Transcript CHAPTER 5 Consumer Credit “Borrowing money is like wetting your bed in the middle of the night.

CHAPTER 5
Consumer Credit
“Borrowing money is like wetting your bed in the middle of the
night. At first all you feel is warmth and release. But very, very
quickly comes the awful, cold discomfort of reality.”
– Elizabeth Gilbert
1
What is Consumer Credit?

2
Credit is an arrangement to receive cash, goods or
services now, and pay for them in the future
 Consumer credit is the use of credit for personal
needs (excludes home loans, home improvement loans
and higher education loans)
 It is a major force in the American economy

There are three ways consumers can finance
current purchases
 Take money from savings
 Use present earnings
 Borrow against future income

Trade-offs are involved in using credit
Which Is It?
Does consumer credit increase or
decrease your purchasing power?
A.
Consumer credit increases your
purchasing power
B. Consumer credit decreases your
purchasing power
C. Consumer credit has no effect
on your purchasing power
The correct answer is (B). Sounds like a test question, huh?
3
4
The Cost of Credit
 The finance charge is the total dollar amount
you pay for the loan
 Includes interest and fees, such as service
charges or credit-related insurance
 The annual percentage rate (APR) is the
percentage cost of credit on a yearly basis
 The APR provides the true rate of interest for
comparison with other sources of credit
 This rate lets you compare “like with like” when
shopping for rates
 Mandated by the Truth in Lending Act
5
Truth In Lending Act
The Truth In Lending Act requires creditors
to provide you with accurate and complete
credit costs, terms, and APR
Creditors must disclose
credit terms and information...
 In a clear and conspicuous manner
 In a form you can keep

But often in a font you can not possibly read
And
that is where they put all the information they do not want you to read such as what happens if you miss a single
payment – Your interest rate goes up to 1000% and they come and take your house and your first born and you will be in
debt to them for the rest of your life which will not be that long since you will work yourself to death trying to pay the
interest but they do not care because they will have made enough money off you to buy one or maybe even two yachts
and brand new gas bar-b-q and a trip around the world and …
Calculating the Cost of Credit

6
Simple interest
 Computed on principal only and without
compounding – The dollar cost of borrowing
 Interest = Principal x Rate x Time
 Note: Time needs to be expressed in years
 Used for most installment loans (closed-end loans)
 Average daily balance method
 Most credit cards use this method
 Uses a weighted average of the account balance
throughout the current billing period
 If you carried over a balance, new purchases will
be included in your average daily balance
calculation
 So you do not get to take advantage of the “float”
Calculating the Cost of Credit
(continued)

Adjusted balance method
 New purchases are not taken into account and all
payments are deducted from your previous
balance before interest is added
 This is the most favorable to credit card holders
 But – Surprise! – is the least common method
 Previous balance method
 More costly than average balance method, less
costly than adjusted balance method
 Two cycle average daily balance method
 The worst method for card holders
 Luckily, not very common
http://www.asapcreditcard.com/articles/interest-calculation-methods.html
7
Remember Our $299 Stereo?
 It cost us almost two times more than $299
because of the taxes
 What if we had purchased it with a credit card
and only paid the minimum payments?
 18.9% APR
 2.2% minimum
 That is right – The Price Just Doubled Again!
 It will cost us twice as much if we purchase it on
credit and only make the minimum payments
 And since those are all after-tax dollars, the true
cost of the $299 stereo is almost $1,200
8
When to Use Personal Credit?
Home
Purchase
Higher Education or
Career-Related Education
Home Improvement
9
When to Use Consumer Credit?
NEVER!
Well, all right. In case of emergency…
10
Try Our Easy Payment Plan!
11
100% Down!
No Monthly Payments!
Credit Considerations

12
Before you use credit for a major purchase, ask
yourself some questions:




Could I pay cash or make a down payment?
Do I want to use savings for this purchase?
Does purchase fit with my goals and budget?
Could I use the credit I will 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?
13
Advantages of Consumer Credit

Current use of goods and services
 Permit purchase even when funds are low
 Convenient when shopping
 Safer than cash
 Can take advantage of float time
 May get rebates, airline miles or other
bonuses
 Demonstrates financial stability
 Use For Financial Emergencies
14
Disadvantages of Consumer Credit
 Purchases
are more expensive
 Temptation to overspend
Gotta’ love
this one!
 Ties up future income
 Possible financial difficulties
 Potential loss of merchandise due
to late payment or non-payment
 (Unlikely in case of credit cards)
Types of Credit
 Closed-End Credit
 For a specific purpose and amount
 Mortgage loans
 Automobile loans
 Installment loans
 Open-End Credit – a.k.a. line of credit
 Used as needed until limit of credit is reached
 You pay interest and finance charges if you do
not pay the bill in full when due
 Revolving credit – prearranged loan
 Credit cards / Home equity loans
15
Credit Cards
“The bubonic plague of personal
finance” – Jonathan Clements
 Nearly eight out of ten American
households carry one or more credit cards
 One-third are convenience users
 They pay their balance off in full each month
 Often to take advantage of points, miles, etc.
 The other two-thirds are borrowers
 Co-branding – GM, Shell, etc.
 Linking a credit card with a business offering
rebates on products and services
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Credit Cards
(continued)
 Debit Cards versus Credit Cards
 They are not the same
 Laws and regulations differ
 Credit Card Fraud
 $50 limit on credit card fraud
 Almost always waived
 Debit Card Fraud
 $50 limit if reported within 2 days
 $500 limit if reported within 6 months
 Unlimited loss after 6 months!
 Most banks are waiving the above limits
18
Credit Cards
(continued)
 What is the Cost of Convenience?
“But aren’t credit cards a good way to save money? As long
as you pay the total amount each month, you are essentially
getting a free loan. Plus they are so convenient,” said Cathy.
“Not so fast,” said Roy. “By taking advantage of the ‘float’ as
it is called, you may save a few dollars a year. But the pennies
you save each year are swamped by the hundreds or even
thousands of dollars you spend because of the very same
convenience you speak so highly of. How many times have you
rationalized the purchase of items simply because you told
yourself you wouldn’t have to pay for it until next month? And
then when the bill came the next month, you ask yourself, ‘How
did I spend $500!?’ The cost of that convenience is very high.”
True Confessions!
19
How Many Credit Cards Do You Have?
A. Zero, zilch, nada, no way. Forget it.
They ain’t gettin’ their hooks in me!
B. Only one! I swear it! I only use it to
buy gas.
C. Okay. I have two. I use one to pay off
the other …
D. More than two and I lost count a long
time ago. Plus I would not tell you
even if I did know!
True Confessions, Continued
And How Much Do You Owe?
A. Nothing! I am serious! I do not owe
a cent!
B. Less than $1,000
C. Between $1,000 and $5,000
D. More than $5,000 (You can lie if you do
not want us to know…)
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Credit Cards
(continued)
 Use your credit card like a debit card
 If you can not pay off the balance at
the end of the month, Do Not Use It!
 If you find that you abuse your credit
card, Cut The Damned Thing Up!
Notice that I use the singular instead of the plural?
Do not have more than one credit card!
There simply is not any valid reason to have more than one.
(Well, actually, there might be one or two.)
22
Home Equity Loans
 Based on the current market value of your
home less the amount still owed on the
mortgage (asset – liability = equity)
 a.k.a. 2nd mortgage, 2nd trust deed, HELOC
 Will be much cheaper than a credit card
 Interest is normally tax-deductible (Schedule A)
 Danger! ¡Peligro!
 Do not pay your credit cards and you can destroy
your credit rating – bad, but not a big deal
 Do not pay your home equity loan and you can
lose your home – Big Deal!
23
Home Equity Loans
(continued)
 Example:
 Home currently worth $200,000
 Still owe $150,000 on the mortgage
 Home Equity = $50,000 ($200,000 – $150,000)
 A reputable lender would let you borrow up
to 75% or 80% or even maybe 90% of the
current value of your home
 80% of $200,000 = $160,000
 $160,000 – $150,000 mortgage = $10,000
 You would be eligible for a $10,000 home equity
line of credit
24
Home Equity Loans
(continued)
 But some unscrupulous lenders will let
you borrow more than the available
equity in your home!
 Have you heard or seen the ads?
“Get a 125% Home Equity Loan!”
“Consolidate your car loans and credit card
bills into one easy monthly payment!”
“Run up your credit card bills all over again!”
“Lose your house to us when we foreclose!”
25
Home Equity Loans
(continued)
 Same example – 125% home equity loan:
 Home currently worth $200,000
 Still owe $150,000 on the mortgage
 Home Equity = $50,000 ($200,000 – $150,000)
 125% of $200,000 = $250,000
 $250,000 – $150,000 mortgage = $100,000
 If you used over $50,000 of your available
credit – only ½ of your line of credit – you
would owe more than the house is worth!
 If you got into financial trouble, you would be
tempted to simply walk away from your home
26
Sources of Consumer Credit

Inexpensive loans
 Parents and family members
 Do Not Even Think About It!
 (Except for down payment on a home – more in chapter 7)
 Loans based on assets, such as a savings acct
 A secured loan should have a lower interest rate
than an unsecured loan (all other things equal)

Medium-priced loans
 Commercial banks and credit unions

Expensive loans
 Retailers such as car or appliance dealers
 Bank credit cards and cash advances
27
“Secured” vs “Unsecured” Credit

Secured Credit – Loans based on assets
called “collateral”
 Auto Loans
 Home Loans

Unsecured Credit
 Credit cards
 Most all other forms of consumer credit
28
A “Secured” Credit Card

An excellent way to begin building your credit
is to obtain a “secured credit card”
 Deposit $500 in a savings account
 Receive a credit card with a limit of $500
 Use the credit card …
 Remembering to pay off the balance each month!
 Make sure the issuer reports your credit usage!

After a year or less, you will have built up
enough of a credit history to get an
“unsecured credit card”
 You can then close account & get your $500 back
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Measuring Your Credit Capacity

Before you take out a loan, ask yourself...
 Can you afford the loan?
 What do you plan to give up in order to make
the payments?

Look closely at your…
 Debt Payments-to-Income Ratio and
 Debt-to-Equity Ratio
Or better yet, “Make Love, Not Loans!”
30
Credit Capacity Indicators
Debt Payments-to-Income Ratio
monthly payments*
monthly after tax income
Da’ Book sez, “Should be
less than 20%.” I think
that is obscenely high!
*Not including housing
Example: Debt Payments-to-Income
Ratio (page 149)
Monthly Gross Income
31
$1,500
Less:
All Taxes
270
Social Security / Medicare
112
Monthly IRA Contribution
50
Monthly Net Income
$1,068
Monthly Installment Credit Payments
Squeezya
25
MonsterCard
20
Disaster Card
15
Auto Loan
Total Monthly Payments
Debt Payments-to-Income Ratio ($213 / $1,068)
153
$213
19.94%
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Credit Capacity Indicators
Debt-to-Equity Ratio
total liabilities*
=
Should be < 1.00
net worth
Again, this is far too high!
Businesses try to keep it
down to between
0.30 and 0.50
*Excluding home value
and mortgage
Example: Debt-to-Equity Ratio
Assets (excluding value of home)
Automobile
Furniture
Computer
Miscellaneous
Total Assets (excluding home)
$8,000
1,200
400
2,400
$12,000
Liabilities (excluding home mortgage)
Auto Loan
$6,500
MonsterCard
4,300
Disaster Card
1,400
American Excuse
Total Liabilities (excluding home)
Debt-to-Equity Ratio ($13,000 / $12,000)
800
$13,000
1.08!
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“Would You Co-sign For Me?”
 Before co-signing a loan consider...
 If the person does not pay, you will have to
 Can you afford to pay if the person does not?
 It will affect your credit report as well as theirs
 Request that a copy of overdue payment notices
be sent to you
– Three out of four co-signers
end up paying!
 Surprise
The correct answer, by the way,
to the above question is “No.”
Your Credit Report

Credit bureaus collect information
 Experian, Trans Union, and Equifax
 888-567-8688 / 888-5OPT-OUT
 “Get me off your mailing list!”
 Number of mix-ups and errors in credit reports
have declined recently but it is still very high
 Bureaus get information from banks, finance and
credit card companies, merchants, and others
 Each year, you can get a free credit report from
each of the three major credit bureaus
 Use the “Central Source” to get all three at once
 http://www.annualcreditreport.com
 877-FACT-ACT (877-322-8228)
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Your “FICO” Credit Score
36
 Your credit score is generated by a company
called Fair Isaac Corporation using the data from
Experian, Trans Union, and Equifax
 FICO scores range from upper-300’s to mid800’s
 Generally, anything over 700 is excellent
 Computer will automatically approve you
 At around 600, your credit application is
supposed to be manually reviewed
 Does not always happen (more later)
 Mid-500’s or lower, you are considered a high
risk
Your “FICO” Credit Score
37
(continued)
 What makes up your FICO score?
 Past payment history (35%)
 Amounts owed (30%)
 Are you “maxed out?”
 Rule of thumb: Never pass 75% of your credit
capacity
 Length of credit history (15%)
 Amount of new credit (10%)
 Can be a “red flag” if you open too many accounts in
a short period of time
Psst! Do not tell anyone
 Types of credit (10%)
about this info on this
 No more “Authorized User”
slide. It is a secret!
http://finance.yahoo.com/banking-budgeting/article/109347/the-fico5-the-componentsthat-make-up-a-fico-credit-score?mod=bb-creditcards
Fair Credit Reporting Act
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Is your credit report accurate?
 You can get a free copy of your report if you are
denied credit
 In addition to the free annual copy of your credit
report from each of the three credit bureaus
 Inaccurate information must be corrected within
30 days
 Only authorized persons have access to your
report
 Ha! Ha! Ha! Ha! Ha! This is a good one!
 Anyone can access your credit report!
 Adverse data can be reported for seven years
and bankruptcy for ten years
Identity Theft

39
Protect yourself by shredding old credit slips,
account statements, and credit offers you
receive in the mail
 Shredders are cheap; get a decent one
 Spend about $30 to $50

You may not know your identity has been
stolen until you receive a bill with charges that
are not yours
 Almost 10 million thefts in 2008, $1,200 per victim!
 That is $12 billion
Finding good statistics on identity theft is not easy.
Anyone want to validate my numbers?
40
Identity Theft
(continued)

Take three actions once you know
 Contact the fraud departments of each of the three
major credit bureaus
 Contact the creditors for any accounts that have
been tampered with or opened illegally
 File a police report

Identity Theft Resource Center
 http://www.idtheftcenter.org/
Why should you bother filing a police report?
41
Identity Theft
(continued)

Sources of identity theft
 30% – Security breaches at businesses
 30% – Consumer’s lost and stolen wallets,
checkbooks, etc.
 15% – “Friends” and family members
 9% – Stolen mail
 9% – Attacks and scams targeting home computers

Credit protection businesses
 $10 - $30 per month to protect & insure your
identity
 Virtually all of the services can be done by you for
free
42
Identity Theft
(continued)

Freezing your credit
 Blocks new lines of credit being open
 Free in California if you have been already targeted
 Otherwise, $10 per credit bureau (3 x $10 = $30)

Fraud alerts
 A fraud alert notifies lenders that you have or you
believe you have been targeted (no charge)
 Time limit – 90 days up to 7 years

Other innovative protection methods
 Counter-intelligence!
 Analyzing transaction data
Many companies will do some or all of these services for a fee.
43
Identity Theft
(continued)

An entire industry is springing up
 TrustedID – specializes in credit freezes ($15/mo)
 LifeLock – specializes in fraud alerts ($10/mo)
 CardCops – gathers stolen information that is
already circulating on the Internet, alerts you if it
finds any information on you ($19.99/month)
 IdentitySweep – same as CardCops ($14.95/mo)
 IdentityForce – $17.95/month
 MyPublicInfo – $79.95/year
Hmm. Paying for protection. Makes you feel as though you
are dealing with organized crime!
44
What Creditors Look For: 5 C’s
 Character – Do you pay bills on time?
 Capacity – Can you repay the loan?
 Capital – What are your assets and net worth?
 Collateral – What do you have of value that the
lender can take if you do not repay?
 Conditions – What economic conditions could
affect your repayment of the loan?
Discussion: Who gets credit? Who doesn’t?
45
What If You Are Denied Credit?
 Ask the creditor to clarify the specific reason for
denial of credit
 Check your credit report file (It is free, remember?)
 Apply to another creditor with different
standards
 Take steps to improve your creditworthiness
 You have the right to provide a 100-word
explanation in your file
 For example, you could explain if you were out of
work due to an extended illness and were
therefore late paying bills for a time
46
What If You Are Denied Credit?
(continued)
 The majority of credit applications are now
electronically pre-screened
 If your FICO score is below approximately 600, the
application is supposed to be reviewed by a human
 In practice, the credit company often simply
rejects the application entirely
 Or automatically sends the application to their “sub-
prime” department
 Unfortunately, one account in default can put

your score in the low-500’s
The moral? Check your credit files before you
apply for credit. Get rid of erroneous data.
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What If You Are Denied Credit?
(continued)
 Do Not Fall For…
“We Will Repair Your Credit –
100% Satisfaction Guaranteed!”
Anything legitimate that these people can do
for you, you can do for yourself for free!
Anything illegitimate they suggest is either
illegal or simply will not work
Let’s look at some credit card applications…
Once
Again,
How Long Will It Take?
48
How long can adverse credit data (late
payments, charge offs, etc.) be reported on your
credit report?
A.
B.
C.
D.
3 years
5 years
7 years
10 years
The correct answer is (C).
Once
Again,
How Long Will It Take?
49
How long can a bankruptcy be reported on
your credit report?
A.
B.
C.
D.
3 years
5 years
7 years
10 years
The correct answer is (D). Now, do not forget these two
numbers, 7 & 10.
50
Avoiding & Correcting Credit Mistakes
Fair Credit Billing Act
 Notify creditor of error in writing within 60 days
 Send it to the correct address
 They must respond within 30 days
 Credit card company has 90 days to resolve
the problem or tell you why they think the bill is
correct
 Will not affect your credit rating while in dispute
 You can withhold payment on shoddy goods if
you have paid for them with a credit card
What’s the Significance?
51
And This One?
52
53
Complaining about Consumer Credit

First try to solve the problem directly with
the creditor
 If that does not work, there are more formal
complaint procedures
 There are a variety of consumer credit
protection laws and federal agencies who
administer and assist with complaint
procedures
 www.ftc.gov/credit
54
Equal Credit Opportunity Act
 You know what this one is supposed to do
 “Some of us are more equal than others”
 Don’t Give Up! Never Give Up!
 Someone out there wants to lend to you!
 And after you have established yourself
as a good credit risk, the others will come
calling…
You can then tell ‘em to “Kiss Off!”
55
Managing Your Debts

Notify creditors if you can not make a
payment
 Debt collection practices require…
 If a debt collector calls you, within five days
they must send you a written notice of amount
owed
 You can dispute the debt
 The debt collector has 30 days to verify the
debt
 Send the collector a letter stating that all further
contact should be via the U. S. Postal Service
56
Fair Debt Collection Practices Act
Collection agencies...
 Can not be abusive or threaten
 Can not call you at work if you say not to
 Can not tell boss and friends
 Can not call you at odd hours
 Must follow set procedures
 The act does not apply to creditors that try
and collect the debt themselves
57
Consumer Credit Counseling Service
 One option for those in credit trouble is to seek
help from a non-profit credit counseling service
 National Foundation for Consumer Credit,
 Consumer Credit Counseling Service,
 Debt Counselors of America, etc.
 Credit card companies pay for their operation
 Provide education about credit
 Provide help with spending plan
 Provide debt counseling services for those with
serious financial problems
58
Warning Signs of Debt Problems




Paying only the minimum balance each month
Increasing the total balance due each month
Missing or alternating payments or paying late
Intentionally using overdraft protection or taking
frequent cash advances
 Using credit or savings to pay routine bills such as
food
 Getting second or third payment notices
 Not talking to your partner about money
 Or talking only about money
 Depending on overtime to meet routine expenses
59
Warning Signs of Debt Problems
(continued)
 Using up your savings
 Borrowing money to pay old debts
 Not knowing how much you owe
 Going over your credit limit on credit cards
 Having little or no savings for the unexpected
 Being denied credit due to a credit report
 Getting a credit card revoked by the issuer
 Putting off medical or dental visits because you
can’t afford them now
60
Declaring Personal Bankruptcy
 Personal bankruptcy rate is the highest it has
ever been
 Bankruptcy was designed as a last resort but
has become an “acceptable” tool of credit
management
 The 2005 Bankruptcy Abuse Prevention and
Consumer Protection Act was designed to
end abuses of the current system
 (Paid political announcement sponsored by the credit
card industry and the politicians they own)
Who is to Blame?
61
The credit card companies deserve a
significant or at least partial share of the
blame for the record number of bankruptcies
because they gave too much credit to too
many people.
A. Strongly agree
B. Agree
C. Disagree
D. Strongly disagree
Bankruptcy: The Last Resort

Chapter 13





Plan to pay a portion of your debt
Trustee distributes money to your creditors
Can keep most of your property
Must have a regular income
Chapter 7




Submit a petition and pay the fee yourself, or …
Lawyers charge >$500, including court costs
Can keep some property
Idea is a “fresh start”

But the person may still wind up being hounded by
debt collectors anyway!
62
63
“The Best Congress Money Can Buy”

Provisions of the 2005 Bankruptcy Abuse Prevention
and Consumer Protection Act

Creates a “means test” to determine whether you can use
Chapter 7


Meant to funnel people into Chapter 13


“Fresh start”
“Reorganize”
Boon for credit card companies
 Who wrote the legislation, by the way?
 Congress or the credit card companies?

Complements of The K Street Project (Look it up!)
 Reads “like a credit card industry wish list”

The backlash resulted in the Credit CARD Act of 2009
64
After Bankruptcy You No Longer Owe...
 Retail store charges
 Bank credit card charges
 Unsecured loans
 Unpaid hospital or physician bills
After Bankruptcy You Still May Owe...
 Taxes & fines
 Child support & Alimony
 College loans & Co-signer obligations
 Debts arising from illegal activities (ex: DUIs)
Bankruptcy:
Should You Consult a Lawyer?
 Only
if you believe it is okay not to
consult a doctor and instead decide
to take out your appendix by yourself
Find a good lawyer, by the way.
65
“Uh, Oh!”
66
On your tenth wedding anniversary, you splurge on
a $5,000 second honeymoon, which you charge to
your credit card. With an interest rate of 15.9%, how
long will it take you to pay back the debt if you make
only the 2.2% minimum payment each month?
13 years
B. 19 years
C. 28 years
D. It will be paid off out of your estate when you die
A.
The correct answer is (C).
“Uh, Oh!”
67
(continued)
And how much of a finance charge will you
pay in those 28 years?
A.
B.
C.
D.
$2,976
$4,820
$7,129
$15,281
The correct answer is (C).
“Uh, Oh!”
68
(continued)
Under the new law, the credit
card companies now must
disclose how long it will take
you pay the balance and how
much you will actually pay if
you only make the minimum
payments. The hope is that
people who have not taken
BUS-121 will be motivated
to pay off their balance
quicker. But, of course, all
of you already knew this,
right?
(Nod your heads, “Yes.”
Thank you very much.)
The Bottom Line on Credit
Make Love,
Not Loan$!
69