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CHAPTER 6: BORROWING ONOPEN ACCOUNT
The Basic Concepts of Credit
Why Borrow? Avoid paying cash for large
purchases (like a car) Meet financial emergencies Convenience Investment purposes
Improper Uses of Credit
Meet basic living expenses Make impulse purchases Purchase non-durable goods
(like restaurant meals) College Student
Rule of Thumb!
THE PRODUCT PURCHASED SHOULD OUTLIVE THE CREDIT PAYMENTS
Don’t letcreditsquash you!
Minimum Payments means Maximum Years
Calculations here are based on a minimum 3 percentpayment and 15.0 percent annual interest rate.
Some Credit Danger Signs
Establishing Credit
Open checking and savings accounts. Get one card and make small purchases. Build a good credit history by:
Not getting overextended.Fulfilling all terms of credit obligations.Consistently paying on time.Immediately notifying creditors if
unable to pay.Being truthful when applying.
What is the toughest part of the consumer credit process?
Servicing the loan (I.e.,making payments) in a prompt and timely fashion. In many respects, this is the most important element.
How much credit can you stand?
Total monthly consumer credit paymentsMonthly take-home pay
Monthly consumer credit payments (excluding mortgage) should not exceed
20% of your monthly net income.
DEBT SAFETY RATIO =
Example:
Consider someone who takes home $2,500 a month.
$2,500 x 20% = $500This is the maximum amount this
individual should have to use to pay off personal loans and consumer credit.
Open Account Credit Credit extended to a consumer in advance of
any transaction. Consumer can buy/borrow up to a specified
amount--the credit limit. Usually, interest can be avoided by paying
balance in full. Sources of open account credit:
Financial institutionsRetail Stores/merchants
Biggest types of open account creditBank credit cardsRetail charge cards
Bank Credit Cards: Issued by financial institutions
Features include: Line of credit dependent upon applicant’s
financial status and ability to pay Cash advances and balance transfers Other services or rebates—in the end, the
cardholder pays for these “free” services Interest rates and fees
Credit Card Fees Interest
Generally high Prime rate + a percentage
Annual fee – assessed for the “privilege” of using the card
Transaction fees “not using our credit card” fee Late-payment fees Over-the-limit fees Balance transfer fees Foreign transaction fees World’s Worst Credit Card
MyBank
MyStore
Reward (Co-branded) Credit Cards
Features of traditional bank credit card with an incentiveFrequent flyer programsAutomobile rebate programOther merchandise rebates—
cruises lines, major oil companies, phone companies
Most carry higher interest rates than regular bank cards.
Interest Rates on Bank Card Charges
Most bankcards have one rate for purchases and a different one for cash advancesInterest on merchandise/service
purchases may have grace periodInterest on cash advance begins the
day the advance is taken out Watch our for those special low introductory
rates that many banks offer Interest rates on credit cards are higher than
any other form of consumer credit
Affinity Cards
Visa or MasterCard issued in conjunction with a sponsoring group
Sponsoring groups receive share of the profits (usually ½ to 1 % of retail purchases)
Cardholder usually pays higher fees or interest
Secured Credit Card
You have to put up collateral to get the card—deposit money
Line of credit is equal to the amount of deposit
Targeted at people with no credit or bad credit histories
Issued as Visa or MasterCard
Student Credit Cards
Often come packaged with special promotional programs (free music CDs, movie tickets, etc.)
Most require that you be enrolled in a 2- or 4- year college and have some sort of income
Credit Card Offers
Retail Charge Cards
Second largest category of credit cards
Usually more expensive than bank credit cards
Build loyalty
Debit Card:
Looks like a credit card but works like writing a check—accesses your checking account.
Does not provide line of credit. Greater liability exposure in
event of fraud ($50-$500) Prepaid card is a debit card with
fixed amount available—does not access your checking account.
Revolving Credit Lines:
Open account credit offered by banks and other financial institutions.
Usually offer higher credit lines and lower interest rates than credit cards!
Money accessed by writing checks.
Forms of revolving credit: Overdraft protection lines – line of
credit linked to checking account that enables depositor to overdraw
Unsecured personal credit linesAvailable on an as-needed basis
Home equity credit linesSecured by the equity in owner’s
homeInterest tax deductible (if you
itemize deductions)
Obtaining and Managing Open Account Credit
Steps in opening an account:
1. Complete and submit application.
2. Lender investigates creditworthiness.
3. Lender obtains credit bureau report.
4. Lender makes credit decision; may use credit scoring.
The Credit ApplicationApplicant submits information on income, marital status, employment history, existing accounts, etc.
The Credit ApplicationApplicant submits information on income, marital status, employment history, existing accounts, etc.
The Lender
Verifies application;turns it over to the Credit Bureau.
The Credit Bureau
The Credit ApplicationApplicant submits information on income, marital status, employment history, existing accounts, etc.
The Lender
Verifies application;turns it over to the Credit Bureau.
Reporting agency thatgathers and sells infoabout people.Gets information from:• subscribing creditors• creditors you use as reference• public documents
The Credit Bureau
The Credit ApplicationApplicant submits information on income, marital status, employment history, existing accounts, etc.
The Lender
Verifies application;turns it over to the Credit Bureau.
Credit Bureau submits report back to lender; lender then makes
Reporting agency thatgathers and sells infoabout people.Gets information from:• subscribing creditors• creditors you use as reference• public documents
The Credit Decision
The Credit Decision Credit scoring scheme will be
used Values are assigned to such
factors as your age, annual income, number of years on your present job, rent or own and how long, age of cars, number and type of credit cards you hold, level of your existing debts, savings accounts, phone, and general credit references
Fair Isaac & Co. Scores (FICO Scores)
Uses only credit information in its calculations Payment history 35% Amounts owed 30% Length of credit history 15% New credit 10% Types of credit used 10%
FICO Scores
Range from a low of 300 points to a maximum of 850 points
The higher the score, the lower the risk to the lender
Distribution of FICO scores in 2005:
Computing Finance Charges
Lenders must discloseAnnual percentage rate (APR), the true
rate of interest paid over life of loan. Method used in computing finance
charges. Balance to which interest rate applied
generally determined using one of four variations of the Average Daily Balance (ADB) method.
ADB including new purchases—for each day in the billing cycle, add the outstanding balance, including new purchases, and subtract payments and credits, then divide by the number of days in the billing cycle; most frequently used—no grace period on new purchases if you carry a balance.
ADB excluding new purchases—same as first method, excluding new purchases; the most consumer friendly!
Two-cycle ADB including new purchases—calculated like the first method, but using the average daily balance for both the current and previous billing cycles; least consumer friendly method!
Two-cycle ADB excluding new purchases—same as the two-cycle method, but excluding new purchases
Example:Calculate the finance charges on a credit
card account which has an annual interest rate of 18% (or 1.5% per month) and uses
the average daily balance method including new purchases.
5 $582 $ 2,910 7 932 6,52415 986 14,790 4 961 3,844
Total: 31 $28,068
ADB = $28,068 31 = $905.42Monthly APR = .18 12 = .015Finance charge = $905.42 x .015 = $13.58
ADB Including New Purchases:
# of Days Balance Weighted (1) (2) Balance (1x2)
Refer to Exhibit 6.6 in text—What a difference the balance method makes! Examples shown below all have: Same stated rate of 19.8%Same account activity
Method Finance Charges
ADB including new purchases $132.00
ADB excluding new purchases 66.00Two-cycle ADB
including new purchases 196.20Two-cycle ADB
excluding new purchases 131.20
Managing Your Credit Cards Review statements promptly
each month and verify each entry.
Pay at least the minimum monthly payment by due date.
Returned merchandise credited to your account.
Using Credit Wisely
Shop around, comparing:Annual fees & other feesAPRLength of grace periodBalance method
+ Short, interest-free loan + Simplified record keeping+ Easier resolution to unsatisfactory
purchases+ Convenience and emergencies
Disadvantages of Credit CardsEasy to overspendHigh interest costs
Advantages of Credit Cards
Avoid credit problems by: Using discipline when purchasing. Reducing the number of cards you
carry. Being selective in accepting
preapproved credit offers. Not making new charges. Paying more than the minimum. Paying off cards with highest finance
charges first. Transferring balances to card with low
introductory rate and paying off quickly.
Important Consumer Credit Legislation
Key legislation deals withCredit discrimination.Disclosure of credit information.Billing procedures, errors, complaints,
and recourse on unsatisfactory purchases.
Disclosure of finance charges, other fees, credit terms, and loss of credit card.
Protection against collector harassment
New Credit Card Rules
H.R. 627:Credit Card Accountability Responsibility and Disclosure Act of 2009 4.6 – average number of credit cards
owned by college students $3,173 - 2008 national average for
undergraduate credit card debt 21% of undergrads have balances
between $3,000 and $7,000 February 22, 2010 - effective date of new
credit card legislation
Credit Card Fraud Never give account number to someone
who calls you—you must initiate the call. Use only secure Internet sites. Never put credit card info on checks or
personal info on charge slips. Keep your eye on your card! Draw line through blank spaces on slip. Destroy old cards and shred old statements
and slips. Report lost or stolen cards immediately!
Options if you’re getting into trouble...
Try credit counselors Help you prepare a budget and repayment
schedule. Deal with creditors to possibly reduce some
interest & fees. File Bankruptcy
Chapter 13—debt restructuring. Chapter 7—wipe the slate clean. Other bankruptcy options.
THE END!
