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1 Credit. 2 What is credit? In the context of our class, credit is obtained when we can take possession of something without paying the full amount at.

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Presentation on theme: "1 Credit. 2 What is credit? In the context of our class, credit is obtained when we can take possession of something without paying the full amount at."— Presentation transcript:

1 1 Credit

2 2 What is credit? In the context of our class, credit is obtained when we can take possession of something without paying the full amount at the same time. The authors of our book point out that consumers in the USA by mid year 2000 had run up $1.5 trillion in debt, not including mortgages. When you consider that the US economy generated about $10 trillion in income that year, consumer debt is about 15% of GDP - Gross Domestic Product - the measure of output or income in an economy. Even the Federal Government purchases things on credit. A while back there was an article in the Wall Street Journal reminding the reader that George Washington, Thomas Jefferson, Alexander Hamilton and others debated the issue of federal debt.

3 3 This is a class in personal finance, so I will stick to credit issues for people. So why borrow? - so you can have stuff now, - to meet an emergency, - for convenience and safety, and - for investment purposes. Be careful, because - you have to pay the bills eventually and interest is charged, - you may get in so deep you cant pay all the bills - it is possible to become so much in debt that a person can not make the whole monthly payment.

4 4 The Debt Safety Ratio - DSR DSR = monthly consumer credit payments/monthly take home pay. The rule of thumb is that this ratio should not be above 0.2 and if it does you are getting into the zone where you might not be able to pay your bills. Remember, you still have utilities, groceries, and other day to day items to buy. Plus, may have rent and car payments. Example of calculation: say your monthly take home pay is $ and your monthly consumer credit debt is Your ratio is then / =.21 when rounded to 2 decimals. This means 21% of your take home pay goes to consumer credit payments.

5 5 Why would anyone extend you credit? Why, to make money, of course! And are they going to give you credit if they think they are going to lose money on you? I think not. So, if you want credit you have to show you wont be a bad investment for the folks extending the credit. How do you show you are credit worthy? The easiest answer is to just make tons of money so you really do not need credit. Maybe you cant do that, so establish a good credit history. You can start this by using a checking account wisely - not bouncing checks - and paying your bills on time. If you get a credit card, paying bills on time shows you can handle credit. I DISAGREE WITH THE AUTHORS, WHO SAY GET A LOAN EVEN IF YOU DONT NEED IT TO HELP YOU ESTABLISH GOOD CREDIT - HORSEHOCKEY!

6 6 Open Account Credit This type of credit is extended before a transaction is made. Extenders of credit typically set a limit to the amount you can use. Store based credit cards limit your spending to their store, while bank based cards let you spend wherever the card is honored. Many credit cards today let you make cash advances, some have features like airplane travel insurance, some have rebates and cash back features. Note that sometimes you have to pay for these features. Some cards have an annual fee, some dont. Some allow a grace period, meaning if you pay the card in full 20 to 30 days after a purchase, you are not charged any interest.

7 7 Interest rates on credit cards Banks have what is called a prime lending rate. The prime rate is given to the best customers of the bank. Credit card interest rates are usually prime plus some amount, typically 7 to 10%. How interest is calculated Here we go over the ADB (average daily balance) including new purchases method. Say the credit card has an 18% annual rate (compounded monthly) and the next billing period lasts from Feb. 1 through March days. Say the balance on Feb. 1 is 100 and then on Feb. 15 $200 in additional charges are made and then on Feb more dollars are charged up. So, by March 3 we see 100 was the balance for 14 days, 300 was the balance for 13 days and 600 was the balance for 4 days. We use these values to calculate the average balance during the period.

8 8 You remember an average says add up the values and divide by the number of numbers added up. So 14 days of 100 adds up to 1400 and we would add 3900 and 2400 (13 days of 300 and 4 days of 600) to get 7700 and then we divide by 31 days to get The monthly interest rate of.015 would be applied to this amount so the interest charge for the period is times.015 = 3.73 Usury Usury is the notion that charging interest, or high interest should be illegal. Some states set limits on rates. Dont confuse credit cards and debit cards. Debit cards are just like writing a check. The money comes right out of your account.

9 9 Interest charges on credit cards used to be tax deductible, but no more. But, if you get a second mortgage on your house (you borrow the equity in the house) the interest on the mortgage is tax deductible. In this sense, home equity loans provide an advantage over credit cards.


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