Chapter 5


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Chapter 5

  1. 1. Chapter 5 Consumer Credit: Advantages, Disadvantages, Sources, and Costs Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
  2. 2. Consumer Credit <ul><li>Analyze advantages and disadvantages of using consumer credit </li></ul><ul><li>Assess the types and sources of consumer credit </li></ul><ul><li>Determine whether you can afford a loan and how to apply for credit </li></ul><ul><li>Determine the cost of credit by calculating interest using various interest formulas </li></ul><ul><li>Develop a plan to protect your credit and manage your debts </li></ul>Chapter Objectives 5-
  3. 3. Objective 1 Analyze Advantages and Disadvantages of Using Consumer Credit <ul><li>Credit </li></ul><ul><ul><li>An arrangement to receive cash, goods or services now, and pay for them in the future </li></ul></ul><ul><ul><li>Based on trust in people’s ability and willingness to pay bills when due </li></ul></ul><ul><li>Consumer credit </li></ul><ul><ul><li>Use of credit by individuals for personal needs, except a home mortgage </li></ul></ul><ul><ul><li>A major force in our economy </li></ul></ul>5-
  4. 4. Uses and Misuses of Credit <ul><li>Before you use credit for a major purchase, consider: </li></ul><ul><ul><li>Do I have the cash for the down payment? </li></ul></ul><ul><ul><li>Do I want to use my savings for this purchase? </li></ul></ul><ul><ul><li>Does the purchase fit my budget? </li></ul></ul><ul><ul><li>Could I use the credit I’ll need in some better way? </li></ul></ul><ul><ul><li>Can I postpone this purchase? </li></ul></ul><ul><ul><li>What are the opportunity costs of postponing this purchase? </li></ul></ul><ul><ul><li>What are the dollar and psychological costs of using credit for this purchase? </li></ul></ul>5-
  5. 5. Advantages of Credit <ul><li>Current use of goods and services </li></ul><ul><li>Permits purchase even when funds are low </li></ul><ul><li>A cushion for financial emergencies </li></ul><ul><li>Advance notice of sales </li></ul><ul><li>Easier to return merchandise </li></ul><ul><li>Convenient when shopping </li></ul><ul><li>Provides a record of expenses </li></ul>5-
  6. 6. Advantages of Credit <ul><li>One monthly payment </li></ul><ul><li>Safer than carrying cash </li></ul><ul><li>Needed for hotel reservations, car rentals, and shopping online </li></ul><ul><li>Take advantage of float time/grace period </li></ul><ul><li>Rebates, airline miles, or other bonuses </li></ul><ul><li>Credit indicates financial stability </li></ul>5-
  7. 7. Disadvantages of Consumer Credit <ul><li>Temptation to overspend </li></ul><ul><li>Can create long-term financial problems and slow progress toward financial goals </li></ul><ul><li>Potential loss of merchandise due to late or non-payment </li></ul><ul><li>Ties up future income </li></ul><ul><li>Credit costs money - more costly than paying with cash </li></ul>5-
  8. 8. Objective 2 Assess the Types & Sources of Consumer Credit <ul><li>Two Basic Types of Consumer Credit </li></ul><ul><li>Closed-End Credit </li></ul><ul><ul><li>One-time loans for a specific purpose paid back in a specified period of time </li></ul></ul><ul><li>Open-End Credit </li></ul><ul><ul><li>Use as needed until line of credit max reached </li></ul></ul>5-
  9. 9. Closed-End Credit <ul><li>One-time loans for a specific purpose that you pay back in a specified period of time, and in payments of equal amounts </li></ul><ul><li>Mortgage, automobile, and installment loans for furniture, appliances and electronics </li></ul><ul><li>3 most common types of closed-end credit </li></ul><ul><ul><ul><li>Installment sales credit </li></ul></ul></ul><ul><ul><ul><li>Installment cash credit </li></ul></ul></ul><ul><ul><ul><li>Single-lump credit </li></ul></ul></ul>5-
  10. 10. Open-End Credit <ul><li>Use as needed until line of credit max reached </li></ul><ul><ul><li>Credit cards </li></ul></ul><ul><ul><li>Department store cards </li></ul></ul><ul><ul><li>Home equity loans </li></ul></ul><ul><li>You pay interest and finance charges if you do not pay the bill in full when due </li></ul><ul><li>Revolving check credit </li></ul><ul><li>Bank line of credit </li></ul>5-
  11. 11. Sources of Consumer Credit <ul><li>Loans </li></ul><ul><ul><li>Borrowing money with an agreement to repay along with interest within a certain amount of time </li></ul></ul><ul><li>Inexpensive loans </li></ul><ul><ul><li>Parents or family members </li></ul></ul><ul><li>Medium-priced loans </li></ul><ul><ul><li>Commercial banks, savings and loan associations, and credit unions </li></ul></ul><ul><li>Expensive loans </li></ul><ul><ul><li>Finance and check cashing companies </li></ul></ul><ul><ul><li>Retailers such as car or appliance dealers </li></ul></ul><ul><ul><li>Bank credit cards and cash advances </li></ul></ul>5-
  12. 12. Sources of Consumer Credit <ul><li>Home Equity Loans </li></ul><ul><ul><li>Loan based on your home equity </li></ul></ul><ul><ul><ul><li>Current market value of your home minus the amount you still owe on the mortgage </li></ul></ul></ul><ul><ul><li>Interest is tax deductible </li></ul></ul><ul><ul><li>Should only be used for major purchases </li></ul></ul><ul><li>Credit Cards </li></ul><ul><ul><li>Average cardholder has > 9 credit cards </li></ul></ul><ul><ul><li>Convenience users vs. Borrowers </li></ul></ul><ul><ul><li>Finance charge = total amount paid to use credit </li></ul></ul>5-
  13. 13. Sources of Consumer Credit <ul><li>Debit Cards </li></ul><ul><ul><li>Debit cards electronically subtract money from your savings or checking accounts </li></ul></ul><ul><ul><li>Most commonly used at ATMs </li></ul></ul><ul><li>Stored Value Cards </li></ul><ul><ul><li>Gift cards </li></ul></ul><ul><ul><li>Prepaid cards </li></ul></ul>5-
  14. 14. Sources of Consumer Credit <ul><li>Smart Cards </li></ul><ul><ul><li>Plastic card equipped with a computer chip that can store 500 times as much data as a normal credit card </li></ul></ul><ul><li>Travel and Entertainment (T&E) cards </li></ul><ul><ul><li>Not really “credit cards”; balance is due in full each month </li></ul></ul><ul><ul><li>Diners Club; American Express </li></ul></ul><ul><ul><li>You don’t pay for services or goods at the time you purchase them </li></ul></ul>5-
  15. 15. Objective 3 Determine Whether You Can Afford a Loan and How to Apply for Credit <ul><li>Before you take out a loan, ask yourself... </li></ul><ul><li>Can you meet all your essential expenses and still afford the monthly loan payments ? </li></ul><ul><ul><li>What do you plan to give up in order to make the payment? </li></ul></ul>5-
  16. 16. 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 . 5-
  17. 17. General Rules of Credit Capacity Debt To Equity Ratio Total Liabilities Net Worth* = Should be < 1 *Excluding home value 5-
  18. 18. The Five C’s of Credit <ul><li>Character - Do you pay bills on time? </li></ul><ul><li>Capacity - Can you repay the loan? </li></ul><ul><li>Capital - What are your assets and net worth? </li></ul><ul><li>Collateral - What assets do you have to secure the loan? </li></ul><ul><li>Conditions- Lenders will review how general economic conditions will affect your ability to repay your loan </li></ul>5-
  19. 19. FICO & VantageScore <ul><li>FICO Credit Score </li></ul><ul><ul><li>350 to 850 </li></ul></ul><ul><ul><li>Higher score = less risk </li></ul></ul><ul><ul><li>Available from for a fee </li></ul></ul><ul><li>VantageScore </li></ul><ul><ul><li>New scoring technique </li></ul></ul><ul><ul><li>Developed collaboratively by 3 credit agencies </li></ul></ul><ul><ul><li>Range = 501 to 990 </li></ul></ul>5-
  20. 20. Factors of Creditworthiness <ul><li>ECOA (Equal Credit Opportunity Act) </li></ul><ul><ul><li>Gives all applicants the same rights. </li></ul></ul><ul><ul><li>Credit providers may not discriminate based on: </li></ul></ul><ul><ul><ul><li>Age </li></ul></ul></ul><ul><ul><ul><li>Social Security or public assistance </li></ul></ul></ul><ul><ul><ul><li>Housing loans ( redlining ) </li></ul></ul></ul><ul><ul><li>If you are denied credit, you have the right to know the reasons </li></ul></ul><ul><ul><ul><li>You can request a copy of your credit report within 60 days if you are denied credit based on what is in your files </li></ul></ul></ul>5-
  21. 21. Your Credit Report <ul><li>Credit Reports </li></ul><ul><ul><li>Record of your complete credit history </li></ul></ul><ul><li>Credit Bureaus </li></ul><ul><ul><li>Agencies that collect information on how promptly people and businesses pay their bills </li></ul></ul><ul><ul><li>Experian , Trans Union and Equifax are the 3 major credit bureaus </li></ul></ul><ul><ul><li>Credit Bureaus obtain information from banks, finance companies stores, credit card companies and other lenders </li></ul></ul>5-
  22. 22. Your Credit Report <ul><li>Credit Files </li></ul><ul><ul><li>Typically contain detailed credit data along with considerable personal information: </li></ul></ul><ul><ul><ul><li>Name, address, SSN, DOB (self & spouse) </li></ul></ul></ul><ul><ul><ul><li>Employer, position and income (current & previous, self and spouse) </li></ul></ul></ul><ul><ul><ul><li>Home owner or renter </li></ul></ul></ul><ul><li>Fair Credit Reporting Act (1971) </li></ul><ul><ul><li>Law allows out-of-date information to be deleted, as well as the right to correct misinformation </li></ul></ul>5-
  23. 23. Your Credit Report <ul><li>Who can obtain a credit report? </li></ul><ul><ul><li>Only authorized persons have access to your report for approved legitimate business purposes </li></ul></ul><ul><li>Time Limits on Unfavorable Data </li></ul><ul><ul><li>Adverse data can be reported for 7 years </li></ul></ul><ul><ul><li>Bankruptcy can be reported for 10 years </li></ul></ul>5-
  24. 24. Your Credit Report <ul><li>Incorrect Information in Your File </li></ul><ul><ul><li>You may request a copy of your credit </li></ul></ul><ul><ul><li>information within 60 days of being denied </li></ul></ul><ul><ul><li>credit </li></ul></ul><ul><ul><li>You may request a free copy of your credit </li></ul></ul><ul><ul><li>report annually </li></ul></ul><ul><ul><li>What are Your Legal Rights? </li></ul></ul><ul><ul><li>You have the legal right to sue the credit bureau or the creditor that has caused you harm </li></ul></ul>5-
  25. 25. Objective 4 Determine the Cost of Credit by Calculating Interest Using Various Interest Formulas <ul><li>Finance charge </li></ul><ul><ul><li>Total dollar amount you pay to use credit </li></ul></ul><ul><ul><li>Includes interest costs and fees, such as service charges, credit-related insurance premiums, or appraisal fees </li></ul></ul><ul><li>Annual Percentage Rate (APR) </li></ul><ul><ul><li>Percentage cost of credit on a yearly basis </li></ul></ul><ul><ul><li>Key to comparing costs when shopping for rates </li></ul></ul><ul><li>It is important to shop for credit </li></ul>5-
  26. 26. Tackling the Trade-Offs <ul><li>Term (length of loan) versus interest cost </li></ul><ul><li>Lender risk versus interest rate </li></ul><ul><li>To reduce the lender’s risk and thus the interest rate you can: </li></ul><ul><ul><li>Accept a variable interest rate </li></ul></ul><ul><ul><li>Provide collateral to secure a loan </li></ul></ul><ul><ul><li>Provide up-front cash </li></ul></ul><ul><ul><li>Take a shorter term loan </li></ul></ul>5-
  27. 27. Calculating the Cost of Credit <ul><li>Simple interest </li></ul><ul><ul><li>Computed on principal only without compounding </li></ul></ul><ul><ul><li>The dollar cost of borrowing </li></ul></ul><ul><ul><li>Interest = Principal x rate x Time </li></ul></ul><ul><li>Simple interest on the declining balance </li></ul><ul><ul><li>Interest is paid only on the amount of original principal not yet repaid </li></ul></ul><ul><li>Add-on interest </li></ul><ul><ul><li>Interest calculated on full amount of principal </li></ul></ul><ul><ul><li>Interest added to original principal </li></ul></ul><ul><ul><li>Payment = Total divided by number of payments to be made </li></ul></ul>5-
  28. 28. Calculating the Cost of Credit <ul><li>Cost of Open-End Credit </li></ul><ul><ul><li>Truth in Lending Act requires that open-end creditors inform consumers as to how the finance charge and APR will affect their costs </li></ul></ul><ul><li>Cost of Credit and Expected Inflation </li></ul><ul><ul><li>Lenders incorporate the expected rate of inflation when deciding how much interest to charge </li></ul></ul><ul><li>Avoid the Minimum Monthly Payment Trap </li></ul><ul><ul><li>The longer you take to pay off the bill, the more interest you pay </li></ul></ul>5-
  29. 29. Objective 5 Develop a Plan to Protect Your Credit and Manage Your Debts <ul><li>Fair Credit Billing Act (FCBA, 1975) </li></ul><ul><li>Notify creditor of error in writing within 60 days </li></ul><ul><li>Pay the portion of the bill not in dispute </li></ul><ul><li>Creditor must respond within 30 days </li></ul><ul><li>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 </li></ul>5-
  30. 30. P rotecting Your Credit <ul><li>Disputed item won’t affect your credit rating while in dispute </li></ul><ul><li>Can withhold payment on damaged or shoddy goods or poor services if purchased with a credit card </li></ul><ul><li>Must make sincere attempt to resolve problem with creditor </li></ul>Fair Credit Billing Act (FCBA, 1975) 5-
  31. 31. What to Do If Your Identity is Stolen? <ul><li>Contact the three major credit bureaus </li></ul><ul><ul><li>Ask the fraud department to institute a fraud alert </li></ul></ul><ul><ul><li>Request that creditors call you for permission before opening any new accounts in your name </li></ul></ul><ul><li>Contact creditors </li></ul><ul><ul><li>Check for any accounts that have been tampered with or opened fraudulently </li></ul></ul><ul><li>File a police report </li></ul><ul><ul><li>Keep a copy </li></ul></ul>5-
  32. 32. Protecting Your Credit From Theft or Loss <ul><li>Shred any papers that contain personal information </li></ul><ul><li>Close your accounts immediately if you suspect an identity thief has accessed the account </li></ul><ul><li>Be sure your credit card is returned after a purchase </li></ul><ul><li>Keep a record of credit card numbers </li></ul><ul><li>Notify your credit card company immediately if your card is lost or stolen </li></ul>5-
  33. 33. Protecting Your Credit Information on The Internet <ul><li>Use a secure browser </li></ul><ul><li>Keep records of online transactions </li></ul><ul><li>Review monthly bank and credit card statements </li></ul><ul><li>Read the privacy and security policies of websites you visit </li></ul><ul><li>Keep personal information private </li></ul><ul><li>Never give your password to anyone </li></ul><ul><li>Don’t download files sent by strangers </li></ul>5-
  34. 34. Co-signing a Loan <ul><li>Co-signing means guaranteeing the debt </li></ul><ul><ul><li>Lender would not require a co-signer if borrower were a good risk </li></ul></ul><ul><ul><li>Can you afford it if the borrower defaults? </li></ul></ul><ul><ul><ul><li>If borrower doesn’t pay, cosigner is liable for the full amount plus any late or collection fees </li></ul></ul></ul><ul><ul><ul><li>If payment is missed, creditor can collect from the cosigner first </li></ul></ul></ul>5-
  35. 35. Complaining About Consumer Credit <ul><li>First: Try to solve the problem directly with the creditor </li></ul><ul><li>If that fails: Use formal complaint procedures </li></ul><ul><li>A variety of Consumer Credit Protection Laws and Federal Agencies administer and assist with complaint procedures </li></ul>5-
  36. 36. Consumer Credit Protection Laws <ul><li>Truth in Lending and Consumer Leasing Acts </li></ul><ul><li>Equal Credit Opportunity Act (ECOA) </li></ul><ul><li>Fair Credit Billing Act </li></ul><ul><li>Fair Credit Reporting Act </li></ul><ul><li>Consumer Credit Reporting Reform Act (1977) </li></ul><ul><li>Electronic Funds Transfer Act </li></ul><ul><li>Your Rights Under Consumer Credit Laws </li></ul><ul><ul><li>Complain to the creditor </li></ul></ul><ul><ul><li>File a complaint with the government </li></ul></ul><ul><ul><li>If all else fails, sue the creditor </li></ul></ul>5-
  37. 37. Managing Your Debts <ul><li>Warning Signs of Debt Problems </li></ul><ul><li>Paying only the minimum balance each month </li></ul><ul><li>Trouble even paying the minimum balance </li></ul><ul><li>Total balance increases every month </li></ul><ul><li>Missing loan payments or paying late </li></ul><ul><li>Using savings to pay for necessities </li></ul><ul><li>Getting second or third payment notices </li></ul><ul><li>Borrowing money to pay old debts </li></ul><ul><li>Exceeding the credit limits on your credit cards </li></ul><ul><li>Denied credit due to a bad credit report </li></ul>5-
  38. 38. Managing Your Debts <ul><li>Debt Collection Practices </li></ul><ul><li>The Federal Trade Commission enforces the Fair Debt Collection Practices Act (FDCPA) </li></ul><ul><ul><li>Prohibits certain practices by debt collectors </li></ul></ul><ul><ul><li>Does not eliminate legitimate debts </li></ul></ul>5-
  39. 39. Managing Your Debts <ul><li>Consumer Credit Counseling Services (CCCS) </li></ul><ul><ul><li>Non-profit and supported by contributions from banks, merchants, etc. </li></ul></ul><ul><ul><li>Provides education about credit </li></ul></ul><ul><ul><li>Provides help with spending plan </li></ul></ul><ul><ul><li>Provides debt counseling services for those with serious financial problems </li></ul></ul><ul><ul><li>Can develop a debt consolidation plan and negotiate reduced interest rates </li></ul></ul>5-
  40. 40. Other Counseling Services <ul><li>Universities, local county extension agents, credit unions, military bases, and state and federal housing authorities provide nonprofit counseling services </li></ul><ul><li>Check with your financial institution or consumer protection office for a list of reputable, low-cost financial counseling services </li></ul>5-
  41. 41. Declaring Personal Bankruptcy <ul><li>U.S. Bankruptcy Act of 1978 </li></ul><ul><li>Chapter 7 = straight bankruptcy </li></ul><ul><li>Chapter 13 = wage earner plan </li></ul>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 5-
  42. 42. Chapter 7 Bankruptcy <ul><li>Submit a petition to the court that lists assets and liabilities, and pay a filing fee </li></ul><ul><li>Many, but not all, debts are forgiven </li></ul><ul><li>Assets sold to pay creditors </li></ul><ul><li>Can keep some assets (home, vehicle,..) </li></ul><ul><li>Intent = a fresh start </li></ul><ul><li>Most filed are this type </li></ul>5-
  43. 43. After Chapter 7 <ul><li>You May No Longer Owe: </li></ul><ul><ul><li>Retail store charges </li></ul></ul><ul><ul><li>Bank credit card charges </li></ul></ul><ul><ul><li>Unsecured loans </li></ul></ul><ul><ul><li>Unpaid hospital or physician bills </li></ul></ul><ul><li>You Still May Owe... </li></ul><ul><ul><li>Certain taxes and fines </li></ul></ul><ul><ul><li>Child support and alimony </li></ul></ul><ul><ul><li>Educational loans </li></ul></ul><ul><ul><li>Debts from willful or malicious act </li></ul></ul>5-
  44. 44. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 <ul><li>Makes it more difficult for consumers to file a Chapter 7 bankruptcy </li></ul><ul><ul><li>Forces a Chapter 13 repayment plan </li></ul></ul><ul><ul><li>Debtors must wait 8 years from their last bankruptcy to file again </li></ul></ul><ul><ul><li>Clamps down on “bankruptcy mills” that seek to game the system </li></ul></ul><ul><ul><li>Includes provisions for consumer education on debt management and financial planning </li></ul></ul>5-
  45. 45. Chapter 13 Bankruptcy <ul><li>Debtor with regular income proposes a plan to eliminate his debts over time </li></ul><ul><li>Information provided to the court the same as under Chapter 7 </li></ul><ul><li>Plan may last up to five years </li></ul><ul><li>Debtor makes payments to a court-appointed trustee </li></ul>5-
  46. 46. Obtaining Credit after Bankruptcy <ul><li>May be more difficult </li></ul><ul><li>But, creditors may consider the inability to file bankruptcy again for 8 years </li></ul><ul><li>Could be easier for Chapter 13 filers who have repaid some debt versus Chapter 7 filers who made no effort to repay </li></ul>5-
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