5A

Consumer Credit #1

Credit –

An arrangement to receive cash, goods, or services now and pay for them in the future.

Types of credit ???

Objective 1

Analyze Advantages and Disadvantages of Using Consumer Credit

• •

Credit

– 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 – Dates back to colonial times; exploded after invention of cars (installment loans; traveling) –

A major force in our economy

5-2

Uses and Misuses of Credit

Before you use credit for a major purchase, ask: – 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?

5-3

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 5-4

More 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, cash-back rewards, or other “perks” • Credit indicates financial stability 5-5

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 5-6

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

Examples of each?

5-7

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-

loan for high-priced items

2. Installment cash credit-

loan of cash for personal use

3. Single-lump credit-

loan repaid on a specific day 5-8

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) pre-arranged loan for a specified amount; can be accessed with special checks 5-9

Sources of Consumer Credit

• • •

Loans

– Borrowing money with an agreement to repay, along with interest, within a certain amount of time (e.g., 3 years)

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 (e.g., department store credit cards) – Bank credit cards and cash advances 5-10

Sources of Consumer Credit

• •

Home Equity Loans

– Loan based on 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 5-11

Sources of Consumer Credit

•

Debit Cards

– Debit cards electronically subtract money from savings or checking accounts – Most commonly used at ATMs – Widely accepted at stores also •

Stored Value Cards

– Gift cards – Prepaid cards 5-12

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 (e.g., health info)

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 goods or services at the time of purchase 5-13

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?

– Add up basic monthly expenses and subtract from take-home pay; will the difference cover the monthly payment? (NO? Can’t afford it!) – What do you plan to give up in order to make the payment?

5-14

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 a house payment, which is a long-term liability

5-15

General Rules of Credit Capacity Debt To Equity Ratio Total Liabilities Net Worth*

=

Should be < 1

*Excluding home value The lower the ratio, the better; e.g., 0.5 or 0.25

5-16

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 5-17

FICO & VantageScore

•

FICO Credit Score

– 300 to 850 range – Higher score = less risk – Available from http://www.myfico.com

for a fee; can sometimes get for free from lenders •

VantageScore

– New scoring technique – Developed collaboratively by 3 credit agencies – Range = 501 to 990 5-18

Credit Scoring Factors

• Bill payment history, weighted to emphasize past 12 months (35%) • Proportion of outstanding debt to available credit limits (30%) • Length of credit history (15%) • Number of recent credit inquiries (10%) • Mix of types of credit used (10%)

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 5-20

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

the 3 major credit bureaus are – Credit Bureaus obtain information from banks, finance companies stores, credit card companies and other lenders 5-21

Four Main Parts to a Credit Report

•

Identifying Information:

name, SS Number, current/previous addresses, birthdate, employer •

Public Record Information from Local Courthouse:

liens, foreclosures, bankruptcy •

Other Credit History Information:

list of loans and credit cards, timeliness of payments, defaults and negative information (7 years) •

Inquiries:

Usually 2 years; self-initiated and promotional (for marketing purposes)

Your Credit Report

•

Who can obtain a credit report?

– Only authorized persons have access to your report for approved legitimate business purposes –

Examples???

•

Time Limits on Unfavorable Data

– Adverse data can be reported for 7 years – Bankruptcy can be reported for 10 years 5-23

Wrap Up

• Concept Check 5-1- Reasons to Borrow and Advantages/Disadvantages • Concept Check 5-2- Definition of Terms; Difference Between Credit and Debit Cards • Concept Check 5-3- Definition of Terms