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									 5A     Consumer Credit #1

Credit – An arrangement to receive
cash, goods, or services now and pay
for them in the future.

Types of credit ???
                    Objective 1
 Analyze Advantages and Disadvantages
       of Using Consumer Credit

• Credit
  – Based on trust in people’s ability and
    willingness to pay bills when due
• Consumer Credit
  – Use of credit by individuals for personal
    needs, except a home mortgage
  – Dates back to colonial times; exploded
    after invention of cars (installment loans; traveling)
  – A major force in our economy
                                                             5-2
    Uses and Misuses of Credit
Before you use credit for a major purchase, ask:
– Do I have the cash for the down payment?
– Do I want to use my savings for this purchase?
– Does the purchase fit my budget?
– Could I use the credit I’ll 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?
                                                         5-3
         Advantages of Credit
• Current use of goods and services
• Permits purchase even when funds are low
• A cushion for financial emergencies
• Advance notice of sales
• Easier to return merchandise
• Convenient when shopping
• Provides a record of expenses
                                             5-4
     More Advantages of Credit

• One monthly payment
• Safer than carrying cash
• Needed for hotel reservations, car rentals,
  and shopping online
• Take advantage of “float” time/grace period
• Rebates, airline miles, cash-back rewards,
  or other “perks”
• Credit indicates financial stability
                                                5-5
Disadvantages of Consumer Credit

• Temptation to overspend
• Can create long-term financial problems
  and slow progress toward financial goals
• Potential loss of merchandise
  due to late or non-payment
• Ties up future income
• Credit costs money - more costly
  than paying with cash
                                             5-6
                      Objective 2
          Assess the Types & Sources of
                Consumer Credit
    Two Basic Types of Consumer Credit
•   Closed-End Credit
     – One-time loans for a specific purpose paid
       back in a specified period of time

• Open-End Credit
     – Use as needed until line of credit max reached


    Examples of each?
                                                        5-7
           Closed-End Credit

• One-time loans for a specific purpose that you
  pay back in a specified period of time, and in
  payments of equal amounts
• Mortgage, automobile, and installment loans for
  furniture, appliances and electronics
• 3 most common types of closed-end credit
  1. Installment sales credit- loan for high-priced items
  2. Installment cash credit- loan of cash for personal use
  3. Single-lump credit- loan repaid on a specific day

                                                            5-8
           Open-End Credit

• Use as needed until line of credit max reached
  – Credit cards
  – Department store cards
  – Home equity loans
• You pay interest and finance charges if you do
  not pay the bill in full when due
• Revolving Check Credit (Bank Line of Credit)-
  pre-arranged loan for a specified amount; can
  be accessed with special checks
                                                   5-9
   Sources of Consumer Credit
Loans
  – Borrowing money with an agreement to repay,
    along with interest, within a certain amount of
    time (e.g., 3 years)
• Inexpensive loans
  – Parents or family members
• Medium-priced loans
  – Commercial banks, savings and loan
    associations, and credit unions
• Expensive loans
  – Finance and check cashing companies
  – Retailers (e.g., department store credit cards)
  – Bank credit cards and cash advances
                                                      5-10
    Sources of Consumer Credit
• Home Equity Loans
  – Loan based on home equity
    • Current market value of your home minus the
      amount you still owe on the mortgage
  – Interest is tax-deductible
  – Should only be used for major purchases
• Credit Cards
  – Average cardholder has > 9 credit cards
  – Convenience users vs. borrowers
  – Finance charge = total amount paid to use
    credit
                                                    5-11
   Sources of Consumer Credit
• Debit Cards
  – Debit cards electronically
    subtract money from savings or
    checking accounts
  – Most commonly used at ATMs
  – Widely accepted at stores also


• Stored Value Cards
  – Gift cards
  – Prepaid cards
                                     5-12
   Sources of Consumer Credit
• Smart Cards
  – Plastic card equipped with a
    computer chip that can store
    500 times as much data as
    a normal credit card (e.g., health info)
• Travel and Entertainment (T&E) cards
  – Not really “credit cards”; balance is due in
    full each month
  – Diners Club; American Express
  – You don’t pay for goods or services at the
    time of purchase
                                                   5-13
               Objective 3
  Determine Whether You Can Afford a
   Loan and How to Apply for Credit

  Before you take out a loan, ask yourself...
Can you meet all your essential expenses and
still afford the monthly loan payments?
– Add up basic monthly expenses and subtract
  from take-home pay; will the difference cover
  the monthly payment? (NO? Can’t afford it!)
– What do you plan to give up in order to make
  the payment?
                                                  5-14
General Rules of Credit Capacity
     Debt Payments-to-Income Ratio

                Monthly Debt Payments*
                  Net Monthly Income


  Consumer credit payments should not
  exceed a maximum of 20% of your net
               income.
*Not including a house payment, which is a long-term liability
                                                                 5-15
General Rules of Credit Capacity
             Debt To Equity Ratio


    Total Liabilities
                                        = Should be < 1
         Net Worth*


   *Excluding home value
The lower the ratio, the better; e.g., 0.5 or 0.25
                                                          5-16
         The Five C’s of Credit

• Character - Do you pay bills on time?
• Capacity - Can you repay the loan?

• Capital - What are your assets
     and net worth?
• Collateral - What assets do you have to
     secure the loan?
• Conditions- Lenders will review how general
     economic conditions will affect your ability
     to repay your loan

                                                    5-17
       FICO & VantageScore

• FICO Credit Score
  – 350 to 850
  – Higher score = less risk
  – Available from http://www.myfico.com for a
    fee; can sometimes get for free from lenders
• VantageScore
  – New scoring technique
  – Developed collaboratively by 3 credit agencies
  – Range = 501 to 990
                                                   5-18
       Credit Scoring Factors

• Bill payment history, weighted to
  emphasize past 12 months (35%)
• Proportion of outstanding debt to
  available credit limits (30%)
• Length of credit history (15%)
• Number of recent credit inquiries (10%)
• Mix of types of credit used (10%)
   Factors of Creditworthiness
ECOA (Equal Credit Opportunity Act)
  – Gives all applicants the same rights.
  – Credit providers may not discriminate based on:
     • Age
     • Social Security or public assistance
     • Housing loans (redlining)
  – If you are denied credit, you have the right
    to know the reasons
     • You can request a copy of your credit report
       within 60 days if you are denied credit
       based on what is in your files
                                                      5-20
          Your Credit Report
• Credit Reports
  – Record of your complete credit history
• Credit Bureaus
  – Agencies that collect information on how
    promptly people and businesses pay their
    bills
  – Experian, Trans Union and Equifax are
    the 3 major credit bureaus
  – Credit Bureaus obtain information from
    banks, finance companies stores, credit
    card companies and other lenders
                                               5-21
 Four Main Parts to a Credit Report

• Identifying Information: name, SS Number,
  current/previous addresses, birthdate, employer
• Public Record Information from Local
  Courthouse: liens, foreclosures, bankruptcy
• Other Credit History Information: list of loans
  and credit cards, timeliness of payments, defaults
  and negative information (7 years)
• Inquiries: Usually 2 years; self-initiated and
  promotional (for marketing purposes)
         Your Credit Report

• Who can obtain a credit report?

  – Only authorized persons have access to
    your report for approved legitimate business
    purposes

  – Examples???

• Time Limits on Unfavorable Data

  – Adverse data can be reported for 7 years

  – Bankruptcy can be reported for 10 years
                                                   5-23
Wrap Up

• Concept Check 5-1- Reasons to Borrow
  and Advantages/Disadvantages
• Concept Check 5-2- Definition of Terms;
  Difference Between Credit and Debit
  Cards
• Concept Check 5-3- Definition of Terms

								
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