Credit

What is Credit? When you borrow money to purchase something and promise to pay the money back later, you are using credit.

Terms you need to know: Principal: the amount of money borrowed Finance charge: the interest charges on the amount you owe (principal + interest accrued) Interest Rate: interest charged over time for using credit, written as a percent of the principal over one year.

So, how much am I paying? That depends on a lot of things: –Amount of money borrowed (Principal) –Length of time to pay back the principal –The annual rate of interest (% extra charged per year) –Repayment schedule (how often payments are made) –Method used to calculate interest

Example: $1000 installment loan at 9% interest Term of Loan:24 months36 months Monthly Payment$45.69$31.80 Total interest paid$96.56$ Total Payment$1,096.56$1, Who is better off?

Example (cont.) Even though the principal and the interest rate were the same, the amount paid was different. Why? Time! A shorter loan term (24 months) had higher monthly payments, but paid less overall (less time to accrue interest). The longer loan (36 months) had lower payments, but ended up paying more!

Simple Interest The interest is only paid on the original amount borrowed for the length of tie the borrower has use of the credit. Ex. I borrow $1000 at 5% and repaid the loan in one payment at the end of the year. Simple interest, 5% of $1000 for 1 year is $50. $1000*.05=$50 $1000+$50=$1050

Compound Interest Interest is calculated on the original principal plus all interest accrued to that point in time. Since interest is paid on interest as well as the amount borrowed, the effective interest rate is greater than the nominal (stated) interest rate. In English: Interest is charged on interest, making Compound Interest greater than Simple interest

Example of Compound Interest I borrow $1000 at 5% interest for 1 years, paying it back at the end of the year. Interest is compounded semiannually (2X a year) After 6months, $25 interest is charged. (5% of $1000/2). At the end of the year, the interest is calculated on the principal ($1000) plus the Interest already charged ($25), so the second interest payment is $25.63 (5% of $1025/2) The total interest paid is $ ($25+$25.63) vs. $50 in simple interest. Compound interest is greater than simple interest!

Huh? Okay, let’s simplify: Simple interest is calculated once- Principal times interest rate. Compound interest is calculated again and again, adding any extra interest.- Principal + interest times interest rate. The added difference makes compound interest greater than simple. It may seem like a little bit, but given time, it adds up!

Start of YearPrincipal amountInterest at 5%Principal at end of the year -$100.00$5.00$ $5.25$ $5.51$ $5.79$ $6.08$ $6.38$ $6.70$ $7.04$ $7.39$ $7.76$ $162.90$8.14$ $171.04$8.55$ $179.59$8.98$ $188.57$9.43$ $198.00$9.90$ $207.90$10.39$218.29

What do those numbers mean? They mean that over time, compound interest grows and grows! If that chart was a savings account, by doing nothing but leaving $100 in it for a 15 years, your money DOUBLED! Now imagine if you put in $1000, or $10,000! Or if it had a higher interest rate, say 10%! Or if you added $100 to the account every year! The money earned would be even higher! By doing very little, you can earn a lot of money over time!

Or… Or, if that $100 was on a loan or credit card, your debt could grow and grow until the interest you owe was more than the original principal!

Credit Score or Rate Your credit score is how well you pay off your credit and other bills. Pay on time, don’t carry much debt, your score is good. Pay late, owe a lot, default on loans, your credit score is poor.

Good/Bad/No Credit Good credit score gets more credit and lower interest rates Bad credit score limits amount of credit and gets higher interest rates No credit: If you have not credit history (no bills, loans or credit cards) banks and credit card companies do not know if you will pay back your loans. It is like bad credit. It is important to establish good credit early to build up a good credit score.

Credit Cards How they work: 1.Merchant passes card through machine, gets approval from the credit company for the amount 2.When you sign the paper, you agree to pay the amount 3.Merchant deposits receipt in bank who credits their account and bills the credit company.

How a Credit Card works cont. 4.Credit card company pays the merchant’s bank account and debits the issuer’s account 5.Issuer of your card bills you for the purchase, which you pay.

Paying Credit Cards Credit cards charge interest on money owed, compounded monthly. Often, credit cards can charge interest rates around %, which can add up over time. Add up a lot!

Extra Costs of Credit Cards Annual Fees- once a year charge for using the card Grace Period- time between when you are billed and when you have to pay Over limit fee- usually $25 if you exceed your credit line. Cash Advance Fee- usually 2% for any cash withdrawals from an ATM Late Payment- usually $25 if min. payment is not on time.

Are Credit Cards Bad? No, they aren’t bad. Credit is useful if you do not want to carry large amounts of cash. They also allow you to make a purchase you may not have the money to pay for at that time. Just make sure you pay off your debt quickly. Don’t owe so much that you are paying more than you can afford.

But… If you get carried away, run up your bills and only pay the minimum, a card with a high interest rate will take YEARS to pay off. So you could be paying for something you bought years ago, and paying more than it originally cost! And, if you max out your credit, you can’t buy what you may really need. Finally, having a lot of debt and missing payments hurts your credit score, making it harder to get more credit when you need it!

Installment Loans

Installment Loan A form of credit where the money is borrowed all at once Payment is made on a regular schedule for a set amount Ex. Auto Loan, Mortgage (home loan), Student Loan

Secured vs. Unsecured Loans Secured Loans: security or collateral is used to guarantee the loan. If you fail to repay loan, the lender keeps the security. Collateral ex. Home, property, valuables. Unsecured Loan: made solely on the person’s promise to repay the loan. Less money available without the collateral. Poor credit score, less likely to get an unsecured loan.

Auto Loan vs. Auto Lease

Loan Loan: Bank gives you money to buy car. Over the next 3 to 5 years you pay back the principal and interest. The car is the collateral on the loan. When you are done, you own the car.

Lease Lease: Payments are made for the right to use the car. At the end of the period, the bank takes the car. A lease is like renting the car for a long period of time. Often there are stipulations about mileage and condition for the lease.

Loan Making Payments on a $18,000 car $2,500 Down Payment $1,260 Sales Tax $20,126 paid remaining principle + interest ($559/monthx 36 months) $23,886 TOTAL PAYMENT Minus resale value

Lease Making Payments on a $18,000 car $400 Lease Fee $317 Prepayment Fee $11,412 Monthly Payments ($317x36) $12,129 TOTAL PAYMENT But no CAR!

Which is better, Loan or Lease? Loan (Advantages) You keep the car! Drive it for years to come without making a payment! But… (Disadvantages) –Pay more initially –Pay more monthly –Pay more overall Lease (Advantages) –Pay less initially –Pay less monthly –Pay less overall But…(Disadvantages) No car once the lease runs out. You have to lease or buy another car. May cost more in the long run.

The cost of taking longer to repay The term of your loan determines final cost 3 different auto loans for $13,500 at 12.5% # of payments 36 (3 years) 48 (4 years) 60 (5 years) Amount per payment $451.62$358.82$ Total Paid$16,258.32$17,223.36$18, Interest Paid $2,758.32$3,723.36$4,723.20

Buying a House

Mortgage Def.: a long term loan to buy a house or other property. The house and land it sits on are collateral for the loan. If the borrower doesn’t make payments, the lender can take the home through foreclosure. Most mortgages require a cash down payment of 5%,10%,or 20%

Escrow Def.: monthly payment on property which includes the mortgage and other costs. –Principal: amount borrowed –Interest: interest owed on the principal –Real Estate Taxes: taxes assessed on property by county, city/town and school district. –Property Insurance: insurance coverage against theft, fire and natural disasters.

Closing Costs When the final purchase of a home occurs, called a closing, the costs can reach thousands of dollars for taxes, fees, insurance and lawyer fees.

How much for a house? On a 30 year, $150,000 mortgage with a fixed interest rate of 7.5%, a homeowner who keeps the loan full term (30 years) will pay $377,000! $150,000 for the home $227, in interest on the loan!

So why buy a home? Equity: The value of your home to be used as collateral for other loans. As you pay for your home, you build equity. This can be used to get a home equity loan or home equity line of credit to make more purchases: cars, vacation homes, pay for college, etc.

Benefits of a good interest rate: Home Price Down Payment Mortgage6% rate8% rate10% rate $80,000$8,000$72,000$432/ month $528/ month $632/ month $140,000$15,000$125,000$749/ month $917/ month $1,097/ month $240,000$40,000$200,000$1,199/ month $1,468/ month $1,755/ month

Length of Mortgage Most mortgages are offered as 15 or 30 year mortgages. The length of time determines how much is paid per month and how much is paid overall for the house.

Adv/Disadv of 30 year mortgage Adv. –Lower monthly payments than 15 year –Stretches money; buyer can afford a larger house because of the lower payment Dis. –Builds equity at a slow rate –Overall interest paid is much higher than 15 yr. –Tend to have higher interest rates than 15 yr.

Adv/Disadv of 15yr. mortgage Adv. –Build equity much faster –Overall interest is less than 30yr. mortgages –Interest rates tend to be lower Dis –Monthly payments are higher than 30yr. Mortgages –Buyers restricted to a smaller home because of high monthly payments

Effect of term on a $100,000 mortgage Monthly payment at 8% interest Total payment at 8% interest 15 year mortgage $ year mortgage $ year mortgage $172, year mortgage $264,240

Student Loans Loans to pay for higher education Backed by government Low interest rates make them easy to get and easy to pay for.