CHAPTER 6

Using Credit

© 2008 Thomson South-Western

 The Basic Concepts of Credit

Why Borrow?
 Avoid paying cash for large purchases
(a car, a home)
 Meet financial emergencies
 Convenience
 Investment purposes

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 Improper Uses of Credit

 Meet basic living expenses

 Make impulse purchases
 Purchase non-durable goods
(like restaurant meals)

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 Rule of Thumb!

 THE PRODUCT PURCHASED

SHOULD OUTLIVE THE
CREDIT PAYMENTS

Don’t let
credit
squash you!

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 Minimum Payments means
Maximum Years

Calculations here are based on a minimum 3 percent

payment and 15.0 percent annual interest rate. 6-5
Some Credit Danger Signs

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 Establishing Credit

 Open checking and savings accounts.

 Get one card and make small purchases.
 Build a good credit history by:
– Not getting overextended.
– Fulfilling all terms of credit obligations.
– Consistently paying on time.
– Immediately notifying creditors if unable to
pay.
– Being truthful when applying.
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 How Much Credit Can You Stand?

DEBT SAFETY RATIO =

Total monthly consumer credit payments
Monthly take-home pay

Monthly consumer credit payments

(excluding mortgage) should not exceed
20% of your monthly net income.

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Credit Guidelines Based on
Ability to Pay

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Monthly Consumer Loan Payments
and Debt Safety Ratio

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Monthly Consumer Loan Payments
and Debt Safety Ratio

6-11
 Steps for Women in Establishing
Credit

 Consistently use your own legal

name when filing a credit application.
Ex: Mary Brown, not Mrs. John Brown
 Have information reported to credit
bureau in your name as well as your
husband’s.
 Consider retaining separate credit file
when you marry.
6-12
 Open Account Credit MyStore

 Credit extended to a consumer in

advance of any transaction
 Consumer can buy/borrow up to a
specified amount, the credit limit.
 Generally offered by financial institutions
and retail stores/merchants
 Monthly credit statements
 Usually interest can be avoided by paying
balance in full.
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 Bank Credit Cards MyBank

 Issued by financial institutions

 Features include:
– Line of credit dependent upon applicant’s
financial status and ability to pay
– Cash advances and balance transfers
– Other services or rebates
– Interest rates and fees

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 MyBank

Credit Card Fees MyStore

 Interest
– Generally high
– Prime rate + a percentage
 Annual fees
 Transaction fees
 Late-payment fees
 Over-the-limit fees
 Balance transfer fees
 Foreign transaction fees
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 Special Types of Bank Credit Cards

 Reward cards
– Frequent flyer programs
– Auto rebate programs
– Other merchandise rebates
 Affinity cards
 Secured credit cards
 Student credit cards

6-16
 Retail Charge Cards

 Second largest category

 Department stores
 Oil companies, etc.
 Build loyalty
 Users expected to pay in full on receipt of
monthly bill

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 Debit Cards

 Looks like a credit card but works like

writing a check—accesses your checking
account.
 Does not provide line of credit.
 Greater liability exposure in event of
fraudulent use.
 Prepaid card is a debit card with fixed
amount available—does not access your
checking account.
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 Revolving Credit Lines

 Open account credit offered by

banks and other financial
institutions
 Usually offer higher credit lines and
lower interest rates than credit
cards
 Money accessed by writing checks
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 Forms Of Revolving Credit

 Overdraft protection lines

 Unsecured personal credit lines
– Available on an as-needed basis
 Home equity credit lines
– Secured by equity in owner’s home
– Interest tax deductible (if deductions
are itemized)
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 Obtaining and Managing
Open Forms of Credit

Steps in opening an account:

1. Complete and submit application.
2. Lender investigates creditworthiness.
3. Lender obtains credit bureau report.
4. Lender makes credit decision; may use
credit scoring.

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The Credit Application
Applicant submits information
on income, marital status,
employment history,
existing accounts, etc.

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The Credit Application
Applicant submits information
on income, marital status,
employment history,
existing accounts, etc.
The Lender
Verifies application;
turns it over to
the Credit Bureau.

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The Credit Application
Applicant submits information
on income, marital status,
employment history,
existing accounts, etc.
The Lender
Verifies application;
The Credit Bureau turns it over to
the Credit Bureau.
Reporting agency that
gathers and sells info
about people.
Gets information from:
•subscribing creditors
•creditors you use as reference
•public documents

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The Credit Application
Applicant submits information
on income, marital status,
employment history,
existing accounts, etc.
The Lender
Verifies application;
The Credit Bureau turns it over to
the Credit Bureau.
Reporting agency that
gathers and sells info
Credit Bureau
about people.
submits report back
Gets information from:
to lender; lender then
•subscribing creditors
makes
•creditors you use as reference
•public documents
The Credit Decision

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 Fair Isaac & Co. Scores (FICO
Scores)
 Uses only credit information in
its calculations
– Payment history 35%
– Amounts owed 30%
– Length of credit history 15%
– New credit 10%
– Types of credit used 10%
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 FICO Scores

 Range from a low of 300 points to a

maximum of 850 points
 The higher the score, the lower the risk
to the lender
 Distribution of FICO scores in 2005:

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 Computing Finance Charges

 Lenders must disclose:

– Annual percentage rate (APR), the true rate
of interest paid over life of loan.
– Method used in computing finance charges.
 Balance to which interest rate is applied
generally determined using one of four
variations of Average Daily Balance (ADB)

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 Computing Finance Charges

 ADB excluding new purchases

Most consumer friendly
 ADB including new purchases
Most frequently used—no grace period on new
purchases if you carry a balance.
 Two-cycle ADB excluding new purchases
Calculated using last 2 billing cycles.
 Two-cycle ADB including new purchases
Least consumer friendly
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Example: A consumer starts the first month with a zero
balance and charges $1,000, of which he pays off only the
minimum amount due (1/36 of balance due). The next month,
he charges another $1,000. He then pays off the entire
balance due. This same pattern is repeated three more times
during the year. The interest rate is 19.8 percent.

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 ADB Including New Purchases:
# of Days Balance Weighted
(1) (2) Balance (1x2)

5 $582 $ 2,910
7 932 6,524
15 986 14,790
4 961 3,844
Total: 31 $28,068
ADB = $28,068  31 = $905.42
Monthly APR = 0.18  12 = 0.015
Finance charge = $905.42 x 0.015 = $13.58
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 Managing Your Credit Cards

 Review statements promptly each

month and verify each entry.
 Pay at least the minimum monthly
payment
– Or, if possible, pay off the entire amount
each month to avoid finance charges
 Pay by due date.
 Returned merchandise credited to
your account.
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 Using Credit Wisely

 Shop around, comparing:

– Annual fees & other fees
– APR
– Length of grace period
– Balance method

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 Using Credit Wisely

 Advantages of Credit Cards

+ Short, interest-free loan
+ Simplified record keeping
+ Easier resolution to unsatisfactory purchases
+ Convenience and emergencies

 Disadvantages of Credit Cards

– Easy to overspend
– High interest costs
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 Avoid Credit Problems

 Using discipline when purchasing.

 Reducing the number of cards you carry.
 Being selective in accepting preapproved
credit offers.
 Not making new charges.
 Paying more than the minimum.
 Paying off cards with highest finance
charges first.
 Transferring balances to card with low
introductory rate and paying off quickly. 6-35
 Important Consumer Credit
Legislation

 Key legislation deals with

– Credit discrimination.
– Disclosure of credit information.
– Billing procedures, errors, complaints,
and recourse on unsatisfactory
purchases.
– Disclosure of finance charges, other
fees, credit terms, and loss of credit
card.
– Protection against collector harassment.
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 Credit Card Fraud

 Never give account number to someone who

calls you—you must initiate the call.
 Use only secure Internet sites.
 Never put credit card info on checks or personal
info on charge slips.
 Keep your eye on your card!
 Draw line through blank spaces on slip.
 Destroy old cards and shred old statements and
slips.
 Report lost or stolen cards immediately!

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 Options If You’re In Trouble

 File Bankruptcy
– Chapter 13—wage earner plan: debt
restructuring.
– Chapter 7—straight bankruptcy: wipe
the slate clean.
 Try credit counselors
– Help you prepare a budget and
repayment schedule.
– Deal with creditors to possibly reduce
some interest & fees. 6-38