Managing Credit: Credit Cards and Consumer Loans

Credit

Arrangement to receive cash, goods, or services now and pay for them later

Consumer Credit

use credit to buy consumer goods and services:

• credit cards, car loans, and student loans

spreads the cost of more expensive items over time; use now pay later,

can have negative impact on household financial statements

types of consumer credit

1. closed-end credit

2. open-end credit

closed-end credit

credit used for specific purposes eg. car loans, student loans

open-end credit

also known as ‘revolving credit’

approved to a specific credit limit

not for particular purchases - no maximum time period for repayment of debt

eg. credit cards, personal loans, home equity lines of credit

Sources of Consumer Credit

Depository Institutions

Consumer Finance Companies

Sales Finance Companies

Federal Government

Payday Loans & Pawn Shops

Depository Institutions

Banks and Credit Unions

Consumer Finance Companies Do What?

Obtain funds from investors and short-term borrowing rather than depositors

Higher interest rates for riskier loans - may require collateral

Sales Finance Companies

Make consumer loans to buyers of products offered through their parent companies - usually large retailers (ie. Ford or Toyota)

Federal Government

Provides student loans and small business loans

Payday Loans & Pawn Shops

Regularly provide short-term loans to people who don’t have other options

should be considered last resort option

Advantages of Consumer Credit

1. Buy now - pay later

2. Convenience & Safety

3. Source of Emergency Cash

Advantages of Consumer Credit - Buy Now - Pay Later

• availability of credit improves the standard of living

• only worth it if you can afford payments without sacrificing other worthy financial goals - and the product lasts until paid off

Advantages of Consumer Credit - Convenience and safety

• harder for thieves to use than cash

• when balance each month is paid off - have free credit offered by card issuer

Disadvantages of Consumer Credit (4)

1. increased cost

2. impact on household financials

3. risk of overspending

4. higher insurances premiums

Disadvantages of Consumer Credit - increased cost

• pay either a fee or higher price for purchase

Disadvantages of Consumer Credit - impact on household financials

• liquidity & debt ratios will look worse with more credit usage

• increased exposure to risk

• Lower credit score can increase cost/decrease availability of future credit

Disadvantages of Consumer Credit - risk of overspending

• credit increases risk of spending more than you earn

Disadvantages of Consumer Credit - higher insurance premiums

• many insurance companies use credit history for pricing decisions

Measuring Credit Capacity

• before borrowing money - it is important to have a plan for repaying debt

• main a summary of your household debt usage

• financial ratios help assess whether your finances can handle an increased level of debt

• assess creditworthiness using the 5 Cs of Credit

Using Financial Ratios to Measure Credit Capacity

Debt payment ratio = Total monthly debt payments / After-tax monthly income

THE 5 C’S OF CREDIT

1. capacity

2. capital

3. collateral

4. character

5. conditions

THE 5 C’S OF CREDIT - capacity

• do you have sufficient income

• how big are your current payment obligations

THE 5 C’S OF CREDIT - capital

how much are your assets worth

how much are your debts worth

what is your net worth

THE 5 C’S OF CREDIT - collateral

• pledging any asset as security for the loan

• do you have money in checking, savings & investment accounts?

THE 5 C’S OF CREDIT - character

• have you used credit before - clean credit record?

• have you ever filed for bankruptcy?

• how long have you lived & worked from current employer

THE 5 C’S OF CREDIT - condtions

• do you have a secure job

• is the company you work for in good financial shape?

• are general economic conditions favourable?

Understanding Your Credit Score

• lenders evaluate creditworthiness by checking outstanding debt obligations and history of making payments

• credit bureaus classify you based on their estimate of your credit risk, using credit scoring system, such as FICO

Three Major Credit Bureaus

1. equifax

2. experian

3. transunion

FICO CREDIT SCORE FACTORS

1. type of credit used

2. payment history

3. amounts owed

4. length of credit history

5. new credit

Improving Credit Score

• correct outdated and incorrect info in credit report

• consistently make timely payments

• reduce your total debt

• develop a longer credit history

• include a mix of different types of credit - not just credit cards

• close accounts that you haven’t used already

When and How to Use Consumer Credit

1. don’t use credits for items you can’t afford

2. pay your credit card balance in full by due date

3. keep track of monthly expenses to ensure monthly cash flow is on target

4. limit yourself to a small amount of credit cards

5. avoid high-interest consumer credit

6. avoid consumer credit with annual fees

Strategies for Reducing Debt

1. set up debt repayment plan

2. obtain debt consolidation loan at a lower interest rate

3. take a second job specifically for repaying debt

4. develop a zero-based budget

5. live with family or friends to reduce your expenses

6. sell assets

Your Consumer Credit Rights

o Full information from prospective lender

o Clear and accurate billing statements

o Limits on interest rate increases and fees

o Freedom from discrimination

o Privacy of financial information

o Know why you were denied credit

o Fair and respectful debt collection

o Accuracy of reported credit information

o Correcting information on your credit report

Clear and Accurate Billing Statements

within 60 days of billing error:

1. second a written notice to the credit card issuer

   • company must immediately credit your account - pending resolution of the dispute

2. withhold payment for the disputed item

   • issuer cannot charge your interest or penalties on the disputed amount while it is in dispute

Accuracy of Reported Credit Information

• you are entitled to have info reported fairly and accurately

• check credit reports regularly

• credit reporting agencies must notify you when they add new negative info to your file

• negative credit information must be removed from file after seven years

What If It’s Gone Too Far and You’re in Financial Distress?

• do not simply avoid talking to the bank

• contact the bank directly

• consult a professional credit counsellor:

• as last resort - file for bankruptcy:

  • appears on your credit report for 19 years

  • may affect ability to get a home mortgage or other credit

  • the long-lasting impact may outweigh the benefits of debt reduction

Personal Bankruptcy - CANADA VS USA

Canada:

• bankruptcy and insolvency act

• consumer proposal

• bankruptcy trustee

US:

• title 11 united states code

• chapter 7

• chapter 13

• bankruptcy lawyer

types of bankruptcy

1. personal bankruptcy CAN

2. consumer proposal CAN

Personal Bankruptcy

Liquidation or sale of most assets

Proceeds are used to pay creditors to the extent possible, and then most financial obligations are cleared

Certain obligations are unaffected, such as alimony, child support, student loans, and debts not disclosed in court

Consumer Proposal

• tax law - most debtors must file for this

• protects you from creditors’ claims while you develop & implement a repayment plan under court supervision

• usually involves reduced balances and payments - you generally keep all assets

types of credit cards

bank credit cards

retail credit cards

travel and entertainment cards

debit cards

smart cards & new technology

bank credit cards

vise, mastercard, discover

accepted by most vendors

retail credit cards

home depot, neiman marcus, macy’s best buy

most can only be used at their own stores

travel and entertainment cards

allow business customers to delay payment and to coincide with their company reimbursement system

ie. diners club and american express

debit cards

subtract your purchases electronically directly from checking or savings

smart cards and new technology

unlike debit & ATM cards - actual store electronic cash

credit card terminology

• annual fees

• annual percentage rate (APR)

• transaction, bulling and due dates

• minimum payment

• penalties and fees

ANNUAL PERCENTAGE RATE (APR)

annual percentage rate = total annual finance charges + annual fee / average loan balance over the year

grace period

period of time from the transaction to the due date

credit card finance charge

• number of billing periods per year is 12 months

• account balance calculation depends on the calculation used by the lender

• average daily balance is most common

finance charge equation

finance charge = nominal rate / number of billing periods per year x account balance owed

common types of consumer loans

• home equity loans

• automobile loans

• student loans

home equity loans

• secured by your home

• similar to primary mortgage loan

home equity

difference between the market value of the property and the remaining balance on your mortgage

automobile loans

• purpose of buying a car

• limited to some percentage of the current market value of the car (collateral)

student loans

federal and private

Secured Vs Unsecured Loan

• secured loan gives the lender the right to take certain assets or property if the loan is not repaid according to its terms

• pledged property is collateral for the loan - the lender records a lien

Comparing Consumer Loan Alternatives - Interest Rates - fixed-rate loan vs variable-rate loan

fixed- has the same interest rate throughout its life

variable- the periodic rate fluctuates with a predetermined measure

Comparing Consumer Loan Alternatives - payment arrangements

single-payment loans - require the balance to be paid in full at some point in the future

installment loans - allow the borrower to repay overtime - usually in monthly payments that include principal and interest

Finance Charges - Simple Interest

interest = remaining balance of loan x nominal rate / payments per year

Finance Charges - Add-on Interest

• the interest is added to the amount borrowed before the payments are calculated

• payment = amount of loan + (amount of loan x nominal rate x number of years) / number of payments

Finance Charges - Discount Interest

the lender subtracts the interest due from the principal amount before the borrower gets the money - results in a higher APR

Consumer Loan Payments - repayment of principal

• as you make payments on a loan - amount of the payment going towards principal increases - amount going toward interest decreases

Consumer Loan Payments - early repayment of installment loans

• you pay off your loan before the maturity date by paying extra principal in each payment

Consumer Loan Payments - balloon loan

• A special type of instalment loan involving a final “balloon” payment that is larger than the other instalment payments

Consumer Loan Payments - interest-only loans

charge a stated APR on the balance owed in each period and require repayment of the full balance within a relatively short period of time - similar to a balloon loan

Consumer Loan Payments

• repayment of principal

• early repayment of instalment loans

• balloon loan

• interest-only loans