Chapter 5 Student Guide

Executive Summary

Consumer credit plays a fundamental role in the American economy and

individual financial planning. While it offers significant advantages such as
immediate access to goods and services, convenience, and emergency
funding, it also carries substantial risks, including the temptation to
overspend, potential financial problems, and damage to one's reputation.
This briefing outlines the definition, types, sources, costs, and management
of consumer credit, emphasizing the importance of responsible use and
consumer protection.

1. What is Consumer Credit?

"Credit is an arrangement to receive cash, goods, or services now and pay

for them in the future." Consumer credit specifically refers to "the use of
credit for personal needs (except a home mortgage)." It is a "major force in
the American economy" and a "basic factor in personal and family financial
planning."

1.1. Advantages of Consumer Credit:

 Immediate Access: Enables individuals to "enjoy goods and services

now – a car, a home, an education – or it can provide for emergencies."

 Emergency Funding: Credit cards can "provide for emergencies" and

facilitate payment plans based on future income.

 Record of Expenses: Provides a documented history of spending.

 Grace Period: Offers "up to a 50-day ‘float’," allowing time before

finance charges accrue.

 Convenience and Security: Allows shopping and travel "without

carrying a large amount of cash."

 Financial Stability Indicator: "Credit indicates stability."

1.2. Disadvantages of Consumer Credit:

 Temptation to Overspend: A primary risk, potentially leading to

"serious long-term financial problems, damage family relationships,
and delay progress toward financial goals."
  Loss of Assets and Reputation: "Failure to repay may result in loss
of income, valuable property, and your good reputation."

 Legal Action and Bankruptcy: Can "lead to court action and

bankruptcy."

 Ties Up Future Income: Commits future earnings to past purchases.

 Higher Costs: "Credit costs money and paying for purchases over a
period of time is more costly than paying with cash."

1.3. Considerations Before Using Credit:

Before making a major purchase using credit, individuals should consider:

 Availability of cash for a down payment.

 Opportunity cost of using savings.

 Fit within budget.

 Alternative uses for the credit.

 Possibility of postponing the purchase.

 Opportunity costs of postponing.

 Dollar and psychological costs of using credit.

2. Types and Sources of Consumer Credit

Consumer credit is broadly categorized into two main types:

2.1. Types of Credit:

 Closed-End Credit: "You pay back one-time loans in a specified

period of time and in payments of equal amounts."

 Examples: Mortgage loans, automobile loans, installment sales credit

(for merchandise), installment cash credit (direct money loan), and
single lump-sum credit (repaid in total on a specified day, typically 30-
90 days).

 Open-End Credit: "Loans are made on a continuous basis and you are
billed periodically for at least partial payment."

 Examples: Department store cards, bank cards (Visa, MasterCard),

travel and entertainment cards (American Express, Diners Club), and
overdraft protection. Interest or other finance charges may apply.
2.2. Sources of Consumer Credit:

Credit is available from various financial institutions, each with specific

lending policies and loan types:

 Inexpensive Loans: Often family members, characterized by "low

interest."

 Medium-Priced Loans: Typically from "commercial banks, savings

and loan associations, and credit unions." They offer "personalized
service and are usually patient with borrowers."

 Expensive Loans: Feature "high interest rates, often ranging from 12

to 25 percent." These include cash advances from banks on credit
cards.

Specific Sources and Policies:

 Commercial Banks: Seek customers with established credit history,

often require collateral, vary rates based on loan type, time, credit
history, and security.

 Consumer Finance Companies: Often lend to consumers without

established credit history, may offer unsecured loans, process
applications quickly, but rates vary by loan balance.

 Credit Unions: Lend exclusively to members, offer unsecured loans,

may require payroll deductions, and provide various repayment
schedules.

 Life Insurance Companies: Lend against the cash value of a life

insurance policy, deducting the owed amount from policy benefits if
not repaid.

 Federal Savings Banks (Savings and Loan Associations): Lend to

all creditworthy individuals, often require collateral, and rates vary
based on loan size, payment length, and security.

 Home Equity Loans: Loans "based on your home equity – the

difference between the current market value of your home and the
amount you still owe on the mortgage." Interest is often tax-
deductible, but they "should only be used for major items such as
education, home improvements, or medical bills, and you must use
them with care."

3. Affordability and Credit Application

3.1. Assessing Loan Affordability:

Before taking a loan, individuals should ask:

 "Can you meet all of your essential expenses and still afford the
monthly loan payments?"

 "What do you plan to give up to make the monthly loan payment?"

3.2. General Rules of Credit Capacity:

 Debt Payments-to-Income Ratio: Monthly debt payments

(excluding mortgage) divided by net monthly income. Experts
recommend "no more than 20 percent of your net income on consumer
credit payments."

 Debt-to-Equity Ratio: Total liabilities divided by net worth (excluding

home value and mortgage). "A debt-to-equity ratio of 1 is the upper
limit of debt obligations."

3.3. The Five C’s of Credit:

Lenders use these factors to determine creditworthiness:

1. Character: The borrower's trustworthiness and integrity.

2. Capacity: The borrower's ability to repay additional debts.

3. Capital: The amount of assets exceeding liabilities.

4. Collateral: A valuable asset pledged to secure a loan.

5. Conditions: General economic conditions affecting repayment ability

(e.g., unemployment, recession).

3.4. Your Credit Report and Score:

 Credit Report/File: "A record of your complete credit history."

Compiled by "Credit Bureaus" (Experian, TransUnion, Equifax) from
lenders.

 Fair Credit Reporting Act (1971): Regulates credit reports, requiring

"out-of-date information to be deleted," giving "consumers access to
their files, as well as the ability to correct misinformation," and placing
"limits on who can obtain your credit report."

 Credit Score: "A number that reflects the information in your credit
report." It summarizes credit history and predicts repayment likelihood.
  FICO Score: Ranges from 300 to 850; higher scores indicate lower
risk.

 VantageScore: Ranges from 501 to 990, developed collaboratively by

the three credit reporting companies.

 Improving Credit Score: "Long-term responsible credit behavior is

the most effective way to improve future scores." This includes paying
bills on time, lowering balances, and wise credit use.

3.5. Equal Credit Opportunity Act (ECOA):

"States that race, color, age, sex, marital status, and certain other factors
may not be used to discriminate against you in any part of a credit dealing."
It also ensures consumers have the right to know reasons for credit denial
and obtain a free credit report if denied based on it. "Redlining,"
discrimination based on neighborhood demographics, is banned for housing
loans.

4. The Cost of Credit

4.1. Key Terms:

 Finance Charge: "The total dollar amount you pay to use credit."
Includes interest, service charges, credit-related insurance, or appraisal
fees.

 Annual Percentage Rate (APR): "The percentage cost (or relative

cost) of credit on a yearly basis." It's "key to comparing costs,
regardless of the amount of credit or how much time you have to repay
it."

4.2. Calculating APR:

While precise APR can be found in tables, an approximate formula is

provided: r = (2 * n * I) / (P * (N + 1)) Where:

 r = Approximate APR

 n = Number of payment periods in one year

 I = Total dollar cost of credit

 P = Principal (net amount of loan)

 N = Total number of payments

4.3. Tackling Trade-Offs:

  Term vs. Interest Costs: Longer loan terms typically result in smaller
monthly payments but "the greater the amount you must pay in
interest charges."

 Lender Risk vs. Interest Rate: To reduce lender risk (and thus the
interest rate), borrowers can accept variable interest rates, provide
collateral, make an up-front cash payment, or take a shorter-term loan.

4.4. Interest Calculation Methods:

 Simple Interest: "Interest computed on principal only and without

compounding." Interest = Principal × Interest Rate × Time.

 Declining Balance Method: Used when simple interest is paid in

multiple payments; interest is paid only on the remaining principal
balance.

 Add-On Interest Method: Interest is calculated on the "full amount

of the original principal," regardless of payment frequency.

4.5. Cost of Open-End Credit:

The Truth in Lending Act requires creditors to disclose how finance charges
and APR affect costs. Lenders also incorporate "expected rate of inflation
when deciding how much interest to charge." Consumers should "avoid the
minimum monthly payment trap" as it leads to more interest paid over time.

5. Protecting Your Credit and Managing Debts

5.1. Protecting Your Credit:

 Fair Credit Billing Act (FCBA) (1975): Establishes procedures for

"promptly correcting billing mistakes, refusing to make credit card
payments on defective goods, and promptly crediting payments."

 Dispute Process: Notify creditor in writing, pay undisputed portion,

creditor must respond within 30 days and resolve within two billing
periods (max 90 days).

 Creditors cannot damage your credit rating or collect disputed

amounts during negotiation.

 Identity Theft: If suspected, "contact the credit bureaus, the

creditors, and file a police report immediately."

 General Protection Tips: Shred personal documents, check

machines for skimming, close compromised accounts, stop fraudulent
 checks, ensure credit card return, keep card numbers on record, and
notify companies immediately of lost/stolen cards.

 Online Protection: Use secure browsers, keep transaction records,

review statements, read privacy policies, keep personal information
private, never share passwords, and avoid downloading unknown files.

5.2. Cosigning a Loan:

"Cosigning means you agree to be responsible for loan payments if the other
party fails to make them." It implies the primary borrower is a poor risk, and
the cosigner is liable for the full debt, fees, and collection costs without the
creditor first attempting collection from the borrower.

5.3. Consumer Credit Laws & Agencies:

Several federal agencies enforce consumer credit protection laws (e.g., Truth
in Lending, ECOA, FCBA, Fair Credit Reporting Act, Card Act). If problems
arise, consumers should first try to resolve them directly with the lender; if
unsuccessful, file a formal complaint with the appropriate agency (e.g.,
Federal Trade Commission, Office of the Comptroller of the Currency,
National Credit Union Administration, Federal Deposit Insurance Corporation).
The Consumer Financial Protection Bureau (CFPB) offers a "one-stop
shop complaint website for credit card issues."

5.4. Managing Your Debts:

Warning signs of debt problems include:

 Only paying minimum balances or struggling to do so.

 Increasing credit card balances.

 Missing or late loan payments.

 Using savings for necessities.

 Receiving multiple payment due notices.

 Borrowing to pay old debts.

 Exceeding credit limits.

 Being denied credit due to a bad report.

5.5. Debt Collection Practices:

The Federal Trade Commission enforces the Fair Debt Collection Practices
Act (FDCPA), which "prohibits certain practices by debt collectors" but
"does not erase the legitimate debts that consumers owe."

5.6. Financial Counseling Services:

 Consumer Credit Counseling Services (CCCS): A non-profit

offering debt counseling, often free or low-cost, emphasizing
prevention and setting up realistic budgets.

 Other non-profit services are available through universities, credit

unions, military bases, and housing authorities.

5.7. Declaring Personal Bankruptcy:

"Bankruptcy is 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." It should be a "last resort because it severely damages your
credit rating." Medical bills are a leading cause.

 U.S. Bankruptcy Act of 1978:Chapter 7: "Straight bankruptcy,"

where assets are liquidated to pay creditors.

 Chapter 13: "Wage earner plan bankruptcy," allowing debtors to

repay a portion of their debts over time.

 Effects: Obtaining credit can be more difficult post-bankruptcy, though

some find it easier due to debt removal. Chapter 13 filers who have
repaid some debt may find it easier to obtain new credit than Chapter
7 filers. Consumer bankruptcy filings have significantly increased over
the past decades, notably after the 2006-2010 economic downturn,
despite reform legislation.

Conclusion

Responsible consumer credit use is vital for financial well-being.

Understanding its advantages and disadvantages, types, sources, costs, and
protective measures empowers individuals to make informed decisions.
When debt becomes unmanageable, seeking financial counseling and
understanding the legal frameworks, including bankruptcy as a last resort,
are crucial steps.