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Learning Objectives

  • LO 5.1: Define consumer credit and analyze advantages and disadvantages of using consumer credit.

  • LO 5.2: Assess the types and sources of consumer credit.

  • LO 5.3: Determine whether you can afford a loan and how to apply for credit.

  • LO 5.4: Calculate the cost of credit by using various interest formulas.

  • LO 5.5: Create a plan to protect your credit and manage your debts.

LO 5.1: What is Consumer Credit?

  • Definition of Credit: An arrangement to receive cash, goods, or services now and pay for them later.

  • Consumer Credit: Refers to the use of credit for personal needs, excluding home mortgages.

  • Importance:

    • Major force in the American economy.

    • Essential for personal and family financial planning.

    • Involves responsibility and risks.

Uses and Misuses of Credit

  • Considerations before Major Purchases:

    • Do I have sufficient cash for the down payment?

    • Am I willing to use my savings for this purchase?

    • Does this purchase align with my budget?

    • Could I utilize needed credit more effectively for another purpose?

    • Is postponing the purchase an option?

    • What are the opportunity costs associated with postponing my purchase?

    • What psychological and monetary costs may arise from using credit?

Advantages of Credit

  • Immediate Enjoyment: Provides the advantage of cashing in on opportunities (buying cars, homes, education, etc.) instantly, while payday often comes later.

  • Financial Safety Net: Useful in emergencies. Payment plans can ease financial burdens based on expected future income.

  • Record Keeping: Offers detailed records of expenses.

  • Float Period: Credit cards allow for up to a 50-day payment window without interest.

  • Convenience: Enables shopping and travel without carrying cash.

  • Credit Worthiness Indicator: A good credit history can demonstrate financial stability.

Disadvantages of Consumer Credit

  • Overspending: Credit may tempt consumers to spend beyond their means.

  • Long-term Consequences: Can lead to significant financial problems, strained family interactions, and hinder reaching financial goals.

  • Asset Risk: Failure to repay credit can lead to income loss or forfeiture of property and can damage reputation.

  • Legal Consequences: May result in lawsuits or bankruptcy.

  • Income Limitations: Future income can be tied up with debts and obligations.

  • Costliness of Credit: Long-term payment plans can become more expensive than one-time cash purchases.

LO 5.2: Types of Consumer Credit

  • Closed-end Credit: Repaid through equal payments in a specified period. Examples include:

    • Installment Sales Credit: High-priced items purchased through loan.

    • Installment Cash Credit: Direct loans of money for personal needs.

    • Single Lump-sum Credit: Loans paid entirely at a set time (typically 30-90 days).

  • Open-end Credit: Continuous loans requiring periodic payments. Interest and finance charges may apply. Examples include:

    • Bank cards (Visa, MasterCard)

    • Department store cards

    • Overdraft protection

Examples of Closed-end and Open-end Credit

  • Closed-end Credit Examples:

    • Mortgage loans

    • Automobile loans

    • Installment loans (installment sales contracts, installment cash credit)

  • Open-end Credit Examples:

    • Store cards (including department stores)

    • Credit cards (such as Visa, MasterCard)

    • Overdraft protection

Volume of Consumer Credit

  • Trends in Consumer Credit (2000-2023):

    • Significant recognition of consumer credit's impact on the economy.

  • Data Source: Federal Reserve, Consumer Credit-G.19

Open-end Credit: Credit Cards

  • Average Cardholder: More than nine credit cards, including bank and retail cards.

  • Types of Users:

    • Convenience Users: Pay balances in full monthly.

    • Borrowers: Do not pay balances in full monthly.

  • Grace Period: Time period with no finance charges applied.

  • Finance Charge: Total dollar cost for credit use.

  • Warnings: "Teaser rates" and potential annual fees.

LO 5.3: Can You Afford a Loan?

  • Equal Credit Opportunity Act (ECOA): Outlaws discrimination in lending based on race, color, age, sex, marital status, or other factors.

  • Self-assessment Questions:

    • Can you cover essential expenses while meeting loan payments?

    • What expenses will you forgo to make loan payments?

Credit Capacity Measurements

  • Debt Payments-to-Income Ratio: Calculated by dividing monthly debt payments (excluding housing) by net monthly income — recommended not to exceed 20%.

  • Debt-to-Equity Ratio: Total liabilities divided by net worth; recommended upper limit is 1.

The Five C’s of Credit

  1. Character: Reliability to repay loans.

  2. Capacity: Financial ability to repay loans.

  3. Capital: Assets and net worth considered by the lender.

  4. Collateral: What is pledged against the loan?

  5. Conditions: Impact of economic conditions on debt repayment ability.

Your Credit Report

  • Definition: Complete record of credit history.

  • Credit Bureaus: Agencies that aggregate payment information (Experian, TransUnion, Equifax).

  • Contents of a Credit File:

    • Personal details such as name, address, and Social Security number.

    • Employment and income history.

    • Rental or homeownership status and any returned checks.

Fair Credit Reporting Act

  • Overview: Legislation regulating credit report use and ensuring consumer accuracy and access to information.

  • Rights Provided: Consumers can dispute inaccuracies and limit who can access credit reports.

Credit Scores

  • Definition: Numerical representation of credit history indicating repayment likelihood.

  • FICO Score: Ranges from 300 to 850, with higher scores indicating lower risk.

  • VantageScore: Developed collaboratively among credit bureaus, scoring ranges from 501 to 990.

Factors Impacting Creditworthiness

  • ECOA Requirements: Age, assistance income, and redlining are not factors in denial.

  • Risk-based pricing disclosures: Must be provided to consumers.

What if Your Application is Denied?

  • Right to know reasons for denial under ECOA.

  • Procedures for disputing inaccurate or incomplete information encountered in your credit file.

Improving Your Credit Score

  • Early Steps: Review credit report accuracy.

  • Long-term Strategies: Tend to timely bill payments, lower credit utilization, and wise credit management over time.

LO 5.4: The Cost of Credit

  • Finance Charge Definition: Total amount paid for the credit, including interest and possible fees.

  • Annual Percentage Rate (APR): Yearly percentage cost of credit facilitating cost comparisons.

Calculating the APR

  • APR Calculations: Can be approximated using a formula involving payment periods, costs, principal, and payments scheduled.

  • Compounding Impact: Different payment methods affect APR calculation – lump sum vs. installment impacts overall costs.

Trade-Offs in Financing

  • Long-Term Financing Considerations: Understanding that larger monthly payments often lead to higher total interest costs.

  • Lender Risk vs. Interest Rate: Mitigating risk can lower interest rates through collateral or variable rates.

Calculating Cost of Credit

  • Simple Interest Definition: Calculated only on principal, without compounding.

  • Declining Balance Method: Interest computed on unpaid principal.

  • Add-on Interest Method: Applies to total original loan amount irrespective of repayments.

LO 5.5: Protecting Your Credit

  • Fair Credit Billing Act (FCBA): Enforces procedures for disputes in billing errors and complaints regarding defective goods.

  • Steps to Handle Errors: Notify creditors in writing, pay undisputed portions, respond within specified timeframes.

Identity Theft and Credit Protection

  • Steps to Handle Identity Theft: Promptly report incidents to credit bureaus, creditors, and authorities.

  • Protection Tips: Protect sensitive information and monitor credit reports regularly.

Cosigning a Loan

  • Implications: Cosigning creates liability for the entire debt if the primary borrower defaults.

  • Evaluating Risks: Assess affordability if the borrower fails to repay.

Consumer Credit Protection Laws

  • Overview of Key Laws: Include acts that govern truthful lending and consumers' rights in credit dealings.

Consumer Financial Protection Bureau (CFPB)

  • Role in Consumer Issues: Provides oversight and support for credit-related complaints.

Managing Your Debts

  • Warning Signs: Identify behaviors indicative of potential debt troubles, such as only making minimum payments or increasing balances without repayment.

Debt Collection Practices

  • Regulations: Governed by the Fair Debt Collection Practices Act which sets standards for collector behaviors, not erasing legitimate debts.

Financial Counseling Services

  • Consumer Credit Counseling Services (CCCS): Non-profits offering financial education and budgeting assistance.

  • Other Support Services: Available through universities, credit unions, and governmental agencies.

Declaring Personal Bankruptcy

  • Definition and Types: Legal process of asset distribution due to repayment inability; includes Chapter 7 (straight bankruptcy) and Chapter 13 (wage earner plan).

  • Consequences: Severe impact on credit ratings; often a last resort.

U.S. Consumer Bankruptcy Filings

  • Recent Trends: Increases in filings despite legal changes; a direct effect of economic conditions.

Effects of Bankruptcy on Credit

  • Post-Bankruptcy Credit Access: Varied implications for obtaining new credit post-filing, influenced by the type of bankruptcy pursued (Chapter 7 vs Chapter 13).