This Document Contains Chapters 5 to 6 5 INTRODUCTION TO CONSUMER CREDIT CHAPTER OVERVIEW This chapter defines consumer credit and analyzes its advantages and disadvantages. The importance of consumer credit in our economy is explained and uses and misuses of credit are discussed. Financial and personal opportunity costs of using credit are emphasized. Next, two types of consumer credit—closedend credit and open-end credit—are differentiated. Then, general rules of measuring credit capacity such as debt payments-to-income ratio and debt-to-equity ratio are explained. This is followed by coverage of building and maintaining a credit rating. Next, the information that creditors look for in granting or refusing credit is identified. Finally, the steps in avoiding and correcting credit mistakes are outlined. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Define consumer credit and analyze its advantages and disadvantages. Consumer credit is borrowing money to obtain goods and services by individuals and families for personal needs. Among the advantages of using credit are the ability to purchase goods when needed and pay for them gradually, the ability to deal with financial emergencies, convenience in shopping, and establishment of a credit rating. Disadvantages are that credit costs money, encourages overspending, and ties up future income. Obj. 2 Differentiate among various types of credit. Closed-end (installment) and open-end (revolving) credit are two types of consumer credit. With closed-end credit, the borrower pays back a one-time loan in a stated period of time and with a specified number of payments. With open-end credit, the borrower is permitted to take loans on a continuous basis and is billed for partial payments periodically. Obj. 3 Assess your credit capacity and build your credit rating. Two general rules for measuring credit capacity are the debt payments-to-income ratio and the debt-to-equity ratio. In reviewing your credit worthiness, a creditor seeks information from one of the two national credit bureaus or a regional credit bureau. Obj. 4 Describe the information creditors look for when you apply for credit. Creditors determine credit worthiness on the basis of the five Cs: character, capacity, capital, collateral, and conditions. LEARNING OBJECTIVES Obj. 5 Identify the steps you can take to avoid and correct credit mistakes. CHAPTER SUMMARY If a billing error occurs on your account, notify the creditor in writing within 60 days. If the dispute is not settled in your favour, you can place your version of it in your credit file. You may also withhold payment on any defective goods or services you have purchased with a credit card as long as you have attempted to resolve the problem with the merchant. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 143). • Point out the learning objectives (p. 143) in an effort to highlight the key points in the chapter. • Ask students if they have borrowed money to finance a purchase. What did they consider in making the decision to borrow money? • Point out financial and personal opportunity costs in using credit. • Ask students if they have credit and debit cards. How did they obtain their first credit card? • Ask students if anyone has asked a friend or relative to cosign a loan. • Ask students if they know what information creditors use in determining whether a loan will be approved. • Ask students what they might do if they purchase defective goods or services with a credit card. CHAPTER 5 OUTLINE I. What Is Consumer Credit? A. Consumer Credit in Our Economy B. Uses and Misuses of Credit C. Advantages of Credit D. Disadvantages of Credit II. Types of Credit A. Consumer Loans B. Revolving Credit C. Protecting Yourself against Debit/Credit Card Fraud D. Financing at a Bank III. Measuring Your Credit Capacity A. Can You Afford a Loan? B. General Rules of Credit Capacity C. Co-signing a Loan D. Building and Maintaining Your Credit Rating IV. Applying for Credit A. A Scenario from the Past B. What Creditors Look For C. What If Your Application Is Denied? V. Avoiding and Correcting Credit Mistakes A. In Case of a Billing Error B. Identity Crisis: What to Do if Your Identity is Stolen CHAPTER 5 LECTURE OUTLINE • Credit is an arrangement to receive cash, goods, or services now and pay for them in the future. Instructional Suggestions • Discussion Question: What types of activities and purchases would be restricted without consumer credit? • Discussion Question: What are alternatives in financing current purchases? • Class Exercise: Ask students what would happen to our economy if every one had to pay cash for each major purchase. • Assignment: Have students survey three or four individuals to determine their uses of credit. • Class Exercise: Ask students what were their financial and psychological costs of borrowing. WHAT IS CONSUMER CREDIT (p. 144) • Consumer credit is the use of credit for personal needs of individuals and families. The Importance of Consumer Credit in Our Economy (p. 144) • • All economists recognize consumer credit as a major force in the American economy. The movement of the baby boom generation into the age group that tends to use credit most heavily has added to the growth of consumer credit. Uses and Misuses of Credit (p. 145) • • • There are many valid reasons for using credit: ∗ a medical emergency ∗ an immediate need for a car ∗ buying now to protect against rising prices Consider the trade-offs: ∗ Do I have cash to make the purchase? ∗ Do I want to use my savings for the purchase? ∗ Does the purchase fit my budget? ∗ Could I postpone my purchase? ∗ What are the opportunity costs of postponing the purchase? ∗ What are the dollar costs and the psychological costs of using credit? Effective use of credit can help us satisfy our wants and needs. Misused, credit can result in default, bankruptcy, and loss of reputation. Advantages of Credit (p. 145) • • • • • • • • • • Buy and enjoy now and pay from future income Purchase goods even when funds are low Advance notices of sales Order by phone or to buy on approval Easier to return merchandise Shopping convenience No need to carry large amounts of cash Simplified bookkeeping of expenses Use credit cards as identification when cashing checks Rebate offers on purchases CHAPTER 5 LECTURE OUTLINE • • Instructional Suggestions Cash bonus based on total purchases during the year Credit indicates stability and responsibility Disadvantages of Credit (p. 146) • • • • • • Credit costs money Credit may cause overspending Credit may result in loss of merchandise or income Credit ties up future income Financial and Personal Opportunity Costs An intelligent decision to use credit demands careful evaluation of your current debt, future income, the added cost, and the consequences of overspending. • Class Exercise: Is it possible to live without using any form of consumer credit? Have students debate this issue. • Concept Check 5-1 (p. 147) • Assignment: Ask students to obtain a credit application from a local department store. Let them complete the application and apply for credit. • Discussion Question: Let the students discuss the pros and cons of using credit and debit cards. • Current Example: Smart cards: new financial services are possible using chip technology and pave your way for the global acceptance of smart cards. TYPES OF CREDIT (p. 147) • There are two types of consumer credit—consumer loan and revolving credit. Consumer Loans (p. 147) • • Consumer loan is used for a specific purpose and is for a specified amount. Mortgage loans, automobile loans, and installment loans for purchasing furniture or appliances are examples of consumer loans. Revolving Credit (p. 147) • Revolving credit is a form of credit that many retailers use. You have an option to pay the bill in full within 30 days without interest charges or of making stated monthly installments based on the account balance plus interest. • You can make any purchases using revolving credit as long as you do not exceed your line of credit, and pay interest. You may also obtain a bank line of credit. • Credit Cards. A bank credit card differs from other credit cards in that it is issued by a bank or other financial institution. • Don’t confuse credit card with a debit card. The debit card debits your account at the moment you buy goods or services, while the credit card extends credit and delays your payment. • Protect yourself against debit/credit card fraud. • Travel and Entertainment (T & E) cards are not really credit cards, because the monthly balance is due in full. • A home equity loan is usually set up as a revolving line of credit, typically with a variable interest rate. Protecting Yourself Against Debit/Credit Card Fraud CHAPTER 5 LECTURE OUTLINE Instructional Suggestions (p. 149) • Credit card fraud is very inconvenient although the holder is protected financially. You can protect yourself by: • Signing your new card as soon as it arrives • Treating your card like money • Shred anything with your account number on it • Don’t give your credit card number to anyone • Don’t write your credit card number anywhere public • Remember to get your card and receipt after a transaction • Advise the card issuer of any upcoming changes in spending patterns • Notify the card issuer immediately if card is lost or stolen • Notify issuer is you don’t receive your bill or you are a victim of fraud • Request a copy of your credit report every few years Car Loans Buying a vehicle is the second largest investment you will probably make. There are many options available for financing your purchase. Financing at a Bank Most financial institutions offer consumer installment loans to purchase an automobile. • • Financing at the dealer: Factory financing enables you to get a loan directly from the manufacturer and you can expect to pay lower interest rates. Leasing: Leasing offers lower monthly payments. In a close ended lease the company is responsible for the residual and in an open ended lease you are responsible for the residual value of the vehicle. • Concept Check 5-2 (p. 157) CHAPTER 5 LECTURE OUTLINE Instructional Suggestions MEASURING YOUR CREDIT CAPACITY (p. 158) • The only way to determine how much credit you can assume is to first learn how to make an accurate and sensible personal or family budget. • Discussion Question: What factors should be considered when a person is determining the amount of credit he or she should take on? • Discussion Question: Ask students if they would cosign a loan for a friend or relative. • Assignment: Have students talk to several friends and relatives to determine if they ever cosigned a loan? If yes, what were the consequences of cosigning? • Supplementary Resource: Contact a credit bureau to obtain information on the services provided and the fees charged. • Assignment: Ask students to check the Yellow Pages of a telephone directory to locate credit bureaus in their own areas. Can You Afford a Loan? (p. 158) • Before you take a loan, ask yourself whether you can meet all of your essential expenses and still afford the monthly loan payments. General Rules of Credit Capacity (p. 158) • • • Debt Payments-to-income ratio is calculated by dividing monthly debt payments (not including house payments) by net monthly income. ∗ Experts suggest that you spend no more than 20 percent of your net (after-tax) income on credit payments. Gross debt service (GDS) ratio is calculated by dividing your monthly mortgage payments (including principal, interest, heating and taxes) by your gross monthly income. ∗ Lenders will not allow you to spend more than 30 to 32 percent of your gross income on shelter costs. Total debt service (TDS) ratio is calculated by dividing your monthly mortgage payment including payments on any outstanding debt by your gross monthly income. ∗ Lenders will not allow you to spend more than 40 percent of your gross income on shelter and nonshelter financial obligations. Co-signing a Loan (p. 159) • • As many as three out of four cosigners are asked to repay the loan. If you cosign, consider the following before you cosign: 1. Be sure you can afford to pay the loan. 2. Your liability for this loan may keep you from getting other credit that you may want. 3. You could lose the property you have pledged. 4. Check your provincial law. 5. Request that overdue payment notices be sent to you. CHAPTER 5 LECTURE OUTLINE Instructional Suggestions Building and Maintaining Your Credit Rating (p. 160) • • • • • • • If you want a good rating, you must use credit with discretion; limit your borrowing to your capacity to pay the loan, and live up to the terms of your contracts. Credit Bureaus. There are two main credit bureaus in Canada: Equifax Canada (www.equifax.ca) and Trans Union of Canada (wwww.tuc.ca). In addition, several thousand regional credit bureaus collect credit card information about consumers. These firms sell the data to creditors that evaluate credit applications. Who provides data to credit bureaus? Credit bureaus obtain their data from banks, finance companies, merchants, credit card companies, etc. These sources regularly send reports to credit bureaus containing information about the kinds of credit they extend to customers, the amounts and terms of that credit, and customers’ paying habits. What is in your credit file? The credit bureau file contains your name, address, SIN, and birth date, and may include detailed credit information on outstanding balances, the number and amounts of payments past due, the frequency of 30, 60, 90-day delinquencies, any suits, judgments, or tax liens. Credit Bureau regulation in Canada. Most provinces have legislation regarding consumer reporting agencies such as credit bureaus. The principle concerns are the protection of consumer privacy with respect to credit information and the consumer’s right not to suffer from false credit and personal information. Access to credit reports. While you have a right to know the contents of your file at any time, others may view your file only if you have given written consent or if you have been sent a written notice that your report has been obtained. In the event that you do not apply for credit but a request for information is made, the credit bureau must inform you of the request and provide you with the name and address of the requestor. Time Limits on Adverse Data. Most of the information in your credit file may be reported for only seven years. • Assignment: Have students talk to others to determine how they first established credit. • Concept Check 5-3 (p. 165) CHAPTER 5 LECTURE OUTLINE • Incorrect Information in Your Credit File. When you notify the credit bureau that you dispute the accuracy of information, it must reinvestigate and modify or remove inaccurate data. If dispute is not resolved, you may place a statement of 100 words or less in your file. APPLYING FOR CREDIT (p. 166) • Instructional Suggestions • Text Highlight: Typical questions in a credit application are shown in Exhibit 5-6, and Exhibit 5-7 shows how a credit application might be scored. (pp. 166, 167) • Concept Check 5-4 (p. 170) • Concept Check 5-5 (p. 172) Legislation starts all credit applicants off on the same footing. By law, race, colour, age, sex, marital status, and certain other factors may not be used to discriminate against you. What Creditors Look For? (p. 166) • Most lenders build their credit policies around the five C’s of credit: character, capacity, capital, collateral, and conditions. What if Your Application is Denied? (p. 170) • Ask questions if your application is denied. You have the right to know the specific reasons for denial. AVOIDING AND CORRECTING CREDIT MISTAKES (p. 170) • The best way to maintain your credit standing is to repay your debts on time. In Case of Billing Error (p. 171) • If you think your bill is wrong or you want more information about it, notify the creditor. Pay all the parts of the bill that are not in dispute. Identity Crisis: What to Do if Your Identity is Stolen (p. 171) • • • Contact the fraud departments of each of the two major credit bureaus. Contact the creditors for any accounts that have been tampered with or opened fraudulently. File a police report. CONCLUDING ACTIVITIES • Point out the chapter summary (p. 173) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. • Let students start a journal of personal finance information and readings related to consumer credit. • Have students create a case problem for class use on a personal financial experience related to consumer credit. CHAPTER 5 QUIZ ANSWERS True-False 1. T 2. F 3. F 4. T 5. T 6. T 7. T 8. T Multiple Choice 9. D 10. B 11. B 12. B 13. A 14. C 15. D 16. C Name ________________________________________ Date____________________________ CHAPTER 5 QUIZ TRUE-FALSE _____1. Credit encourages overspending and ties up future income. _____2. With revolving credit, the borrower pays back a onetime loan in a specified period of time and with a specified number of payments. _____3. With consumer loans, the borrower is permitted to take loans on a continuous basis and is billed for partial payments periodically. _____4. General rules for measuring credit capacity are the debt payments-to-income ratio and the GDS and TDS ratios. _____5. Creditors determine credit worthiness on the basis of character, capacity, capital, collateral, and conditions. One thing you can do to protect yourself from credit card fraud is to sign your credit card as soon as you receive it. Car financing at a bank may require a minimum down payment. _____6. _____7. _____8. A person has the right to know the contents of his/her credit bureau file at any time MULTIPLE CHOICE _____9. An example of a consumer loan is a. incidental credit. b. revolving check credit. c. credit cards. d. installment loans. _____10. An example of revolving credit is a. installment sales credit. b. revolving line of credit. c. mortgage loans. d. automobile loans. _____11. A credit arrangement that has no extra costs and no specific repayment plan is called a(n) a. Open-end credit b. Incidental credit c. Close-end credit d. Consumer loan _____12. Which one of the following is not one of the five Cs of credit? a. Conditions b. Climate c. Character d. Capacity _____13. Most of the information in your credit file may be reported for only __________ years. a. b. c. d. 7 15 20 23 _____14. Which of the following is not an example of consumer credit? a. car loan b. credit card c. home mortgage d. personal line of credit _____15. _______________ is an arrangement to receive cash, goods or services today and pay for them in the future. a. Personal Financial Planning b. Debit Cards c. Money Management d. Credit _____16. Which of the following is not a step you can take to recognize fraud over the internet? a. Use a secure browser b. Keep records of your online transactions c. Give payment information to all businesses d. Read policies of website you visit ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT CHECK QUESTIONS Concept Check 5-1 (p. 147) 1. How might consumers with credit card debt fare if a cyclical slowdown occurs? If your income does not increase to cover rising costs, your ability to repay credit commitments will diminish. (p. 144) 2. What is Consumer Credit? Consumer credit refers to the use of credit for personal needs (except a home mortgage) by individuals and families. (p. 144) 3. Why is consumer credit important to our economy? All economists now recognize consumer credit as a major force in the American economy. Any forecast or evaluation of the economy includes consumer spending trends and consumer credit as a sustaining force. (p. 144) 4. What are the uses and misuses of credit? Financing a Corvette on credit when a Ford Escort is all your budget allows. Using credit cards to buy frivolous goods and services. Purchasing nonessential products on an impulse. Valid reasons for using credit are: a medical emergency; need for a car; and buying an item now for less money than it will cost later. (p. 145) 5. What are the advantages and disadvantages of credit? Advantages of using credit are: purchasing goods and services when they are needed and paying for them gradually, meeting financial emergencies, achieving convenience in shopping, establishing a credit rating, making forced savings, and employing credit as leverage. Disadvantages are: credit costs money, encourages impulse buying and overspending, and ties up future income. Furthermore, credit misuse can create serious long-term financial difficulties. (pp. 146-147) Concept Check 5-2 (p. 157) 1. What are the two types of consumer credit? Closed-end and open-end are two types of consumer credit. With closed-end (or installment-credit, the borrower pays back a one-time loan in a specific number of payments in a specific period of time. With open-end credit, or revolving credit, the borrower is permitted to take loans on a continuous basis and is billed for partial payments periodically. (p. 147) 2. What is a home equity loan? A home-equity loan is based on the difference between the current market value of your home and the amount you still owe on your mortgage. A home-equity loan is usually set up as a revolving line of credit, typically with a variable interest rate. (p. 153) Concept Check 5-3 (p. 165) 1. What are the general rules of measuring credit capacity? Two general rules for measuring credit capacity are: debt payments-to-income ratio, GDS ratio and TDS ratio. None of these methods is perfect for everyone; the limits given are only guidelines. Only you, based on the money you earn, your current obligations, and your financial plans for the future, can determine the exact amount of credit you need and can afford. You must be your own credit manager. (p.158) 2. What can happen if you co-sign a loan? You may end up paying the loan yourself. Despite the risks, there may be times when you decide to co-sign a loan for a friend or a relative. Before you co-sign, make sure you know what cosigning involves. For example, be sure you can afford to pay the loan. If the borrower defaults, you could damage your credit rating, and you could lose the property you pledge. (p. 159) 3. What can you do to build and maintain your credit rating? A good credit rating is a valuable asset that should be nurtured and protected. If you want a good rating, you must use credit with discretion; limit your borrowing to your capacity to repay, and live up to the terms of your contracts. The quality of your credit rating is entirely up to you. (p. 160) 4. How do you correct erroneous information in your credit file? When you notify the credit bureau that you dispute the accuracy of information, it must reinvestigate and modify or remove inaccurate data. If reinvestigation does not resolve the dispute to your satisfaction, you may send a letter, which will be placed in your file, explaining why you think the record is inaccurate. (p. 162) 5. What is credit scoring? A system used by lenders and others to assess the credit risk of prospective borrowers when they apply for credit cards, automobile loans and home mortgages. (p. 164) Concept Check 5-4 (p. 170) 1. What are five C’s of credit? Creditors evaluate the five C’s (character, capacity, capital, collateral, and conditions) in granting or denying credit. For example, is the borrower prompt in paying bills? Has the borrower declared personal bankruptcy or been forced by courts to pay bills? What is the borrower’s occupation, income, and how long has he/she been working? What is the borrower’s net worth? Is the loan to be secured by collateral? What general economic conditions can affect a borrower’s ability to repay a loan and other obligations? Creditors use different combinations of the above facts to reach their decisions. (p. 166) 2. What can you do if your credit application is denied? You can ask to know the specific reasons for denial. If it is based on a credit report, you are entitled to know the specific information in the credit report that led to denial. Then, visit or telephone the credit bureaus to find out what information is reported. You may ask the bureaus to investigate any inaccurate or incomplete information and correct its records. (p. 170) Concept Check 5-5 (p. 172) 1. What should you do to protect your rights if there is a billing error? First, notify the creditor in writing. State the suspected amount of the error on the item you want explained. Then pay all the parts of the bill that are not in dispute. (p. 171) 2. What can you do if your identity is stolen? You should call the fraud departments of each of the two major credit bureaus. Then you should contact the creditors for any accounts that have been tampered with, and finally, file a police report. (p. 171) OPENING CASE QUESTIONS (p. 143) 1. Why are today’s consumers spending and borrowing heavily? Consumers are spending and borrowing heavily because they have remained resilient during the mild recession which was driven by the technology slump and reduction in corporate profits. 2. Why do some experts suggest that a new class of borrowers may be especially at risk if the economic growth slows? Some experts agree that during an economic slowdown, people may lose their jobs, large income growth could end, and the value of stock portfolios may decline. FINANCIAL PLANNING PROBLEMS (pp. 173) 1. What are the two basic types of credit? Describe and distinguish between them. (Obj. 1) The two basic types of credit are consumer loans and revolving credit. With Consumer loans, also known as installment loans, you pay back one-time loans in a specified period of time with a predetermined payment schedule. With revolving credit, loans are made on a continuous basis and you are billed periodically for at least partial payment. 2. A few years ago, Misha Azim purchased a home for $100,000. Today, the home is worth $150,000. His remaining mortgage balance is $50,000. Assuming that Misha can borrow up to 80 percent of the market value, what is the maximum amount he can borrow? Present market value of Misha’s home = $150,000. Misha can borrow up to 80 percent of the market value, or $120,000. Misha still owes $50,000 mortgage on his home. Therefore, he can borrow an additional $70,000 ($120,000 - $50,000). 3. Louise Gendron’s monthly gross income is $2,000. Her employer withholds $400 in federal and provincial income taxes and $160 in CPP contributions per month. Louise contributes $80 per month for her RRSP. Her monthly credit payments for VISA, MasterCard, and Diners/En Route cards are $35, $30, and $20, respectively. Her monthly payment on an automobile loan is $285. What is Louise’s debt payments-to-income ratio? Is Louise living within her means? Louise’s Gross Income Less: Income taxes Less: CPP contribution Less: RRSP contribution Net take-home pay = = = = = $2,000 -400 -160 -80 $1,360 Her monthly payments on VISA, MasterCard, Diners/En Route Card, and a car loan add up to $370 per month. Louise’s debt payments to income ratio is 370 to 1,360, or 27.2 percent. This ratio exceeds the recommended 20 percent figure. Therefore, Louise is overextended. Her maximum monthly loan and credit card payments should not be over $272 (20 percent of $1,360). 4. (a) Calculate your net worth based on your present assets and liabilities. Refer students to Exhibit 2-3: Creating a Personal Balance Sheet. (b) Referring to your net worth statement, determine your safe credit limit. Use the debt paymentsto-income formula. Refer students to the section on General Rules of Credit Capacity. 5. Dinesh Dani flew to Toronto to attend his brother’s wedding. Knowing that his family would be busy, he did not ask anyone to meet him at the airport. Instead, he planned to rent a car to use while in Toronto. He has no nationally known credit cards but is prepared to pay cash for the rental car. The car rental agency refuses to rent him a car, even though the agency has several cars available. Why do you think Dinesh is unable to rent a car? If a consumer does not have a record of credit use, a lender might require a larger down payment or a co-signer. Or, the lender might even refuse to make the loan. Firms that rent or lease goods, such as car rental agencies, hotels, etc., often want evidence that a customer is responsible and trustworthy to minimize chances of theft, damage, or nonpayment. Being approved for a bank credit card (VISA, MasterCard) is often considered as evidence that a person is financially responsible. 6. Juan Villavera, a recent college graduate, has accepted a teaching position at Brockville High School. Juan moved to Brockville and applied for a car loan at the Royal Bank. He had never used credit or obtained a loan. The bank notified him that it will not approve the loan unless he had a co-signer. On what basis has the bank denied Juan credit? The bank probably decided to require a co-signer because of Juan’s lack of employment and credit history and not because of his age. A young person often has not yet established credit-worthiness. However, the law requires that a creditor evaluate each applicant on the basis of the individual circumstances. Credit cannot be denied solely on the basis of a person’s age. 7. Friedrich Reine has had a student loan, two auto loans, and three credit cards. He has always made timely payments on all obligations. He has a savings account of $2,400 and an annual income of $25,000. His current payments for rent, insurance, and utilities are about $1,100 per month. Friedrich has accumulated $12,800 in an individual retirement account. Friedrich’s loan application asks for $10,000 to start up a small restaurant with some friends. Friedrich will not be an active manager; his partner will run the restaurant. Will he get the loan? Explain your answer. Even though Friedrich has always made timely payments on all obligations, he is not likely to get a $10,000 loan to start up a small restaurant with some friends. The lender knows that Friedrich will not be an active manager, and his partner may not have any experience in running a restaurant. Moreover, restaurants have one of the highest failure rates in the business world. His current yearly income of $25,000 minus expenses for rent, insurance and utilities will leave just enough money to live. His savings of $2,400 are not sufficient to pay off a loan, and he can not access a $12,800 RRSP account until he is 69 ½ years old. FINANCIAL PLANNING ACTIVITIES (p. 174) 1. Survey friends and relatives to determine the process they used in deciding whether or not to use credit to purchase an automobile or a major appliance. What risks and opportunity costs did they consider? This activity can be beneficial to both students and those to whom they talk. The responses will vary, but the process will generally be the same. Using credit increases the amount of money that a consumer can spend to purchase goods and services now. But it decreases the amount of money that will be available to spend in the future. Although credit permits more immediate satisfaction of needs and desires, it does not increase total purchasing power. For most consumers, there are three alternatives in financing a current purchase: they can draw upon their savings, use their present earnings, or borrow against their expected future income. 2. Think about the last three major purchases you have made. a. Did you pay cash? Why? b. If you paid cash, what opportunity costs were associated with the purchase? c. Did you use credit? If so, why? d. What were the financial and psychological opportunity costs of using credit? a. Paid cash. Cash was available, and it is cheaper to pay cash than to pay finance charges on a purchase. b. Opportunity costs of using cash: The money spent now can’t be used for another purchase. Also, if the money was in a bank earning interest, the amount of interest is forgone. c. Used credit. Current savings were insufficient to make a purchase with cash, but credit was available at an attractive interest rate from the merchant or a local bank. d. Financial and psychological opportunity costs of using credit: Refer students to text pages 145147 where financial and personal opportunity costs are discussed. Let them decide which opportunity costs are more important for them than others. 3. Prepare a list of similarities and differences in the reasons that the following individuals might have for using credit: a. b. c. d. A teenager A young adult A growing family of four A retired couple a. A teenager may wish to use credit to buy a used car to go to work, to purchase a VCR, a musical instrument, or simply to take a small loan to establish credit. b. A young adult may need credit to purchase an automobile, a major appliance, or a loan for a condominium. c. A growing family of four may need credit for the purchase of a home, furniture, major appliances, or to finance a family vacation. d. A retired couple, hopefully, would have saved enough money so that they won’t need to borrow. But even the retired couple may need to borrow for any unforeseen medical or other emergencies. 4. Using the Internet to Obtain Information about Credit Cards. Choose one of the following organizations and visit its home page on the Internet. Then prepare a report that summarizes the information the organization provides. How can this information help you in choosing your credit card? a. Canoe Money—provides information on your credit card rates. b. The Canadian Broadcasting Corporation—provides information on how to regain financial health, uses and misuses of credit cards, and many other related topics. Although student answers will vary depending on which Internet site they visit, you may want to use this opportunity to discuss the issue of how we can get in trouble by misusing credit cards and how we can protect ourselves against credit card fraud. 5. Using your Home Equity to Obtain a Loan. Visit your local financial institutions, such as banks, trust companies, and credit unions, to obtain information about getting a home equity loan. Compare their requirements for the loan. Responses will vary, but let students find out what percent of a home’s appraised value can be borrowed and at what interest rate. Once a revolving line of credit is arranged, how often and for how long borrowings are permitted Emphasize that a home equity loan should be used only for items such as education, home improvements, or medical bills. If you miss a payment, you can lose your home. Let students compare annual loan maintenance fees and other costs of setting up an equity credit line. 6. Talk to a person who has co-signed a loan or to a representative from a financial institution. What experiences did this person have as a cosigner? Answers will vary, but some studies of certain types of lenders show that as many as three of four cosigners are asked to repay the loan. 7. What changes might take place in your personal net worth during different stages of your life? How might these changes affect your credit limits? Generally, net worth increases with age. And, as net worth increases so does your credit limit. Remember, a creditor may not turn you down or decrease your credit because of your age, may not ignore your retirement income in rating your application, may not close your credit account or require you to reapply because you reach a certain age or retire. Furthermore, a creditor may not deny you credit or close your account because credit life insurance or other credit-related insurance is not available to persons of your age. 8. Survey credit representatives such as bankers, managers of credit departments in retail stores, managers of finance companies, credit union officers, managers of credit bureaus, and savings and loan officers. Ask what procedures they follow in granting or refusing a loan. When any one of the above lenders extends credit to its customers, it recognizes that some customers will be unable or unwilling to repay the debt. Therefore, lenders must establish policies for determining who will receive credit. Most lenders build their credit policies around the five C’s of credit: character, capacity, capital, collateral, and conditions. Most of the above creditors use different kinds of rating systems. Some rely strictly on their own instinct and experience. Others use a credit-scoring or statistical system to predict whether you are a good credit risk. 9. Bring to class examples of credit-related problems of individuals or families. Suggest ways in which these problems might be solved. Examples of credit-related problems will vary. First, try to solve the problem directly with the creditor. Only if that fails should you bring more formal complaint procedures. 10. Compile a list of places that can be called to report credit practices, to get advice, help with credit problems, and to check out a creditor’s reputation before signing a contract. Students’ answers should include the two major credit bureaus, as well as regional agencies. (p. 158) LIFE SITUATION CASE A Hard Lesson on Credit Cards (p. 175) 1. Why should parents of students beware? Parents should beware because their children are highly sought-after credit card customers. Students may easily get into heavy debts. 2. How do credit card marketers entice college students? Credit card marketers entice college students by offering free t-shirts, chances to win airline tickets, and no cosigners are required for those 18 or over. 3. Where do students turn for help when they get into debt trouble? Students turn to their parents for help. 6 CHOOSING A SOURCE OF CREDIT: THE COSTS OF CREDIT ALTERNATIVES CHAPTER OVERVIEW All of us can get into credit difficulties if we do not understand how and when to use credit. This chapter identifies major sources of consumer credit—chartered banks, Trust companies, credit unions, finance companies, life insurance companies, and parents and relatives. Next, in determining cost of credit, we emphasize the finance charge and the Annual Percentage Rate (APR). Then we show how the cost of credit can be determined by calculating interest with various interest formulas. In dealing with your debts credit counselling services, and the serious effects of debt. We describe the various private and governmental sources that assist consumers with debt problems. Finally we explain and distinguish between the consumer proposals and bankruptcy, to assess the choices in declaring personal bankruptcy. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Analyze the major sources of consumer credit. The major sources of consumer credit are chartered banks, trust companies, credit unions, finance companies, life insurance companies, and family and friends. Each of these sources has unique advantages and disadvantages. Parents or family members are often the source of the least expensive loans. They may charge you only the interest they would have earned had they not made the loan. Such loans, however, can complicate family relationships. Obj. 2 Obj. 3 Determine the effective cost of borrowing by considering the quoted rate, the number of compounding periods, the timing of the interest payments, and any other service charges. Develop a plan to manage your debts. Compare the finance charge and the annual percentage rate (APR) as you shop for credit. For a borrower, the most favourable method of calculating the cost of open-end credit is the adjusted balance method. In this period, creditors add finance charges after subtracting payments made during the billing period. Debt has serious effects if a proper plan for managing it is not implemented. Most experts agree that emotional problems, the use of money to punish, the expectations of instant comfort, keeping up with the Joneses, overindulgence of children, misunderstanding or lack of communication among family members, and the amount of finance charges are common reasons for indebtedness. Obj. 4 Obj. 5 Evaluate various private and governmental sources that assist consumers with debt problems. If you cannot meet your obligations, contact your creditors immediately. Before signing up with a debt consolidation company, investigate it thoroughly. Better yet, contact a credit counselling service or other debt counselling organizations. Assess the choices in declaring personal bankruptcy. A debtor’s last resort is to declare bankruptcy. Consider the financial and psychological costs of bankruptcy before taking this extreme step. A debtor can declare insolvency either through a consumer proposal or through an assignment in bankruptcy. Such organizations help people manage their money better by setting up a realistic budget and planning for expenditures. These organizations also help people prevent debt problems by teaching them the necessity of family budget planning and providing education to people of all ages. Some people find obtaining credit more difficult after filling bankruptcy. Others find obtaining credit easier because they have relieved themselves of their prior debts or because creditors know they cannot file another bankruptcy case for a period of time. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 177). • Point out the learning objectives (p. 174) in an effort to highlight the key points in the chapter. • Ask students to provide examples of experiences of using credit with different lending sources. • Discuss actions that could be taken if a person gets into financial difficulty as a result of overusing credit. CHAPTER 6 OUTLINE I. Sources of Consumer Credit A. What Kind of Loan Should You Seek? II. The Cost of Credit A. The Effective Cost of Borrowing B. Tackling the Trade-Offs C. Calculating Your Loan Payments D. Financial Planning Calculations E. Credit Insurance III. Managing Your Debts A. Warning Signs of Debt Problems B. The Serious Consequences of Debt IV. V. Consumer Credit Counselling Services Declaring Personal Bankruptcy A. Fending Off Bankruptcy Consolidation Loans B. Bankruptcy and Insolvency Act C. Effect of Bankruptcy on Future Credit CHAPTER 6 LECTURE OUTLINE Instructional Suggestions SOURCES OF CONSUMER CREDIT (p. 177) • • Financial and other institutions, the sources of credit, come in all shapes and sizes. They play an important role in our economy, and they offer a broad range of financial services. Before deciding whether to borrow money, ask yourself these three questions: 1. Do I need a loan? 2. Can I afford a loan? 3. Can I qualify for a loan? What Kind of Loan Should You Seek? (p. 177) • • • Inexpensive Loans: Parents or family members; money borrowed on financial assets held by a lending institution. Medium-Priced Loans: Chartered banks and credit unions. New car loans may cost 8 to 12 percent; used car loans and home improvement loans may cost slightly more. Expensive Loans: The most expensive loans are available from finance companies, retailers, and banks through credit cards. Finance companies often lend to those who cannot obtain credit from banks or credit unions. The interest ranges from 12 to 25 percent. THE COST OF CREDIT (p. 180) • You should determine how much it will cost you and whether you can afford it. Then you should shop for the best terms. Two concepts to remember are the finance charge and the annual percentage rate. The Effective Cost of Borrowing (p. 180) • • • The finance charge is the total dollar amount paid to use credit. It includes interest costs, service charges, credit-related insurance premiums, and appraisal fees. Annual percentage rate is the percentage cost (or relative cost) of credit on a yearly basis. The APR is the key to comparing credit costs. All creditors must state the cost of their credit in terms of the finance charge and the APR. Tackling the Trade-offs (p. 181) • Term versus interest costs: the longer the term for a loan at a given interest rate, the greater the amount that must be paid in interest charges. • Exercise: Have students describe family financial situations that would use certain sources of consumer credit. • Discussion Question: Ask students what are alternatives in financing a current purchase. • Current Example: When refinancing a car loan, it’s driver beware; low interest rates and low payments lure borrowers who may wind up paying more. • Concept Check 6-1 (p. 180) • Discussion Question: What methods can be used to compare different types of loans and credit plans? CHAPTER 6 LECTURE OUTLINE • • Lender risk versus interest rate: the greater the risk for the lender, the higher the cost of credit. Variable interest rate, a secured loan, a large down payment, and a shorter-term loan are less expensive. Instructional Suggestions • Assignment: Have students ask several individuals how they would compare loans at different financial institutions. How aware are people of the Truth-in-Lending requirements? • Concept Check 6-2 (p. 188) Calculating Your Loan Payments (p. 183) • A fixed–rate installment loan imposes financial responsibility as it is designed to pay off the loan over a predetermined period of time. Each payment is a blend of principal and interest. • A floating rate personal line of credit: Lines of credit usually charge a variable interest rate tied to the lender’s prime rate. Interest is compounded daily. Using this means that it will take you considerably longer to repay your loan. Financial Planning Calculations (p. 183) • Cost of open-end credit. Creditors use various systems to calculate the balance on which they assess finance charges. ∗ The adjusted balance method, where finance charges are added after subtracting payments made during the billing period. ∗ The previous balance method, where creditors give no credit for payments made during the billing period. ∗ The average daily balance method, where creditors add your balances for each day in the billing period and then divide by the number of days in the period. • Cost of credit and expected inflation. Lenders, seeking to protect their purchasing power, add the expected rate of inflation to the interest they charge. • Avoid the minimum monthly payment trap. You should always pay off the total balance as quickly as possible to avoid high interest charges. Credit Insurance (p. 187) • Credit insurance ensures the repayment of a loan in the event of death, disability, or loss of property of the borrower. The lender is named the beneficiary and directly receives any payments made on submitted claims. CHAPTER 6 LECTURE OUTLINE MANAGING YOUR DEBTS (p. 188) • If you cannot make your payments, contact creditors at once and try to work out a modified payment plan with them. Do not wait until your account is turned over to a debt collector. Warning Signs of Debt Problems (p. 188) • Instructional Suggestions • Current Example: Use Visa’s practical advice to make the most of your money. Visit www.visa.com/ct/main.html. • Text Highlight: Exhibit 6-1 lists some danger signals of potential debt problems. (p. 186) • Discussion Question: What actions are commonly recommended if a person has difficulty making credit payments? • Concept Check 6-3 (p. 190) • Exercise: Have students present a role playing situation between a credit counselor and a person with financial difficulties. • Supplementary Resource: Talk to a credit counselor to obtain information about common causes of credit problems and suggestions to avoid and solve these difficulties. • Concept Check 6-4 (p. 190) Referring to over indebtedness as the nation’s number one family financial problem, a nationally noted columnist lists the following as frequent reasons for indebtedness: ∗ emotional problems ∗ the use of money to punish ∗ the expectation of instant comfort ∗ keeping up with the Joneses ∗ expensive indulgence of children ∗ misunderstanding or lack of communications ∗ the amount of the finance charge. The Serious Consequences of Debt (p. 189) • Excessive indebtedness may result in a mixture of personal and family problems such as heavy drinking, a neglect of children, marital difficulties, and drug abuse. But help is available to those who seek it. CONSUMER CREDIT COUNSELLING SERVICES (p. 190) • A consumer credit counselling service is a non-profit organization that provides debt counselling services for families and individuals with serious financial problems • Credit counselling activities are divided into two parts. (1) Aiding families with serious debt problems by helping such families manage their money better and by setting up a realistic budget and plan for expenditures; (2) Helping prevent debt problems by teaching the necessity of family budget planning, providing education to people of all ages regarding the pitfalls of unwise credit buying, suggesting techniques for family budgeting, and encouraging credit institutions to provide full information about the costs and terms of credit and to withhold credit from those who cannot afford to repay it. • Universities, military bases, credit unions, and provincial and federal housing authorities sometimes provide nonprofit counselling services. • Current Example: Use Visa’s practical advice to make the most CLEARING PERSONAL BANKRUPTCY (p. 191) • Unfortunately for some debtors, bankruptcy has become an acceptable tool of credit management. The personal bankruptcy rate has increased by 86.5 percent from 1990 to 2007. • Text Highlight: Exhibit 6-2 shows the increase in Canadian personal bankruptcies. • Discussion Question: Is declaring bankruptcy too easy in our society? Do too many people use the process to get out of their debts? • Assignment: Have a couple of students talk to a lawyer about the process of declaring bankruptcy. Have them report their findings to the class. Fending off Bankruptcy: Consolidation Loans (p. 191) • • • • A consolidation loan is used to discharge a collection of existing debts. Its advantages are that it will have a single interest rate on the full amount of your selected debts and you may be able to extend the term of the loan beyond that of your initial debts, allowing you to make smaller payments as you repay the loan. The disadvantages are twofold: cost and term. In general, you will be asked to pay a higher interest rate because you are considered to be a higher risk for the lender. In addition, as you extend the term of the loan, you will find that the total of what you pay might be considerably higher than the sum of your debt load. If you decide to use a consolidation loan, it is best to limit it to paying off only your highest interest debts. Bankruptcy and Insolvency Act (p. 193) • • • • The Bankruptcy and Insolvency Act, a federal law initiated in1992 and amended in 1997, regulated bankruptcy and proposal proceedings in Canada. More changes to this Act were approved on Dec 14, 2007. These changes are expected to become law by the end of 2008. By this Act you are allowed to declare insolvency either through a consumer proposal or through an assignment in bankruptcy. A consumer proposal is a maximum 5-year plan for paying creditors all or portion of the total debt owed. To be eligible, you must be insolvent and be less than $75,000 in debt. The new law will increase this amount to $250,000. Both the court and your creditors must approve a consumer proposal. The advantage is that a consumer proposal will save you from bankruptcy if it is approved. If you go bankrupt, the first step will be the assignment of your assets to a licensed trustee. A meeting will then be held among your creditors. Your secured creditors are paid first, after that, your remaining assets will be distributed by specified order with the costs of the bankruptcy administration taking precedence over all claims. Once this process is complete the court can grant you a discharge. CHAPTER 6 LECTURE OUTLINE • Instructional Suggestions Not all your assets will be seized or considered in a bankruptcy proceeding. Some of your property will be protected from creditors by provincial law. Typically, items that you require to live and earn a living will be exempt from the tally of your assets. Effect of Bankruptcy on Future Credit (p. 193) • • • • Different people have different experiences in obtaining credit after they file a bankruptcy case. Some find obtaining credit more difficult. The bankruptcy law prohibits your employer from discharging you simply because you have filed a bankruptcy case. The costs associated with submitting a consumer proposal are a basic fee of approximately $1,500, a small filing fee, and an additional 20 percent of the amount of your assets that are distributed. In the case of bankruptcy, the costs include a smaller basic fee but potentially greater additional fees. There are also intangible costs associated with bankruptcy such as the difficulty to obtain credit in the future, as bankruptcy reports are retained in credit bureaus for 7 years. • Concept Check 6-5 (p. 194) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 194), key formulas (p. 195), and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. (p. 195). • Use Chapter Quiz in the Instructor’s Manual. CHAPTER 6 QUIZ ANSWERS True-False 1. T 2. T 3. T 4.F 5. T 6. F 7. T 8. F Multiple Choice 9. B 10. D 11. D 12. C 13. A 14. A 15. D 16. C Name ________________________________________ Date____________________________ CHAPTER 6 QUIZ TRUE-FALSE _____1. Parents or family members are often sources of the least expensive loans. _____2. A float period enables cheaper credit purchases. _____3. The APR is the percentage cost (or relative cost) of credit on a yearly basis. _____4. The most basic method of calculating interest is the compound interest formula. _____5. Providing collateral can help you negotiate a lower interest rate for your loan. _____6. Making only the minimum monthly payment on your credit card is a wise decision. _____7. The most expensive loans are loans received from retailers. _____8. An APR of 8 percent compounded quarterly, has an EAR of 8.50%. MULTIPLE CHOICE _____9. The best method of comparing credit cost is the a. time value of money. b. finance charge and the APR. c. declining balance method. d. add-on and adjusted balance method. _____10. Which consumer credit source has been viewed historically as a lender of last resort? a. Chartered bank b. Trust company c. Credit union d. Finance company _____11. You can obtain expensive loans from a. chartered banks and credit unions. b. parents or family members. c. banks through credit cards. d. finance companies and retailers. _____12. Some creditors add finance charges after subtracting payments made during the billing period, this is called the a. previous balance method. b. average daily balance method. c. adjusted balance method. d. annual percentage rate method. _____13. Consumer credit counselling services a. are nonprofit organization that help families with severe financial difficulties. b. extend consolidation loans. c. sell credit insurance. d. are lending institutions. _____14. _____________ is any type of insurance that ensures repayment of the loan in the event the borrower is unable to repay it. a. Credit Insurance b. Life Insurance c. Property and Casualty Insurance d. Health Insurance _____15. A __________ loan is when you pledge property or other assets as collateral. a. Upfront Cash b. Collateral Loan c. Fixed-Rate Loan d, Secured Loan _____16. The fairest method that creditors use to calculate the balance on which they apply interest charges is the a. Adjusted balance method b. Previous balance method c. Average daily balance method d. Declining balance method SUPPLEMENTARY LECTURE Main points: • Almost all supermarkets accept major credit cards. • Supermarket industry sales are in the billions of dollars strong, but supermarket profit margins are very thin (about 1 percent of sales). • New technology in checkout lanes is making the cost of processing a credit card transaction more competitive with the cost of check and cash transactions. • New computer systems are speeding a credit card transaction; a transaction can easily be completed in seconds. Discussion Questions: • Should consumers buy groceries with credit cards? • Give examples of how new technology is being incorporated in checkout lanes to render them both cost and time efficient. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 6-1 (p. 180) 1. Why do students fall prey to late-payment fees? Students often do not understand how and when to use credit. (p. 176) 2. What are the major sources of consumer credit? Major sources of consumer credit are chartered banks, consumer finance companies, credit unions, life insurance companies, and trust companies. (p. 177) 3. What are some advantages and disadvantages of securing a loan from a credit union? From a finance company? Credit unions offer medium-priced loans with interest rates ranging from 8-12 percent. They provide credit life insurance, are usually sympathetic to borrowers with legitimate payment problems, and provide personalized service. The most expensive loans are available from finance companies, retailers, and banks through credit cards. Finance companies often lend to those who cannot obtain credit from banks or credit unions. The interest ranges from 12-25 percent. (pp. 177-178) Concept Check 6-2 (p. 188) 1. Distinguish between APR and EAR. The annual percentage rate is the percentage cost (or relative cost) of credit on a yearly basis. The APR is your key to comparing costs, regardless of the amount of credit or how much time you have to repay it. The EAR is the annual rate adjusted for compounding. (p. 180) 2. What can you learn from a loan amortization schedule? You can learn your beginning and ending loan balances, the amount of interest paid and the amount of your payment that went towards paying down your principal. (p. 182) 3. Distinguish among adjusted balance, previous balance, and the average daily balance methods of calculating the cost of open-end credit. Some creditors add finance charges after subtracting payments made during the billing period; this is called the adjusted balance method. Other creditors give you no credit for payments made during the billing period; this is called the previous balance method. Under the third method, the average daily balance method, creditors add your balances for each day in the billing period and then divide by the number of days in the period. (p. 185) Concept Check 6-3 (p. 190) 1. What are the most frequent reasons for indebtedness? Frequent reasons for indebtedness are emotional problems, the use of money to punish, the expectation of instant comfort, keeping up with the Joneses, expensive indulgence of children, misunderstanding or lack of communications among family members, and the amount of finance charges. (p. 188) 2. What are the common danger signals of potential debt problems? Danger signals include the following, as well as those listed in Exhibit 6-2 (p.189). * * * * * * * * * * * * * Paying only the minimum balance each month on credit card bills Increasing the total balance due each month on credit accounts Missing payments, paying late, or paying some bills this month and others next month Intentionally using the overdraft or automatic loan features on checking accounts or taking frequent cash advances on credit cards Using savings to pay normal bills such as groceries or utilities Receiving second or third notices from creditors Borrowing money to pay old debts Not knowing how much you owe until the bills arrive Going over your credit limit on credit cards Having little or nothing in savings to handle unexpected expenses Being denied credit because of a negative credit bureau report Getting a credit card revoked by the issuer Putting off medical or dental visits because you can’t afford them right now Concept Check 6-4 (p. 190) 1. What is a consumer credit counselling service? A credit counselling service is a non-profit organization that provides debt-counselling services for families and individuals with serious financial problems. It is also concerned with preventing credit problems and helping consumers solve the problems. It aids families with serious problems by helping such families manage their money better and by setting up a realistic budget and plan for expenditures. (p. 190) 2. What are the two major activities of credit counselling services? a. Aiding families with serious debt problems by helping such families manage their money better and by setting up a realistic budget and plan for expenditures. b. Helping prevent debt problems by teaching the necessity of family budget planning, providing education to people of all ages regarding the pitfalls of unwise credit buying, suggesting techniques for family budgeting, and encouraging credit institutions to provide full information about the costs and terms of credit and to withhold credit from those who cannot afford to repay it. 3. What options do consumers have for financial counselling? Nonprofit counselling services are sometimes provided by universities, military bases, credit unions, local county extension agents, and provincial and federal housing authorities. These organizations are likely to charge little or nothing for such assistance. You can also check with your local bank or consumer protection office to see whether it has a listing of reputable, low-cost financial counselling services. (p. 187) Concept Check 6-5 (p. 194) 1. What is the purpose of a consumer proposal? A consumer proposal is a maximum 5-year plan for paying creditors all or portion of the total debt owed. To be eligible, you must be insolvent and be less than $75,000 in debt. Both the court and your creditors must approve a consumer proposal. The advantage is that a consumer proposal will save you from bankruptcy if it is approved. (p. 192) 2. What is the difference between a consumer proposal and bankruptcy? Consumer proposals save you from bankruptcy by establishing a 5-year plan, which will allow you to repay your creditors. When you file for bankruptcy, you have no intention of repaying your creditors. (p. 192) 3. How does bankruptcy affect your job and future credit? Different people have different experiences in obtaining credit after they file bankruptcy. Some find obtaining credit more difficult. Others find obtaining credit easier because they have relieved themselves of their prior debts or because creditors know that they cannot file another bankruptcy case for a period of time. Obtaining credit may be easier for people who file a consumer proposal and repay some of their debts than for people who file bankruptcy and make no effort to repay their debts. Bankruptcy legislation prohibits your employer from discharging you simply because you have filed a bankruptcy case. (p. 193) 4. What are the costs of declaring bankruptcy? The costs associated with submitting a consumer proposal are a basic fee of approximately $1,500, a small filing fee of $100, and an additional 20 percent of the amount of your assets that are distributed. In the case of bankruptcy, the costs include a smaller basic fee but potentially greater additional fees. Both have a fee of $170 for budget counseling. There are also intangible costs associated with bankruptcy such as the difficulty to obtain credit in the future, as bankruptcy reports are retained in credit bureaus for 7 years. (p. 194) OPENING CASE QUESTIONS (p. 176) 1. What is Huan Kwo’s advice to student groups? Huan Kwo advises student groups to beware of teaser rates. 2. Are teaser rates unique to student credit cards? Teaser rates are not unique to student credit cards. They are misleading to most people. 3. Should you get a secured credit card? Why or why not? Yes, you should get a secured credit card because your credit limit depends on your savings at the issued bank. Therefore, you cannot over-extend your credit. FINANCIAL PLANNING PROBLEMS (p. 195) 1. Dave borrowed $500 and paid $50 in interest when he repaid the principal after one year. The bank also charged him a $5 service on a discount basis. What was the effective cost of his loan? (Obj. 2) Solution: Total interest cost = $50 Total funds available = $500 - $5 = $495 Effective cost = $50 ÷ $495 = 0.101 or 10.1% 2. If the 5% interest rate quoted on Dave’s loan had been compounded monthly, what would have been the effective annual interest rate charged on the loan? (Obj. 2) Solution: EAR = (1 + 0.05/12)12 – 1 = 0.05116 or 5.12% 3. The CLSP has agreed to lend you funds to complete your 3 years bachelors’ degree. The government will lend you $2400 today, if you agree to repay the loan 5 years from now with a lump sum payment of $5000. What annual interest is CLSP charging you? (Obj. 2) Using the Present Value and Future Value computation (Appendix 1B), the annual interest rate is 15.81%. 4. If Dave had borrowed the $500 for one year at an APR of 5%, compounded monthly, what would have been his monthly loan payment? What would have been the breakdown between interest and principal of the fifth payment? (Obj. 2) Solution: Monthly interest rate = 0.05 ÷ 12 = 0.004167 PMT = $500 ÷ {[1 – (1 ÷ 1.004167)12] / 0.004167} = $42.80 The balance after the fourth payment would be: Balance = $42.80 {[1 – (1 ÷ 1.004167)12] / 0.004167} = $336.10 and the components of the fifth payment would be: Interest = $336.10 x (0.05 ÷ 12) = $1.40 Principal = $42.80 - $1.40 = $41.40. 5. Assume Dave borrowed the $500 on his personal line of credit. Interest is charged at a rate of 5%, but calculated on a daily basis. Dave is required to pay a minimum of 5 percent of the remaining loan balance every month. What would be Dave’s first monthly loan payment? Assume a 30-day month. (Obj. 2) Solution: Interest: Principal; $500 x 0.05 x (30/365) = $ 2.05 $500 x 0.05 = $25.00 $27.05 6. Bobby is trying to decide between two credit cards. One has no annual fee and an 18-percent interest rate, and the other has a $40 annual fee and an 8.9-percent interest rate. Should he take the card that is free or the one that costs $40? The first card may not charge an annual fee, but that does not mean that it’s “free?” It depends how Bobby plans to use it. He should compare other charges besides the annual fee. For example, what is the late payment fee? Over-the-limit fee? Cash advance fee? Some cards may even charge him for customer calls. Comparing all the fees charged is important. Equally important is the interest rate. If Bobby can lower his interest rate by switching to a new card, he can potentially save hundreds of dollars a year, more than making up for the $40 annual fee. 7. Sidney took a $200 cash advance by using cheques linked to her credit card account. The bank charges a 2-percent cash advance fee on the amount borrowed and offers no grace period on cash advances. Sidney paid the balance in full when the bill arrived. What was the cash advance fee? What was the interest for one month at an 18-percent APR? What was the total amount she paid? What if she had made the purchase with her credit card (assuming no overcredit limit) and paid the bill in full promptly? • • • • Sidney’s cash advance fee was $4.00. ($200 x .02) At an 18% APR, she paid $3.00 interest for a month [0.18/12 = (2 x 1 x I)/200(1+1) solve for I ] She paid a total amount of $207. ($200 + $3 + $4) If Sidney had made the purchase with her credit card and paid off the bill in full promptly, she would have paid only $200. 8. Dorothy lacks cash to pay for a $600 dishwasher. She could buy it from the store on credit by making 12 monthly payments of $52.74 each. The total cost would then be $632.88. Instead, Dorothy decides to deposit $50 a month in the bank until she has saved enough money to pay cash for the dishwasher. One year later, she has saved $642—$600 in deposits plus interest. When she goes back to the store, she finds that the dishwasher now costs $660. Its price has gone up 10 percent—the current rate of inflation. Was postponing her purchase a good trade-off for Dorothy? No, it was not a good trade-off for Dorothy to postpone her purchase. By waiting one year, she had to pay more to buy the dishwasher. Now she had saved $642, but the price of the dishwasher has increased from $600 to $660. If she had used credit to buy the dishwasher a year before, she would have paid only $632.88. However, it is possible that not incurring a debt and not being responsible for monthly payments were more important to Dorothy than the money she would have saved if she had used credit. 9. You have been pricing a compact disc player in several stores. Three stores have the exact same price of $300. Each of these stores charges 18 percent APR, has a 30-day free ride, and sends out bills on the first of the month. On further investigation, you find that Store A calculates the finance charge by using the average daily balance method, that Store B uses the adjusted balance method, and that Store C uses the previous balance method. Assume that you purchased the disc player on May 5 and that you made a $100 payment on June 15. What will the finance charge be for June if you made your purchase from Store A? from Store B? from Store C? Store A: Average Daily Balance ($300 - $100 /2 = $250) Store B: Adjusted Balance Method ($300 - $100 = $200) Store C: Previous Balance Method ($300 - $0 = $300) Finance Charge $3.75 ($250 × .015) $3.00 ($200 × .015) $4.50 ($300 × .015) Remember, Store C does not count the amount you paid during the month and charges interest for the entire month on the beginning balance of $300. Note, too that 18 percent APR is equivalent to 1.5 percent monthly rate. 10. What are the interest cost and the total amount due on a six-month loan of $1,500 at 13.2 percent simple annual interest? Using the simple interest formula: I = P x r x T = $1,500 × 0.132 × 1/2 year = $99.00 Total amount due = $1,500 + $99 = $1,599. FINANCIAL PLANNING ACTIVITIES (p. 196) 1. Survey friends and relatives to find out how they determine the need for credit. Just about everyone has short-term or long-term needs for credit. Most big ticket items such as an automobile, furniture, major appliances, large screen televisions and entertainment centers usually call for the need of credit. Not too many individuals can afford to pay cash for homes or other types of real estate. 2. Prepare a list of sources of inexpensive loans, medium-priced loans, and expensive loans in your area. What are the trade-offs in obtaining a loan from an “easy” lender? Sources of inexpensive loans will most likely be parents, family members, and friends. A local chartered bank, where one has a savings and checking account, is also a good source of the least expensive loans. If one does not maintain a checking or savings account in a chartered bank, it can still be a good source of medium-priced loans. A credit union, if one belongs to it, is probably another source for medium-priced loans. The most expensive loans will most likely be available from finance companies, retailers, and banks through credit cards. Finance companies often lend to those who cannot obtain credit from banks or credit unions. Borrowing from car dealers, appliance stores, department stores, and other retailers is also relatively expensive. 3. Using the Internet to obtain information about the costs of credit. As pointed out in the beginning of this chapter, credit costs money, therefore, you must conduct the cost/benefit analysis before making any major purchase. While most people consider credit costs, there are others who simply ignore this and find themselves in financial difficulties. To help avoid this problem, each one of the following organizations has a home page on the Internet. The Quicken Financial Network helps consumers save money when purchasing, financing, or refinancing. CCC Consumer Credit Counselling offers financial counselling and debt consolidation services. Canoe Money brings you the latest rates for mortgages, credit cards, auto loans, home equity loans, personal loans, as well as a slew of financial advice. Choose one of the above organizations and visit its Web site. Then prepare a report that summarizes the information provided by the organization. Finally decide how this information could help you to better manage your credit and its costs. Although student answers will vary depending on which Internet site they visit, you may want to use this opportunity to reinforce that students should conduct the cost-benefit analysis before borrowing money. 4. When you choose financing, what are the trade-offs between the features you prefer (term, size of payments, fixed or variable interest, or payment plan) and the cost of your loan? Some of the major trade-offs you should consider are: a. Term versus interest costs. Many people choose longer-term financing because they want smaller monthly payments, but more dollars must be paid in interest charges. b. Lender risk versus interest rate. If you want to minimize your borrowing costs, consider variable interest rate, a secured loan, up-front cash, and a shorter term. 5. How are the simple interest and simple interest on the declining balance formulas used in determining the cost of credit? Simple interest is the interest computed on principal only and without compounding; it is the cost of borrowing money. This cost is based on three elements: the amount borrowed, the rate of interest, and the amount of time for which the principal is borrowed. In the simple interest on the declining balance method, you pay interest only on the amount of the original principal that has not yet been repaid; the more frequent the payments, the smaller the interest paid will be. Of course, the amount of credit you have at your disposal is also smaller. 6. Your friend is drowning in a sea of overdue bills and is being harassed by a debt collection agency. Prepare a list of the steps that he or she should take if the harassment continues. Certain practices by agencies that collect debts for creditors are regulated by law. While legislation does not erase the legitimate debts that consumers owe, it does regulate the ways in which debt collection agencies do business. 7. Visit a local office of a consumer credit counselling service. What assistance can debtors obtain from this office? What is the cost of this assistance, if any? a. Helping families with serious debt problems by assisting such families manage their money better and by setting up a realistic budget and plan for expenditures b. Helping prevent debt problems by teaching the necessity of family budget planning, providing education to people of all ages regarding the pitfalls of unwise credit buying, suggesting techniques for family budgeting, and encouraging credit institutions to provide full information about the costs and terms of credit and to withhold credit from those who cannot afford to repay it Counselling is usually free. However, when a credit counselling service administers a debt repayment plan, it sometimes charges a nominal fee to help defray administrative costs. 8. What factors would you consider in assessing the choices in declaring personal bankruptcy? Why should personal bankruptcy be the choice of last resort? Obtaining credit may be more difficult in the future. Furthermore, there are court costs, attorney’s fees, trustee’s fees and other monetary costs. There are also psychological costs. Therefore, the extreme step of declaring bankruptcy should be taken only when no other options for solving financial problems exist. LIFE SITUATION CASE Financing Sophie’s Geo Metro (p. 197) 1. What is perhaps the most important item shown on the disclosure statement? Explain why. The annual percentage rate (APR) is perhaps the single most important item shown on the disclosure statement. By relating the finance charge to the amount financed, it provides a single percentage figure which borrowers may use to compare the costs of obtaining a loan from various financial institutions. 2. What is included in the finance charge? The finance charge is the sum of all the costs of credit, including all charges which Sophie must pay before and during the term of the loan. In Sophie’s case, the disclosed finance charge consists of the interest she will pay for the three-year loan period. 3. What is the amount Sophie will receive from the bank? $6,000 4. Should Sophie borrow from Bank A or Bank B? Explain why. Bank A. The 5 percent difference in the APRs of the two banks means that Sophie would have to pay $15 extra every month if she gets her loan from the second bank. COMMENTS ON CONTINUOUS CASE FOR PART 2A (p. 198) Using Financial Services: Savings, Checking, and Credit 1. What is the minimum amount that the Mortimers should have in an emergency fund? They should have $23,400 in an emergency fund, which is the equivalent of 6 times their monthly expenses. (6 x $3,900) 2. What should the Mortimers do to increase the amount of money they set aside for emergencies? They should decrease their car loan and credit card debts, in other words, their high interest costs. They should also minimize the amount of money spent on items like clothes, which are not necessities, and most of all, establish a financial plan in order to rectify their bad spending habits. 3. Pamela and Isaac have separate checking accounts. Do you think they should give up their separate checking accounts and open a joint checking account? While student answers may vary, it should be pointed out that a large number of married couples have trouble maintaining a joint checking account. Regardless if they choose separate checking accounts or a joint checking account, it is important that they establish some guidelines on how they spend their money. The key to their financial success may not be the type of checking account they choose, but establishing a realistic budget that helps them gain control of their finances. 4. If you were Pamela or Isaac, how would you go about paying off your credit card debts and other liabilities? Until their credit card debts are paid off, the Mortimers should limit credit card purchases and make larger monthly payments. 5. What would you recommend to the Mortimers regarding their future use of credit? Many financial planners would suggest that they take scissors and cut up most of the credit cards that they now have. These same financial planners would probably tell the Mortimers that one or possibly two major credit cards would be more than enough for this couple. The credit cards that remain should be used only when there is a “true” emergency. Solution Manual for Personal Finance Jack Kapoor, Les Dlabay, Robert J. Hughes, Arshad Ahmad 9780071320597, 9781259453144
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