Slides by Pamela L Hall Western Washington University

Slides by Pamela L. Hall Western Washington University Credit Management Chapter 5 1

Introduction w Many of you have probably received credit card offers (either on campus or through the mail) if you are a college student w About 80% of college students have credit cards w Proper use of a credit card can help establish a solid credit history w Improper use can take years to heal 2

What is Credit? w Receiving money, goods and services on the basis of an agreement that the borrower will repay the lender with a specified time period at a specified rate of interest w Today total consumer credit is over $1. 5 trillion (excludes home mortgages and home equity loans) w Americans carry over 1 billion credit cards w Over 1 million Americans file for personal bankruptcy each year (twice as many as 10 years ago) 3

Figure 5. 1: Outstanding Consumer Debt 4

Types of Consumer Credit w Revolving credit n n Consumer can make a number of different purchases, up to a certain credit limit A minimum payment is due each month and interest is charged on the unpaid balance (average is 14. 5%/year) w Installment loans n Consumer borrows a fixed amount and repays the principal plus interest at regular intervals (usually monthly) w Lender usually holds title to asset until final payment is made w Mortgage loans and home equity loans n Mortgage is an installment loan secured by real estate w Typically have a term of 15 or 30 years 5

Deciding How Much to Borrow w Failure to set debt limits is one reason why people get in trouble with credit cards n Guideline: No more than 10 to 20% of your takehome pay should go toward repayment of installment or revolving credit (exclude mortgage payment) w National average is 13. 5% 6

The Right Reasons for Borrowing w Purchasing large, important goods or services n n n House Car College education w Dealing with emergencies n n Loss of job Death of relative (plane tickets on short notice are expensive) 7

The Right Reasons for Borrowing w Taking advantage of opportunities n Good sale on computer (you are saving for one anyway) w Convenience n Easy to pay with a credit card (pay off your balance every month) when doing day-to-day shopping w Establishing or improving your credit rating n Good way for a college student to establish a credit rating 8

The Wrong Reasons for Borrowing w Living beyond your means n Do you have to use your credit card to pay your basic living expenses (because you can’t afford not to)? w Buy groceries w Buy clothes w Buy gasoline w Pay your taxes 9

Sources of Consumer Credit w Financial Institutions n Commercial banks, savings banks, credit unions w National Credit Cards n University alumni associations, sports franchises, etc. are issuing credit cards with their logo (can be used anywhere a regular bank-issued card is accepted) w These organizations receive a fee from the issuing bank n Retailer-specific credit cards (such as Sears and JCPenney) w Can only be used at a specific store 10

Sources of Credit w Consumer Finance Companies n Company specializing in consumer loans w Ex: Household Finance w Make relatively short-term loans w Charge high interest rates w Generally unsecured w Application forms are easier to fill out than a bank’s w Takes a short period of time to receive approval 11

Sources of Credit w Life-Insurance Companies n Policyholders may be able to borrow against their life insurance policy (up to the amount they have paid in premiums) w Brokerage Account Loans n Buying on margin 12

Sources of Credit w Personal loan from family and friends n Always treat these in a businesslike manner w Lots of potential for interpersonal conflict w Pawnbrokers n n n Issues loans for a very low percentage of an item’s face value Item is held as security until the loan is repaid in full Should be viewed as a lender of last resort 13

Applying for Credit w How creditors evaluate loan applications n Capacity w Can you afford to repay the debt w Examines current income (and expected future earning potential) vs. current expenses w Are you a good credit risk? n Character w Do you live within your means or above it? w Do you pay your bills on time? w Do you demonstrate stability? n Collateral w Property to secure a loan 14

The Role of Credit Bureaus w Credit bureau—a clearinghouse for consumer credit information n What’s in your credit file? w Identifying information w Your credit history n Including whether or not you pay your bills on time w Information of public record n n Bankruptcies, lawsuits, criminal convictions You may request a copy of your credit record at any time w If you’ve recently been denied credit, the credit reporting service must provide you a copy free of charge 15

What to Do If You Are Denied Credit w The lender must provide you with a written explanation n Try negotiating with the lender w Ask for a lower loan amount n Try another lender w Different lenders have different lending policies n Some are more lenient than others 16

Calculating Total Finance Charges w Lenders are required to clearly state the annual percentage rate (APR) n Finance charge: total dollar amount charged for credit w Function of n n n Amount you borrow APR Term of loan Annual percentage rate: interest rate paid per dollar per year for credit Principal: the amount borrowed 17

Figure 5. 5: Finance Charges and the Amount Borrowed Note: All of the loans have annual interest rates of 8 percent and terms of 36 months. 18

Figure 5. 6: Finance Charges and APRs Note: All of the loans are for $10, 000 and have terms of 36 months. 19

Figure 5. 7: Finance Charges and Repayment Terms Note: All of the above loans are for $10, 000 and have APRs of 8 percent. 20

Calculating Periodic Interest w Most consumer debt calculates periodic interest using the simple interest method n The outstanding balance on the loan is multiplied by the periodic interest rate 21

Choosing the Lowest-Cost Credit Card w Three main areas to consider n Annual fee w Ranges from $0 to $50 annually n n n Late payment and other fees Annual percentage rate Grace period—how long you have to pay for new purchases without having to pay interest charges w Ranges from 0 days to 30 days n If you pay your bill in full every month, get a card with no annual fee and a grace period of at least 25 days n This way you won’t pay interest charges 22

Choosing the Lowest-Cost Credit Card w Many credit card companies offer a low interest rate for a short time period (to lure you in—called a teaser rate) and then raise the interest rate substantially w Or the company may offer a great rate unless one payment is late and then the rate rises substantially n Read the fine print 23

Credit Abuse w If you abuse your credit, it can have lasting repercussions n Repossession—collection of collateral by the lender w May not settle the debt if market value of asset doesn’t cover amount of loan still outstanding n n Remaining debt is called deficiency judgment Wage garnishment—a portion of borrower’s wages is paid directly to lender by the employer w Requires a court order 24

Credit Abuse w Bankruptcy—borrower is relieved of debts, court divides assets/income among creditors n n n Action of last resort Virtually eliminates chances of securing future credit Over 1 million Americans file for bankruptcy each year w Most are voluntary filings n n Chapter 7: assets are seized by court and sold, funds are prorated among creditors (after court costs/legal fees)— 70% of bankruptcies n Creditors usually receive only small percentage of what’s owed Chapter 13: individuals establish a 3 -year plan of debt repayment n Debtor retains possession of property n Creditors usually receive 60 -70% of what’s owed 25

Credit Abuse w Bankruptcy doesn’t eliminate all forms of debt n n Student loans Back taxes Child support Alimony w Bankruptcy shouldn’t be considered a ‘quick fix’ n n n Remains on your credit record for 10 years Won’t get reasonable credit terms during that time May be difficult to rent an apartment, obtain car insurance, etc. 26

Credit Counseling and Credit Repair Services w A credit counselor is a trained professional who helps you develop a budget and arrange a program of debt repayment n Non-profit Consumer Credit Counseling Service w Funded by lenders and credit card companies (vested interest in repayment) w Credit Repair Doctors often claim they can ‘erase your bad credit’ n Can’t deliver on their promises—don’t’ use them 27