Credit Management

Credit Management Chapter 5

Introduction • Many of you have probably received credit card offers (either on campus or through the mail) if you are a college student • About 80% of college students have credit cards • Proper use of a credit card can help establish a solid credit history • Improper use can take years to heal

What is Credit? • Receiving money, goods and services on the basis of an agreement that the borrower will repay the lender with a specified time period at a specified rate of interest • Today total consumer credit is over $1.5 trillion (excludes home mortgages and home equity loans) • Americans carry over 1 billion credit cards • Over 1 million Americans file for personal bankruptcy each year (twice as many as 10 years ago)

Figure 5.1: Outstanding Consumer Debt

Types of Consumer Credit • Revolving credit • Consumer can make a number of different purchases, up to a certain credit limit • A minimum payment is due each month and interest is charged on the unpaid balance (average is 14.5%/year) • Installment loans • Consumer borrows a fixed amount and repays the principal plus interest at regular intervals (usually monthly) • Lender usually holds title to asset until final payment is made • Mortgage loans and home equity loans • Mortgage is an installment loan secured by real estate • Typically have a term of 15 or 30 years

Deciding How Much to Borrow • Failure to set debt limits is one reason why people get in trouble with credit cards • Guideline: No more than 10 to 20% of your take-home pay should go toward repayment of installment or revolving credit (exclude mortgage payment) • National average is 13.5%

The Right Reasons for Borrowing • Purchasing large, important goods or services • House • Car • College education • Dealing with emergencies • Loss of job • Death of relative (plane tickets on short notice are expensive)

The Right Reasons for Borrowing • Taking advantage of opportunities • Good sale on computer (you are saving for one anyway) • Convenience • Easy to pay with a credit card (pay off your balance every month) when doing day-to-day shopping • Establishing or improving your credit rating • Good way for a college student to establish a credit rating

The Wrong Reasons for Borrowing • Living beyond your means • Do you have to use your credit card to pay your basic living expenses (because you can’t afford not to)? • Buy groceries • Buy clothes • Buy gasoline • Pay your taxes

Sources of Consumer Credit • Financial Institutions • Commercial banks, savings banks, credit unions • National Credit Cards • University alumni associations, sports franchises, etc. are issuing credit cards with their logo (can be used anywhere a regular bank-issued card is accepted) • These organizations receive a fee from the issuing bank • Retailer-specific credit cards (such as Sears and JCPenney) • Can only be used at a specific store

Sources of Credit • Consumer Finance Companies • Company specializing in consumer loans • Ex: Household Finance • Make relatively short-term loans • Charge high interest rates • Generally unsecured • Application forms are easier to fill out than a bank’s • Takes a short period of time to receive approval

Sources of Credit • Life-Insurance Companies • Policyholders may be able to borrow against their life insurance policy (up to the amount they have paid in premiums) • Brokerage Account Loans • Buying on margin

Sources of Credit • Personal loan from family and friends • Always treat these in a businesslike manner • Lots of potential for interpersonal conflict • Pawnbrokers • Issues loans for a very low percentage of an item’s face value • Item is held as security until the loan is repaid in full • Should be viewed as a lender of last resort

Applying for Credit • How creditors evaluate loan applications • Capacity • Can you afford to repay the debt • Examines current income (and expected future earning potential) vs. current expenses • Are you a good credit risk? • Character • Do you live within your means or above it? • Do you pay your bills on time? • Do you demonstrate stability? • Collateral • Property to secure a loan

The Role of Credit Bureaus • Credit bureau—a clearinghouse for consumer credit information • What’s in your credit file? • Identifying information • Your credit history • Including whether or not you pay your bills on time • Information of public record • Bankruptcies, lawsuits, criminal convictions • You may request a copy of your credit record at any time • If you’ve recently been denied credit, the credit reporting service must provide you a copy free of charge

What to Do If You Are Denied Credit • The lender must provide you with a written explanation • Try negotiating with the lender • Ask for a lower loan amount • Try another lender • Different lenders have different lending policies • Some are more lenient than others

Calculating Total Finance Charges • Lenders are required to clearly state the annual percentage rate (APR) • Finance charge: total dollar amount charged for credit • Function of • Amount you borrow • APR • Term of loan • Annual percentage rate: interest rate paid per dollar per year for credit • Principal: the amount borrowed

Note: All of the loans have annual interest rates of 8 percent and terms of 36 months. Figure 5.5: Finance Charges and the Amount Borrowed

Note: All of the loans are for $10,000 and have terms of 36 months. Figure 5.6: Finance Charges and APRs

Note: All of the above loans are for $10,000 and have APRs of 8 percent. Figure 5.7: Finance Charges and Repayment Terms

Calculating Periodic Interest • Most consumer debt calculates periodic interest using the simple interest method • The outstanding balance on the loan is multiplied by the periodic interest rate

Choosing the Lowest-Cost Credit Card • Three main areas to consider • Annual fee • Ranges from $0 to $50 annually • Late payment and other fees • Annual percentage rate • Grace period—how long you have to pay for new purchases without having to pay interest charges • Ranges from 0 days to 30 days • If you pay your bill in full every month, get a card with no annual fee and a grace period of at least 25 days • This way you won’t pay interest charges

Choosing the Lowest-Cost Credit Card • Many credit card companies offer a low interest rate for a short time period (to lure you in—called a teaser rate) and then raise the interest rate substantially • Or the company may offer a great rate unless one payment is late and then the rate rises substantially • Read the fine print

Credit Abuse • If you abuse your credit, it can have lasting repercussions • Repossession—collection of collateral by the lender • May not settle the debt if market value of asset doesn’t cover amount of loan still outstanding • Remaining debt is called deficiency judgment • Wage garnishment—a portion of borrower’s wages is paid directly to lender by the employer • Requires a court order

Credit Abuse • Bankruptcy—borrower is relieved of debts, court divides assets/income among creditors • Action of last resort • Virtually eliminates chances of securing future credit • Over 1 million Americans file for bankruptcy each year • Most are voluntary filings • Chapter 7: assets are seized by court and sold, funds are prorated among creditors (after court costs/legal fees)—70% of bankruptcies • Creditors usually receive only small percentage of what’s owed • Chapter 13: individuals establish a 3-year plan of debt repayment • Debtor retains possession of property • Creditors usually receive 60-70% of what’s owed

Credit Abuse • Bankruptcy doesn’t eliminate all forms of debt • Student loans • Back taxes • Child support • Alimony • Bankruptcy shouldn’t be considered a ‘quick fix’ • Remains on your credit record for 10 years • Won’t get reasonable credit terms during that time • May be difficult to rent an apartment, obtain car insurance, etc.

Credit Counseling and Credit Repair Services • A credit counselor is a trained professional who helps you develop a budget and arrange a program of debt repayment • Non-profit Consumer Credit Counseling Service • Funded by lenders and credit card companies (vested interest in repayment) • Credit Repair Doctors often claim they can ‘erase your bad credit’ • Can’t deliver on their promises—don’t’ use them

Credit Management