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U.S. Economy Runs on Credit
Credit is the engine that makes possible growth & development through the economy.
Ex) Septic Tank installation at center
Credit can be Dangerous if MisusedRevolving Credit – a line of
credit that has a maximum limit. It can be used on an ongoing basis until that limit is reached.
Ex) Credit cards, & lines of credit
Dangers of CreditEasy access to credit
allowed many consumers to accumulate more debt than they can manage.
Whenever in a financial pinch, they add more debt to cover the shortfall.
Eventually leading to disaster!
Informed ConsumersIt is the bank’s best interest &
the consumer’s best interest if the consumer is informed about the cost of using credit, and the dangers involved.
Banks want to lend money to make money, but . . .
The bank doesn’t want to struggle to collect money owed to them.
Annual Percentage Rate (APR)
The amount of interest charged on the loan principal expressed as a yearly figure.
Does not include:◦Annual fees◦Transaction fees◦Penalties◦Loan origination fees◦Etc.
Different Ways Interest is ChargedSum-of-Digits MethodPrevious Balance MethodAdjusted Balance MethodAverage Daily Balance Method
Sum-of-Digits MethodInterest gets paid firstPaying ahead doesn’t save you
any $Has built in prepayment
penalties, which may be fixed charges or may be based on the Sum-of-Digits Methods
Sum-of-Digits MethodSum-of-Digits Method –
method of calculating finance charges that takes the total finance charge, divides it by the number of months in the loan term, and assigns a higher ratio of interest to the early payments.
Example of Sum-of-Digits Method
Consider a 12 month loan.Add 12 + 11 + 10 + so onThe sum of the digits 1 through 12 = 781st month of the loan, 12/78ths of the
payment goes towards interest2nd month of the loan, 11/78ths of the
payment goes towards interestAlthough the total cost to the consumer
is the same, there is no advantage to paying early, because the interest is front-loaded.
Example of Sum-of-Digits paymentsLook at example on page 208Read paragraphs explaining savings
differences
House Payment ExampleMortgage payment history
“Rule of 78”A method of
calculating payments
The name derives from how the denominator sums for a 1-year period
Sum-of-Digits MethodCan work for loans of any durationThe denominator used is always
the sum of the total monthsEx) a 15-month loan would have a
denominator of 120.
Previous Balance Method
The amount owed at the beginning of the billing cycle with calculated interest on that figure, regardless of payments or charges
Used with open-ended credit
Adjusted Balance Method
Payments made are subtracted during the billing cycle, however new purchases are not included.
Used with open-ended credit
Average Daily Balance MethodMost common methodThe balances for each day of the
billing cycle are added and then divided by the number of days in the billing cycle to yield an average figure on which the finance charge is calculated.
Minimum PaymentsMost credit cards require a
minimum payment of about 4% of the unpaid balance every month
Used to be only 2% but that only paid the interest, and the credit card companies could keep indebted to them forever
TermTerm – the length of the loan (ex:
60 months, 48 months, etc)The length of the term affects the
finance chargeThe longer the term, the more $
paid backSee example on page 210
OverextensionHappens when you take on more
debt than you can affordSome consumers mistakenly
believe that just because someone approves them for credit, that must mean they can afford it.
Ex) they take on 3, 4, or 5 credit cards, but then they can only afford to make minimum payments
Overextension can be Disastrous!If you’re overextended, and an
emergency arises, or a situation changes, such as a job loss, you are in major trouble!
A snowball effect may occur as late charges, penalty interest rates, & other fees apply
Consequences of overextension
Ruined credit ratingMissed opportunities on great
deals Important things may have to be
passed over (orthodontics for kids, etc)
If all your money is already going out to make debt payments, when gas prices go up, your entire budget may collapse!
The Role of Banks Regarding CreditPredatory Lending – occurs when
lenders create problems for consumers by making credit too easily available without regard to the borrower’s ability to pay.
Not really in the bank’s best interestBanks need creditworthy customersCollecting debt is expensive, & almost
impossible on loans in default
Credit CounselingCounseling agencies (some are for-
profit, some are non-profit)Help you reorganize your debts &
sometime negotiate termsBanks will often accept such
arrangements rather than lose their money altogether.
Be Careful with Credit Counseling
Some credit-counseling companies are simply looking for ways to offer more subprime loans or to make a profit by doing stuff that you could do on your own
Bankruptcy is the last option
Only in extreme casesHas long-term consequencesSeek professional legal advice 1st!