CHAPTER5 Consumer Credit “Borrowing money is like wetting your bed in the middle of the night. At first all you feel is warmth and release. But very, very quickly comes the awful, cold discomfort of reality.” – Elizabeth Gilbert
What is Consumer Credit? • Credit is an arrangement to receive cash, goods or services now, and pay for them in the future • Consumer credit is the use of credit for personal needs (excludes home loans, home improvement loans and higher education loans) • It is a major force in the American economy • There are three ways consumers can finance current purchases • Take money from savings • Use present earnings • Borrow against future income • Trade-offs are involved in using credit
Which Is It? Does consumer credit increase or decrease your purchasing power? • Consumer credit increases your purchasing power • Consumer credit decreases your purchasing power • Consumer credit has no effect on your purchasing power The correct answer is (B). Sounds like a test question, huh?
The Cost of Credit • The finance charge is the total dollar amount you pay for the loan • Includes interest and fees, such as service charges or credit-related insurance • The annual percentage rate (APR) is the percentage cost of credit on a yearly basis • The APR provides the true rate of interest for comparison with other sources of credit • This rate lets you compare “like with like” when shopping for rates • Mandated by the Truth in Lending Act
Truth In Lending Act • The Truth In Lending Act requires creditors to provide you with accurate and complete credit costs, terms, and APR • Creditors must disclose • credit terms and information... • In a clear and conspicuous manner • In a form you can keep • But often in a font you can not possibly read • And that is where they put all the information they do not want you to read such as what happens if you miss a single payment – Your interest rate goes up to 1000% and they come and take your house and your first born and you will be in debt to them for the rest of your life which will not be that long since you will work yourself to death trying to pay the interest but they do not care because they will have made enough money off you to buy one or maybe even two yachts and brand new gas bar-b-q and a trip around the world and …
Calculating the Cost of Credit • Simple interest • Computed on principal only and without compounding – The dollar cost of borrowing • Interest = Principal x Rate x Time • Note: Time needs to be expressed in years • Used for most installment loans (closed-end loans) • Average daily balance method • Most credit cards use this method • Uses a weighted average of the account balance throughout the current billing period • If you carried over a balance, new purchases will be included in your average daily balance calculation • So you do not get to take advantage of the “float”
Calculating the Cost of Credit (continued) • Adjusted balance method • New purchases are not taken into account and all payments are deducted from your previous balance before interest is added • This is the most favorable to credit card holders • But – Surprise! – is the least common method • Previous balance method • More costly than average balance method, less costly than adjusted balance method • Two cycle average daily balance method • The worst method for card holders • Luckily, not very common http://www.asapcreditcard.com/articles/interest-calculation-methods.html
Remember Our $299 Stereo? • It cost us almost two times more than $299 because of the taxes • What if we had purchased it with a credit card and only paid the minimum payments? • 19.9% APR • 2.2% minimum • That is right – The Price Just Doubled Again! • It will cost us twice as much if we purchase it on credit and only make the minimum payments • And since those are all after-tax dollars, the true cost of the $299 stereo is almost $1,200
When to Use Personal Credit? • Home Purchase • Higher Education or Career-Related Education • Home Improvement
When to Use Consumer Credit? NEVER! Well, all right. In case of emergency…
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Credit Considerations • Before you use credit for a major purchase, ask yourself some questions: • Could I pay cash or make a down payment? • Do I want to use savings for this purchase? • Does purchase fit with my goals and budget? • Could I use the credit I will need in some better way? • Can I postpone this purchase? • What are the opportunity costs of postponing this purchase? • What are the dollar and psychological costs of using credit for this purchase?
Advantages of Consumer Credit • Current use of goods and services • Permit purchase even when funds are low • Convenient when shopping • Safer than cash • Can take advantage of float time • May get rebates, airline miles or other bonuses • Demonstrates financial stability • Use For Financial Emergencies
Disadvantages of Consumer Credit • Purchases are more expensive • Temptation to overspend • Ties up future income • Possible financial difficulties • Potential loss of merchandise due to late payment or non-payment • (Unlikely in case of credit cards) Gotta’ love this one!
Types of Credit • Closed-End Credit • For a specific purpose and amount • Mortgage loans • Automobile loans • Installment loans • Open-End Credit – a.k.a. line of credit • Used as needed until limit of credit is reached • You pay interest and finance charges if you do not pay the bill in full when due • Revolving credit – prearranged loan • Credit cards / Home equity loans
Credit Cards “The bubonic plague of personal finance” – Jonathan Clements • Nearly eight out of ten American households carry one or more credit cards • One-third are convenience users • They pay their balance off in full each month • Often to take advantage of points, miles, etc. • The other two-thirds are borrowers • Co-branding – GM, Shell, etc. • Linking a credit card with a business offering rebates on products and services
Credit Cards (continued) • Debit Cards versus Credit Cards • They are not the same • Laws and regulations differ • Credit Card Fraud • $50 limit on credit card fraud • Debit Card Fraud • $50 limit if reported within 2 days • $500 limit if reported within 6 months • Unlimited loss after 6 months! • Most banks and credit unions will waive the above limits
Credit Cards (continued) • What is the Cost of Convenience? “But aren’t credit cards a good way to save money? As long as you pay the total amount each month, you are essentially getting a free loan. Plus they are so convenient,” said Cathy. “Not so fast,” said Roy. “By taking advantage of the ‘float’ as it is called, you may save a few dollars a year. But the pennies you save each year are swamped by the hundreds or even thousands of dollars you spend because of the very same convenience you speak so highly of. How many times have you rationalized the purchase of items simply because you told yourself you wouldn’t have to pay for it until next month? And then when the bill came the next month, you ask yourself, ‘How did I spend $500!?’ The cost of that convenience is very high.”
True Confessions! How Many Credit Cards Do You Have? • Zero, zilch, nada, no way. Forget it. They ain’t gettin’ their hooks in me! • Only one! I swear it! I only use it to buy gas. • Okay. I have two. I use one to pay off the other … • More than two and I lost count a long time ago. Plus I would not tell you even if I did know!
True Confessions, Continued And How Much Do You Owe? • Nothing! I am serious! I do not owe a cent! • Less than $1,000 • Between $1,000 and $5,000 • More than $5,000 (You can lie if you do not want us to know…)
Credit Cards (continued) • Use your credit card like a debit card • If you can not pay off the balance at the end of the month, Do Not Use It! • If you find that you abuse your credit card, Cut The Damned Thing Up! Notice that I use the singular instead of the plural? Do not have more than one credit card! There simply is not any valid reason to have more than one. (Well, actually, there might be one or two.)
Home Equity Loans • Based on the current market value of your home less the amount still owed on the mortgage (asset – liability = equity) • a.k.a. 2nd mortgage, 2nd trust deed, HELOC • Will be much cheaper than a credit card • Interest is normally tax-deductible (Schedule A) • Danger!¡Peligro! • Do not pay your credit cards and you can destroy your credit rating – bad, but not a big deal • Do not pay your home equity loan and you can lose your home – Big Deal!
Home Equity Loans (continued) • Example: • Home currently worth $200,000 • Still owe $150,000 on the mortgage • Home Equity = $50,000($200,000 – $150,000) • A reputable lender would let you borrow up to 75% or 80% or even maybe 90% of the current value of your home • 80% of $200,000 = $160,000 • $160,000 – $150,000 mortgage = $10,000 • You would be eligible for a $10,000 home equity line of credit
Home Equity Loans (continued) • But some unscrupulous lenders will let you borrow more than the available equity in your home! • Have you heard or seen the ads? • “Get a 125% Home Equity Loan!” • “Consolidate your car loans and credit card bills into one easy monthly payment!” • “Run up your credit card bills all over again!” • “Lose your house to us when we foreclose!”
Home Equity Loans (continued) • Same example – 125% home equity loan: • Home currently worth $200,000 • Still owe $150,000 on the mortgage • Home Equity = $50,000 ($200,000 – $150,000) • 125% of $200,000 = $250,000 • $250,000 – $150,000 mortgage = $100,000 • If you used over $50,000 of your available credit – only ½ of your line of credit – you would owe more than the house is worth! • If you got into financial trouble, you would be tempted to simply walk away from your home
Sources of Consumer Credit • Inexpensive loans • Parents and family members • Do Not Even Think About It! • (Except for down payment on a home – more in chapter 7) • Loans based on assets, such as a savings acct • A secured loan should have a lower interest rate than an unsecured loan (all other things equal) • Medium-priced loans • Commercial banks and credit unions • Expensive loans • Retailers such as car or appliance dealers • Credit cards and cash advances
“Secured” vs “Unsecured” Credit • Secured Credit – Loans based on assets called “collateral” • Auto Loans • Home Loans • Unsecured Credit • Credit cards • Most all other forms of consumer credit
A “Secured” Credit Card • An excellent way to begin building your credit is to obtain a “secured credit card” • Deposit $500 in a savings account • Receive a credit card with a limit of $500 • Use the credit card … • Remembering to pay off the balance each month! • Make sure the issuer reports your credit usage! • After a year or less, you will have built up enough of a credit history to get an “unsecured credit card” • You can then close account & get your $500 back
Measuring Your Credit Capacity • Before you take out a loan, ask yourself... • Can you afford the loan? • What do you plan to give up in order to make the payments? • Look closely at your… • Debt Payments-to-Income Ratio and • Debt-to-Equity Ratio Or better yet, “Make Love, Not Loans!”
Debt Payments-to-Income Ratio monthly payments* monthly after tax income Credit Capacity Indicators Da’ Book sez, “Should be less than 20%.” I think that is obscenely high! *Not including housing
Credit Capacity Indicators Debt-to-Equity Ratio total liabilities* = Should be < 100% net worth Again, this is far too high! Businesses try to keep it down to between 30% and 50% *Excluding home value and mortgage
“Would You Co-sign For Me?” • Before co-signing a loan consider... • If the person does not pay, you will have to • Can you afford to pay if the person does not? • It will affect your credit report as well as theirs • Request that a copy of overdue payment notices be sent to you • Surprise– Three out of four co-signers end up paying! The correct answer, by the way, to the above question is “No.”
Your Credit Report • Credit bureaus collect information • Experian, Trans Union, and Equifax • 888-567-8688 / 888-5OPT-OUT • “Get me off your mailing list!” • Number of mix-ups and errors in credit reports have declined recently but it is still very high • Bureaus get information from banks, finance and credit card companies, merchants, and others • Each year, you can get a free credit report from each of the three major credit bureaus • Use the “Central Source” to get all three at once • http://www.annualcreditreport.com • 877-FACT-ACT (877-322-8228)
Your “FICO” Credit Score • Your credit score is generated by a company called Fair Isaac Corporation using the data from Experian, Trans Union, and Equifax • FICO scores range from upper-300’s to mid-800’s • Generally, anything over 700 is excellent • Computer will automatically approve you • At around 600, your credit application is supposed to be manually reviewed • Does not always happen (more later) • Mid-500’s or lower, you are considered a high risk
Your “FICO” Credit Score (continued) • What makes up your FICO score? • Past payment history (35%) • Amounts owed (30%) • Are you “maxed out?” • Rule of thumb: Never pass 75% of your credit capacity • Length of credit history (15%) • Amount of new credit (10%) • Can be a “red flag” if you open too many accounts in a short period of time • Types of credit (10%) • No more “Authorized User” Psst! Do not tell anyone about this info on this slide. It is a secret! http://finance.yahoo.com/banking-budgeting/article/109347/the-fico5-the-components-that-make-up-a-fico-credit-score?mod=bb-creditcards
Fair Credit Reporting Act • Is your credit report accurate? • You can get a free copy of your report if you are denied credit • In addition to the free annual copy of your credit report from each of the three credit bureaus • Inaccurate information must be corrected within 30 days • Only authorized persons have access to your report • Ha! Ha! Ha! Ha! Ha! This is a good one! • Anyone can access your credit report! • Adverse data can be reported for seven years and bankruptcy for ten years
Identity Theft • Protect yourself by shredding old credit slips, account statements, and credit offers you receive in the mail • Shredders are cheap; get a decent one • Spend about $30 to $50 • You may not know your identity has been stolen until you receive a bill with charges that are not yours • Almost 10 million thefts in 2008, $1,200 per victim! • That is $12 billion Finding good statistics on identity theft is not easy. Anyone want to validate my numbers?
Identity Theft (continued) • Take three actions once you know • Contact the fraud departments of each of the three major credit bureaus • Contact the creditors for any accounts that have been tampered with or opened illegally • File a police report • Identity Theft Resource Center • http://www.idtheftcenter.org/ Why should you bother filing a police report?
Identity Theft (continued) • Sources of identity theft • 30% – Security breaches at businesses • 30% – Consumer’s lost and stolen wallets, checkbooks, etc. • 15% – “Friends” and family members • 9% – Stolen mail • 9% – Attacks and scams targeting home computers • Credit protection businesses • $10 - $30 per month to protect & insure your identity • Virtually all of the services can be done by you for free
Identity Theft (continued) • Freezing your credit • Blocks new lines of credit being open • Free in California if you have been already targeted • Otherwise, $10 per credit bureau (3 x $10 = $30) • Fraud alerts • A fraud alert notifies lenders that you have or you believe you have been targeted (no charge) • Time limit – 90 days up to 7 years • Other innovative protection methods • Counter-intelligence! • Analyzing transaction data Many companies will do some or all of these services for a fee.
Identity Theft (continued) • An entire industry is springing up • TrustedID – specializes in credit freezes ($15/mo) • LifeLock – specializes in fraud alerts ($10/mo) • Now have LifeLock Ultimate! (only $25/mo!) • IdentifySecure –$17.99/month • Now with Registered Sex Offender Tracker! • IdentitySweep – $14.95/mo • Now have IdentitySweep 360-Plus! (only $30/mo!) • IdentityForce – $17.95/month • MyPublicInfo – $69.95/year Hmm. Paying for protection. Makes you feel as though you are dealing with organized crime! http://www.consumerreports.org/cro/2012/02/debunking-the-hype-over-id-theft/index.htm
What Creditors Look For: 5 C’s • Character– Do you pay bills on time? • Capacity– Can you repay the loan? • Capital– What are your assets and net worth? • Collateral– What do you have of value that the lender can take if you do not repay? • Conditions– What economic conditions could affect your repayment of the loan? Discussion: Who gets credit? Who doesn’t?
What If You Are Denied Credit? • Ask the creditor to clarify the specific reason for denial of credit • Check your credit report file (It is free, remember?) • Apply to another creditor with different standards • Take steps to improve your creditworthiness • You have the right to provide a 100-word explanation in your file • For example, you could explain if you were out of work due to an extended illness and were therefore late paying bills for a time
What If You Are Denied Credit? (continued) • The majority of credit applications are now electronically pre-screened • If your FICO score is below approximately 600, the application is supposed to be reviewed by a human • In practice, the credit company often simply rejects the application entirely • Or automatically sends the application to their “sub-prime” department • Unfortunately, one account in default can put your score in the low-500’s • The moral? Check your credit files before you apply for credit. Get rid of erroneous data.
What If You Are Denied Credit? (continued) • Do Not Fall For… “We Will Repair Your Credit – 100% Satisfaction Guaranteed!” Anything legitimate that these people can do for you, you can do for yourself for free! Anything illegitimate they suggest is either illegal or simply will not work Let’s look at some credit card applications…
Once Again, How Long Will It Take? How long can adverse credit data (late payments, charge offs, etc.) be reported on your credit report? • 3 years • 5 years • 7 years • 10 years The correct answer is (C).
Once Again, How Long Will It Take? How long can a bankruptcy be reported on your credit report? • 3 years • 5 years • 7 years • 10 years The correct answer is (D). Now, do not forget these two numbers, 7 & 10.
Avoiding & Correcting Credit Mistakes Fair Credit Billing Act • Notify creditor of error in writing within 60 days • Send it to the correct address • They must respond within 30 days • Credit card company has 90 days to resolve the problem or tell you why they think the bill is correct • Will not affect your credit rating while in dispute • You can withhold payment on shoddy goods if you have paid for them with a credit card