Personal Finance: An Integrated Planning Approach

1. Personal Finance:An Integrated Planning Approach Winger and Frasca Chapter 6 Short-Term Credit Management: Consumer Credit

2. Introduction • This chapter talks about the use of consumer credit. • The reasons for the wise use of credit are reviewed as well as the pitfalls of using credit poorly. • The steps involved with establishing credit are reviewed as well as how to maintain a good credit record. • Today, consumers need to be wise shoppers for credit since there are more sources of credit as well as more fees that can be assessed. • Today, this is a more competitive market so consumers need to shop around.

3. Chapter Objectives • To evaluate reasons for and against using credit and decide whether credit is appropriate for you • To be able to take the necessary steps to establish credit and develop a credit history • To identify what is meant by sales credit and how it is used

4. Chapter Objectives (Continued) • To understand how to use credit cards properly and to know your legal rights as a borrower against credit mistakes • To identify the important characteristics of installment loans • To compare the various sources of credit and to learn what to do if you experience credit problems

5. Topic Outline • Arranging and Using Credit • Sales Credit • Cash Credit • Obtaining Credit and Resolving Credit Problems

6. ARRANGING AND USING CREDIT • Reasons for using credit • Disadvantages of using credit • How to get credit (& keep it) • What the lenders look for • Begin a credit record • Special concerns for married women • Credit accounts • The role of the credit bureau • Contents of a credit report • If you are denied credit

7. Reasons for Using Credit • As a shopping convenience • To increase total consumption benefits • As an inflation hedge • As a source of emergency funds

8. Disadvantages of Using Credit • Temptation to overspend • Credit costs • Less flexibility with future budgets

9. How to Get Credit (& Keep it) • You should consider what the lender looks for. • You should begin a credit record. • You should review your credit report annually. • You should repair a bad credit record.

10. What the Lender Looks for Lenders often use the three C’s of credit to determine the credit worthiness of an applicant. These are: • Character: have you met your previous obligations? • Capital: do you have sufficient financial assets? • Capacity: can you meet your future obligations?

11. Begin a Credit Record • Open checking and savings accounts • Open a retail charge account with a local store or major oil company • Qualify for a small installment loan • Make sure that your credit record follows you • Have a telephone installed • Don’t apply for too much credit

12. Special Concerns for Married Women • Always use your own name, such as Nancy Hall. • Don’t use social titles, such as Mrs. Edward Hall. • Make sure that all credit information is reported under your name as well as your husband’s. • Inform creditors that you wish to maintain your own credit history. • Know the difference between a joint and individual credit account.

13. Credit Accounts • Joint credit account • Both spouses are responsible for the debt. • Divorced or separated spouses should cancel joint accounts. • Individual credit account • Only you are responsible for debt (not your spouse). • Account will appear only on your credit report (not on your spouse’s credit report).

14. The Role of the Credit Bureau • The credit bureau does not decide who receives credit. • It acts as a clearinghouse for information on the past use of credit. • The credit bureau stores information on legal actions against you. • They store all credit inquiries for the last year and all employment related inquiries for the last two years. • It sells this information to lenders.

15. Contents of a Credit Report • All existing credit accounts are included • Information on each credit account includes: • Credit limit, amount borrowed, account balance, and your payment history • Who is responsible for paying the account • Public record information • Bankruptcies, tax liens, and monetary judgments • Who has obtained a copy of the report

16. If You Are Denied Credit • You are entitled to one free report from the reporting agency that supplied the report upon which the decision was based. • Review the report and correct any mistakes. • Submit your own written statement on any disputed items. • Have old adverse information removed from report. • Have anyone who received the report notified of any corrected entries.

17. SALES CREDIT • Kinds of accounts • Regular charge account • Open-end account • Closed-end account • Revolving account • Major issuers of credit cards • MasterCard, Visa, American Express, Discover • Selecting a credit card

18. Kinds of Accounts • Regular charge account: billed for purchases at the end of month • Open-end account: revolving credit account with an agreement that continues as long as account is open • Closed-end account: there is a separate installment contract for each purchase • Revolving charge account: the credit limit is determined by credit record and net worth • Partial payment must be made each month • Interest is charged on unpaid balance and • Account may never actually be paid off.

19. The Truth in Lending Act Requires that the lender provide the following information for revolving charge account: • Annual percentage rate (APR) applied to balance • Method for calculating interest • Grace period, if any, before interest will be charged • Minimum monthly payment • Penalties for late payment • Permission to investigate credit history

20. Interest Computation Methods For revolving credit cards, interest is calculated several ways. These are: • Previous balance method • Adjusted balance method • Average daily balance method • Including current purchases • Excluding current purchases • Two-cycle average daily balance method

21. Previous Balance Method • Interest rate applied to balance at end of previous month. • Example: • Previous balance = $500 • Monthly interest rate (21%/12) = 1.75% • Interest charge = 1.75% × 500 = $8.75

22. Adjusted Balance Method • Equal to the previous balance less any payments or returns made during the current billing cycle • Example: • Previous balance = $500 • Less current payment = 34 • Adjusted balance = $466 • Monthly interest rate (21%/12) = 1.75% • Interest charge = 1.75% × $466 = $8.16

23. Average Daily Balance Method(including current purchases)

24. Average Daily Balance Method(including current purchases) • Average daily balance = total/days • 17,177/31 = $554.10 • Monthly interest rate (21%/12) = 1.75% • Interest charge = 1.75% × $554.10 = $9.70

25. Average Daily Balance Method(excluding current purchases)

26. Average Daily Balance Method(excluding current purchases) • Average daily balance = total/days • 14,786/31 = $476.97 • Monthly interest rate (21%/12) = 1.75% • Interest charge = 1.75% × $476.97 = $8.35

27. Interest Charges on Balances Illustrations: • Previous balance method $8.75 • Adjusted balance method $8.16 • Average daily balance method • Including current purchases $9.70 • Excluding current purchases $8.35

28. Two-Cycle Average Daily Balance Method • When you fail to completely pay off the balance in the present month, the grace period is eliminated in the previous month. • The lender can go back two periods to collect interest on unpaid balance. • This method hurts those cardholders who pay off their balances every other month.

29. Major Issuers of Credit Cards • Bank credit cards are issued by MasterCard, Visa, and Discover. • Travel and entertainment cards are issued by American Express. • Other cards are issued by: • Department store chains • Major gasoline retailers.

30. Annual membership fee Variable rate information Balance computation method Late payment fee Return check charge Copy charge Annual percentage rate Grace period Cash advance fee Over-the-limit penalty Replacement fee Fees for optional services Minimum finance fee Transaction fee Credit Card Cost Comparison

31. Credit limit Total disability insurance Unemployment insurance Accident insurance Rental car collision insurance Warranty protection Merchandise loss protection Credit life insurance Rebates & discounts Frequent flyer miles Rebates Discounts Credit card registry Purchase price protection Credit Card Benefit Comparison

32. Protection Against Credit Card Fraud • Sign a new credit card immediately upon receipt. • Record card numbers, expiration dates, and phone number for card company in case you need to call. • Destroy old bills, receipts, and credit cards. • Check sales receipt and compare with credit card statement monthly. • Be careful giving out your credit card number. • Report lost or stolen cards immediately.

33. Correcting Credit Card Mistakes • Notify the creditor in writing within 60 days of the billing date. • Pay all parts of the bill that are not in dispute. • Creditor will notify you within 30 days of its decision. • If no error is found, you must pay or you will be reported as delinquent. • If you still challenge in writing, the creditor must report that information. You should insure that the information is provided to the credit bureau. • A creditor cannot threaten your credit rating while you are resolving a credit dispute.

34. Other Credit Terms • Chargeback • A disputed amount charged back to the merchant by the credit card company. • Credit blocking • When a merchant contacts the credit card issuer for an estimated charge such as a hotel room or a rental car. • The amount of the estimated charge reduces your credit limit on the card that you used to hold the hotel room or rental car. • This in effect reduces your available credit until the actual charge is put through.

35. Credit Cards versus Debit Cards • With a debit card, your bank balance is immediately reduced. With a credit card, there is a grace period. • With a debit card, your protection against loss is dependent on how quickly you notify the issuer. The sooner you notify the issuer, the greater your protection. • If you notify the issuer within 2 days, your loss is limited to $500. If you wait 60 days or more, your losses may be unlimited. • With a credit card, your loss is limited to $50 for a stolen card.

36. Cash Credit • Cash credit is extended in the form of cash. • Sales credit is extended in connection with purchasing a good or service. • An installment contract is an agreement between you the person selling an item. • Promissory note: a contract binding a borrower to future repayment of the amount borrowed • Security agreement: establishes the creditor’s security interest in the good for which the credit was extended

37. Methods for Charging Interest • Simple interest method • Percentage rate applied to outstanding loan balance • Discount method • Interest deducted from the credit extended you • Add-on method • Interest added to amount borrowed at beginning of loan

38. Figure 6.6: A 12-month installment loan with annual simple interest of 12 percent

39. Total payments on discount loan amount financed 1 – (discount rate ×t ) = $1,136.36 $1,000 1 – (0.12 ×t ) = Discount Method

40. Total payments on add-on loan = amount financed × [1 + (add-on rate ×t ) ] $1,000 × [1 + (0.12 ×t ) ] $1,120 = Add-on Method

41. Figure 6.7: Comparative interest on credit of $1,000 to be repaid in 12 equal monthly installments Contract Rate Interest Method Monthly Payment Total Interest Paid APR Simple Discount Add-on 12% 12% 12% 12.00% 24.28% 21.46% $88.85 94.72 93.33 $ 66.19 136.36 120.00

42. Annual Percentage Rate (APR) • The true or effective interest rate • APR considers the impact of compounding • The APR is the rate that you should use to judge the relative cost of credit • In the absence of other loan fees, it is the rate charged on the outstanding loan balance • It is calculated as the ratio of finance charges to the average amount of credit over the term of the loan expressed as a percentage

43. Areas of Special Concern • Always read the entire credit agreement and understand the clauses included • Some clauses that borrowers should be especially careful about agreeing to are: • Prepayment and the rule of 78 • The acceleration clause • The add-on clause • The balloon payment

44. Prepayment and the Rule of 78 • Borrowers need to understand how interest is calculated if they repay the loan early. • Agreements that use the add-on method for calculating installment payments usually use a method called the rule of 78. The rule of 78: • Penalizes early loan repayments • Is difficult to calculate and is beneficial to lenders • Pushes interest earned by creditor to front of loan • Pushes your repayment of principal to end of loan.

45. Acceleration Clause • Late payment of even one payment can cause the entire unpaid balance to be due immediately • If this happens and you cannot make the payment, the item may be repossessed • The laws guiding repossession differ by state • If the item is sold for less than the loan balance, the borrower is obligated to pay the remaining balance • If the lender sells the item, any expenses associated with the sale are added to the loan balance

46. Add-On Clause • Although courts seldom enforce this clause, a borrower should be aware of the potential danger if this clause is included in a credit agreement. • If a consumer purchases multiple items (even at different times) and finances these items, the lender can repossess all items if purchased under a add-on credit agreement. For example: • In January, purchase a TV; agree to repay monthly for 1 yr • In June, purchase a refrigerator using the same credit agreement; make a payment for one month but miss the second payment; both the TV and refrigerator can be repossessed.

47. Balloon Payment • The last installment payment that is generally for an amount much greater than the other monthly payments. • Borrowers do not generally prepare sufficiently for the amount needed to make this payment. • If borrower has not prepared sufficiently, they may be required to borrow money to make the payment or else have the item repossessed.

48. Sources of Credit • Today, there are many sources of credit so a wise consumer needs to shop around. • Be sure to understand the loan do’s and don’ts. • The traditional source of credit is banking institutions. • Other sources of credit are: • Consumer finance companies • Life insurance policies • Margin accounts on stocks and bonds • 401(k) accounts • Pawnbrokers

49. A Credit Management Strategy • Credit management is similar to cash management. • The objective is to minimize the cost of credit. • Consider the following guidelines: • Use the grace period fully • Avoid expensive credit on revolving charge accounts • Think of borrowing in total not just each item financed. • Using your credit card wisely and paying off your monthly balance can improve your credit score and thus lower the interest rate that you will be charged.

50. RESOLVING PERSONAL DEBT PROBLEMS • The best way to resolve problems is avoidance. • Credit counselors recommend limiting consumer credit to 20% of your take-home pay. • Always figure the impact of new debt on this limit prior to agreeing to borrowing additional money. • If you do run into a problem, contact the creditor. • Most creditors will work with borrowers who show good faith in making payments. • Seek credit counseling if you are unable to resolve the problem yourself.