by doing stuff that you could do on your own

Bankruptcy is the last option

Only in extreme casesHas long-term consequencesSeek professional legal advice 1st!

Book Work:“Checkpoints”

◦Pg. 211◦Pg. 212

7.4 Assessment◦Pg. 213 #1-4