In-Depth Notes on Credit Cards and Open Credit

Learning Objectives

• 6.1 Know how credit cards work.
• 6.2 Understand the costs of credit.
• 6.3 Describe the different types of credit cards.
• 6.4 Know what determines your credit card worthiness and how to secure a credit card.
• 6.5 Manage your credit cards and open credit.

Introduction

• Credit cards are convenient; however, they can be costly if not managed properly.
• Some cards charge interest rates over 20% on unpaid balances.
• Many consumers overlook interest charges on essential purchases.
• Importance of managing credit wisely to avoid spiraling debt.

Understanding Credit Cards and Open Credit

• Credit:
  • Involves receiving cash, goods, or services with an obligation to pay later.
• Open Credit (Revolving Credit):
  • A line of credit extended before the purchase.
  • Unpaid balances plus interest carry over to the next month.
  • Higher credit line balances result in higher costs.

Interest Rates

• Annual Percentage Rate (APR):
  • The true simple interest rate paid over the loan's duration.
  • APR must be disclosed for consumer loans.
• Types of APR:
  • Fixed APR: Remains constant.
  • Variable APR: Can change based on economic factors.
• Teaser Rates:
  • Initial lower rate that increases after a period.
• Compound Interest:
  • Interest calculated on the initial principal and also on the accumulated interest from past periods.

Calculating the Balance Owed

• Balance Calculation Methods:
  • Average Daily Balance Method: Daily balance averaged over the billing cycle.
  • Previous Balance Method: Interest calculated on the prior month’s balance, regardless of payments made.
  • Adjusted Balance Method: Considers payments made during the billing cycle.

Cash Advances

• Cash Advances:
  • Similar to taking out a loan.
  • Higher interest rates charged immediately.
  • Typical fees: 2-4% of the amount advanced.
  • Payments for purchases are prioritized over cash advances.

Grace Period

• Grace Period:
  • Time before interest accrues on unpaid balances.
  • Usually 21-25 days from the billing date.
  • No grace period for cash advances.
  • Unpaid balances from previous months cancel the grace period.

Annual Fees

• Annual Fee:
  • Fixed charge imposed by credit card companies.
  • Majority of major issuers waive this if the card is used at least once a year.
  • Merchant’s discount fee:
  • Percentage paid to the credit card issuer by merchants for each transaction.

Credit Card Fees

• Typical fees:
  • Annual Fee
  • Cash Advance Fee
  • Late Fee
  • Over-the-Limit Fee
  • Penalty Rate

Pros and Cons of Credit Cards

• Advantages:

  • Convenience and identification.
  • Online and phone purchase facilitation.
  • Bill consolidation; use products before payment.
  • Extended warranties, travel insurance, rewards.

• Disadvantages:

  • Encourages overspending and poor tracking of expenses.
  • High-interest rates lead to future income obligations.
  • Potential for severe budget issues if spending is uncontrolled.

Understanding Creditworthiness

• Five Cs of Credit:
  • Character: Borrower's reputation.
  • Capacity: Ability to repay.
  • Capital: Value of assets owned.
  • Collateral: Asset pledged for the loan.
  • Conditions: Economic environment and lending terms.

Credit Evaluation Process

• Credit Score:
  • Indicated by credit bureaus based on consumers’ financial history.
  • Affects loan approvals and interest rates.
  • Common scales (FICO, VantageScore) range from 300 to 850.

Monitoring Your Credit Score

• Check for errors.
• Obtain a free annual credit report from the three major bureaus at annualcreditreport.com.
• Ensure all information is accurate and belongs to you.

Consumer Credit Rights

• Rights Include:
  • Address complaints directly to creditors.
  • Federal laws protect consumers against credit complaints.

Choosing a Source of Open Credit

• Types of Credit Cards:
  • Bank Credit Cards: Issued by banks or corporations.
  • Travel and Entertainment Cards: Require full balance payment monthly.
  • Single-Purpose Cards: Usable only at a specific retailer.
  • Traditional Charge Accounts: Used for specific company purchases with pay-per-bill options.

Conclusion

• Effective credit management involves understanding fees, evaluating creditworthiness, and recognizing the pros and cons of credit use.
• Awareness of how different credit types work aids in making informed financial decisions, ultimately leading to better financial health and reduced debt.