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    CONSUMER CREDIT [ ].doc CONSUMER CREDIT [ ].doc Document Transcript

    • 5 CONSUMER CREDIT Credit Cards and Consumer Loans Learning Objectives Upon reading this chapter, students should: * Be able to compare advantages and disadvantages of using consumer credit to make purchases * Understand and assess the various types of consumer credit * Know how to take steps to protect and establish good consumer credit * Recognize and evaluate credit card alternatives, including terms and costs * Appreciate the hazards of credit card use, including the risk of identity theft Chapter Summary Today, the national saving rate has declined significantly. More and more people are relying on credit to manage their personal finances. Any time an individual receives cash, goods, or services and arranges to pay for them later, they are buying on credit. Consumer credit, credit for purchases of personal needs, has several types. The most common types of consumer credit are; credit card accounts, automobile loans, home equity loans and student loans. The advantages of consumer credit are as follows, (1) buy now, pay later; (2) convenience and safety, (3) source of emergency cash. However, they also have disadvantages, (1) financial statement impact, the more you borrow the worse your liquidity and debt ratios look, (2) increased costs for products as a result of spreading the cost out over time, (3) risk of overspending, (4) higher insurance premiums because insurance companies utilize a consumer’s credit history as a means of determining insurance premiums. The ratio of debt to assets has increased more than 30 percent over the past two decades. The average U.S. household has eight credit cards and more than $8,000.00 on them. There are two general types of credit arrangements available. Closed end credit is credit that a lender approves for a specific purpose. This type of credit is often called a consumer loan. The second type is open-end credit. It is also called revolving credit. The lender preapproves an amount of credit known as a credit limit. The factors utilized by lenders in determining your credit worthiness is known as the “five C’s of credit”. They are as follows: 1. Capacity – a lender’s assessment of you ability to repay your debts. 2. Capital – lender’s are interested in your net worth or amount of capital. 3. Collateral – a loan protected by collateral is safer to one lender than one is not. 4. Character- a lender is interested in your previous credit, employment and education. 5. Conditions – every loan and borrower represents a unique situation, and a lender will sometimes take individual circumstances into account. If an individual has insufficient credit,
    • or has a history of late payments, a lender will require a co-signor. A person who agrees to take responsibility if you don’t make your payments as agreed. If an individual is denied a loan they will receive written notification and a letter stating the reason for the denial. Some of the common reasons for being denied are insufficient job history or adverse information in your credit report. There are laws in place which protect consumers and their credit. In applying for credit, individuals have the following rights; (1) the right to full and accurate information; (2) the right to freedom from discrimination; (3) creditors may not consider gender in credit decisions. An individual’s credit information is reported by a credit bureau. There are three major credit reporting agencies. They are TransUnion, Experian, and Equifax Credit Information Services. You are entitled to a free copy of your credit report by contacting any of the agencies. Your credit report includes some of the following information; (1) any requests for credit lines, (2) inquiries into your credit, (3) outstanding loans in your name. Your credit score is calculated by using a system known as the FICO score. The FICO system establishes a range from 300 to 850. If there is any erroneous information on your credit report you have a right to have it investigated by the credit reporting agencies. All lenders are required to provide you with complete statements every month. If there are any disputed charges on the bill, you are given 60 days to contest any charge on your account. Credit cards are the most common type of open end credit available to consumers. There are several types of credit cards: 1. Bank credit cards – a bank credit card allows the holder to make purchases anywhere the chard is accepted. Some cards also allow the holder to borrow cash by taking a cash advance. 2. Retail credit cards – a business, like Home Depot, who offers their own credit cards, are known as retail cards. These cards sometimes offer discounts to account holders and often charge significantly higher fees. 3. Debit cards – A debit card allows a borrower to subtract the cost of their purchase from their checking or savings account electronically. Some credit card companies charge high annual fees. Therefore, it is important to know the cost of the card you maintain. The most important feature of a credit card is the annual percentage rate. (APR). The APR is the standardized annual cost of credit, including mandatory fees paid by the borrower. It is important to review all the terms of a credit card offer. A credit card offer that promises a rate of zero percent interest for six months, may not disclose all of the hidden fees which accompany the transaction. It is vital to an individual’s personal financial health to read all the terms and conditions of a credit card offer. There are a number of important terms to understand when dealing with credit cards. For example, an individual should know their payment due dates, required minimum payment, if a grace period applies and any penalties they may incur as a result of a late payment. When comparing various credit card options, a person needs to understand how a finance charge is calculated. The finance charge is the dollar amount of interest charged by the lender in a particular billing cycle. It is calculated as follows: Finance charge = Periodic rate x Account balance owed. The best deals on cards are those which calculate finance charges using the average daily balance with a grace period. There are several advantages to using credit cards; (1) method of identification, (2)
    • means of record keeping for business expenses; (3) ability to make remote purchases, (4) free credit, (5) ease of returning merchandise. The disadvantages of credit cards are; (1) loss of privacy, (2) possible identity theft, (3) possibility of overspending. Key Terms APR The standardized annual cost of credit, including all mandatory fees paid by the borrower, expressed as a percentage rate. Stands for annual percentage rate. Average daily balance The average of the balances owed on each day of the billing cycle. Bank credit card A credit card issued by a depository institution Bankruptcy The legal right to ask a court of law to relieve you of certain debts and obligations. Billing date The last day of a billing cycle. Credit card transactions made after the billing date appear on the next month’s bill. Cash advance A cash loan from a credit card account. Closed-end credit Loans for a specific purpose paid back in a specified period of time, usually with monthly payments. Consumer credit Credit used for personal needs other than home purchases. Convenience check A check supplied by a credit card lender for the purpose of making a cash advance. Cosigner A person who agrees to take responsibility for repayment of a loan if the primary borrower defaults. Credit An arrangement to receive cash, goods, or services now and pay later. Credit bureau A company that collects credit information on individuals and provides reports to interested lenders. Credit limit The preapproved maximum amount of borrowing for an open-end credit account. Also known as a credit line. Due date The date by which payment must be received by the lender if the account holder is to avoid late penalties and, in some cases, interest on new transactions. Electronic cash Money in digitized format. Finance charge The dollar amount of periodic interest charged by a lender on a credit account. Grace period The time before interest begins to accrue on new transactions. Late payment penalty A penalty fee charged to an account for making a payment after the due date. Minimum payment The minimum amount that must be paid by the due date to maintain good credit standing and avoid late payment penalties. Open-end credit Preapproved continuous loans that can cover many purchases and usually requires monthly partial payments. Also known as revolving credit.
    • Overlimit charge A penalty fee charged to an account for exceeding the credit limit. Periodic rate The stated rate divided by the number of billing periods per year. Retail credit card A credit card that can be used only at the sponsoring retailer’s outlets. Smart card A card that stores identification and electronic cash in a computer chip. Teaser rate A short-term below-market interest rate intended to encourage new customers to apply for a credit card. Transaction date The date on which you make a credit card purchase. Travel and entertainment A credit card that requires payment of the full balance each (T&E) card billing cycle. . Lecture Notes 1. With credit cards, students sometimes have difficulty in understanding how finance charges on their account are calculated. Have students understand the following terminology. The finance charge is the dollar amount of interest charged by a lender in a particular billing cycle. However, the more problematic portion of calculating interest on credit cards depends on the period used. The most common method is where the lender calculates the balance owed on each day of the billing cycle, adding any new charges made. Teach students the two most important aspects to remember when comparing credit card rates: (1) Always compare the rates based on APR, rather than the nominal and (2) Tell students to read the credit card agreement carefully. 2. We are currently in an environment where interest rates haven begun to rise. As a result, the prime rate has increased with each of the seventeen rate hikes implemented by the Federal Reserve. However, the willingness of the American public to reduce the amount of debt outstanding has increased. Have students examine historical trends in saving and debt. Ask students to consider the effect of increased debt, and the potential pitfalls if a borrower cannot make their minimum monthly payment, or is forced to file for bankruptcy. 3. Negative credit information has the potential to significantly affect an individual’s ability to borrow money at a competitive rate of interest. Students may not realize that one or two late payments, or a threat of legal action, will remain on an individuals’ credit report for seven years. Have students discuss the implications for untimely loan and credit card payments. In addition, ask students to discuss the implications of the fees which a credit card company will assess. Often students in particular will not pay attention to their credit at such an early age. Have students discuss the implications of negative credit data and its impact on the “five C’s” for them later in life. 4. Unfortunately, consumers pay little attention to their credit reports. Ask the class how many have looked at their credit report. Next ask the class to return home and survey one or two family members, how many of them have reviewed their credit reports? Have students discuss the importance of periodically reviewing their credit report. Often times, student do not realize that an open line of credit, for example $1,000 to a store like the Gap, shows as a potential line of credit on their report. This affects any future credit line requests the students may make. Have students discuss the benefits of applying for a retail store card. More often than not, these retailers will offer a 10% or 15% percent discount for opening an account.
    • Ask students to discuss the implications of that retail credit card. The purpose of these activities is to have students understand the larger picture of credit card debt and its impact on their FICO score and personal financial well being. Suggestions for Learning Activities 1. Have students visit the following website: http://www.ftc.gov/bcp/conline/pubs/credit/freereports.htm. Ask students to read the press release. Ask them to answer the following questions in class after reading the release: a. Can consumers obtain a credit report free of charge? b. Where do consumers go to request the free report? c. Why should consumers review their credit report? d. Are there any pitfalls or scams consumers should be aware of? 2. After completing the above exercise, ask students to request their free credit report. Upon receiving it, ask students to answer the following questions in the form of a one page written essay: a. Did you obtain your credit score? b. What information is listed on your report? c. How many inquiries have been made into your credit in the past year? d. How many credit cards do you have outstanding? e. How much credit do you have available? f. How many credit cards do you have and what types are they? g. Did you learn anything about yourself, or learn something new after reviewing your credit report? 3. Ask students to form groups of three or four and assign them the following tasks. a. First, they must interview two individuals, and find out how many credit cards they currently have. b. Second, have the students do a comparison of three types of bank credit cards and the APR available on each of them. c. Third, have the students find out what someone can do to stop receiving credit card offers in the mail. d. Lastly, ask the students to review a balance transfer offer and see if there are any fees associated with transferring a credit card balance from one card to another. The groups can report their findings to the class after they have done the research. 4. Have students contact one of their credit card providers. Ask the students who have outstanding debt to negotiate with the bank to see if they can have their interest rate on the card lowered. Have students report back to the class on their experience. Suggestions for Additional Resources 1. http://www.ftc.gov/bcp/conline/pubs/credit/freereports.htm 2. https://www.annualcreditreport.com/cra/index.jsp 3. www.experian.com 4. http://www.myfico.com/ 5. http://www.ftc.gov/bcp/menu-credit.htm
    • 6. For an article on consumer credit protection go to: http://www.federalreserve.gov/pubs/consumerhdbk/ 7. http://www.transunion.com 8. http://www.econsumer.equifax.com 9. For a press release on credit cards go to: http://www.occ.treas.gov/toolkit/newsrelease.aspx? Doc=2GDVIIRU.xml. Answers to Self-check Questions 5.1 1. Name the most common types of consumer credit. Credit cards, auto loans, home equity loans and student loans. 2. List the advantages and disadvantages of using consumer credit. • Advantages: Buy now, pay later, convenience and safety and emergency cash. • Disadvantages: Financial impact on personal ratios, increased costs, risk of overspending, and higher insurance. 3. How much credit does the typical U.S. household have? Eight credit cards with more than $8,000. Total debt averages 18 percent of assets and the total amount of consumer credit is more than $2.1 trillion. 4. In what ways can having bad credit hurt you? Makes it harder to obtain loans, hurts your credit rating, increases your interest rates and insurance premiums, and affects your financial standing with potential employers and landlords. 5.2 1. Define revolving credit and closed-end credit. • Revolving or open end - generally not earmarked for a particular purchase • Closed end - credit that a lender approves for a specific purpose 2. List some examples of closed-end credit. Auto or student loan.. 3. List some examples of open-end credit. Credit cards and home equity lines of credit. 5.3 1. Define cosigner. A person who agrees to take responsibility if you don’t make your payments as agreed 2. What are five C’s of credit? Capacity, capital, collateral, character, conditions. 3. Give an example of common reasons for being denied credit for each of the five C’s. Low income relative to debt, low net worth, no collateral, poor credit history, no cosigner. 5.4 1. List ways to improve your credit score. Making payments on time, reducing your debt, developing a longer history, close accounts you haven’t used recently, correct bad information on your report. 2. Define credit bureau. A company that collects credit information on individuals and provides reports to interested lenders, landlords, employers, and insurers.
    • 3. What are your legal rights in obtaining credit? Full and accurate information, freedom from discrimination, know what’s in your credit report, and to dispute items you disagree with. 5.5 1. List the types of cards available today. Bank and retail credit cards, travel and entertainment cards, debit cards, and smart cards. 2. Define cash advance, APR, grace period and finance charge. • Cash advance: A cash loan from credit card account. • Annual percentage rate (APR): Standardized annual cost of credit, including all mandatory fees paid by the borrower, expressed as a percentage rate. • Finance charge: The dollar amount of periodic interest charged by the lender on a credit account. • Grace period: The time before interest begins to accrue on new transactions. 3. Cite the two important rules to remember when comparing credit card terms. 1. Always compare the rates based on APR rather than the nominal, or stated, rate. 2. Read your credit agreement carefully to determine how finance charges are calculated. 5.6 1. List the advantages of credit card usage. Useful for identification and for record keeping, the ability to make remote purchases, easier to return merchandise and free credit before the end of the grace period. 2. List the disadvantages of credit card usage. Most expensive way to borrow, negative effects of marketing, loss of privacy, fraud and identity theft risk. Answers to Summary Questions 1. A home equity loan is considered a type of consumer credit. True or false? 2. Credit cards should be compared based on annual percentage yield. True or false? 3. If a bank loans you money for a new car, this is a type of: a. closed-end credit. b. open-end credit. c. revolving credit. d. cash advance. 4. Credit cards, such as MasterCard and Visa, are examples of: a. closed-end credit. b. open-end credit. c. collateralized credit. d. wholesale credit. 5. Which of the following is not one of the five C's of credit? a. conditions b. capacity c. credibility
    • d. capital 6. When lenders evaluate your sources of income and your expenses, they are considering your: a. capacity b. capital c. collateral d. character 7. Under the Consumer Credit Reporting Reform Act of 1997, the burden of proof for accuracy of credit information is placed on consumers rather than creditors. True or false? 8. Credit cards that calculate finance charges without including new charges during the billing cycle allow cardholders to borrow without paying interest if paid by the end of the grace period. True or false? 9. Making the minimum payment on a credit card bill: a. ensures that the bill will be repaid in the minimum time period. b. ensures that late payment penalties will not be imposed. c. will not reduce the overall debt significantly. d. gives you the best credit standing available. 10. Which of the following is an advantage credit cards have over other forms of consumer credit? a. buy now, pay later b. source of emergency cash c. safe alternative to cash d. easier to return merchandise Answers to “Applying this Chapter” Questions 1.Discuss the pros and cons of using consumer credit for purchases for your Christmas/holiday shopping. The advantages of using consumer credit is that you can buy more than you could otherwise. Also, any purchases you make on credit cards will be easier to return if they are defective. The disadvantages are that you will more likely overspend and, unless you have sufficient extra money, you may have difficulty repaying the debt. If you cannot pay the full amount due at your next statement, you will be subject to high interest charges which will increase the total cost of your holiday purchase. 2. You have a $750 balance on your credit card. You want to purchase a new stereo system for your car. However, your credit limit is $1,000. What is the most you can finance on your card? You have $250 left on your credit limit, however, before you use it all, you must keep in mind that interest charges may bring you over the $1,000 ceiling. 3. Suppose you get turned down by a lender for having making late payments on your mortgage? How do you improve your credit history? You need to be sure to make all of your payments on time in the future. You could arrange for automatic withdrawal of these funds from your checking account to ensure that the payment is received by the lender on time.
    • 4. You have a FICO score of 200. Give some possible reasons and some possible solutions. This is an extremely low FICO score and probably means that you have a serious problem with your credit. Factors will include excessive numbers of open credit accounts, high balances, a history of late payments, and possibly delinquent loans. In order to remedy this situation, you will have to develop a plan for paying down outstanding loans and making timely payments on your credit accounts. If there is any information on your credit report that is incorrect, you should be sure to notify the credit reporting agencies to have it removed. 5. What is the potential problem with “teaser rates” for credit cards? The cards may have high annual fees and commonly have clauses that allow the rate to increase substantially if you make payments late, exceed your credit limit, or experience a change in credit status. Teaser rates on credit cards offer a very low initial rate of interest, but the cards may have high annual fees and commonly have clauses that allow the rate to increase substantially if you make payments late, exceed your credit limit, or experience a change in credit status. 6. The total annual finance charges on your credit card account are $200. You also pay an annual fee of $50. If your average outstanding balance during the year is $1,000, what is the annual percentage rate? APR = ($200 +$50) / $1,000 = .25 or 25% 7. When are balance transfers a good idea? If the rate on another card is substantially different from your current credit card, but the terms are otherwise the same, you can transfer your balance to the new card and save money on annual interest costs. You must weigh this savings against any fees that might be charged for the service from either lender. 8. Carrie Chandler opens her June credit card bill and sees that her balance is a bit higher than she thought. When she more carefully examines the bill, she sees that there was a $75 payment to “Shoppers Cooperative” that she knows she did not authorize. Looking back at her May bill, which she unfortunately didn’t look at very carefully the previous month, she sees a $75 payment to the same company that month, too. Explain the steps that Carrie should take to resolve this problem. How much might she be responsible for paying? If she suspects unauthorized use of her credit card she should notify the card issuer immediately. She should probably get a new card account and stop using the old card. Her maximum liability is $50 if she reports the unauthorized usage promptly. In this situation, which does not appear to involve identity theft, she may be able to simply have the charge removed by her credit card company, since she did not authorize it. Answers to “You Try It!” Questions Calculating APR You’ve just received a credit card solicitation in the mail that offers you a 4 percent APR. Your current card, which has an outstanding balance of $5,000, has an APR of 14 percent. What factors should you consider in making the decision to transfer your balance? How much interest will you save the first month by switching cards, assuming you make no additional charges and both cards calculate interest based on the average daily balance?
    • You should consider other terms and conditions such as when the new rate expires and what it will revert to after the teaser period, annual fees, penalties, and differential rates for cash advances and purchases. Also consider whether a higher rate applies to balance transfers and cash advances. The difference in rate is 10%/12 = .833%. You will save $5,000 x ..00833 = $41.66 a month. Comparing Cards Using your most recent statements, evaluate the credit cards you currently hold, if any. Make a table that compares their features, including annual fee, APR, method of finance charge calculation, and penalty fees. If you carry a balance forward on one or more cards, make a plan for paying off your cards, starting with the one with the highest costs and least desirable features. Answers will vary.