CH-7 Choosing a Source of Credit: The Costs of Credit Alternatives – Personal Finance : Chapter Notes

7 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—commercial banks, savings and loan associations, 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, we discuss the Fair Debt Collection Practices Act, consumer credit counseling, and the serious effects of debt. We describe the various private and governmental sources that assist consumers with debt problems. We explain the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Finally we explain and distinguish between the Chapter 7 and Chapter 13 bankruptcy laws to assess the choices in declaring personal bankruptcy. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: My Life LO 7-1 Analyze the major sources of consumer credit. The major sources of consumer credit are commercial banks, savings and loan associations, credit unions, finance companies, life insurance companies, and family and friends. Each of these sources has unique advantages and disadvantages. My Life LO 7-2 Determine the cost of credit by calculating interest with various interest formulas. Compare the finance charge and the annual percentage rate as you shop for credit. Under the Truth in Lending law, creditors are required to state the cost of borrowing so that you can compare credit costs and shop for credit. My Life LO 7-3 Develop a plan to manage your debt. The Fair Debt Collection Practices Act prohibits certain practices by debt collection agencies. Debt has serious effects if a proper plan for managing it is not implemented. My Life LO 7-4 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 your local Consumer Credit Counseling Service or other debt counseling organizations. 7-1 My Life LO 7-5 Assess the choices in declaring personal bankruptcy. A debtor’s last resort is to declare bankruptcy, permitted by the U.S. Bankruptcy Act of 1978. Consider the financial and psychological costs of bankruptcy before taking this extreme step. A debtor can declare Chapter 7 (straight) bankruptcy or Chapter 13 (wage earner plan) bankruptcy. INTRODUCTORY ACTIVITIES • Point out the What will this mean for me? on page 229. • Point out the learning objectives (p. 229) in an effort to highlight the key points in the chapter. • Ask students to comment on the My Life scenario for the chapter (p. 229). • 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. WHAT'S NEW TO THIS EDITION New Content: Predatory lending Revised content: Expensive loans Updated Did You Know feature Revised content: Cost of credit and expected inflation Updated Exhibit 7-6 Bankruptcy filings Revised content: Chapter 7 bankruptcy New Dashboard feature Defines predatory lending and how these lenders exploit lower-income and minority borrowers. Provides revised and updated examples. Gives updated information for using a credit card in a foreign country. Provides updated information about cost of credit and expected inflation. Includes new statistics for U.S. consumer bankruptcy filings for 2010-2012. Provides revised Chapter 7 bankruptcy filing court fees. Explains the importance of paying bills in a timely manner. 7-2 New Content: Predatory lending Revised content: Expensive loans Updated Did You Know feature Revised content: Cost of credit and expected inflation Updated Exhibit 7-6 Bankruptcy filings Revised content: Chapter 7 bankruptcy New Dashboard feature Defines predatory lending and how these lenders exploit lower-income and minority borrowers. Provides revised and updated examples. Gives updated information for using a credit card in a foreign country. Provides updated information about cost of credit and expected inflation. Includes new statistics for U.S. consumer bankruptcy filings for 2010-2012. Provides revised Chapter 7 bankruptcy filing court fees. Explains the importance of paying bills in a timely manner. CHAPTER 7 OUTLINE I. Sources of Consumer Credit A. What Kind of Loan Should You Seek? 1. Inexpensive Loans 2. Medium-priced Loans 3. Expensive Loans II. The Cost of Credit A. The Finance Charge and the Annual Percentage Rate (APR) 7-3 B. Tackling the Trade-Offs 1. Term Versus Interest Costs 2. Lender Risk versus Interest Rate 3. Variable Interest Rate 4. A Secured Loan 5. Upfront Cash 6. A Shorter Term C. Calculating the Cost of Credit 1. Simple Interest 2. Simple Interest on the Declining Balance 3. Add-On Interest 4. Cost of Open-End Credit 5. Cost of Credit and Expected Inflation 6. Cost of Credit and Tax Considerations 7. Avoid the Minimum Monthly Payment Trip D. When the Repayment Is Early: The Rule of 78s E. Credit Insurance F. Cost of Credit and the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (The Credit Card Act) III. Managing Your Debts A. Debt Collection Practices B. Warning Signs of Debt Problems C. The Serious Consequences of Debt IV. Consumer Credit Counseling Services A. What the CCCS Does B. Alternative Counseling Services V. Declaring Personal Bankruptcy A. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 1. Chapter 7 Bankruptcy 2. . Chapter 13 Bankruptcy B. Effect of Bankruptcy on Your Job and Your Future Credit C. Should a Lawyer Represent You in a Bankruptcy Case? 1. What are the Costs 7-4 CHAPTER 7 LECTURE OUTLINE Instructional Suggestions I. SOURCES OF CONSUMER CREDIT (p. 230) • Financial 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. 230) • Inexpensive Loans: Parents or family members; money borrowed on financial assets held by a lending institution. • Medium-Priced Loans: Commercial banks and credit unions. New car loans may cost 6 to 8 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%. • Use PPT slides 7-3 and 7-4. • Supplementary Resource: Contact the American Financial Services Association, 1101-14th St., NW, Washington, DC 20005 for a copy of Finance Facts and other information on consumer credit. • Exercise: Have students describe family financial situations that would use certain sources of consumer credit. • Use PPT slide 7-3. • Discussion Question: Ask students what are alternatives in financing a current purchase. • Current Example: People are persuaded to take loans priced way beyond their means, usually secured on their homes; eviction is often the price of default. • Text Highlight: Point out Exhibit 7-1 which shows the sources of consumer credit and their major features. (p. 233) • Practice Quiz 7-1 (p. 232) 7-5 CHAPTER 7 LECTURE OUTLINE Instructional Suggestions II. THE COST OF CREDIT (p. 234) • The Truth in Lending Law of 1969 requires creditors to state the cost of borrowing as a dollar amount. Two concepts to remember are the finance charge and the annual percentage rate. The Finance Charge and the Annual Percentage Rate (APR) (p. 234) • 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. 235) • 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. • 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. Calculating the Cost of Credit (p. 237) • The two most common methods of calculating interest are compound and simple interest formulas. • Simple interest is the interest computed on principal only and without compounding; it is the dollar cost of borrowing money. • The simple interest formula is: I = P  r  T. The APR formula is: APR = 2  n  1 P(N+1) • Simple interest on the declining balance. When more than one payment is made on a simple interest loan, the method of computing interest is known as the declining balance method. • Add-on interest: When the add-on interest method is used, interest is calculated on the full amount of the original principal. • Transparency Master: Use Master 7-1 to demonstrate the differences in interest charges with different finance charge methods. • Text Highlight: Point out the “Financial Planning Calculations” box on p. 236 for the arithmetic of the annual percentage rate. • Use PPT slide 7-5. • Current Example: Credit catch-22 for buyers with no borrowing history, getting a car loan can be a challenge. • Discussion Question: What methods can be used to compare different types of loans and credit plans? • Supplementary Resources: Contact the Bankcard Holders of America, 560 Herndon Parkway, Herndon, VA 22070, to obtain a copy of Credit Card Rate List. Truth in Lending Simplified is available from the Federal Reserve Bank of New York, Public Information Dept., 33 Liberty St., New York, NY 10045; and a sample of the Bank Credit Card Observer from 3086 Old Lincoln Highway, Kendall Park, NJ 08824. • Use PPT slide 7-7. 7-6 CHAPTER 7 LECTURE OUTLINE 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? • 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. • Cost of credit and tax considerations. The Tax Reform Act of 1986 did not affect the deductibility of home mortgage interest, but beginning in 1991 you can no longer deduct interest paid on consumer loans. When the Repayment is Early: The Rule of 78’s (p. 243) • Creditors use the rule of 78’s, also called “the sum of the digits.” to determine how much interest has been paid at any point in a loan. • The Truth in Lending law requires that creditors disclose whether or not you are entitled to a rebate of the finance charge if the loan is paid off early. Credit Insurance (p. 245) • 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. Cost of Credit and the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (The Credit Card Act) (p. 245) • Use PPT slides 7-8 through 7- 10. • Text Reference: Point out the different methods that are used to compute the finance charge on a credit card or a charge account. (p. 239) • Use PPT slides 7-9, • Transparency Master 7-2: shows three methods of computing finance charges. • Transparency Master 7-3: Show an example of the Rule of 78s. • Text Highlight: Point out the “Did You Know?” feature on page 242. • Text Highlight: Point out Financial Planning Calculations box on page 244 (Other methods of determining the cost of credit). • Practice Quiz 7-2 (p. 246) 7-7 CHAPTER 7 LECTURE OUTLINE Instructional Suggestions III. MANAGING YOUR DEBTS (p. 246) • 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. Debt Collection Practices (p. 246) • The Federal Trade Commission enforces the Fair Debt Collection Practices Act, which prohibits certain practices by agencies that collect debts for creditors. Warning Signs of Debt Problems (p. 247) • 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. 249) • Excessive indebtedness may result in heavy drinking, a neglect of children, marital difficulties, and drug abuse. But help is available to those who seek it. • Use PPT slides 7-11 through 7- 14. • Supplementary Resource: Manage your debt with Money calculators. To stay in control of your debt, visit www.money.com/tools. • Text Highlight: Point out Exhibit 7-2 (p. 247) which summarizes the steps one may take if a debt collector calls. (Use Transparency Master 7-4). • Current Example: Use Visa’s practical advice to make the most of your money. Visit www.visa.com/ct/main.html. • Use PPT slide 7-14 and 7-15 • Supplementary Resources: Two dedicated debt-reduction software programs are Zilch, $37; Practical Applications; compatible with Windows 3.1/95; 301-932-7027; and Debt Analyzer 97, $28; Insight Software Solutions; compatible with Windows 3.1/95/NT; 801-295-1890. • Text Reference: Point out Exhibit 7-3 (p. 248 which lists reasons why consumers don’t pay their debts. • Discussion Question: What actions are commonly recommended if a person has difficulty making credit payments? • Text Highlight: Point out Exhibit 7-4 (p. 249) which lists the danger signals of potential debt problems. • Practice Quiz 7-3 (p. 250) 7-8 CHAPTER 7 LECTURE OUTLINE Instructional Suggestions IV. CONSUMER CREDIT COUNSELING SERVICES (p. 250) • A Consumer Credit Counseling Service is a local, non-profit organization affiliated with the National Foundation for Consumer Credit. It provides debt counseling services for families and individuals with serious financial problems What the CCCS Does (p. 251) • The CCCS aids families with serious debt problems by helping them manage their money better, and through education. • Anyone overburdened by credit obligations can phone, write, or visit a CCCS office. The CCCS requires that an application for credit counseling be filled, and then an appointment is arranged for a personal interview with the applicant. Alternative Counseling Services (p. 252) • Counseling services are also available from universities, military bases, credit unions, local county extension agents, and state and federal housing authorities. • Use PPT slide 7-16 through 7- 18 • Exercise: Have students present a role playing situation between a credit counselor and a person with financial difficulties. • Current Example: Once upon a time, only deadbeats had money garnisheed from their wages. But now you can choose payroll deduction to pay off your debts every month. • Supplementary Resource: Talk to a credit counselor to obtain information about common causes of credit problems and suggestions to avoid and solve these difficulties. • Use PPT slide 7-17. • Practice Quiz 7-4 (p. 253 ) 7-9 CHAPTER 7 LECTURE OUTLINE Instructional Suggestions V. DECLARING PERSONAL BANKRUPTCY (p. 254) • Debt burden, unemployment, divorce rates, and household net worth are all indicators of personal bankruptcies. However, the Bankruptcy Recovery Act of 1978, which made personal bankruptcy easier, is also considered an important cause of the increase in personal bankruptcies. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (p. 255). • In a Chapter 7 bankruptcy, a debtor is required to draw up a petition listing his or her assets and liabilities. Chapter 7 bankruptcy grants a debtor a chance to make a fresh start in life. • Chapter 13 bankruptcy. A debtor with a regular income proposes to a bankruptcy court a plan for extinguishing his or her debts from future earnings. Effect of Bankruptcy on Your Job and Your Future Credit (p. 256) • 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. Should a Lawyer Represent You in a Bankruptcy Case? (p. 257) • Although it is possible to reduce costs by purchasing the legal forms in a local stationery store and completing them yourself, an attorney is strongly recommended. • Use PPT slide 7-19 through 7- 25. • Current Example: The 2005 bankruptcy law makes it tougher for Americans to escape their debts by filing for bankruptcy. • 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. • Use PPT slide 17-23. • Text Highlight: Point out the “Financial Planning for Life’s Situations” box on page 258 and let students take the credit IQ quiz. • Class Activities: Show PPT slides 7-21 and 7-22. • Practice Quiz 7-5 (p. 258) 7-10 CONCLUDING ACTIVITIES • Use the "My Life Stage" feature to highlight the main financial planning activities from the chapter for various ages and life situations. • Point out the summary of learning objectives (p. 260), key formulas (p. 261), and key terms in the text margin (p. 260). • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Financial Planning Case (pp. 262-264). • Have students do one or more of the end-of-chapter activities (p. 263). • Use Chapter Quiz in the Instructor’s Manual. WORKSHEETS FROM PERSONAL FINANCIAL PLANNER FOR USE WITH CHAPTER 7 Use the "Your Personal Financial Planner in Action" activities to encourage students to plan and implement various personal financial decisions. Sheet 30 Credit Card/Charge Account Comparison Sheet 31 Consumer Loan Comparison CHAPTER 7 QUIZ ANSWERS True-False Multiple Choice 1. T (p. 230) 6. B (p. 234) 2. T (p. 233) 7. D (p. 233) 3. F (p. 234) 8. A (p. 231) 4. F (p. 237) 9. C (p. 239) 5. T (p. 246) 10. A (p. 250) 7-11 Name ________________________________________ Date____________________________ CHAPTER 7 QUIZ TRUE-FALSE 1 . Parents or family members are often the source of the least expensive loans. 2. The consumer finance companies specialize in personal installment loans and second mortgages. 3. The finance charge is the percentage cost (or relative cost) of credit on a yearly basis. 4. ThThe most basic method of calculating interest is the compound interest formula. 5. The Federal Trade Commission enforces the Fair Debt Collection Practices Act. MULTIPLE CHOICE _____6. The best method of comparing credit cost is the a. rule of 78s. b. finance charge and the APR. c. declining balance method. d. add-on and adjusted balance method. _____7. Which consumer credit source often lend to consumers without established credit history? a. Commercial bank b. Savings and loan association c. Credit union d. Finance company 8. You can often obtain medium-priced loans from a. commercial banks and credit unions. b. parents or family members. c. banks through credit cards. d. finance companies and retailers. 9. 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. 7-12 10 . A Consumer Credit Counseling Service is a a. local, nonprofit organization affiliated with the National Foundation for Consumer Credit. b. profit organization operated by the Better Business Bureau. c. governmental institution. d. lending institution that helps families with severe financial difficulties. 7-13 SUPPLEMENTARY LECTURE 7-1 Fair Debt Collection * If you use credit cards, owe money on a personal loan, or are paying on a home mortgage, you are a “debtor.” If you fall behind in repaying your creditors, or an error is made on your accounts, you may be contacted by a “debt collector.” You should know that in either situation, the Fair Debt Collection Practices Act requires that debt collectors treat you fairly and prohibits certain methods of debt collection. Of course, the law does not erase any legitimate debt you owe. This brochure answers commonly asked questions about your rights under the Fair Debt Collection Practices Act. What debts are covered? Personal, family, and household debts are covered under the Act. This includes money owed for the purchase of an automobile, for medical care, or for charge accounts. Who is a debt collector? A debt collector is any person who regularly collects debts owed to others. This includes attorneys who collect debts on a regular basis. How may a debt collector contact you? A collector may contact you in person, by mail, telephone, telegram, or fax. However, a debt collector may not contact you at inconvenient times or places, such as before 8 a.m. or after 9 p.m., unless you agree. A debt collector also may not contact you at work if the collector knows that your employer disapproves of such contacts. Can you stop a debt collector from contacting you? You can stop a debt collector from contacting you by writing a letter to the collector telling them to stop. Once the collector receives your letter, they may not contact you again except to say there will be no further contact or to notify you that the debt collector or the creditor intends to take some specific action. Please note, however, that sending such a letter to a collector does not make the debt go away if you actually owe it. You could still be sued by the debt collector or your original creditor. May a debt collector contact anyone else about your debt? If you have an attorney, the debt collector must contact the attorney, rather than you. If you do not have an attorney, a collector may contact other people, but only to find out where you live, what your pone number is, and where you work. Collectors usually are prohibited from contacting such third parties more than once. In most cases, the collector may not tell anyone other than you and your attorney that you owe money. What must the debt collector tell you about the debt? * Source: http://www.ftc.gov/bcp/conline/pubs/credit/fdc.htm, March 27, 2013 7-14 Within five days after you are first contacted, the collector must send you a written notice telling you the amount of money you owe; the name of the creditor to whom you owe the money; and what action to take if you believe you do not owe the money. May a debt collector continue to contact you if you believe you do not owe money? A collector may not contact you if, within 30 days after you receive the written notice, you send the collection agency a letter stating you do not owe money. However, a collector can renew collection activities if you are sent proof of the debt, such as a copy of a bill for the amount owed. What types of debt collection practices are prohibited? Harassment. Debt collectors may not harass, oppress, or abuse you or any third parties they contact. For example, debt collectors may not: • Use threats of violence or harm; • Publish a list of consumers who refuse to pay their debts (except to a credit bureau); • Use obscene or profane language; or • Repeatedly use the telephone to annoy someone. False statements. Debt collectors may not use any false or misleading statements when collecting a debt. For example, debt collectors may not: • Falsely imply that they are attorneys or government representatives; • Falsely imply that you have committed a crime; • Falsely represent that they operate or work for a credit bureau; • Misrepresent the amount of your debt; • Indicate that papers being sent to you are legal forms when they are not; or • Indicate that papers being sent to you are not legal forms when they are. Debt collectors also may not state that: • You will be arrested if you do not pay your debt; • They will seize, garnish, attach, or sell your property or wages, unless the collection agency or creditor intends to do so, and it is legal to do so; or • Actions, such as a lawsuit, will be taken against you, when such action legally may not be taken, or when they do not intend to take such action. Debt collectors may not: • Give false credit information about you to anyone, including a credit bureau; • Send you anything that looks like an official document from a court or government agency when it is not; or • Use a false name. Unfair practices. Debt collectors may not engage in unfair practices when they try to collect a debt. For example, collectors may not: • collect any amount greater than your debt, unless your state law permits such a charge; • deposit a post-dated check prematurely; • use deception to make you accept collect calls or pay for telegrams; • take or threaten to take your property unless this can be done legally; or 7-15 • contact you by postcard. What control do you have over payment of debts? If you owe more than one debt, any payment you make must be applied to the debt you indicate. A debt collector may not apply a payment to any debt you believe you do not owe. What can you do if you believe a debt collector violated the law? You have the right to sue a collector in a state or federal court within one year from the date the law was violated. If you win, you may recover money for the damages you suffered plus an additional amount up to $1,000. Court costs and attorney' s fees also can be recovered. A group of people also may sue a debt collector and recover money for damages up to $500,000, or one percent of the collector' s net worth, whichever is less. Where can you report a debt collector for an alleged violation? Report any problems you have with a debt collector to your state Attorney General' s office and the Federal Trade Commission. Many states have their own debt collection laws, and your Attorney General' s office can help you determine your rights. 7-16 SUPPLEMENTARY LECTURE: 7-2 FTC Testifies about Credit Counseling Abuses* Testimony Says that Some Firms Are Deceiving Consumers Although credit counseling can provide financially distressed consumers with valuable assistance, according to the Federal Trade Commission, some firms may be misleading consumers about who they are, what they do, or how much they charge. In Commission testimony submitted today before the Senate Committee on Governmental Affairs, the Permanent Subcommittee on Investigations, FTC Commissioner Thomas Leary cautioned that some companies use their non-profit status as a badge of trustworthiness to attract customers, who are then duped into paying large fees. Those fees are sometimes funneled to for-profit companies. Leary explained that instead of teaching consumers about their finances and how to manage debt as it promised, some credit counseling agencies (CCAs) indiscriminately enroll their clients in “debt management plans” (DMPs) without regard to their particular financial situation. This kind of debt management – under which consumers pay debt managers who then pay their creditors – can be beneficial for some consumers, but not for all. “Along with these changes in the industry have come complaints about troubling practices, including possible deception about the services offered, poor administration of DMPs, and undisclosed fees associated with DMPs,” Leary said. Leary stated that the FTC’s greatest concern is deception by CCAs about the nature and costs of their services, including the following practices: • Failure to pay creditors in a timely manner or at all. Some credit counseling agencies that offer debt management plans may fail to pay creditors in a timely fashion or at all. This can result in serious consumer harm, such as late fees that the creditors impose. • Promises of results that cannot be delivered. Some agencies promise that they will lower consumers’ interest rates, monthly payments, or overall debt by an unrealistic amount. Some also make false promises to eliminate accurate negative information from consumers’ credit reports. • Failure to abide by telemarketing laws. To the extent that these agencies are not bona fide non-profit organizations, they must comply with the FTC’s Telemarketing Sales Rule, including the National Do-Not-Call Registry. “The Commission has pursued a vigorous program to halt fraud and deception by those who purport to be able to solve consumers’ financial difficulties,” Leary stated. The testimony listed several Commission actions, including a November 2003 lawsuit against AmeriDebt – a large, Maryland-based credit counseling firm that, according to the FTC’s complaint, aggressively advertises itself as a non-profit dedicated to assisting consumers with their finances. The FTC complaint further alleges that AmeriDebt advertises its services as “free,” when in fact the company retains a consumer’s entire first payment as a “contribution.” In addition to the AmeriDebt litigation, Leary explained that the FTC’s law enforcement efforts currently include several non-public investigations of credit counseling agencies. The Commission’s testimony also mentions a February 2004 lawsuit against two debt negotiation companies (Innovative Systems Technology, Inc., and Debt Resolution Specialists, Inc.), a September 2002 lawsuit against another debt negotiation company (Jubilee Financial Services, Inc.), and numerous cases under the Credit Repair * Source: http://www.ftc.gov/opa/2004/03/credittestimony.htm, February 28, 2005 7-17 Organizations Act (CROA), including sweeps like Operation Eraser and Operation New ID-Bad IDea. Leary explained that the FTC has engaged in extensive consumer education efforts to help protect consumers from credit counseling and credit repair scams. Most recently, the FTC and the Internal Revenue Service (IRS) jointly issued tips for choosing a credit counseling organization. Those tips advise consumers to: • Pay careful attention to the fees an agency charges, the nature of the services it offers, and the terms of the contract; • Make sure that creditors are willing to work with the agency the consumer plans to choose; and • Consider using agencies that offer actual counseling and education, instead of simply enrolling all clients in DMPs. The testimony stated that credit counseling can provide valuable assistance to consumers in financial distress, and that many, if not most, CCAs operate honestly and fairly. Consumers who fall victim to the types of practices discussed in the testimony, however, “may find themselves in even more dire financial straits than before,” Leary said. He concluded that the FTC remains committed to working with its law enforcement partners to protect consumers against financial fraud and deception. The Commission vote to approve the testimony was 5-0. Copies of the testimony are available from the FTC’s Web site at http://www.ftc.gov and also from the FTC’s Consumer Response Center, Room 130, 600 Pennsylvania Avenue, N.W., Washington, D.C. 20580. The FTC works for the consumer to prevent fraudulent, deceptive, and unfair business practices in the marketplace and to provide information to help consumers spot, stop, and avoid them. To file a complaint, or to get free information on any of 150 consumer topics, call toll-free, 1-877-FTC-HELP (1 877-382-4357), or use the complaint form at http://www.ftc.gov. The FTC enters Internet, telemarketing, identity theft, and other fraud-related complaints into Consumer Sentinel, a secure, online database available to hundreds of civil and criminal law enforcement agencies in the U.S. and abroad. 7-18 SUPPLEMENTARY LECTURE: 7-3 Advertisements Promising Debt Relief May Be Offering Bankruptcy* Washington, D.C. -- Debt got you down? You’re not alone. Consumer debt is at an all time high. What’s more, record numbers of consumers are filing for bankruptcy. Whether your debt dilemma is the result of an illness, unemployment, or simply overspending, it can seem overwhelming. In your effort to get solvent, be on the alert for advertisements that offer seemingly quick fixes. While the ads pitch the promise of debt relief, they rarely say relief may be spelled bankruptcy. And although bankruptcy is one option to deal with financial problems, it’s generally considered the option of last resort. The reason: its long term negative impact on your creditworthiness. A bankruptcy stays on your credit report for 10 years, and can hinder your ability to get credit, a job, insurance, or even a place to live. The Federal Trade Commission (FTC) cautions consumers to read between the lines when faced with ads in newspapers, magazines or even telephone directories that say: “Consolidate your bills into one monthly payment without borrowing.” “STOP credit harassment, foreclosures, repossessions, tax levies and garnishments,” “Keep Your Property.” “Wipe out your debts! Consolidate your bills! How? By using the protection and assistance provided by federal law. For once, let the law work for you!” You’ll find out later that such phrases often involve bankruptcy proceedings, which can hurt your credit and cost you attorneys’ fees. If you’re having trouble paying your bills, consider these possibilities before considering filing for bankruptcy: • Talk with your creditors. They may be willing to work out a modified payment plan. • Contact a credit counseling service. These organizations work with you and your creditors to develop debt repayment plans. Such plans require you to deposit money each month with the counseling service. The service then pays your creditors. Some nonprofit organizations charge little or nothing for their services. • Carefully consider a second mortgage or home equity line of credit. While these loans may allow you to consolidate your debt, they also require your home as collateral. If none of these options is possible, bankruptcy may be the likely alternative. There are two primary types of personal bankruptcy: Chapter 13 and Chapter 7. Each must be filed in federal bankruptcy court. . The consequences of bankruptcy are significant and require careful consideration. Chapter 13 allows you, if you have a regular income and limited debt, to keep property, such as a mortgaged house or car, that you otherwise might lose. In Chapter 13, the court approves a repayment plan that allows you to pay off a default during a period of three to five years, rather than surrender any property. Chapter 7, known as straight bankruptcy, involves liquidating all assets that are not exempt. Exempt property may include cars, work related tools and basic household furnishings. Some property may be sold by a court appointed official—a trustee—or turned over to creditors. You can receive a discharge of your debts under Chapter 7 only once every six years. SUPPLEMENTARY LECTURE: 7-4 * Source: http://www.ftc.gov/bcp/conline/pubs/alerts/bankrupt.htm.. 7-19 IRS Takes Steps to Ensure Credit Counseling Organizations Comply With Requirements for Tax- Exempt Status* For decades, many organizations have provided valuable credit counseling and education that assist consumers in putting their personal finances in order. The Internal Revenue Service continues to view organizations that counsel and educate consumers as qualifying for tax exemption under Section 501(c)(3) of the Internal Revenue Code. However, federal and state officials have become increasingly aware that as the market for consumer credit has undergone changes in the past 30 years, so have some of the entities that offer services to debtors. Many of these services do not provide meaningful education or counseling. For example, some organizations put their clients on fixed payment plans to pay down their debt. But an organization that offers only this service, without significant education and counseling, would not qualify for tax-exempt status. IRS officials are concerned that some credit counseling organizations that might have qualified for tax- exempt status in the past may no longer qualify due to changes in the services they provide. This problem is magnified because the organizations, by reason of their tax exemption, are exempted from many state and federal consumer protections. For example, the Credit Repair Organization Act of 1997 sought to further regulate the practice of for-profit organizations involved in “credit repair,” a series of activities aimed at improving a customer’s credit history. But the Act exempted Section 501(c)(3) organizations from the provisions of this law. A similar pattern of exceptions for tax-exempt organizations is replicated in many state consumer laws. The IRS is concerned that the combination of tax-exempt status and exemption from consumer protections may leave certain taxpayers vulnerable. To address this concern, the Exempt Organizations (EO) office of the IRS has taken the following steps: • Credit counseling organizations submitting applications for exemption will only receive that status after a full review, which includes answering additional questions and a close analysis of the marketing materials the organizations distribute. The aim is to ensure that the organizations’ activities qualify for tax exemption. . • EO officials held sessions to train both those reviewing new applications for exempt organization status and those examining existing qualified organizations. Developed in conjunction with state charity officials and the Federal Trade Commission, these training sessions focused on changes in the credit counseling industry and their implications for the EO office. • EO has initiated a project to address concerns in this area and to recommend strategies. A number of examinations of consumer credit services organizations have commenced. The results of these examinations will be monitored to assess the extent to which tax-exempt credit counseling organizations are operating in a manner that conforms with the laws and regulations governing Section 501(c)(3) status. • EO officials are conducting outreach with the consumer credit industry and attorneys practicing in this area and speaking to them on the tax rules relating to non-profit consumer credit organizations. * Source: http://www.irs.gov/uac/IRS-Takes-Steps-to-Ensure-Credit-Counseling-Organizations-Comply-With- Requirements-for-Tax-Exempt-Status. 7-20 SUPPLEMENTARY LECTURE: 7-5 Out of Work? How to Deal with Creditors It’s become an all-too-familiar headline and lead story—job cuts, dot.com failures, corporate restructuring and lay-offs. If you’ve recently lost your job, your first thoughts may be, “how will I make ends meet.” Money matters are a source of stress and frustration for many people. The Federal Trade Commission (FTC) publishes free brochures spelling out your rights when it comes to fair debt collection and credit reporting practices. Fair Debt Collection If you find that you can’t pay your bills on time, contact your creditors immediately. Try to work out a modified payment plan that reduces your payments to a more manageable level. Don’t wait until your accounts have been turned over to a debt collector. At that point, your creditors have given up on you. The federal Fair Debt Collection Practices Act requires debt collectors to treat you fairly by prohibiting certain methods of debt collection. To learn more, call the FTC’s Consumer Response Center for a free copy of Fair Debt Collection, or visit www.ftc.gov. Fair Credit Reporting Non-payment and late payments may affect your credit rating and your ability to get credit in the future. Although creditors usually consider a number of factors in deciding whether to grant credit, most creditors rely heavily on your credit history. That’s one reason it’s important to make sure your credit report is accurate. For example, if your file showed that you were once late in making payments, but didn’t show that you are no longer delinquent, it would be inaccurate. The credit reporting agency must show that your payments now are current. The Fair Credit Reporting Act protects you by requiring credit bureaus to furnish correct and complete information to businesses to use in evaluating your applications for credit, insurance or a job. For more information, request a free copy of Fair Credit Reporting. The FTC works for the consumer to prevent fraudulent, deceptive and unfair business practices in the marketplace and to provide information to help consumers spot, stop and avoid them. To file a complaint or to get free information on consumer issues, visit www.ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357); TTY: 1-866-653-4261. The FTC enters Internet, telemarketing, identity theft and other fraud-related complaints into Consumer Sentinel, a secure, online database available to hundreds of civil and criminal law enforcement agencies in the U.S. and abroad.  Source: http://www.ftc.gov/bcp/conline/pubs/alerts/outwkalrt.htm 7-21 .SUPPLEMENTARY ACTIVITY: 7-1 Credit Repair Clinics: No Rx for Bad Debt* Credit clinics promise miracle cures, but only time can heal bad credit. No one can remove accurate negative information from your credit report. If it contains inaccurate information, however, you can dispute it at no charge. “Turned down because of bad credit? We can help!” Buyer beware. The miracle cures promised on late-night television and in classified advertisements usually end with consumers as victims of malpractice. Credit repair organizations, also known as “credit clinics,” claim to remove negative information from a consumer’s credit report. Or they promise a bankcard “regardless of previous credit history.” Their fees can be substantial, ranging from hundreds to thousands of dollars. CORRUPTING CONSUMER PROTECTIONS Operating on the edge and even outside of the law, credit clinics abuse laws and policies established to protect consumers. They saturate credit reporting agencies’ consumer assistance systems with multiple disputes, hoping that accurate negative information will be erased from a client’s credit files. This tactic rarely works. Experian, and other credit bureaus, are skilled at recognizing credit clinics, negating their success. COSTLY FOR CONSUMERS, BUREAUS, AND LENDERS Still, credit clinics have a powerful, negative impact on: • Their own clients, who learn an expensive lesson. Legitimate negative information remains on their credit files, and their fees are rarely refunded. • Credit bureaus, which waste time and money to review and respond to frivolous claims, estimated at up to 30 percent of the consumer assistance workload. • Lenders, who face greater difficulty making prudent credit granting decisions without accurate, complete credit information. This increases the cost of credit for all consumers. • Consumers with legitimate complaints, who lose the time and attention they deserve to solve their problems. The only winners are the credit clinics themselves, which frequently collect their fees and move to new areas to victimize new consumers. * Reports on Credit is published by the Experian Consumer Education Department to help consumers better understand important credit and other financial issues. You may reproduce and distribute this report. For more information, call 972-390-3525 or visit the web site at www.experian.com. 7-22 THE CREDIT REPAIR TRUTH Credit clinics would never tell uninformed consumers these facts: • Virtually everything a credit repair clinic does legally can be done by consumers themselves for free or at minimum cost. • No one can legally remove accurate information from a credit report. Federal law provides that negative information can remain on the credit report for up to seven years (up to ten years for bankruptcies). So only time can erase bad credit. • Any consumer can dispute inaccurate information at no charge. Experian credit reports contain an easy-to-complete dispute form to help consumers challenge inaccurate information. • There are no miracle cures for bad credit. If you need help repaying creditors, managing debt, or setting up a personal budget, contact Consumer Credit Counseling Services. CCCS is a reputable, nonprofit organization with more than 1,300 offices nationwide. (1-800-388-CCCS) LENDERS WANT TO SAY “YES” Remember that credit grantors are in business to lend you money. However, their livelihood depends on extending credit only to consumers who repay their debts. Accurate credit reports are one tool they rely on to make sound, impartial decisions. If credit repair clinics’ actions distort credit histories, creditors risk increased losses from bad debts. These losses will be passed on to other customers like you. HELP IS AVAILABLE Experian recognizes that the credit process sometimes is confusing. If you have a question or problem, simply call 1-800-682-7654. Consumer assistance representatives are there to help you. 7-23 SUPPLEMENTARY ACTIVITY: 7-2 The Fair Credit Reporting Act* Federal law restricts who may see a copy of your credit report. You may request a copy, of course. But the Fair Credit Reporting Act prohibits others from seeing it without specific legitimate reasons. The Fair Credit Reporting Act (FCRA) protects your rights as a credit-active consumer. Enacted by the U.S. Congress in 1970, the FCRA took effect in 1971. Perhaps its most important provision is the restriction it places on who may see a copy of your credit report. You may request a copy, of course. But credit grantors, insurance underwriters, and employers can see your report only when they intend to use the information: • In connection with a credit transaction • For employment purposes • To underwrite insurance • In connection with a legitimate business need • In response to a court order or federal grand jury subpoena If you apply for a government license or other benefit, a government agency may obtain a copy of your report to determine your eligibility but only when the law requires the agency to consider your financial responsibility or status. ERASING BAD MARKS Another consumer protection of the FCRA prevents past errors from haunting you forever. The law requires credit bureaus to delete serious negative credit information from your credit report after a certain number of years. Bankruptcies, for example, remain no more than 10 years. Tax liens, lawsuits, and judgments are erased after seven years. Similarly, accounts placed for collection or written off by the creditor can stay on your report no more than seven years. (State laws also govern the retention of data on your credit report. Whenever state laws are stricter than the federal law, Experian abides by the state laws.) By requiring negative information to be deleted, the law allows credit-active consumers to rebuild a positive credit history over time. Positive information stays on your report indefinitely. * Reports on Credit is published by the Experian Consumer Education Department to help consumers better understand important credit and other financial issues. You may reproduce and distribute this report. For more information, call 972-390-3525 or visit the web site at www.experian.com. 7-24 ADDITIONAL PROTECTIONS Following are some of the FCRA’s other consumer protections: • If you are denied credit, you may obtain a copy of your credit report free of charge if you ask for it within 60 days of the denial. • When credit is denied based on information in a credit report, the credit grantor must tell you the name and address of the credit bureau used to secure the information. • Consumers are encouraged to review a full copy of their report before disputing any item. • Consumers may direct disputes to the credit reporting agency. The credit agency then must investigate the item within “a reasonable time.” (Reasonable time” is generally interpreted to be within 30 days.) • Your report must reveal who has received a copy within the past two years for employment purposes or within the past six months for any other purpose. 7-25 ANSWERS TO PRACTICE QUIZZES, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND FINANCIAL PLANNING CASE PRACTICE QUIZZES Practice Quiz 7-1 (p. 232) 1. What are the major sources of consumer credit? Major sources of consumer credit are commercial banks, consumer finance companies, credit unions, life insurance companies, and savings and loan associations. (Exhibit 7-1) 2. What are some advantages and disadvantages of securing a loan from a credit union? From a finance company? Credit unions will make unsecure loans at reasonable interest rates and may offer a variety of repayment schedule. However, credit unions lend to members only, may require a cosigner and payroll deduction to pay off the loan. Also, credit unions may submit large loan applications to a committee of members for approval. Practice Quiz 7-2 (p. 246) 1. Distinguish between the finance charge and the annual percentage rate. The finance charge is the total dollar amount you pay to use credit. It includes interest costs and sometimes other costs, such as service charges, credit-related insurance premiums, or appraisal fees. 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. 2. What are the three variations of simple interest formula? Simple interest on the declining balance, add-on interest, bank discount, and compound interest are variations of simple interest. 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. 4. What is the rule of 78s? Creditor use tables based on a mathematical formula called the rule of 78s, or sometimes “the sum of the digits,” to determine how much interest you have paid at any point in a loan. This formula 7-26 dictates that you pay more interest at the beginning of a loan, when you have the use of more of the money, and that you pay less and less interest as the debt is reduced. Because all of the payments are the same in size, the part going to pay back the amount borrowed increases as the part representing interest decreases. The laws of several states authorize the use of the rule of 78s as a means of calculating finance charge rebates when you pay off a loan early. The Truth in Lending law requires that your creditor disclose whether or not you are entitled to a rebate of the finance charge if the loan is paid off early. Practice Quiz 7-3 (p. 250) 1. What is the Fair Debt Collection Practices Act? The Fair Debt Collection Practices Act prohibits certain practices by agencies that collect debts for creditors. The Act does not apply to creditors that collect debts themselves. While the act does not erase the legitimate debts that consumers owe, it does regulate the ways in which debt collection agencies do business. The Federal Trade commission enforces the Fair Debt Collection Practices Act. 2. 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. 3. What are the common danger signals of potential debt problems? The 16 Danger Signals of Potential Debt Problems* 1. Paying only the minimum balance each month on credit card bills 2. Increasing the total balance due each month on credit accounts 3. Missing payments, paying late, or paying some bills this month and others next month 4. Intentionally using the overdraft or automatic loan features on checking accounts or taking frequent cash advances on credit cards 5. Using savings to pay normal bills such as groceries or utilities 6. Receiving second or third notices from creditors 7. Not talking to your spouse about money or talking only about money 8. Depending on overtime, moonlighting, or bonuses to meet normal expenses 9. Using up your savings 10. Borrowing money to pay old debts 11. Not knowing how much you owe until the bills arrive 12. Going over your credit limit on credit cards 13. Having little or nothing in savings to handle unexpected expenses 14. Being denied credit because of a negative credit bureau report 15. Getting a credit card revoked by the issuer 16. Putting off medical or dental visits because you can’t afford them right now * Source: Advice for Consumers Who Use Credit (Silver Springs, MD: Consumer Credit Counseling Service of Maryland, Inc., n.p., n.d.) 7-27 If your household is experiencing more than two of these warning signals, it’s time to examine your budget for ways to reduce expenses. Practice Quiz 7-4 (p. 253) 1. What is the Consumer Credit Counseling Services (CCCS)? Consumer Credit Counseling Services (CCCS) is a local, non-profit organization affiliated with the National Foundation for Consumer Credit. It provides debt-counseling services for families and individuals with serious financial problems. The CCCS is 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. 2. What are the two major activities of a Consumer Credit Counseling Service? 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. c. Anyone overburdened by credit obligations can phone, write, or visit a CCCS office. Over 1300 CCCS offices are located all over the nation. The CCCS requires that an application for credit counseling be completed, and then an appointment is arranged for a personal interview with the applicant. CCCS counseling is usually free. However, when the CCCS administers a debt repayment plan, it sometimes charges a nominal fee to help defray administrative costs. 3. Alternative Counseling Services In addition to the counseling services of the CCCS, nonprofit counseling services are sometimes provided by universities, military bases, credit unions, local county extension agents, and state 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 counseling services. Practice Quiz 7-5 (p. 258) 1. What is the purpose of Chapter 7 bankruptcy? The purpose of bankruptcy under Chapter 7 is to grant to the honest debtor who is overwhelmed by his debts, a chance to make a fresh start in life and remain a useful member of society by relieving him of the oppressive burden of his debts. 7-28 2. What is the difference between a Chapter 7 and Chapter 13 bankruptcy? In Chapter 7 bankruptcy, a debtor is required to draw up a petition listing his or her assets and liabilities. The debtor submits the petition to a U.S. district court and pays a filing fee. A person filing for relief under the bankruptcy code is called a debtor; the term bankrupt is not used. The discharge of debts in Chapter 7 does not affect alimony, child support, certain taxes, fines, certain debts arising from educational loans, or debts that you fail to disclose properly to the bankruptcy court. Furthermore, debts arising from fraud, embezzlement, drunken driving, larceny, or certain other willful or malicious acts may also be excluded. In a Chapter 13 bankruptcy, a debtor with a regular income proposes to a bankruptcy court a plan for extinguishing his or her debts from future earnings or other property over a period of time. In such a bankruptcy, you normally keep all or most of your property. 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 Chapter 13 bankruptcy and repay some of their debts than for people who file a Chapter 7 bankruptcy and make no effort to repay their debts. The bankruptcy law prohibits your employer from discharging you simply because you have filed a bankruptcy case. 4. What are the costs of declaring bankruptcy? a. Court costs. A filing fee must be paid to the clerk of the court at the time the debtor’s petition is filed. The filing fee may be paid in up to four installments if authorization is granted by the court. b. Attorney’s fees. These fees are usually the largest single item of cost. Often the attorney does not require them to be paid in advance at the time of filing but agrees to be paid in installments after receipt of a down payment. c. Trustee’s fees and costs. The trustee’s fees are established by the bankruptcy judge in most districts and by a U.S. trustee in certain other districts. Although it is possible to reduce these costs by purchasing the legal forms in a local stationery store and completing them yourself, an attorney is strongly recommended. There are also psychological costs. For example, obtaining credit in the future may be difficult since bankruptcy reports are retained in credit bureaus for 10 years. Therefore, the extreme step of declaring personal bankruptcy should be taken only when no other options for solving financial problems exist. FINANCIAL PLANNING PROBLEMS (p. 262) 1. Calculating the Finance Charge on a Loan. Dave borrowed $500 for one year and paid $50 in interest. The bank charged him a $5 service charge. What is the finance charge on this loan? $50 + 5 = $55 2. Calculating the Annual Percentage Rate. In problem 1, Dave borrowed $500 on January 1, 2006, 7-29 and paid it all back at once on December 31, 2006. What was the APR? $55 on $500, or 11% APR 3. Calculating the Annual Percentage Rate. If Dave paid the $500 in 12 equal monthly payments, what was the APR? 6500 1320 500(12 1) 2 12 55     APR  = 20.3% 4. Comparing the Costs of Credit Cards. 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 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. Most important to Bobby is what type of credit card user he is. If he is the type of person who pays in full at the end of each month, annual fees are an important issue for him. If he always pays the minimum payment and carries a balance from one month to the next, the interest rate is a more crucial issue. 5. Calculating the Cash Advance Fee and the Dollar Amount of Interest. Sidney took a $200 cash advance by using checks 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 and paid off the bill in full? • Sidney’s cash advance fee was $4.00. • At an 18% APR, she paid $3.00 interest for one month. • She paid a total of $207. • If Sydney had made the purchase with her credit card and paid off the bill in full promptly, she would have paid only $200. • The answer is true if the card has a grace period, but if there is no grace period (and some cards don’t offer one), she would have paid the $3 interest charge regardless and would have saved only on the cash advance of $4. 6. Comparing the Cost of Credit during Inflationary Periods. 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. 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. Was postponing her purchase a good trade-off for Dorothy? 7-30 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. 7. Comparing Costs of Credit Using Three Calculation Methods. You have been pricing a compact disc player in several stores. Three stores have the identical price of $300. Each store charges 18 percent APR, has a 30-day grace period, 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, Store B uses the adjusted balance method, and that Store C uses the previous balance method. Assume you purchased the disc player on May 5 and that you made a $100 payment on June 15. What will the finance charge be if you made your purchase from Store A? from Store B? from Store C? Store A: Average Daily Balance Finance Charge ($300 + $200 /2 = $250) $3.75 ($250  .015) Store B: Adjusted Balance Method 3.00 ($200  .015) ($300 - $100 = $200) Store C: Previous Balance Method 4.50 ($300  .015) ($300 - $0 = $300) 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. The entire benefit of a grace period disappears when you carry a balance from one month to next. 8. Determining Interest Cost Using the Simple Interest Formula. 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  ½ year Interest = $99.00 Total amount due = $1,500 + $99 = $1,599. 7-31 9. Calculating the Total Cost of a Purchase, the Monthly Payment, and an APR. After visiting several automobile dealerships, Richard selects the used car he wants. He likes its $10,000 price, but financing through the dealer is no bargain. He has $2,000 cash for a down payment, so he needs an $8,000 loan. In shopping at several banks for an installment loan, he learns that interest on most automobile loans is quoted at add-on rates. That is, during the life of the loan, interest is paid on the full amount borrowed even though a portion of the principal has been paid back. Richard borrows $8,000 for a period of four years at an add-on interest rate of 11 percent. Questions a. What is the total interest on Richard’s loan? b. What is the total cost of the car? c. What is the monthly payment? d. What is the annual percentage rate (APR)? a. What is the total interest on Richard’s loan? Cash price = $10,000 Down payment = $2,000 Amount of the loan = $8,000 Length of the loan = 4 years or 48 months Quoted add-on interest = 11 percent Total interest: I = P  r  T = $8,000  0.11  4 = $3,520 b. What is the total cost of the car? Total cost = Down payment + total interest + principal = $2,000 + $3,520 + $8,000 = $13,520 c. What is the monthly payment? Monthly payment = $3,520 + $8,000 divided by 48 = $240 d. What is the annual percentage rate (APR)? APR P (N 1) 2 N I     7-32 $8,000(48 1) 2 12 $3,520     21.55 percent 392,000  84,480  10. Calculating Simple Interest on a Loan. Damon convinced his aunt to lend him $2,000 to purchase a plasma digital TV. She has agreed to charge only 6 percent simple interest, and he has agreed to repay the loan at the end of one year. How much interest will he pay for the year? (LO 7-2) I = P × r × T = $2,000 × .06 × 1 = $120 11. Calculating Simple Interest on a Loan. You can buy an item for $100 on a charge with the promise to pay $100 in 90 days. Suppose you can buy an identical item for $95 cash. If you buy the item for $100, you are in effect paying $5 for the use of $95 for three months. What is the effective annual rate of interest? (LO 7-2) I = P × r × T $5 = $95 × r × ¼ or 95 × r = 5 x 4 95 r = 20 Therefore, r = 20 ÷ 95 = 0.210 or 21% 12. Calculating Interest Using the Simple Interest Formula. Rebecca wants to buy a new saddle for her horse. The one she wants usually costs $500, but this week it is on sale for $400. She does not have $400, but she could buy it with $50 down and pay the rest in 6 months with 10 percent interest. Does Rebecca save any money buying the saddle this way? (LO 7-2) Sale Price = $400 Down Payment = $50 Amount Financed = $400 - $50 = $350 Interest rate (r) = 10% 7-33 Interest paid for 6 months (½ year) = P × r × T = $350 × .10 × ½ = $17.50 Rebecca paid: $400 + $17.50 or $417.50 Rebecca saved: $500 - $417.50 or $82.50 13. Calculating Interest Using the Simple Interest Formula. You just bought a used car for $3,500 from your cousin. He agreed to let you make payments for 3 years with simple interest at 7 percent. How much interest will you pay? (LO 7-2) I = P × r × T = $3,500 × .07 × 3 = $735 14. Calculating Interest Using Bank Discount Method. Your uncle lends you $2,000 less $100 (interest at 5 percent), and you receive $1,900. Use the APR formula to find the true annual percentage rate. (LO 7-2) APR (r) = ( 1) 2    P N n I = $1,900(1 1) 2 1 $100    = $1,900 2 $200  = $3,800 $200 = 0.05263 or 5.263% 15. Calculating the Annual Percentage Rate Using Compound Interest Formula. A $1,000 loan is paid off in 12 equal monthly payments. The stated annual interest rate is 10 percent. What is the annual percentage rate? (LO 7-2) APR(r) = ( 1) 2   P N xn I = $1,000(12 1) 2 12 $100    = $13,000 $2,400 7-34 FINANCIAL PLANNING ACTIVITIES (p.263) 1. Determining Whether a Loan is Needed. 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. Comparing Costs of Loans from Various Lenders. 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 commercial 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 commercial 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 Current Information on Obtaining the Best Credit Terms. Choose a current issue of Money, Kiplinger’s Personal Finance Magazine, or Business Week and summarize an article that provides suggestions on how you could choose the best and yet the least expensive source of obtaining credit. Students answers will vary, but you may want to use this question to emphasize the importance of diligence in shopping for credit. 4. 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. Finance Center. Inc., helps consumers save money when purchasing, financing, or refinancing a new home, car, and credit card transaction. Bankcard Holders of America provides individualized recommendations on the quickest and most inexpensive way to pay off credit card balances. Debtors Anonymous offers financial counseling to debt-ridden consumers. Bank Rate Monitor™ is America’s consumer rate source for mortgages, credit cards, auto loans, home equity, and personal loans. 7-35 Choose one of the above organizations and visit its home page. 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. (Another option would be to ask students to view one of the above Internet sites. 5. Calculating the Cost of Credit Using Three APR Formulas. How are the simple interest, simple interest on the declining balance, and add-on interest 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. When the add-on interest method is used, interest is calculated on the full amount of the original principal. When two or more payments are to be made, use of the add-on method results in an effective rate of interest that is greater than the stated rate. 6. Handling Harassment from Debt Collection Agencies. 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. The Federal Trade Commission enforces the Fair Debt Collection Practices Act (FDCPA), which prohibits certain practices by agencies that collect debts for creditors. The Act does not apply to creditors that collect debts themselves. While the Act does not erase the legitimate debts that consumers owe, it does regulate the ways in which debt collection agencies do business. Exhibit 7-2 summarizes the steps you may take if a debt collector calls. 7. Seeking Assistance from the Consumer Credit Counseling Service. Visit a local office of the Consumer Credit Counseling 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 CCCS counseling is usually free. However, when the CCCS administers a debt repayment plan, it sometimes charges a nominal fee to help defray administrative costs. 8. Assessing the Choices in Declaring Personal Bankruptcy. 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 7-36 financial problems exist. FINANCIAL PLANNING CASE (p. 263) Financing Sue’s Hyundai Excel (p. 263) 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 Sue must pay before and during the term of the loan. In Sue’s case, the disclosed finance charge consists of the interest she will pay for the three-year loan period. 3. What is the amount Sue will receive from the bank? $6,000 4. Should Sue borrow from Bank A or Bank B? Explain why. Bank A. The 5 percent difference in the APRs of the two banks means that Sue would have to pay $15 extra every month if she gets her loan from the second bank. Extra Bonus Questions 1. Estimate Sue Wallace’s opportunity cost of paying $2,000 from her savings to finance her car. Since Sue has withdrawn $2,000 from her savings account, she has foregone the interest she could have received if the money were still in the bank earning interest. Assuming that she was earning 7 percent interest, she will lose $140 in interest during the first year. 2. Do you agree with Sue’s decision to pay $2,000 cash and borrow $6,000? Explain. Yes, Sue made the right decision to pay $2,000 cash down payment. Assuming that she was earning only 7 percent interest on her savings, it was a wise choice to withdraw $2,000. After all, the bank is charging her 15 percent APR. Sue examined the various alternatives and looked into different payment plans that fit her budget and income. 7-37 3. What other options were available to Sue in financing her car? Parents or relatives if they were willing and able to lend Life insurance company, if Sue had cash value life insurance policy with sufficient cash value Credit union, assuming that Sue could become a member of a credit union CONTINUING CASE Managing Credit (p. 265) 1. Given their current situation, list some suggestions on how Shelby and Mark can reduce the cost of using credit. What are some alternative sources of credit they might consider? If needed, the couple should consider borrowing money from parents or family members to lower their borrowing cost. If they have a savings account at a commercial bank or a credit union, they should use the account as a collateral to get a low cost loan. By all means, the couple should shop around for a credit card that offers the lowest possible interest rate. 2. What is the best way for Shelby and Mark to compare the cost of credit from different sources? Among the many sources of information when comparing various sources of credit are: • www.kiplinger.com • www.nfce.com • www.bankrate.com 3. Explain how Shelby and Mark might use The Personal Financial Planner Sheets (Credit Card/Charge Account comparison and Consumer Loan Comparison). Student responses will vary. Sheets 30 and 31 should prove useful to the couple in planning their short-term and long-term financial planning activities related to the credit card usage. DAILY SPENDING DIARY (p. 265) Analysis Questions 1. Describe any aspects of your spending that might indicate an overuse of credit. Student answers will vary. 2. How might your Daily Spending Diary information help you avoid credit problems? Student responses will vary. 7-38 TM 7-1 Comparing APR and Finance Charge Length Monthly Total Finance Total APR of Loan Payment Charge Cost Creditor A 14% 3 years $205.07 $1,382.52 $7,382.52 Creditor B 14% 4 years $163.96 $1,870.08 $7,870.08 Creditor C 15% 4 years $166.98 $2,015.04 $8,015.04 7-39 TM 7-2 Methods of Computing Finance Charges Adjusted Previous Average Daily Balance Balance Balance Monthly interest rate 1 1/2% 1 1/2% 1 1/2% Previous balance $400 $400 $400 Payments $300 $300 $300 (payment on 15th day) Interest charge $1.50 $6.00 $3.75 ($100 x 1.5%) ($400 x 1.5%) (average balance of $250 x 1.5%) 7-40 TM 7-3 An Example of the Rule of 78s Payment Reduction Total No. Interest of Debt Payment 1 $ 28.13 $ 186.87 $ 215.00 2 26.25 188.75 215.00 3 24.37 190.63 215.00 4 22.50 192.50 215.00 5 20.63 194.37 215.00 6 18.75 196.25 215.00 7 16.87 198.13 215.00 8 15.00 200.00 215.00 9 13.13 201.87 215.00 10 11.25 203.75 215.00 11 9.37 205.63 215.00 12 7.50 207.50 215.00 13 5.63 209.37 215.00 14 3.75 211.25 215.00 15 1.87 213.13 215.00 $ 225.00 $ 3,000.00 $ 3,225.00 7-41 TM 7-4 What to Do If a Debt Collector Calls (Exhibit 7-2) 7-42 Name ______________________________________ Chapt er 7: Choosing a Sour ce of Cr edit : The Cost s of Cr edit A lt er nat iv es 2. The total dollar amount paid to use credit. 4. Any type of insurance that ensures repayment of a loan in the event the borrower is unable to repay it. 5. A voluntary plan that a debtor with regular income develops and proposes to a bankruptcy court. In this type of bankruptcy, the debtor normally keeps all or most of the property. 7. A method of computing finance charges that uses a weighted average of the account balance throughout the current billing period. 8. A method of computing interest in which interest is calculated on the full amount of the original principal. 10. A local, nonprofit organization that provides debt counseling services for families and individuals with serious financial problems. (abbreviation) 11. A method of computing finance charges that gives no credit for payments made during the billing period. 1. Interest computed on principal only and without compounding. 3. A federal law that requires creditors to disclose the annual percentage rate (APR) and the finance charge as a dollar amount. 5. One type of personal bankruptcy in which many debts are forgiven. 6. A method of computing interest when more than one payment is made on a simple interest loan. The borrower pays interest only on the amount of the original principal that is not yet repaid. 7. The assessment of finance charges after payments made during the billing period have been subtracted. 9. The percentage cost (or relative cost) of credit on a yearly basis. This rate yields a true rate of interest for comparisons with other sources of credit. (abbreviation) Across Down T R U T H I N L E N D I N G L A W A V E R A G E D A I L Y B A L A N C E D E C L I N I N G B A L A N C E P R E V I O U S B A L A N C E C R E D I T I N S U R A N C E A D J U S T E D B A L A N C E S I M P L E I N T E R E S T F I N A N C E C H A R G E CC H A P T E R 1 3 H A P T E R 7 A D D O N C C C S A P R 1 2 3 4 5 6 7 8 9 10 11 Instructor Manual for Personal Finance Jack R. Kapoor, Les R. Dlabay , Robert J. Hughes, Melissa M. Hart 9780077861643, 9781260013993