I. The Basic Concepts of Credit
A. Why We Use Credit
B. Improper Uses of Credit
C. Establishing Credit
1. First Steps in Establishing Credit
2. Build a Strong Credit History
3. How Much Credit Can You Stand?
II. Credit Cards and Other Types of Open Account Credit
A. Bank Credit Cards
1. Line of Credit
2. Cash Advances
3. Interest Charges
4. Then There Are These Other Fees
C. Special Types of Bank Credit Cards
1. Reward Cards
2. Affinity Cards
3. Secured Credit Cards
4. Student Credit Cards
D. Retail Charge Cards
E. Debit Cards
F. Revolving Credit Lines
1. Overdraft Protection
2. Unsecured Personal Lines
3. Home Equity Credit Lines
III. Obtaining and Managing Open Forms of Credit
A. Opening an Account
1. The Credit Application
2. The Credit Investigation
3. The Credit Bureau
B. The Credit Decision
C. Computing Finance Charges
D. Managing Your Credit Cards
1. The Statement
IV. Using Credit Wisely
A. Shop Around for the Best Deal
B. Avoiding Credit Problems
C. Credit Card Fraud
D. Bankruptcy: Paying the Price for Credit Abuse
1. Wage Earner Plan
2. Straight Bankruptcy
Managing credit is an important part of personal financial planning. Consumer credit can be
used in one form or another to purchase just about every type of good or service imaginable. It
is a convenient way to make transactions, but when consumer credit is misused it can lead to
real problems. It is important for you to understand where consumer credit fits into your
financial plans so that it is used wisely. This chapter covers the following major topics:
1. Consumer credit enables the user to pay for relatively expensive purchases, to deal with
financial emergencies, and to enjoy the convenience of using credit.
2. Disadvantages to using consumer credit generally arise from abuse of credit—people
borrow more than they can handle—and this can eventually lead to bankruptcy.
3. Open account credit is the most popular form of consumer credit. It is provided by
banks, stores, and other merchants and includes bank credit cards, retail charge cards,
travel and entertainment cards, and personal revolving credit lines, which include
overdraft protection and home equity loans.
4. Formal application for open account credit involves a credit investigation; a credit
report will probably be obtained from one of the major credit bureaus.
5. Finance charges are typically based on a variation of the average daily balance method.
6. Using open account credit wisely involves choosing the right card or line of credit,
avoiding credit problems and fraud, and not abusing credit.
Open account credit is a very important concept in the understanding of your personal
financial plan. Improper use of this type of credit can lead to disaster, but wise use of open
account credit can help you implement your overall plan. To understand the application of
open account credit, you should understand some of the key terminology, including the
1. Debt safety ratio
2. Credit history
3. Credit limit
4. Bank credit cards
5. Retail charge cards
6. Cash advance
7. Debit cards
8. Revolving line of credit
9. Overdraft protection
10. Home equity credit lines
11. Credit, character and capacity
12. Credit bureau
13. Credit scoring
14. Finance charges
15. Consumer credit legislation
16. Credit card fraud
17. Personal bankruptcy
18. Credit counseling
Financial Planning Exercises
The following are solutions to problems at the end of the PFIN textbook chapter.
1. Arlene is wise to begin establishing a good credit history early. She should start by
opening bank accounts (checking and savings) and applying for a few credit cards. She
should use these cards sparingly and pay bills promptly. Having a student loan helps
establish her credit history, as by making payments on time, she demonstrates her
ability to meet her loan obligations.
2. If Brian makes payments of $410 and his take-home pay is $1,685, his debt safety ratio
is $410/$1,685 = .24 or 24%, which is slightly above the maximum suggested limit of
20%; as such, Brian should be cautious about incurring any more debt before he pays
off his current obligations.
If his take-home pay were $850 and his payments were $150 per month, his debt safety
ratio would be $150/$850 = .18 or 18%, which is within the recommended guidelines.
However, 18% is close to the maximum suggested limit of 20%, so Brian would do
well to try to reduce his debt load.
3. Beverly's consumer debt safety ratio is calculated as follows: Use worksheet 6.1.
Type of Loan Mo. Payment
Auto loan $ 380
Dept. store charge card 60
Bank credit card 85
Personal line of credit 120
Total Monthly Payments $ 645
Debt Safety Ratio = Total Monthly Consumer Credit Payments
Monthly Take-Home Pay
= $ 645
If Beverly wants her debt safety ratio to be only 12.5% of her current take-home pay,
she must reduce her total monthly payments to $415 ($3,320 x .125).
If Beverly wants her current consumer debt load to equal 12.5% of take-home pay, then
she would have to increase her take-home pay to $5,160 ($645 = 0.125 x Take-home
pay or Take-home pay = $645 ÷ 0.125)
4. If Bill and Ethel have a home appraised at $180,000 and a mortgage balance of only
$90,000, they have equity in the home of $90,000 ($180,000 – $90,000). If an S&L
will lend money on the home at a loan-to-value ratio of 75%, the S&L would be
willing to lend up to $135,000, or .75 x $180,000. Subtracting the first mortgage of
$90,000, the Pattersons could qualify for a home equity loan of $45,000.
According to the latest provisions of the tax code, all of the interest paid on their home
equity loan would be fully deductible (for federal tax purposes). It makes no difference
what the house originally cost; the only thing that matters is that the amount of
indebtedness on the house not exceed its fair market value (which is virtually
impossible given a loan-to-value ratio of 75%). Other than that, a homeowner is
allowed to fully deduct the interest charges on home equity loans of up to $100,000;
since the Pattersons' home equity line is within this limit (theirs is a $45,000 line), the
interest on it is fully deductible.
Note: under current tax laws, the total amount of itemized deductions as reported on
Schedule A may be reduced for taxpayers with adjusted gross incomes greater than a
certain level. Also, if taxpayers do not itemize deductions and take the standard
deduction instead, the tax deductibility feature of a home equity loan would not make a
different in the amount of taxes owed.
5. If Parviz plans to pay his balance in full each month, the interest rate on his credit card
would not matter. Virtually all cards do not charge a fee if the cardholder's balance is
paid in full each billing cycle, provided no late fees or over-the-limit fees apply.
Therefore, he would go with the card which does not have an annual fee.
However, if he knows he will carry a significant balance from one billing cycle to the
next, he may well be better off with the card that charges an annual fee and a lower
interest rate. The higher his balance, the more attractive such a card would become.
However, several words of caution are in order here. If a credit card uses the two-cycle
average daily balance including new purchases method of computing the balance on
which to apply the interest rate, the cardholder's effective rate of return is likely to be
much higher than the stated rate, depending on the timing of when charges and payoffs
are made. Knowing the balance method in addition to the rate charged is crucial to
making a good financial decision.