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Chapter 6 Using Credit How Will This Affect Me? The ability to borrow funds to buy goods and services is as convenient as it is seductive. It is important to understand how to get and maintain access to credit via credit cards, debit cards, lines of credit, and other means. This chapter reviews the common sources of consumer credit and provides a framework for choosing among them. It also discusses the importance of developing a good credit history, achieving and maintaining a good credit score, and protecting against identity theft and credit fraud. The chapter will help you understand the need to use credit intentionally, in a way that is consistent with your overall financial objectives. The student needs to understand that the ability to obtain credit is not an invitation to spend money. The use of credit must be intentional and done for the right reasons. Of special importance to the students is the section on credit cards and credit scoring, specifically the FICO, the largest provider of credit scores by far. The FICO scores are a product of Fair Isaac & Co. LG1 Describe the reasons for using consumer credit, and identify its benefits and problems. This topic is discussed in the section 6–1a Why We Use Credit. LG2 Develop a plan to establish a strong credit history. Section 6-1c included a highlighted graphic, Evaluating Creditworthiness, The 5 C’s of Credit, that discusses things you can do to build a strong credit history. The Debt safety credit ratio is discussed; note it is based upon Monthly take home pay. The Affordability Ratio discussed in chapter 5 was based upon monthly gross salary and applies to mortgages only. The Debt safety credit ratio does not include mortgage payments, only credit card, automobile loans, education loans, personal loans, and other consumer credit payments. Rule of thumb is 10% to 20% with closer to 10% the better. Worksheet 6.1 computes the debt safety ratio. LG3 Distinguish among the different forms of open account credit. Section 6.2 discusses the various forms of open account credit. Home Equity Loans are an important source of credit for homeowners because of their relatively low rates. Financial planners need to understand the advantages of the home equity loans. The answer to Test Yourself question 6-11 [included below] can be used for this discussion. Note the graphic, “Risky Debit Card Use” in Section 6-2e. LG4 Apply for, obtain, and manage open forms of credit. Use the Power Points. This topic is well covered in the text. The answer to Test Yourself questions 13-16 [included below] discusses the common method used to compute finance charges. Section 6-3a discusses the FICO scores and includes a graphic “Improving Your FICO Score” that has useful information. LG5 Choose the right credit cards and recognize their advantages and disadvantages. Section 6-4a list four card features to look for: Annual fees Rate of interest charged on account balance Length of grace period Method of calculating balances Bottom line: Do not take the first credit card offered to you; get the one that is right for you. LG6 Avoid credit problems, protect yourself against credit card fraud, protect yourself against identity theft, and understand the personal bankruptcy process. The best way to avoid credit problems is to use credit for specific purposes: To purchase large outlay items, such as a car, major furniture purposes, etc. To meet a financial emergency For convenience, it is difficult to purchase through the internet with cash For investment purposes, but you must be careful to control the amount Credit cards are great for convenience, but their rates are high if you do not pay the balance within the grace period. Credit card fraud and identity theft are major problems. Section 6-4c has a graphic that discusses ways of protecting yourself from identity theft. Personal bankruptcy follows periods of excess debt. Two most common bankruptcy are: Wage earner plan – Chapter 13, allows creditor to work out a plan to pay debt off, normally during a 3 to 5 year period Straight bankruptcy – “Wiping the slate clean and starting anew” under Chapter 7, does not eliminate federal tax claims, but allow to keep home, car, and personal assets. I suggest the following exercises will make good homework problems. Financial Planning Exercise 2 requires the use of the debt safety ratio which is a good thing to know. The problem uses the ratio to compute amount of debt the debtor can handle. Worksheet 6.1 evaluating Alyssa’s debt status is used in Financial Planning Exercise 3. Financial Planning Exercise 7 requires the student to compare two credit cards and discuss which should be used. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • One of the benefits of using credit is that it allows you to purchase expensive goods and services while spreading the payment for them overtime. Fact: One of the major benefits of buying on credit is that expensive purchases are made more affordable because the consumer is able to pay for them systematically over time. • It’s a good idea to contact your creditors immediately if, for some reason, you can’t make payments as agreed. Fact: Let the lenders know and they’ll often give you a credit extension. This is one of the smartest things you can do to build a sound credit history. However, except for those occasional tight spots, it’s important to make credit payments on time consistently! • Excluding mortgage payments, most families will have little or no credit problems so long as they limit their monthly credit payments to 25 to 30 percent their monthly take-home pay. Fantasy: Most experts suggest that you keep your monthly debt repayment burden, excluding mortgage payments, to 20 percent or less of your take-home pay. Letting it get as high as 25 to 30 percent can lead to serious credit problems. • When you apply for credit, most lenders will contact a credit bureau and let them decide whether or not you should receive the credit. Fantasy: Credit bureaus collect information and maintain credit files about individual borrowers. However, they do not make the credit decision. That’s done by the merchant or financial institution considering extending the credit. • Credit card issuers are required by truth-in-lending laws to use the average daily balance in your account when computing the amount of finance charges you’ll have to pay. Fantasy: Truth in lending laws require only that lenders fully disclose the effective rate of interest being charged and the method used to compute finance charges. Lenders can choose the specific method used to calculate the balances on which they apply finance charges. The average daily balance method is the most widely used. • You use a check rather than a credit card to obtain funds from an unsecured personal line of credit. Fact: Credit cards are not issued with unsecured personal credit lines. Instead, if you want to borrow money through such a line, you do it by simply writing a check directly against it. Financial facts or Fantasies as True/False Questions 1. True False One of the benefits of using credit is that it allows you to purchase expensive goods and services while spreading the payment for them overtime. 2. True False It’s a good idea to contact your creditors immediately if, for some reason, you can’t make payments as agreed. 3. True False Excluding mortgage payments, most families will have little or no credit problems so long as they limit their monthly credit payments to 25 to 30 percent their monthly take-home pay. 4. True False When you apply for credit, most lenders will contact a credit bureau and let them decide whether or not you should receive the credit. 5. True False Credit card issuers are required by truth-in-lending laws to use the average daily balance in your account when computing the amount of finance charges you’ll have to pay. 6. True False You use a check rather than a credit card to obtain funds from an unsecured personal line of credit. Answers: 1. True 2. True 3. False 4. False 5. False 6. True YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. Is Your Credit Card a Good Deal? While your credit card might have been a good deal when you first got it, that may not still be the case. Go to a credit card Internet site like http://www.creditcards.com, which allows you to evaluate numerous credit cards by type. For example, you can focus on 0% APR, rewards, cash back, travel & airline, cards for students, and more types of cards. It’s worth a look – you can do it now. YOU CAN DO IT NOW How Does Your Credit Report Look? When did you last check your credit report? It’s a good idea look at it at least once a year to know where you stand and to assure that there are no errors. The Fair Credit Reporting Act (FCRA) requires each of the national credit reporting firms – Experian, Equifax, and TransUnion – to provide a free copy of your credit report once a year. These three companies have set up an Internet site where you can get your free annual report at https://www.annualcreditreport.com. Be careful not to use other Internet sites that offer free credit reports, free credit monitoring, or free credit scores. Such sites are not authorized to meet the legal requirements of the FCRA and often have strings attached. Just go to the authorized site – you can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Carter Has Had It and Files for Bankruptcy Carter Anderson is overwhelmed by his bills. While making $60,000 a year, he has amassed credit card debt of $24,000, has an $80,000 college loan, holds a $150,000 mortgage, and pays monthly on his leased Jetta. He’s having trouble paying the mortgage monthly and can never seem to pay more than the minimum on his credit card debt. Carter’s wife, Bella, is currently unemployed. Carter has heard that declaring bankruptcy can eliminate some of his debt commitments and give him extra time to deal with others. He’s had it and just filed for bankruptcy. What can Carter look forward to as a result of his decision? Carter can expect some cash flow relief in the short-term and filing for bankruptcy will likely prevent or at least delay foreclosure on his home. However, the bankruptcy filing will adversely affect his credit report for up to the next 10 years. Carter will probably have trouble getting a loan or a new credit card. And if he can borrow money or get a new credit card, he’ll probably have to pay the highest allowable interest rate. By not managing his family’s indebtedness, Carter has exercised the bankruptcy “nuclear option.” This provides short-term relief at the expense of longer-term access to credit on reasonable terms. Applying Personal Finance How’s Your Credit? Establishing credit and maintaining your creditworthiness are essential to your financial well-being. Good credit allows you to obtain loans and acquire assets that you otherwise might not be able to attain. This project will help you to examine your credit. If you’ve already established credit, get a copy of your credit report from one of the credit bureaus mentioned in this chapter. (If you’ve applied for a loan recently, your lender may already have sent you a copy of your credit report.) Carefully examine your report for any inaccuracies, and take the necessary steps to correct them. Then look over your report and evaluate your creditworthiness. If you feel you need to improve your creditworthiness, what steps do you need to take? If you haven’t yet established credit, find an application for a card such as Visa, MasterCard, or a department store or gasoline company credit card. Places to look might be at a department store, banking institution, gas station, or the Internet. Take the application home and fill it out. Then look it over and try to do a self-evaluation of your creditworthiness. Based on the information that you’ve provided; do you think you would qualify for the credit card? What do you see as your major strengths? What are your major weaknesses? Is there anything you can do about them? Financial Planning Exercises 1. Establish a credit history. After graduating from college last fall, Holly Baker took a job as a consumer credit analyst at a local bank. From her work reviewing credit applications, she realizes that she should begin establishing her own credit history. Describe for Holly several steps that she could take to begin building a strong credit record. Does the fact that she took out a student loan for her college education help or hurt her credit record? Here are some things you can do to build a strong credit history: • Use credit only when you can afford it and only when the repayment schedule fits comfortably into the family budget—in short, don’t overextend yourself. • Fulfill all the terms of the credit. • Be consistent in making payments promptly. • Consult creditors immediately if you cannot meet payments as agreed. • Be truthful when applying for credit. Lies are not likely to go undetected. Having a student loan on which you make consistent and regular payments can help you build a good credit history. Payments of a student loan will be considered when determining your debt safety ratio, an indicator of your ability to carry more loans. The student loan will limit the amount of additional you can handle. 2. Evaluating debt burden. Ted Phillips has a monthly take-home pay of $1,685; he makes payments of $410 a month on his outstanding consumer credit (excluding the mortgage on his home). How would you characterize Isaac’s debt burden? What if his take-home pay were $850 a month and he had monthly credit payments of $150? The debt safety ratio is total monthly consumer credit payments divided by the monthly take-home pay. In Ted’s case, with monthly take-home pay of $1,685 and payments of $410, his debt safety ratio is 410/1,685 = 24.3. This ratio is over the preferred maximum of a ratio of 20. Therefore, Ted’s ability to borrow is limited. He needs to pay off some debt or increase his monthly income to take on additional debt. In Ted’s second case, with monthly take-home pay of $850 and payments of $150, his debt safety ratio is 150/850 = 17.6. This ratio is under the maximum of 20. It is over the preferred ratio of 15, but Ted can handle a small additional loan. He should be careful and only borrow if he needs to do so. One more consumer loan and he will be at or over the maximum debt safety ratio and heading to debt trouble. 3. Evaluating debt safety ratio. Use Worksheet 6.1. Chloe Young is evaluating her debt safety ratio. Her monthly take- home pay is $3,320. Each month, she pays $380 for an auto loan, $120 on a personal line of credit, $60 on a department store charge card, and $85 on her bank credit card. Complete Worksheet 6.1 by listing Chloe’s outstanding debts, and then calculate her debt safety ratio. Given her current take-home pay, what is the maximum amount of monthly debt payments that Chloe can have if she wants her debt safety ratio to be 12.5 percent? Given her current monthly debt payment load, what would Chloe’s take-home pay have to be if she wanted a 12.5 percent debt safety ratio? From Worksheet 6.1 below, Chloe’s current debt safety ratio is 19.4 which is close to the maximum of 20 and above the desired ratio of 15. In order to reach the desirable ratio 12.5, Alyssa will have to reduce monthly payments to $415, or increase monthly income to $5,160.4. Comparing credit and debit cards. Samuel Ramirez is trying to decide whether to apply for a credit card or a debit card. He has $8,500 in a savings account at the bank and spends his money frugally. What advice would you have for Samuel? Describe the benefits and drawbacks of each type of card. If Samuel is willing to keep good records of use, a debit card provides the desired convenience without the possibility of high interest on balances. However, if he does not keep good records, use of a debit card may result in overdraft of the related bank account, typically a checking account. The debit card requires a personal identification number, PIN, to use the card which makes it more secure than a credit card. It appears that Samuel has the financial capability to pay any credit card balance during the grace period and will not have to pay the high interest. The credit card will help establish a good credit history that may help to get larger loans in the future. My advice is to use credit cards and pay balance during the grace period. Credit cards: Probably the most popular form of open account credit is the bank credit card. If you have a regular job, you will probably be able to get a credit card although the credit limit may be small [$1,000]. These cards allow their holders to charge purchases worldwide at literally millions of stores. The interest rates on credit cards are usually higher than any other form of consumer credit. However, most credit cards have a grace period of 20 to 30 days during which if you pay the balance, there is no interest charged. Besides the interest charged on bank credit cards, there are other fees you should be aware of. To begin with, many (though not all) bank cards charge annual fees just for the “privilege” of being able to use the card. In most cases, the fee is around $25 to $40 a year, though it can amount to much more for prestige cards. Debit Cards: A big disadvantage of a debit card is that it doesn’t provide a line of credit. In addition, it can cause overdraft problems if you fail to make the proper entries to your checkbook or inadvertently use it when you think you’re using a credit card. Also, some debit card issuers charge a transaction fee or a flat annual fee; and some merchants may even charge you just for using your debit card. On the plus side, a debit card enables you to avoid the potential credit problems and high costs of credit cards. Further, if convenience is the major reason you use a credit card, you might want to consider switching to a debit card for at least some transactions 5. Home equity lines. Kai and Ivy Harris have a home with an appraised value of $180,000 and a mortgage balance of only $90,000. Given that an S&L is willing to lend money at a loan to-value ratio of 75 percent, how big a home equity credit line can Kai and Ivy obtain? How much, if any, of this line would qualify as tax deductible interest if their house originally cost $200,000? Loan-to-value ratio of 75 percent yields [.75 * 180.000] – 90,000 = $60,000 of available credit. Under the 2017 tax act, interest on the home equity loan is only deductible if the proceeds are used for home improvement and if the taxpayer itemizes deductions. Even if the interest is not deductible, the home equity loan is still a low-cost source of credit. The deduction of home equity loan interest is further limited to a principal amount of $100,000 [or if lower the cost of your home]. 6. Using overdraft protection line. Grace Wang has an overdraft protection line. Assume that her October 2020 statement showed a latest (new) balance of $862. If the line had a minimum monthly payment requirement of 5 percent of the latest balance (rounded to the nearest $5 figure), then what would be the minimum amount that she’d have to pay on her overdraft protection line? 5% * 862 = 43.1, rounded to nearest $5, = $45. 7. Choosing between credit cards. Gabriel Clark recently graduated from college and is evaluating two credit cards. Card A has an annual fee of $75 and an interest rate of 9 percent. Card B has no annual fee and an interest rate of 16 percent. Assuming that Gabriel intends to carry no balance and pay off his charges in full each month, which card represents the better deal? If Gabriel expected to carry a significant balance from one month to the next, which card would be better? Explain. Assuming that Gabriel intends to carry no balance and to pay off his charges in full each month Card B would not cost Gabriel any fees. Card A would cost him the annual fee of $75. Assuming Gabriel expected to carry a significant balance from one month to the next, Card A would cost an annual fee of $75 plus 9% of the monthly balance. Card B has no annual fee, but a rate of 16%. If Wyatt has a monthly balance of $100, Card A would cost total fees of $75 + 9%*100 = $84 per year. Card B would have total fees of 16% * 100 = $16. The difference in interest is 7%, thus the breakeven point is the annual fee of $75 divided by 7 %, or a debt balance of $1,071.43. With a debt balance of $1,071.43, card A total fees would be $75 + 9%*1,071.43 = $171.43. Card B annual fees would be 16%* 1,071.43 = $171.43. Thus, if the monthly debt balance is under $1,071.43, Card B is better. Over $1,071.43, Card A is better. 8. Calculating credit card interest. Ruby Wilson, a student at State College, has a balance of $380 on her retail charge card; if the store levies a finance charge of 21 percent per year, how much monthly interest will be added to Ruby’s account? The monthly interest is the annual interest divided by 12. Thus, an annual interest of 21% is a monthly interest of .21/12 = .0175 or 1.75%. With a balance of $380, that is $6.65 per month. If the interest is computed on an Average Daily Balance method, the daily rate is 21% / 365 or 0575% per day or 1.726% per 30 days. 9. Balance transfer credit cards. Zoe Robinson has several credit cards, on which she is carrying a total current balance of $14,500. She is considering transferring this balance to a new card issued by a local bank. The bank advertises that, for a 2 percent fee, she can transfer her balance to a card that charges a 0 percent interest rate on transferred balances for the first nine months. Calculate the fee that Zoe would pay to transfer the balance, and describe the benefits and drawbacks of balance transfer cards. Zoe has a fairly large balance of $14,500 on her credit cards. If her current cards charge her 12% per year, she would be paying $1,740/year or $145/month ($14,500 x .12/12) in interest on this amount. Therefore, if she feels she would not be able to pay off this balance fairly rapidly, she might indeed wish to transfer her balance to a 0% interest rate card for 9 months. If such a card charges a 2% transfer fee, she would pay $290 to transfer her $14,500 balance. She would have paid that amount in interest in 2 months anyway by leaving her balance with her old cards. Most cards have a maximum amount charged to transfer a balance, such as $65 or $75. However, since Martina has multiple cards, she might be charged that maximum several times. Martina should call the customer service number on the new credit card offer, explain her situation, and ask them to calculate what her fees would be to transfer the balance. She should also inquire what the regular rate will be on the new card, because she will have to pay that on her unpaid balance once the special offer time period is over. She should also be aware that if she pays late on such an offer, many times the rate will automatically go up to the card’s regular rate and even higher if she has several late pays. 10. Credit card liability. Luna was reviewing her credit card statement and noticed several charges that didn’t look familiar to her. Lina is unsure whether she should “make some noise,” or simply pay the bill in full and forget about the unfamiliar charges. If some of these charges aren’t hers, is she still liable for the full amount? Is she liable for any part of these charges—even if they’re fraudulent? Luna should immediately notify the credit card issuer of any charges on her statement which are not hers. The customer service representative of the issuing card can give her more information concerning the purchases so that she can determine if she indeed made them and forgot or if they are fraudulent. Her liability would be limited to $50 on any charges she did not make. She definitely should “make some noise”; otherwise she may have to pay the unauthorized charges. 11. Protecting against credit card fraud. Liam O’Sullivan takes pride in managing his finances carefully with great attention to detail. He recently received a phone call in which he was asked to confirm his credit card account number and social security number. Wyatt was pleased he had the information handy and appreciated the caller’s thoroughness. He gladly provided the information. What advice would you give Liam concerning his response? This is an example of a phishing call. You should never give account or social security numbers over the phone unless you made the call. Liam is our risk of identity theft. If he discovers that he has given such information out, he should cancel the credit card immediately. 12. How to Improve FICO Score. Caleb Stewart had a FICO score of 620 when he learned that his neighbor, Bert Collins, has a FICO score of 750. While shopping for a new mortgage, Caleb learns that a new mortgage will cost him about 1/2 percent higher than the rate available to Bert. Advise Caleb how he could possibly increase his FICO score. Refer to the graphic “Improving Your FICO Score” in section 63-a of the chapter. The answer below is from that graphic. Improving your FICO score is a lot like working out to get healthier: It takes time and there’s no quick fix. But here are some tips you might want to follow to reach a high score: Pay your bills on time. If you’ve missed payments, get current and stay current. If you’re having trouble making ends meet, contact your creditors and work out a payment plan. Keep credit card balances low. Pay off debt rather than move it around. Don’t open new credit cards just to increase your available credit. Re-establish your credit history if you’ve had problems in the past. 13. Protecting Against Identity Theft. Sienna Flores lives in a neighborhood where three of her friends have had their identities stolen in the last six months. She’s worried it will happen to her. Explain what Sienna should keep in mind to protect herself from identity theft. From the graphic “Financial Planning Tips” in section 64-b, the following are steps you can take to protect yourself from identity theft. Watch out for the following methods that thieves use to get your information: Dumpster diving. Don’t leave bills or anything with personal information in your trash. Skimming. Watch for unusual “additions” to credit and debit card readers that can steal your numbers. Phishing. Thieves can pretend to be financial institutions or companies and can use Internet pop-ups or send e-mail messages that ask you to disclose personal information. Changing your address. Thieves can reroute your bills to them by completing a change of address form. Old-fashioned stealing. Simple still works. Thieves continue to steal wallets and purses, mail, and new checks or tax information. Also, they sometimes bribe employees to provide access to your personal information. Pretexting. Thieves can obtain your personal information from financial institutions, telephone companies, and other sources under false pretenses. So what should you do? Deter thefts by protecting your information. Be aware of the abovementioned ways in which information is stolen. Detect suspicious activity by consistently checking your financial and billing statements. Defend against identity theft as soon as you suspect a possible problem. Place a “fraud alert” on your credit reports by contacting one of the consumer reporting companies noted earlier in this chapter (Experian, TransUnion, or Equifax). Contact the security departments of each company where an unauthorized account was opened. Test Yourself 6-1 Why do people borrow? What are some improper uses of credit? Whatever their age group, people tend to borrow for several major reasons. • To avoid paying cash for large outlays: Rather than pay cash for large purchases such as houses and cars, most people borrow part of the purchase price and then repay the loan on some scheduled basis. To meet a financial emergency: For example, people may need to borrow to cover living expenses during a period of unemployment or to purchase plane tickets to visit a sick relative. As indicated in Chapter 4, however, using savings is preferable to using credit for financial emergencies. For convenience: Merchants as well as banks offer a variety of charge accounts and credit cards that allow consumers to charge just about anything. Further, in many places—restaurants, for instance—using a credit card is far easier than writing a check. For investment purposes: As we’ll see in Chapter 11, it’s relatively easy for an investor to partially finance the purchase of many different kinds of investments with borrowed funds. Many people use consumer credit to live beyond their means. For some people, overspending becomes a way of life, and it is perhaps the biggest danger in borrowing—especially because it’s so easy to do. Once hooked on “plastic,” people may use their credit cards to make even routine purchases and all too often don’t realize they have overextended themselves until it’s too late. 6-2 Describe the effects of the credit crisis of 2008–2009 on borrowers. As credit became more readily available and easier to obtain, it also became increasingly clear that many consumers were, in fact, severely overusing it. Whether or not the consumer deserved the credit was really not an issue—the only thing that seemed to matter was that it was there for the taking! All this resulted in a credit meltdown unlike anything this country had ever seen. 6-3 Describe the general guidelines that lenders use to calculate an applicant’s maximum debt burden. The willingness of lenders to extend credit depends on their assessment of your creditworthiness—that is, your ability to promptly repay the debt. Lenders look at various factors in making this decision, such as your present earnings and net worth. Equally important, they look at your current debt position and your credit history. 6-4 How can you use the debt safety ratio to determine whether your debt obligations are within reasonable limits? The easiest way to avoid repayment problems and ensure that your borrowing won’t place an undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt! A useful credit guideline (and one widely used by lenders) is to make sure your monthly repayment burden doesn’t exceed 20 percent of your monthly take-home pay. Most experts, however, regard the 20 percent figure as the maximum debt burden and strongly recommend a debt safety ratio closer to 15 percent or 10 percent—perhaps even lower if you plan on applying for a new mortgage in the near future. Note that the monthly repayment burden here does include payments on your credit cards, but it excludes your monthly mortgage obligation. 6-5 What steps can you take to establish a good credit rating? Here are some things you can do to build a strong credit history: • Use credit only when you can afford it and only when the repayment schedule fits comfortably into the family budget—in short, don’t overextend yourself. • Fulfill all the terms of the credit. • Be consistent in making payments promptly. • Consult creditors immediately if you cannot meet payments as agreed. • Be truthful when applying for credit. Lies are not likely to go undetected. 6-6 What is open account credit? Name several different types of open account credit. Open account credit is a form of credit extended to a consumer in advance of any transactions. Typically, a retail outlet or bank agrees to allow the consumer to buy or borrow up to a specified amount on open account. Credit is extended so long as the consumer does not exceed the established credit limit and makes payments in accordance with the specified terms. Open account credit generally is available from two broadly defined sources: (1) financial institutions and (2) retail stores/merchants. Financial institutions issue general-purpose credit cards, as well as secured and unsecured revolving lines of credit and overdraft protection lines. Commercial banks have long been the major providers of consumer credit; and, since deregulation, so have S&Ls, credit unions, major stock-brokerage firms, and consumer finance companies. Retail stores and merchants make up the other major source of open account credit. They provide this service as a way to promote the sales of their products, and their principal form of credit is the charge (or credit) card. Let’s now take a look at these two forms of credit, along with debit cards and revolving lines of credit. 6-7 What is the attraction of reward cards? One of the fastest-growing segments of the bank card market is the reward (cobranded) credit card, which combines features of a traditional bank credit card with an incentive: cash, merchandise rebates, airline tickets, or even investments. About half of credit cards are rebate cards, and new types are introduced almost every day. 6-8 How is the interest rate typically set on bank credit cards? Most of these cards have variable interest rates that are tied to an index that moves with market rates. The most popular is the prime or base rate: the rate a bank uses as a base for loans to individuals and small or midsize businesses. These cards adjust their interest rate monthly or quarterly and usually have minimum and maximum rates. Generally speaking, the interest rates on credit cards are higher than any other form of consumer credit. But more and more banks—even the bigger ones—are now offering more competitive rates, especially to their better customers. Indeed, because competition has become so intense, a growing number of banks today are actually willing to negotiate their fees as a way to retain their customers 6-9 Many bank card issuers impose different types of fees; briefly describe three of these fees. Many (though not all) bank cards charge annual fees just for the “privilege” of being able to use the card. Many issuers also charge a transaction fee for each (non-ATM) cash advance; this fee usually amounts to about $5 per cash advance or 3 percent of the amount obtained in the transaction, whichever is more. Other fees include late-payment fees, over-the-limit charges, foreign transaction fees, and balance transfer fees. 6-10 What is a debit card? How is it similar to a credit card? How does it differ? A debit card provides direct access to your checking account and thus works like writing a check. A big disadvantage of a debit card, of course, is that it doesn’t provide a line of credit. In addition, it can cause overdraft problems if you fail to make the proper entries to your checking account ledger or inadvertently use it when you think you’re using a credit card. Also, some debit card issuers charge a transaction fee or a flat annual fee; and some merchants may even charge you just for using your debit card. On the plus side, a debit card enables you to avoid the potential credit problems and high costs of credit cards. Another difference between debit and credit cards involves the level of protection for the user when a card is lost or stolen. When a credit card is lost or stolen, federal banking laws state that the cardholder is not liable for any fraudulent charges if the loss or theft is reported before that card is used. If reported after the card is used, the cardholder’s maximum liability is $50. Unfortunately, this protection does not extend to debit cards. 6-11 Describe how revolving credit lines provide open account credit. Revolving lines of credit normally don’t involve the use of credit cards. Rather, they’re accessed by writing checks on regular checking accounts or specially designated credit line accounts. They are a form of open account credit and often represent a far better deal than credit cards, not only because they offer more credit but also because they can be a lot less expensive. The three major forms of open (non–credit card) credit are overdraft protection lines, unsecured personal lines of credit, and home equity credit lines. 6-12 What are the basic features of a home equity credit line? A home equity credit line is much like unsecured personal credit lines except that they’re secured with a second mortgage on the home. These lines of credit allow you to tap up to 100 percent (or more) of the equity in your home by merely writing a check. Home equity lines also have a tax feature that you should be aware of: the annual interest charges on such lines may be fully deductible for those who itemize. This is the only type of consumer loan that still qualifies for such tax treatment. According to the latest provisions of the tax code, a homeowner is allowed to fully deduct the interest charges on home equity loans up to $100,000, regardless of the original cost of the house or use of the proceeds. Indeed, the only restriction is that the amount of total indebtedness on the house cannot exceed its fair market value, 6-13 Describe credit scoring and explain how it’s used (by lenders) in making a credit decision. Using the data provided by the credit applicant, along with any information obtained from the credit bureau, the store or bank must decide whether to grant credit. Very likely, some type of credit scoring scheme will be used to make the decision. An overall credit score is developed for you by assigning values to such factors as your annual income, whether you rent or own your home, number and types of credit cards you hold, level of your existing debts, whether you have savings accounts, and general credit references. The biggest provider of credit scores is, by far, Fair Isaac & Co.—the firm that produces the widely used FICO scores. Unlike some credit score providers, Fair Isaac uses only credit information in its calculations. There’s nothing in them about your age, marital status, salary, occupation, employment history, or where you live. Instead, FICO scores are derived from the following five major components, which are listed along with their respective weights: payment history (35 percent), amounts owed (30 percent), length of credit history (15 percent), new credit (10 percent), and types of credit used (10 percent). FICO scores, which are reported by all three of the major credit bureaus, range from a low of 300 to a max of 850. 6-14 Describe the basic operations and functions of a credit bureau. A credit bureau is a type of reporting agency that gathers and sells information about individual borrowers. If, as is often the case, the lender doesn’t know you personally, it must rely on a cost-effective way of verifying your employment and credit history. It would be far too expensive and time-consuming for individual creditors to confirm your credit application on their own, so they turn to credit bureaus that maintain fairly detailed credit files about you. Information in your file comes from one of three sources: creditors who subscribe to the bureau, other creditors who supply information at your request, and publicly recorded court documents (such as tax liens or bankruptcy records). 6-15 What is the most common method used to compute finance charges? According to the Truth in Lending Act, lenders disclose the rate of interest that they charge and their method of computing finance charges. This is the annual percentage rate (APR), the true or actual rate of interest paid, which must include all fees and costs and be calculated as defined by law. The amount of interest you pay for open credit depends partly on the method the lender uses to calculate the balances on which they apply finance charges. Most bank and retail charge card issuers use one of two variations of the average daily balance (ADB) method, which applies the interest rate to the ADB of the account over the billing period. The most common method (used by an estimated 95 percent of bank card issuers) is the ADB, including new purchases. Card issuers can also use an ADB method that excludes new purchases. Balance calculations under each of these methods are as follows: • ADB, including new purchases: For each day in the billing cycle, take the outstanding balance, including new purchases, and subtract payments and credits; then divide by the number of days in the billing cycle. • ADB, excluding new purchases: Same as the first method, but excluding new purchases. 6-16 The monthly statement is a key feature of bank and retail credit cards. What does this statement typically disclose? If you use a credit card, you’ll receive monthly statements similar to the sample bank card statement in Exhibit 6.9, showing billing cycle and payment due dates, interest rate, minimum payment, and all account activity during the current period. Critical Thinking Problems 6.1 The Ramirez Family Seeks Some Credit Card Information Felipe and Lucia Ramirez are a newly married couple in their mid-20s. Conrad is a senior at a state university and expects to graduate in the summer of 2015. Lucia graduated last spring with a degree in marketing and recently started working as a sales rep for the Momentum Systems Corporation. She supports both of them on her monthly salary of $4,250 after taxes. The Ramirez’s currently pay all their expenses by cash or check. They would, however, like to use a bank credit card for some of their transactions. Because neither Felipe nor Lucia knows how to apply for a credit card, they approach you for help. Critical Thinking Questions 1. Advise the couple on how to fill out a credit application. The type of information requested in a typical credit application covers little more than personal/family matters, housing, employment and income, and existing charge accounts. It is important that the information on the application be correct and honest. False or misleading information will almost certainly result in outright rejection of your application. The key items that lenders look at are how much money you make, how much debt you have outstanding and how well you handle it, and how stable you are (for example, your age, employment history, whether you own or rent a home, and so on). 2. Explain to them the procedure that the bank will probably follow in processing their application. The steps involved are first to complete the application. Then the application will be reviewed and the data thereon will be checked with information from other sources such as a credit bureau. Further investigation by the bank may involve contacting references listed on the credit application. Generally, only in the case where a credit report cannot be obtained or when the credit report is marginal will the bank check credit references. 3. Tell them about credit scoring and how the bank will arrive at a credit decision. The bank will use some type of credit scoring scheme will be used to make the decision. An overall credit score is developed for you by assigning values to such factors as your annual income, whether you rent or own your home, number and types of credit cards you hold, level of your existing debts, whether you have savings accounts, and general credit references. Fifteen or 20 different factors or characteristics may be considered, and each characteristic receives a score based on some predetermined standard. The idea is that the more stable you are perceived to be, the more income you make, the better your credit record, and so on, the higher the score you should receive. In essence, statistical studies have shown that certain personal and financial traits can be used to determine your creditworthiness. Indeed, the whole credit scoring system is based on extensive statistical studies that identify the characteristics to look at and the scores to assign. 4. What kind of advice would you offer the Ramirez family on the “correct” use of their card? What would you tell them about building a strong credit record? Of course the simple advice is to only use the card for planned, budgeted purchases. Do not succumb to impulse buying. Raising your FICO score takes time, and there’s no quick fix. But here are some tips that you might want to follow to reach a higher score: • Pay your bills on time. • If you’ve missed payments, get current and stay current. • If you’re having trouble making ends meet, contact your creditors and work out a payment plan. • Keep credit card balances low. • Pay off debt rather than move it around. • Don’t open new credit cards just to increase your available credit. • Reestablish your credit history if you’ve had problems in the past. 6.2 June Starts Over After Bankruptcy A year after declaring bankruptcy and moving with her daughter back into her parents’ home, June Maffeo is about to get a degree in nursing. As she starts out in a new career, she also wants to begin a new life—one built on a solid financial base. June will be starting out as a full-time nurse at a salary of $52,000 a year, and she plans to continue working at a second (part-time) nursing job with an annual income of $10,500. She’ll be paying back $24,000 in bankruptcy debts and wants to be able to move into an apartment within a year and then buy a condo or house in five years. June won’t have to pay rent for the time that she lives with her parents. She also will have child care at no cost, which will continue after she and her daughter are able to move out on their own. While the living arrangement with her parents is great financially, the accommodations are “tight,” and June’s work hours interfere with her parents’ routines. Everyone agrees that one more year of this is about all the family can take. However, before June is able to make a move—even into a rented apartment—she’ll have to reestablish credit over and above paying off her bankruptcy debts. To rent the kind of place she’d like, she needs to have a good credit record for a year; to buy a home, she must sustain that credit standing for at least three to five years. Critical Thinking Questions 1. In addition to opening checking and savings accounts, what else might June do to begin establishing credit with a bank? Obviously, the first thing June has to do is pay back the $24,000 in bankruptcy debt— and the sooner that can be done, the better! She has to show that she now has the discipline to pay off the debt that she owes. She also has to be careful about taking on any new debt—though that probably will not be much of a problem, since she is likely to find new debt very hard to come by. Finally, if she has any monthly bills (like phone bills, etc.), she should make sure she always pays them on time. 2. Although June is unlikely to be able to obtain a major bank credit card for at least a year, how might she begin establishing credit with local merchants? She might look into the possibility of obtaining a charge card from one or two major department stores in her area. While June has to be careful about taking on new debt, she might be able to get approval for a charge card with a low credit limit—say, $250–$300. Then she has to make sure that she uses it judiciously and that she promptly pays the account balance in full each month. 3. What’s one way she might be able to obtain a bank credit card? Explain. For at least a year or so, probably the only way she will be able to obtain a bank credit card is to sign up for a secured credit card. Her first step will be to build a saving account. Then, June can do that by using part of her savings to purchase a CD, which will then act as collateral for the credit card. Again, she will have to take care to use the card sparingly and make payments on time, preferably in full, every month. 4. How often should June monitor her credit standing with credit reporting services? For the first year or two, June should monitor her credit report every six months, then after that, every year or so for the next five to seven years. If she finds any discrepancies in the report, she should contact the credit bureau immediately (in writing). If she is making progress in her fight to get out of debt, that should be reflected in her credit report. If it is not, she should let the credit bureau know. 5. What general advice would you offer for getting June back on track to a new life financially? June needs to know that it is possible to start over again. In addition, she should take the time to reflect on the past and determine what went wrong—knowing that, she can take steps to make sure it does not happen again. She should not overspend, not take on more debt than she can afford, and not let the debt build up. She should make sure that the repayment of the debt fits into her monthly budget and that she stays current on all her bills and credit lines. Terms Found in the Chapter
affinity cards A standard bank credit card issued in conjunction with some charitable, political, or other nonprofit organization.
annual percentage rate (APR) The actual or true rate of interest paid over the life of a loan; includes all fees and costs.
average daily balance (ADB) method A method of computing finance charges by applying interest charges to the ADB of the account over the billing period.
balance transfer A program that enables cardholders to readily transfer credit balances from one card to another.
bank credit card . A credit card issued by a bank or other financial institution that allows the holder to charge purchases at any establishment that accepts it.
base rate The rate of interest a bank uses as a base for loans to individuals and small to midsize businesses
cash advance A loan that can be obtained by a bank credit cardholder at any participating bank or financial institution.
credit bureau An organization that collects and stores credit information about individual borrowers.
credit counselor A professional financial advisor who assists overextended consumers in repairing budgets for both spending and debt repayment.
credit investigation An investigation that involves contacting credit references or corresponding with a credit bureau to verify information on a credit application.
credit limit A specified amount beyond which a customer may not borrow or purchase on credit.
credit scoring A method of evaluating an applicant’s creditworthiness by assigning values to such factors as income, existing debts, and credit references.
credit statement A monthly statement summarizing the transactions, interest charges, fees, and payments in a consumer credit account.
debt safety ratio The proportion of total monthly consumer credit obligations to monthly take-home pay.
grace period A short period of time, usually 20 to 30 days, during which you can pay your credit card bill in full and not incur any interest charges.
home equity credit line A line of credit issued against the existing equity in a home.
line of credit The maximum amount of credit a customer is allowed to have outstanding at any point in time.
minimum monthly payment In open account credit, a minimum specified percentage of the new account balance that must be paid in order to remain current.
open account credit A form of credit extended to a consumer in advance of any transaction.
overdraft protection line A line of credit linked to a checking account that allows a depositor to overdraw the account up to a specified amount.
personal bankruptcy A form of legal recourse open to insolvent debtors, who may petition a court for protection from creditors and arrange for the orderly liquidation and distribution of their assets.
prepaid card A plastic card with a magnetic strip or microchip that stores the amount of money the purchaser has to spend and from which is deducted the value of each purchase.
retail charge card A type of credit card issued by retailers that allows customers to charge goods and services up to a preestablished amount.
revolving line of credit A type of open account credit offered by banks and other financial institutions that can be accessed by writing checks against demand deposit or specially designated credit line accounts.
reward (co-branded) credit card A bank credit card that combines features of a traditional bank credit card with an additional incentive, such as rebates and airline mileage.
secured (collateralized) credit cards A type of credit card that’s secured with some form of collateral, such as a bank CD.
student credit card A credit card marketed specifically to college students.
unsecured personal credit line A line of credit made available to an individual on an as-needed basis.
Wage Earner Plan An arrangement for scheduled debt repayment over future years that is an alternative to straight bankruptcy; used when a person has a steady source of income and there is a reasonable chance of repayment within 3 to 5 years.
Chapter Outline Learning Goals I. The Basic Concepts of Credit A. Why We Use Credit B. Improper Uses of Credit C. Establishing Credit 1. First Steps in Establishing Credit 2. Build a Strong Credit History 3. How Much Credit Can You Handle? II. Credit Cards and Other Types of Open Account Credit A. Bank Credit Cards 1. Line of Credit 2. Cash Advances 3. Interest Charges 4. Other Fees B. Special Types of Bank Credit Cards 1. Reward Cards 2. Affinity Cards 3. Secured Credit Cards 4. Student Credit Cards C. Retail Charge Cards D. Debit Cards E. Revolving Credit Lines Overdraft Protection Unsecured Personal Lines Home Equity Credit Lines III. Obtaining and Managing Open Forms of Credit A. Opening an Account 1. The Credit Application 2. The Credit Investigation 3. The Credit Bureau B. The Credit Decision C. Computing Finance Charges D. Managing Your Credit Cards 1. The Statement 2. Payments IV. Using Credit Wisely A. Shop Around for the Best Deal B. Avoiding Credit Problems C. Credit Card Fraud D. Bankruptcy: Paying the Price for Credit Abuse 1. Wage Earner Plan 2. Straight Bankruptcy Planning over a lifetime Financial Impact of Personal Choices Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
