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Chapter 07

Chapter 07. Choosing a Source of Credit: The Costs of Credit Alternatives. Chapter 7 Learning Objectives. LO7-1 Analyze the major sources of consumer credit. LO7-2 Determine the cost of credit by calculating interest using various interest formulas.

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Chapter 07

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  1. Chapter 07 Choosing a Source of Credit: The Costs of Credit Alternatives

  2. Chapter 7Learning Objectives LO7-1 Analyze the major sources of consumer credit. LO7-2 Determine the cost of credit by calculating interest using various interest formulas. LO7-3 Develop a plan to manage your debts. LO7-4 Evaluate various private and governmental sources that assist consumers with debt problems. LO7-5 Assess the choices in declaring personal bankruptcy. 7-2

  3. Sources of Consumer Credit LO7-1: Analyze the major sources of consumer credit. • WHAT KIND OF LOAN SHOULD YOU SEEK? • Inexpensive loans • Parents or family members • Loans that use your financial assets (CDs or cash value of whole life insurance) as collateral 7-3

  4. Medium-Pricedand Expensive Loans • Medium-priced loans • Commercial banks, savings and loan associations, and credit unions • Expensive loans • Finance and check cashing companies • Retailers such as car or appliance dealers • Bank credit cards and cash advances • Tax refund loans 7-4

  5. The Cost of Credit LO7-2: Determine the cost of credit by calculating interest using various interest formulas. • Truth In Lending Law is the federal law that requires creditors to disclose the annual percentage rate (APR) and the finance charge as a dollar amount • Finance Charge is the total dollar amount you pay to use credit. It includes interest costs, service charges, credit-related insurance premiums, or appraisal fees 7-5

  6. Annual Percentage Rate • The Annual Percentage Rate (APR) is the percentage cost of credit on a yearly basis • Your key to comparing costs, regardless of the amount of credit or how much time you have to repay it • APR is the true rate of interest so you can compare rates with other sources of credit • The law does not set interest rates or other credit charges, but it does require disclosure so that you can compare costs 7-6

  7. Tackling the Trade-Offs • Term versus interest costs • Longer loans with smaller monthly payments results in more total interest • Lender risk versus interest rate Some ways to reduce the lender’s risk and your interest rate: • Accept a variable interest rate • Provide collateral to secure the loan • Make a large cash down payment up front • Accept a shorter-term loan 7-7

  8. Calculating the Cost of Credit • Simple interest • Interest computed on principal only and without compounding • The dollar cost of borrowing • Interest = Principal × Rate of interest × Time I = P × r × T • Simple interest on the declining balance • Used when more than one payment is made on a simple interest loan • Interest is paid only on the amount of original principal not yet repaid • The more frequent your payments, the lower the interest you will pay 7-8

  9. Using the Simple Interest Formula Example: Suppose a relative lends you $1,000 to purchase a laptop computer. Your relative agreed to charge only 5% interest, and you agreed to repay the loan at the end of one year. Calculate the dollar amount of interest on this loan. I = P × r × T Interest = $1,000 × 0.05 × 1 year = $50 7-9

  10. Add-On Interest • Add-on interest • Interest is calculated on the full amount of the original principal • Then this interest amount is immediately added to the original principal • Then the total (interest plus principal) is divided by the number of payments to be made to arrive at the payment amount • When more than one payment is made, this method results in an effective rate of interest higher than stated rate of interest 7-10

  11. Cost of Open-End Credit • Credit cards, department store charge cards, and check overdraft accounts • Creditors are required to let you know the APR and how the finance charge is calculated • Adjusted Balance Method • Payments are subtracted before calculating finance charges • Previous Balance Method • Payments are not subtracted when calculating finance charges 7-11

  12. Example:Previous Balance Method • For example... APR 18% Monthly rate 1.5% Previous balance $400 Payments $300 Finance charge: = 1.5% × $400 = $6.00 7-12

  13. Cost of Open-End Credit(continued) • Average Daily Balance Method • The fairest method of computing finance charges • Creditors add your balances for each day in the billing period and then divide this total by the number of days in the billing period. Then they multiply this average balance by the monthly interest rate • New purchases during the billing period may be included or excluded from the average daily balance calculation 7-13

  14. Cost of Open-End Credit(concluded) • Two-cycle Average Daily Balance Method • May include or exclude new purchases • Method of computing finance charges that uses the average daily balance for two consecutive billing cycles • The Credit CARD Act of 2009 bans this method • Grace Period — creditors must tell you when the finance charges begin 7-14

  15. Cost of Credit, Inflation, and Taxes • COST OF CREDIT AND EXPECTED INFLATION • Borrowers and Lenders are concerned about the goods and services that dollars “can” buy (purchasing power of dollars) rather than the actual credit used • Inflation erodes the purchasing power of money • Each percentage point increase in inflation means a decrease of approximately 1% in the quantity of goods and services you can purchase with a dollar • COST OF CREDIT AND TAX CONSIDERATIONS • Interest paid on consumer credit is not tax deductible 7-15

  16. Minimum Monthly Payment Trap • Avoid the Minimum Monthly Payment Trap • Minimum monthly payment is the smallest amount you can pay and remain in good standing • If you make only the minimum payment each period, you will pay more in interest and it will take you longer to pay off your balance • For example, You purchase a $2,000 sound system using a credit card with 19% interest and a 2% minimum payment. If you pay just the minimum every month, it will take you 265 months (over 22 years) to pay off the debt and will cost you nearly $4,800 in interest payments. 7-16

  17. Early Repaymentand Credit Insurance • EARLY REPAYMENT • The Rule of 78s favors lenders • Formula requires that you pay more interest at the beginning of the loan, when you have the use of more of the money, and pay less and less interest as the debt is reduced • CREDIT INSURANCE • Ensures loan is paid off in the event of death, disability, or loss of property • Three types include credit life, credit accident and health, and credit property • Premiums are quite high 7-17

  18. The Credit CARD Act • The Credit Card Accountability, Responsibility, And Disclosure Act Of 2009 • Limits increases in the APR in the first year • Restricts issuers from charging higher interest rates on existing balances • Teaser rates must be effective for at least 6 months • Issuers must mail statements at least 21 days before payment is due • Disclosure statement must be clear and timely • Card issuers must post card agreements on the internet 7-18

  19. The Credit CARD Act(continued) • Requires statements to report the due dates, potential late fees, interest paid, monthly payment required to pay off the existing balance, and warn about the costs of making only the minimum payments • Sets a consistent due date for card payments each month • Restricts the penalties for going over the credit limit • Prohibits card issuers from issuing cards to consumers under 21 with out a cosigner or independent means to repay debt 7-19

  20. Managing Your Debts LO7-3: Develop a plan to manage your debts. • Notify creditors if you can’t make a payment and try to work out a modified payment plan • If automobiles are repossessed, you will owe difference between selling price and unpaid debt in addition to legal, towing, and storage charges 7-20

  21. Debt Collection Practices • Fair Debt Collection Practices Act • Regulates debt collection agencies • If a debt collector calls you, within five days they must send you a written notice of amount owed, the creditors name, and your right to dispute the debt • You can dispute the debt or pay it • If you dispute debt, you may request verification of the debt within 30 days; If not sent, you can insist that communication about the debt cease • If verification sent, you may pay the debt or give notice that you will not pay 7-21

  22. 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 savings to pay routine bills such as food • Receiving second or third payment notices • Not talking to your partner about money or talking only about money • Depending on overtime to meet routine expenses 7-22

  23. 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 7-23

  24. Frequent Reasons for Indebtedness • Emotional problems such as the need for instant gratification • The use of money to punish or get even • The expectation of instant comfort among young couples who overuse the installment plan • Keeping up with the Joneses • Overindulgence of children • Misunderstanding or lack of communication among family members • Amount of finance charges makes it difficult to repay 7-24

  25. The Serious Consequences of Debt • Robbing Peter to pay Paul can affect family health • May result in loss of job due to garnishments • May result in neglecting the educational needs of children • May result in heavy drinking • May result in neglect of children • May result in marital difficulties • May result in drug abuse • May result in bankruptcy 7-25

  26. Consumer Credit Counseling Services LO7-4: Evaluate various private and governmental sources that assist consumers with debt problems. • If you cannot pay your bills and need help, talk with your creditors and try to work out an adjusted repayment plan or seek help from a nonprofit financial counseling program 7-26

  27. What the CCCS Does • CONSUMER CREDIT COUNSELING SERVICE (CCCS) • A nonprofit which is supported by contributions from banks, credit unions, merchants, etc. • Provides debt counseling services for those with serious financial problems • Aids families by helping set up realistic budget and plan for expenditures • Provides education about credit buying and budgeting • Can administer a debt repayment plan 7-27

  28. How to Choose a Credit Counselor • What services do you offer? • Do you offer free information? • What are your fees? • How will the debt-management plan work? • Can you get my creditors to lower or eliminate my interest and fees? • What if I can’t afford to pay you? • Will you help me avoid future problems? • Will we have a contract? • Are your counselors accredited or certified? 7-28

  29. Alternative Counseling Services • Universities, local county extension agents, credit unions, military bases, and state and federal housing authorities provide nonprofit counseling services • You can check with your bank or consumer protection office to see if it has a listing of reputable, low-cost financial counseling services • The nonprofit American Consumer Credit Counseling website is www.consumercredit.com • Be aware of deceptive credit counseling organizations 7-29

  30. Declaring Personal Bankruptcy LO7-5: Assess the choices in declaring personal bankruptcy. • BANKRUPTCY • A legal process in which some or all of the assets of a debtor are distributed among the creditors because the debtor is unable to pay his or her debts • Declaring bankruptcy is a last resort because it severely damages your credit rating 7-30

  31. Declaring Personal Bankruptcy(continued) • Increasing number of filers are well-educated, middle-class baby boomers • Baby boomers account for 60% of personal bankruptcies • Average age is 38 • Likely to be female • Women account for 36% of filers • A record 2 million people declared bankrupt in 2005 • Bankruptcy is unfortunately an “acceptable” tool of credit management for some 7-31

  32. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 The law requires that: • Executive Office for U.S. Trustees develops a financial management training curriculum to educate individual debtors on how to better manage their finances • Debtors complete an approved instructional course in personal financial management • Clerk of each bankruptcy district maintains a list of credit counseling agencies and instructional courses on personal financial management 7-32

  33. Chapter 7 Bankruptcy • A person filing is called a debtor • Debtor submits a petition to the court that lists assets and liabilities, and pays a filing fee • Known as a Straight Bankruptcy • Many, but not all, debts are forgiven • Most assets are sold to pay creditors • Can keep some assets 7-33

  34. Chapter 7 Bankruptcy(continued) After Chapter 7 Bankruptcy, You May Still Owe… • Certain taxes and fines • Child support and alimony • Educational loans • Debts not disclosed to court • Debts from fraud, embezzlement, driving while intoxicated, or larceny • Debts from willful or malicious acts 7-34

  35. Chapter 13 Bankruptcy • A voluntary plan proposed to the bankruptcy court for those who want to pay a portion of their debt over a period up to five years • Known as a Wage-Earner’s Plan • Payments are made to a trustee • Trustee distributes money to your creditors • Court may allow you to keep property and pay less than full amount of debts • Costs to the debtor include court costs, attorney’s fees, and trustees’ fees and costs 7-35

  36. Tangible Costs of Bankruptcy 7-36

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