Chapter 5 Extra Notes

This comprehensive chapter explores consumer credit, defining it as the

use of credit for personal needs excluding home mortgages, and detailing its
advantages like immediate access to goods and emergencies funds,
alongside its disadvantages, such as the temptation to overspend and
potential long-term financial issues. It categorizes credit into closed-end
(e.g., installment loans) and open-end (e.g., credit cards) types, outlining
various sources of loans from commercial banks to family members, and
discussing how to assess affordability through debt-to-income ratios and
the "five C's of credit." The text also explains the importance of credit
reports and scores and the calculation of credit costs using Annual
Percentage Rate (APR), while offering strategies for protecting credit
from fraud and managing debt, including financial counseling and, as a
last resort, bankruptcy.

Consumer credit refers to the use of credit for personal needs, excluding
a home mortgage. It is a significant force in the American economy and is a
fundamental aspect of personal and family financial planning. When using
credit, it's important to understand that it involves both responsibility and
risks.

Before making a major purchase using credit, it's wise to consider several
questions:

 Do you have the necessary cash for a down payment?

 Do you wish to use your savings for this specific purchase?

 Does the purchase align with your budget?

 Could the credit needed for this purchase be utilized more effectively
elsewhere?

 Is it possible to postpone the purchase?

 What are the opportunity costs of delaying the purchase?

 What are the monetary and psychological costs associated with using
credit?

Advantages of Consumer Credit

Consumer credit offers several benefits, enabling individuals to enjoy goods
and services immediately, such as a car, a home (though a home mortgage
itself isn't consumer credit, credit can help finance a home purchase), or an
education. It can also be crucial for managing emergencies.

Key advantages include:

 Immediate Access to Goods and Services: You can acquire items

when needed and pay for them over time.

 Emergency Fund: Credit cards can provide funds for emergencies,

with repayment plans based on future income.

 Record of Expenses: Credit transactions often provide a clear record

of your spending.

 "Float" Period: Some credit cards offer up to a 50-day "float,"

allowing a period before finance charges accrue.

 Convenience: Credit allows for shopping and travel without the need
to carry large amounts of cash.

 Indication of Stability: The use of credit can indicate financial

stability.

 Establishment of Credit Rating: Responsible use helps establish or

build a credit rating.

Disadvantages of Consumer Credit

Despite its advantages, consumer credit also carries significant risks and
drawbacks:

 Temptation to Overspend: Credit can make it easy to spend more

than you can afford.

 Financial Problems: Overspending can lead to serious long-term

financial difficulties, strain family relationships, and hinder progress
toward financial goals.

 Loss of Assets and Reputation: Failure to repay debts can result in

the loss of income, valuable property, and a damaged reputation.

 Legal Action and Bankruptcy: Non-payment can lead to court action

and even bankruptcy.
  Ties Up Future Income: Using credit means committing future
income to debt repayment.

 Higher Costs: Paying for purchases over time with credit is generally
more expensive than paying with cash, due to interest and other costs.

Types and Sources of Consumer Credit

Consumer credit is broadly categorized into two main types:

 Closed-end credit: This involves one-time loans repaid over a specific

period in equal amounts. Examples include mortgage loans,
automobile loans, and installment loans (like installment sales credit,
installment cash credit, and single lump-sum credit).

 Open-end credit: These loans are made on a continuous basis, with

periodic billing for at least a partial payment. Interest or other finance
charges may apply. Examples include credit cards issued by
department stores, bank cards (Visa, MasterCard), travel and
entertainment cards (American Express, Diners Club), and overdraft
protection.

Consumer credit is available from various sources, including:

 Commercial banks

 Consumer finance companies

 Credit unions

 Life insurance companies

 Federal savings banks (savings and loan associations)

 Family and friends (often the source of "inexpensive" loans with low
interest)

Commercial banks, savings and loan associations, and credit unions typically
offer "medium-priced" loans with moderate interest rates. Some loans, like
cash advances from banks or those from finance companies, can be
"expensive" with high interest rates, often ranging from 12 to 25 percent.

Affording a Loan and Creditworthiness

Before taking out a loan, it's crucial to assess your ability to repay. You
should ask if you can meet all essential expenses while still affording the
monthly loan payments, and what you might need to give up to make those
payments.

Experts recommend that consumer credit payments (excluding house

payments) should not exceed 20 percent of your net monthly
income. Another measure is the debt-to-equity ratio, which should ideally
not exceed 1 (excluding home value and mortgage).

Lenders typically evaluate creditworthiness based on the "five C’s of

credit":

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

2. Capacity: The borrower's ability to take on and pay additional debts.

3. Capital: The borrower's assets exceeding their liabilities.

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

5. Conditions: General economic factors that might affect repayment

ability.

Information about your credit history is compiled in a credit report (or

credit file) by credit bureaus such as Experian, TransUnion, and Equifax. A
credit score, like a FICO score (ranging from 300 to 850) or VantageScore
(ranging from 501 to 990), reflects this information and helps creditors
predict repayment likelihood. A higher score indicates less risk to creditors.

Cost of Credit

The finance charge is the total dollar amount paid to use credit, including
interest costs and other fees like service charges or insurance premiums. The
Annual Percentage Rate (APR) is the percentage cost of credit on a
yearly basis, serving as a key tool for comparing credit costs regardless of
the loan amount or repayment time. Under the Truth in Lending Act, creditors
are required to disclose these costs to enable consumers to shop for credit.

Consumer credit, in general, refers to the use of credit for personal

needs, excluding a home mortgage. It is a fundamental aspect of
personal and family financial planning, though it involves both responsibility
and risks.

Consumer credit is broadly categorized into two main types: closed-end

credit and open-end credit.
Closed-End Credit

Closed-end credit refers to one-time loans that are repaid over a

specified period of time in payments of equal amounts. Once the loan
is paid off, the account is closed.

Examples of closed-end credit include:

 Mortgage loans.

 Automobile loans.

 Installment loans, which can take several forms:

o Installment sales credit: A loan that allows you to receive

merchandise, typically high-priced items.

o Installment cash credit: A direct loan of money for personal

purposes.

o Single lump-sum credit: A loan that must be repaid in total on

a specified day, usually within 30 to 90 days.

Open-End Credit

Open-end credit involves loans that are made on a continuous basis,

where you are billed periodically for at least a partial payment. With
open-end credit, you may have to pay interest or other finance charges. This
type of credit allows for ongoing borrowing up to a certain limit.

Examples of open-end credit include:

 Cards issued by department stores.

 Bank cards, such as Visa and MasterCard.

 Travel and entertainment (T&E) cards, like American Express and

Diners Club.

 Overdraft protection.

Within open-end credit, credit cards are a prominent example. The sources
state that the average cardholder possesses more than nine credit cards,
encompassing bank, retail, and gasoline cards. Users of credit cards are
often distinguished as:

 Convenience users: Individuals who pay off their balances in full

each month.
  Borrowers: Those who do not pay off their balances every month,
incurring finance charges.

Most credit card companies offer a grace period, which is a time frame
during which no finance charges will be added to your account. A finance
charge represents the total dollar amount paid to use the credit, including
interest and other fees. Consumers should also be wary of "teaser rates" and
potential annual fees charged by some credit card companies.

It's also worth noting that debit cards are mentioned in the context of open-
end credit discussions. Unlike credit cards, debit cards electronically
subtract money directly from your savings or checking accounts to
pay for goods and services. They are most frequently used at ATMs. While
related to electronic payments, debit cards draw directly from existing funds
and do not involve borrowing credit like the other types discussed.

The cost of credit refers to the expenses associated with borrowing money.
Understanding these costs is crucial for effective financial planning and
making informed decisions about consumer credit.

Here's a discussion of the cost of credit based on the sources:

 Finance Charge: The primary component of the cost of credit is the

finance charge. This is the total dollar amount you pay to use
credit. It encompasses not only interest costs but can also include
other fees, such as service charges, credit-related insurance premiums,
or appraisal fees.

 Annual Percentage Rate (APR): To provide a standardized way to

compare credit costs, the Annual Percentage Rate (APR) is used.
The APR is the percentage cost of credit on a yearly basis. It is a
key tool for comparing costs, regardless of the specific amount of
credit or the repayment period. The Truth in Lending Act mandates that
creditors disclose both the finance charge and the APR, allowing
consumers to effectively shop for credit.

o Calculating APR: The sources mention two ways to calculate

APR: using an APR formula or using APR tables. While APR tables
are more precise, a formula can approximate the APR: r = (2 * n
* I) / (P * (N + 1)) Where:

 r = Approximate APR
  n = Number of payment periods in one year (e.g., 12 for
monthly payments)

 I = Total dollar cost of credit

 P = Principal, or net amount of loan

 N = Total number of payments scheduled to pay off the

loan

o For example, a $100 loan paid off in 12 equal monthly payments

with a stated annual interest rate of 10 percent, results in an APR
of approximately 18.46 percent (or 18.5%) using this formula.

 Methods of Interest Calculation:

o Simple Interest: This method calculates interest only on the

principal amount and without compounding. If simple interest
is repaid in more than one payment, it's known as the declining
balance method, meaning you pay interest only on the
principal amount you haven't yet repaid. For instance, a $1,000
loan at 5% simple interest for one year would incur $50 in
interest, and the stated rate (5%) would also be the APR in this
specific case.

o Add-on Interest: In contrast, with the add-on interest method,

interest is calculated on the full amount of the original
principal, regardless of payment frequency.

 Trade-Offs Affecting Cost:

o Term vs. Interest Costs: Many individuals opt for longer-term

financing because it results in smaller monthly payments.
However, the sources highlight a crucial trade-off: a longer loan
term at a given interest rate leads to a greater total
amount paid in interest charges.

o Lender Risk vs. Interest Rate: Lenders often adjust interest

rates based on the perceived risk of the borrower. To reduce the
lender's risk and potentially lower the interest rate,
borrowers can:

 Accept a variable interest rate.

 Provide collateral to secure the loan.

  Provide an up-front cash payment.

 Choose a shorter loan term.

 Cost of Open-End Credit: For open-end credit, such as credit cards,

the Truth in Lending Act requires creditors to inform consumers how
the finance charge and APR will affect their costs.

o Grace Period: Many credit card companies offer a grace

period, which is a timeframe during which no finance charges
are added to your account.

o "Teaser Rates" and Annual Fees: Consumers should be aware

of "teaser rates" (introductory low rates that typically increase
later) and potential annual fees charged by some credit card
companies, as these contribute to the overall cost.

o Minimum Payment Trap: A significant financial pitfall is paying

only the minimum monthly balance on credit cards. The longer
you take to pay off the bill, the more interest you will end up
paying.

 Inflation: Lenders consider the expected rate of inflation when

determining how much interest to charge on loans.

 Shopping for Credit: Because the cost of credit can vary

significantly, it is important to shop for credit to compare finance
charges and APRs.

In essence, while credit offers advantages like immediate access to goods

and services, it carries the inherent disadvantage of being more expensive
than paying with cash, primarily due to interest and other fees.

Credit management encompasses the practices and strategies involved in

responsibly handling your credit to maintain financial health, avoid debt
problems, and protect your credit reputation. It involves understanding credit
costs, managing debts, protecting personal information, and knowing your
rights as a consumer [LO 5.5, 26, 33, 36, 37, 42, 43, 45, 51].

Here are key aspects of credit management:

1. Protecting Your Credit and Credit Information

Protecting your credit involves safeguarding your personal financial data and
understanding procedures for correcting errors:

 Fair Credit Billing Act (FCBA): This act sets procedures for promptly
correcting billing mistakes and refusing credit card payments on
defective goods. If you believe a bill is wrong, you should:

o Notify the creditor in writing, including supporting information.

o Pay the undisputed portion of the bill.

o The creditor must respond within 30 days.

o The credit card company has two billing periods (up to 90 days)
to correct your account or explain why the bill is correct.

o A creditor cannot threaten or damage your credit rating while a

billing dispute is being negotiated.

o If a sincere effort to resolve a problem with an item purchased

has been made, but the store is uncooperative, you can ask your
credit card company to stop payment.

 Protecting from Theft or Loss: To protect your credit from theft or

loss, it's recommended to shred papers with personal information,
check machines for "skimming" devices, close suspicious accounts
immediately, stop payments of checks if fraud is suspected, ensure
your credit card is returned after purchases, keep a record of credit
card numbers, and immediately notify your credit card company if your
card is lost or stolen. If you suspect identity theft, contact credit
bureaus, creditors, and file a police report immediately.

 Protecting Information Online: When using the internet, employ a

secure browser, keep records of online transactions, review monthly
bank and credit card statements, read privacy and security policies of
websites, keep personal information private, never give your password
online, and avoid downloading files from strangers.

 Cosigning a Loan: If you cosign a loan, you agree to be responsible

for loan payments if the primary borrower fails to make them. Lenders
typically require a co-signer only if the borrower is not a good risk. As a
co-signer, you are liable for the full debt, plus late fees or collection
costs, and the creditor can collect from you without first attempting to
collect from the borrower. Therefore, you should assess if you can
afford the loan if the borrower defaults.
2. Managing Your Debts

Effective debt management involves recognizing warning signs, seeking help

when needed, and understanding debt collection practices:

 Warning Signs of Debt Problems: Key indicators of potential debt

problems include:

o Paying only the minimum balance each month on credit cards.

o Trouble paying the minimum balance.

o Credit card balances increasing every month.

o Missing loan payments or paying late.

o Using savings to pay for necessities.

o Receiving second or third payment due notices.

o Borrowing money to pay old debts.

o Exceeding credit limits on credit cards.

o Being denied credit due to a poor credit report.

 Debt Collection Practices: The Fair Debt Collection Practices Act

(FDCPA), enforced by the Federal Trade Commission, prohibits certain
practices by debt collectors. While it doesn't erase legitimate debts, it
controls how collection agencies may do business.

 Financial Counseling Services: Non-profit organizations like

Consumer Credit Counseling Services (CCCS) provide debt
counseling to families and individuals. Counseling is often free, though
some repayment plans may involve small administrative fees. These
services focus on preventing and solving problems by helping people
manage money, set realistic budgets, and understand the pitfalls of
unwise credit buying. Universities, credit unions, military bases, and
housing authorities may also offer non-profit counseling services.

 Declaring Personal Bankruptcy: Bankruptcy should be considered a

last resort as it severely damages your credit rating. Medical bills are
noted as a leading cause of bankruptcy. The U.S. Bankruptcy Act of
1978 outlines two main types:
 o Chapter 7 (Straight Bankruptcy): Involves distributing some
or all of the debtor's assets among creditors because the debtor
is unable to pay debts.

o Chapter 13 (Wage Earner Plan Bankruptcy): A plan for

individuals with regular income to repay all or part of their debts
over a period of time.

o Obtaining credit may be more difficult after bankruptcy, but

some find it easier as prior debt burden is removed. Chapter 13
filers who have repaid some debt may find it easier to obtain
credit than Chapter 7 filers who made no effort to repay.

3. Improving Your Credit Score

A credit score reflects your credit history and helps creditors predict your
likelihood of repaying a loan and making timely payments.

 The first step to improving your score is to review your credit report
for accuracy.

 Long-term responsible credit behavior is the most effective way to

improve future scores.

 Paying bills on time, lowering balances, and using credit wisely

will improve your score over time.

4. Your Rights and Remedies

 Fair Credit Reporting Act: This act regulates the use of credit
reports, requiring deletion of out-of-date information, providing
consumers access to their files, allowing correction of misinformation,
and limiting who can obtain your credit report. Most information can be
reported for seven years, while personal bankruptcy can be reported
for ten years.

 Equal Credit Opportunity Act (ECOA): This act prohibits

discrimination in credit dealings based on race, color, age, sex, marital
status, or certain other factors. If you are denied credit, ECOA gives
you the right to know the reasons. If the denial is based on a credit
report, you are entitled to a free report within 60 days and can ask the
bureau to investigate and correct inaccurate information.

 Complaints and Enforcement: If you believe a lender is not

following consumer credit protection laws, first try to resolve the
 problem directly with them. If that fails, formal complaint procedures
can be used by contacting appropriate federal agencies such as the
Federal Trade Commission (FTC), Office of the Comptroller of the
Currency, National Credit Union Administration, or Federal Deposit
Insurance Corporation. The Consumer Financial Protection Bureau
(CFPB) also offers a complaint website specifically for credit card
issues.

Debt management is a critical component of overall credit management,

focusing on strategies and actions to handle your financial obligations
effectively, prevent overwhelming debt, and address problems if they arise
[LO 5.5].

Here's a discussion of debt management based on the sources:

Warning Signs of Debt Problems

Recognizing the signs of potential debt problems is the first step in effective
debt management [LO 5.5]. The sources list several key indicators:

 Paying only the minimum balance each month on credit cards.

 Trouble paying the minimum balance.

 Your total balance on credit cards increases every month.

 Missing loan payments or paying late.

 Using savings to pay for necessities.

 Receiving second or third payment due notices.

 Borrowing money to pay old debts.

 Exceeding the credit limits on your credit cards.

 Being denied credit due to a bad credit report.

Debt Collection Practices

If you are struggling with debt, it's important to be aware of your rights
concerning debt collectors. The Fair Debt Collection Practices Act
(FDCPA), enforced by the Federal Trade Commission, prohibits certain
practices by debt collectors. While this act does not erase legitimate
debts, it controls the ways in which debt collection agencies may do
business.
Financial Counseling Services

For individuals facing debt problems, financial counseling can provide

valuable assistance.

 Consumer Credit Counseling Services (CCCS) is a non-profit

organization that offers debt counseling services to families and
individuals.

 Counseling is usually free, though a small fee might be charged for

administrative costs if CCCS supervises a debt repayment plan.

 CCCS focuses on preventing problems as much as solving them,

helping people manage money better, set up a realistic budget,
and understand the pitfalls of unwise credit buying. They also
encourage credit institutions to avoid lending to those who cannot
afford it.

 Other non-profit credit counseling services may be available through

universities, credit unions, military bases, and state and federal
housing authorities. You should check with your financial institution or
a consumer protection office for reputable, low-cost options.

 If you are unable to resolve a credit card situation directly with the
creditor, the Consumer Financial Protection Bureau (CFPB) has a
complaint website specifically for credit card issues, allowing you to
submit and monitor your complaint.

Declaring Personal Bankruptcy

Bankruptcy should be considered a last resort because it severely

damages your credit rating. Medical bills are identified as a leading cause
of bankruptcy. The U.S. Bankruptcy Act of 1978 outlines two primary types:

 Chapter 7 (Straight Bankruptcy): In this process, some or all of

the debtor's assets are distributed among creditors because the
debtor is unable to pay their debts.

 Chapter 13 (Wage Earner Plan Bankruptcy): This involves a plan

for individuals with regular income to repay all or part of their
debts over a period of time.

Effects of Bankruptcy:
  Obtaining credit may be more difficult after filing for bankruptcy,
though some individuals might find it easier as the burden of prior
debts is removed.

 For those who filed Chapter 13 and repaid some debt, obtaining
credit may be easier compared to Chapter 7 filers who made no
effort to repay.

Before taking the extreme step of declaring bankruptcy, it's essential to

consider its financial and other costs. If you find you cannot meet your
financial obligations, the sources advise contacting your creditors
immediately before resorting to bankruptcy.