Consumer Credit: Its Advantages and Disadvantages

Consumer Credit: Its Advantages and Disadvantages

Learning Objectives

  • LO 5.1: Define consumer credit and analyze its advantages and disadvantages.
  • LO 5.2: Assess types and sources of consumer credit.
  • LO 5.3: Determine loan affordability and application process.
  • LO 5.4: Calculate the cost of credit using various interest formulas.
  • LO 5.5: Develop a plan to protect credit and manage debts.

What is Consumer Credit?

  • Definition: Credit is an arrangement to receive cash, goods, or services now and pay for them in the future. Consumer credit specifically refers to credit used for personal needs (excluding home mortgages).
  • Economic Impact: A significant force in the American economy, it plays a crucial role in personal and family financial planning.
  • Responsibility: Involves risks and responsibilities in repayments.

Uses and Misuses of Credit

  • Before making major purchases, consider:
  • Availability of cash for down payment.
  • Use of savings for the purchase.
  • Fit within budget.
  • Opportunity costs of postponing purchases.
  • Costs (both dollar and psychological) associated with using credit.

Advantages of Credit

  • Immediate Access: Enables immediate enjoyment of goods/services such as vehicles, education, and emergencies.
  • Financial Planning: Facilitates record-keeping of expenses.
  • Float Period: Allows for up to a 50-day float before payments are due.
  • Convenience: Traveling and shopping become easier without carrying cash.

Disadvantages of Consumer Credit

  • Overspending Temptation: Credit can encourage consumers to overspend.
  • Long-term Financial Consequences: Improper credit use may lead to family stress, delayed financial goals, and legal repercussions such as bankruptcy.
  • Future Income Impact: Ties up future income, making it difficult to budget.
  • Costly Payments: Paying over time typically costs more than paying in cash due to interest.

Types of Credit

  • Closed-End Credit: Paid back in one-time loans (e.g., mortgage loans, auto loans, installment loans).
  • Open-End Credit: Continuous loans where users are billed periodically (e.g., credit cards, department store cards).

Sources of Consumer Credit

Major Types of Sources:
  • Commercial Banks: Offer a wide range of loans, often requiring good credit history and collateral.
  • Credit Unions: Serve members and provide favorable loan terms.
  • Finance Companies: Often cater to individuals with less established credit histories.
  • Life Insurance Companies: Provide loans based on cash value of policies.

Debt Affordability

  • Equal Credit Opportunity Act: Protects against discrimination on basis of personal characteristics.
  • Debt Payments-to-Income Ratio: Recommended that no more than 20% of net income goes to credit payments.
  • Five C's of Credit:
  • Character: Borrower's reliability.
  • Capacity: Ability to service debt.
  • Capital: Net worth vs. liabilities.
  • Collateral: Assets pledged against a loan.
  • Conditions: Economic factors affecting repayment ability.

Credit Reports

  • Duties of Credit Bureaus: Agencies compiling credit histories from multiple sources.
  • Content: Personal identification, employment history, credit inquiries, payment history.
  • Fair Credit Reporting Act: Mandates accuracy in reporting and gives consumers rights to dispute inaccuracies.

Credit Scores

  • FICO Score: Ranges from 300 to 850, reflecting credit history.
  • VantageScore: Another scoring model ranging from 501 to 990.
  • Components of FICO Score:
  • 35% Payment History
  • 30% Amounts Owed
  • 15% Length of Credit History
  • 10% Types of Credit Used
  • 10% New Credit

Improving Your Credit Score

  • Regular review of credit reports.
  • Pausing spending and paying bills on time are essential for long-term improvement.

The Cost of Credit

  • Finance Charge: Total dollar cost of using credit, typically expressed as APR (Annual Percentage Rate).
  • Comparison of Costs: Consumers should compare APR and finance charges among different credit products.

Protecting Your Credit

  • Billing Errors: Consumers have 60 days to challenge charges in writing.
  • Identity Theft: Immediate action is required if identity is compromised; notify credit bureaus and creditors.
  • Credit Insurance: Understand provisions of the Fair Credit Billing Act.

Debt Management

  • Warning Signs of Debt Problems: Consistent minimum payments, increasing debt, missing payments, reliance on savings for essentials.

Bankruptcy as Last Resort

  • Definition: Legal mechanism to redistribute debtor's assets to creditors.
  • Chapter 7: Straight bankruptcy; clears most debts.
  • Chapter 13: Wage earner plan; more favorable for maintaining credit post-bankruptcy.

Key Consumer Credit Protection Laws

  • Truth in Lending Act, Fair Credit Billing Act, Equal Credit Opportunity Act, and others enforce consumer protections in credit dealings.