Consumer Credit

Consumer Credit Chapter 10 Learning Objectives • Define consumer credit and discuss the advantages and disadvantages of using credit. • Distinguish between nominal and effective interest rates and differentiate inflationadjusted real returns from nominal returns. • Differentiate among various types of credit. Learning Objectives continued • Outline the concept of security and explain the various security instruments available as collateral for consumer loans. • Describe the process by which credit providers assess credit capacity and risk. • Identify the major providers of consumer credit, describing the lending functions of various institutions. Learning Objectives continued • Understand the implications of consumer bankruptcy and loan losses. • Briefly describe the regulations and codes which govern credit transactions. • Identify the role of the Banking Industry Ombudsman and understand the areas covered by the Code of Banking Practice. INTRODUCTION • Credit is an integral part of the human lifestyle. • Consumer credit is readily available. • It is important to understand the role of credit in civil society. • This involves the consideration of: – Institutions – Instruments – Lending practices – Legal framework WHAT IS CREDIT? “power to buy or borrow on trust” … Macquarie Dictionary • Consumer credit is used to meet personal needs. • Credit increases purchasing power in the short term. • However, credit does not increase total purchasing power because interest and principal must be repaid. WHEN TO USE CREDIT • Credit card payment allows easy access to internet and pay-by-phone facilities. • Credit is safer because it reduces the amount of cash individuals must have. • The inherent problem with credit is the likelihood of overspending. • Misuse of credit can result in: – Decline in quality of lifestyle – Personal bankruptcy Nominal and Effective Interest Rates • Nominal rates are the stated interest rates expressed in ‘per annum’ terms even though the rates may be compounded more frequently than annually. – e.g. 12% p.a. compounded quarterly • Effective rates are those that are compounded only once during the period expressed in the interest. – e.g. 3% per month compounded monthly Nominal and Effective Interest Rates continued Example – $1 is borrowed for 1 year – Bank A: 10% interest compounded annually – Bank B: 10% interest compounded quarterly • Interest charged per period Q1 Q2 Q3 Q4 Total to repay Loan A 10% $1 x 1.10 = $1.10 Loan B 2.5% 2.5% 2.5% 2.5% $1 x (1.025)4 = $1.1038 Nominal and Effective Interest Rates continued • The formula to convert nominal rates to effective rates is: i= 1+j m where i = effective interest rate j = nominal interest rate m = number of compounding intervals per period m –1 Financial Mathematics and the Time Value of Money Simple Interest • Only the original principal earns interest for the length of the transaction. • FV is PV of principal plus total interest earned or FV = PV + I Compound Interest • The interest earned during any given time period is added to the principal and then this new amount earns interest during the next period. FV = PV(1 + i)n INFLATION AND RETURNS • Nominal returns are returns on investment that have not been adjusted for inflation. • Real returns are returns that have been adjusted for inflation. • Example – Inflation rate is 5% and $100 investment will be worth $116 in 1 year’s time. – Nominal return = (116 – 100)/100 = 16% INFLATION AND RETURNS continued • The Fisher effect is relationship between nominal and real rates of return. • Formula is: (1 + i) = (1 + r)(1 + f) where i = nominal rate of interest r = real rate of interest f = rate of inflation TYPES OF CREDIT 1. Housing Loans • Approx. 70% of households live in a dwelling they either own or are buying. • Owner-occupied housing loans are usually calculated on principal-and-reducing interest basis. • Provided by banks, building societies, credit unions and life insurance companies. TYPES OF CREDIT continued • A secondary mortgage market has developed whereby lenders can securitise their portfolio of loans. • Formula to calculate repayments is: C = PV [1 – (1 + i)–n]/i TYPES OF CREDIT continued 2. Credit Cards • Available for cash advances or to purchase goods and services directly. • Charges vary with cost of interest and fees generating conflict. • Growth up market increased with electronic banking (ATMs and EFTPOS). • Attractions include automatic billing and loyalty rewards programs. TYPES OF CREDIT continued 3. Personal Loans • Provide either short of long term funds. • May be secured or unsecured. • Usually for 2 to 5 years. 4. Revolving lines of credit • Borrowers can redraw on their home loan account up to an approved limit. • Overdraft lines of credit provided on cheque accounts by banks. TYPES OF CREDIT continued 5. Motor Vehicle Loans • May be secured or unsecured. • Banks/finance companies provide motor vehicle dealers with plans to offer buyers. 6. Leasing Finance • Financial institution retains ownership of equipment and user rents it. • Rental payments may be tax deductible. TYPES OF CREDIT continued 7. Fully Drawn Advance • May be provided against collateralised real estate mortgages to enable borrowers to purchase consumer goods. 8. Bridging Loans • Single repayment loan where loan is repaid with interest at end of its term. • Enable borrowers to purchase an asset immediately before receiving proceeds from sale of another asset. SECURITY FOR CONSUMER CREDIT • A security interest held by a lender: – Enables the lender to recover losses quickly when borrower breaches contract. – Provides the lender with the rank of secured creditor, and therefore priority, if bankruptcy occurs. • A legal mortgage is created by transfer to the lender of the legal title to a borrower’s property for security purposes only. SECURITY FOR CONSUMER CREDIT • An equitable mortgage can be created by: – Mere deposit of title deeds – Intention to crease a legal mortgage • A registered mortgage is a legal mortgage. • The Torrens system of land titles and security of real estate has been long being established for mortgaging purpose. • A guarantee is a promise to answer for the debt of another person to the lender. SECURITY FOR CONSUMER CREDIT continued • Examples of loans and security arrangements – Loan and security arrangements with Direct Security Loan Housing Loan Lender First mortgage security Borrower SECURITY FOR CONSUMER CREDIT continued – Loan and security arrangements involving a third party Loan Housing Loan Lender Borrower Repayment & guarantee fees First mortgage security and guarantee Guarantor CREDIT ASSESSMENT • Credit analysis involves both: – Objective analysis which considers the factual information needs of the borrower. – Subjective analysis which considers the borrower’s credit-worthiness and personal financial management ability. • Credit information is obtained from: – The credit application form. – Credit ratings agencies. CREDIT ASSESSMENT continued • Credit investigation involves checking the accuracy of the information provided by the borrow. • The lender seeks credit verification by confirming information with sources other lenders, employers, real estate agents and licensed valuers. • The quality and reliability of the primary source of repayment is vital to financial analysis. CREDIT ASSESSMENT continued • Lenders can make two errors when they assess loan applications. – To lend to borrowers who are not creditworthy resulting in a loss. – Disqualifying good borrower applications may also result in a loss due to the opportunity cost that arises. SOURCES OF CONSUMER CREDIT • Major sources of consumer credit are: – Banks – Finance companies – Building societies – Credit unions • Life insurance companies also provide investment and owner-occupied finance to policy holders. BANKRUPTCY • Causes of bankruptcy – unemployment – excessive use of credit – domestic discord – ill health – adverse litigation • Alternatives to bankruptcy include – Informal arrangements – Debtor’s petition – Part IX and Part X arrangements CONSUMER REGULATION COMPLIANCE Benefits to consumers • Full disclosure • Assistance for reasonable cause • Default notice • Access to justice Benefits to lenders • Variations of contract • Taxes • Variation of interest rates • Advertising opportunities • Standardised systems AUSTRALIAN BANKING INDUSTRY OMBUDSMAN SCHEME • ABIOS is a self-regulatory scheme providing an accessible alternative to users of bank services who have disputes with their banks. • It is a free service if disputes relate to personal banking services. CODE OF BANKING PRACTICE • Usually Formulated by Banking Associations. • The Code – Describes standards of good practice. – Promotes information disclosure. – Requires banks to have dispute resolution processes. – Requires banks to reveal details of fees, interest and changes in conditions. SUMMARY • Credit is the power to buy on trust. • Consumer credit is readily available in most countries. • There are many players in the industry offering a wide variety of credit alternatives. • Lenders need to ensure adequate security and ability to repay.