Section 4 Consumer Credit and its cost

1
Section 4 Consumer Credit and its cost

• The Basics of Credit
• Obtaining and protecting your credit
• The Cost of Credit

2
What is Consumer Credit?

• There are three ways consumers can finance
  current purchases.
• Take money from savings.
• Use present earnings.
• Borrow against future income.
• Credit is an arrangement to receive cash, goods
  or services now, and paying for them in the
  future.
• Consumer credit is the use of credit for personal
  needs, except a home mortgage. It is a major
  force in the American economy.
• Trade-offs are involved in using credit.

3
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 Ill 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?

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Advantages of Credit

• Current use of goods and services.
• Permit purchase even when funds are low.
• Use for financial emergencies.
• Convenient when shopping.
• Safer than cash.
• Can take advantage of float time.
• May get rebates, airline miles or other bonuses.
• Demonstrates financial stability.

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Disadvantages of Consumer Credit

• Purchases are more expensive.
• Temptation to overspend.
• Ties up future income.
• Possible financial difficulties.
• Potential loss of merchandisedue to late or
  non-payment.

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Types of Credit

• Closed-End Credit.
• For a specific purpose and amount.
• Mortgage loan.
• Automobile loans.
• Student loans.
• Open-End Credit.
• Use as needed until reaching line of credit.
• You pay interest and finance charges if you do
  not pay the bill in full when due.
• Revolving check credit - prearranged loan.
• Home equity loan.

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What Creditors Look For 5 Cs

• 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 dont repay?
• Conditions - What economic conditions could
  affect your repayment of the loan?

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Credit Capacity Indicators

• Debt Payments Ratio
• Monthly Credit Payments (excluding mortgage) /
  Monthly Income (after taxes)
• Indicates the percentage of a persons
  earnings that goes for debt payments (excluding
  home mortgage) less than 20 is recommended.
• Mortgage Payments Ratio
• Monthly Mortgage Payments / Gross Monthly
  Income Generally, a lender will want your
  monthly mortgage payment to total no more than
  29 of your monthly gross income. This can go up
  to 35 if you are a first time home buyer.
• Net Worth/Liabilities Ratio
• Shows the relationship between total debt and net
  worth. High is best.

9
What If You are Denied Credit?

• Ask the creditor to clarify the specific reason
  for denial of credit.
• Check your credit report file.
• 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.
• Seek help if you think there is discrimination.

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Is your credit report accurate? Fair Credit
Reporting Act

• If you are denied credit based on your report,
  you can get a copy of your credit report free
  within 60 days of your request. Experian, Trans
  Union and Equifax are the three most popular
  credit rating agencies. See the course website
  for useful links.
• Inaccurate information must be corrected within
  30 days.
• Only authorized persons have access to your
  report.
• Adverse data can be reported for seven years and
  bankruptcy for ten years.

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Protection Under OtherConsumer Credit Laws

• Truth in Lending Act
• Consumer Leasing Act
• Equal Credit Opportunity Act
• Fair Credit Billing Act
• Consumer Credit Reporting Reform Act

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The Cost of Credit

• Example 1
• A bank lends you 1,000 today, and asks you to
  pay back principal and 10 interest in one year.
  How much money are you paying in interest?
• 1000 x 0.10 100

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The Cost of Credit

• Example 2
• A loan shark lends you 1,000 today. He quotes
  you a nominal interest rate of 10 over the
  principal, but he wants you to pay in two
  installments 550.00 next week and 550.00 when
  the year is over. How much money are you paying
  in interest?
• 550 550 - 1000 100
• Is the cost really 10?

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The Cost of Credit

• The annual percentage rate (APR) is the
  percentage cost of credit on a yearly basis.

n Number of payments per year N Number of
total payments P Principal Int. Total
Interest payment

• The APR attempts to provide the true rate of
  interest for comparison with other sources of
  credit. This rate lets you compare like with
  like when shopping for rates.

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The Cost of Credit

• What is the APR of the bank loan on Example 1?.

• What is the APR of the loan on Example 2?

• Do these numbers look right to you?

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The Cost of Credit

• Example 3
• A bank lends you 1,000 at a 10 nominal
  interest. The bank wants you to pay in two
  installments 550.00 in six months and 550.00
  at years end. What is this loans APR?

How would this APR estimation differ from the
loan sharks example from before?
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The Cost of Credit

• The Federal Truth in Lending Act requires lending
  companies to disclose the APR when they advertise
  a rate. Typically the APR is found next to the
  nominal rate.
• The APR is a very confusing number! Even mortgage
  bankers and brokers admit it is confusing. The
  APR is designed to measure the "true cost of a
  loan." It is supposed to create a level playing
  field for lenders. It prevents lenders from
  advertising a low rate and hiding fees.

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The Cost of Credit

• If life were easy, all you would have to do is
  compare APRs from the lenders/brokers you are
  working with, then pick the easiest one and you
  would have the right loan. Right? Wrong!
• Different lenders calculate APRs differently! So
  a loan with a lower APR is not necessarily a
  better rate.
• My suggestion, is to take a look at the all
  loans cash flows and calculate the effective
  annual rate of the loan (EFF).

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The Effective Cost of Credit

• Calculating the Effective Cost of Credit implies
  an advanced working knowledge of Time Value of
  Money constructs (i.e. time lines, present value,
  future value, annuities, internal rate of
  return).
• We will take on this task later on our training.
  
• Financial Calculators are great help here. We
  will also learn how to use them in the future.
• I can advance you that

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The Effective Cost of Credit

• The timing and frequency of the interest payments
  is important.
• Finance charges include interest and fees, such
  as application fees, service charges or
  credit-related insurance.
• Banks sometimes request for non-depositor loan
  clients to keep compensating balances in the
  bank. That reduces the amount you have available
  for the intended usage, and raises the percentage
  cost of the loan.
• Credit card interests are calculated over
  different bases. We will also explore this in the
  future in more depth.

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Cost of Open-End Credit (Credit Cards)

• Adjusted balance.
• The assessment of finance charges after payments
  made during the billing period have been
  subtracted.
• Previous balance.
• Method of computing finance charges that gives no
  credit for payments made during the billing
  period.
• Average daily balance.
• Uses a weighted average of the account balance
  throughout the current billing period. If you
  carried over a balance new purchases may be
  included in your average daily balance
  calculation.

22
Choosing and Using a Credit Card

• If you plan to pay each month in full look for a
  card with no annual fee.
• Look for a low interest rate if you plan to carry
  a balance.
• The interest you pay on consumer credit is not
  tax deductible.
• Avoid the minimum monthly payment trap.
• Credit insurance.
• Pays off loan if person dies or becomes disabled.