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 1Analyze 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 economy5-2

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?

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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 expenses5-4

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 stability5-5

Disadvantages of Consumer Credit

• Temptation to overspend

• Can create long-term financial problems and slow progress toward financial goals

• Potential loss of merchandisedue to late or non-payment

• Ties up future income

• Credit costs money - more costly than paying with cash

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Objective 2Assess 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

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Examples of each?

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

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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

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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

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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

credit5-11

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

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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?

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General Rules of Credit Capacity

*Not including a 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.

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General Rules of Credit Capacity

Debt To Equity Ratio

Total Liabilities

Net Worth*= Should be < 1

*Excluding home value

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The lower the ratio, the better; e.g., 0.5 or 0.25

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

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FICO & VantageScore

• FICO Credit Score– 350 to 850– 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

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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

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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 are the 3 major credit bureaus

– Credit Bureaus obtain information from banks, finance companies stores, credit card companies and other lenders

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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

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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