6-1 CHAPTER 6: BORROWING ON OPEN ACCOUNT

6-2 The Basic Concepts of Credit Why Borrow?  To smooth consumption  To avoid paying cash for large purchases (like a car)  To meet financial emergencies  Convenience

6-3 Some Credit Danger Signs  Regularly use credit cards to buy on impulse  Regularly exceed the borrowing limit on the credit cards  Take 60 to 90 days to pay bills that once took 30 days  Have to borrow just to meet basic living needs  Can barely make the minimum required payments on bills  Have no savings

6-4 Rule of Thumb!  THE PRODUCT PURCHASED SHOULD OUTLIVE THE CREDIT PAYMENTS Don’t let credit squash you!

6-5 Establishing Credit  Open checking and savings accounts.  Get one card and make small purchases.  Build a good credit history by: –Not getting overextended. –Fulfilling all terms of credit obligations. –Consistently paying on time. –Immediately notifying creditors if unable to pay. –Being truthful when applying.

6-6 How much credit can you stand? Total monthly consumer credit payments Monthly take-home pay Monthly consumer credit payments (excluding mortgage) should not exceed 20% of your monthly net income. DEBT SAFETY RATIO =

6-7 Steps for Women in Establishing Credit :  Consistently use your own legal name to build credit history. Ex: Mary Brown, not Mrs. John Brown  Have information reported to credit bureau in your name as well as your husband’s.  Consider retaining separate credit file when you marry.

6-8 Open Account Credit  Credit extended to a consumer in advance of any transaction.  Consumer can buy/borrow up to a specified amount, the credit limit.  Usually, interest can be avoided by paying balance in full promptly.

6-9 Bank Credit Cards:  Issued by financial institutions  Features include: –Line of credit dependent upon applicant’s financial status and ability to pay –Cash advances and balance transfers –Other services or rebates –Interest rates and fees

6-10 Other Credit Cards & Charge Accounts:  Retail charge cards (ex: Sears)  30-day charge accounts  Travel & entertainment cards  Prestige cards  Affinity cards  Secured credit cards  Student credit cards

6-11 Debit Card:  Looks like a credit card but works like writing a check—accesses your checking account.  Does not provide line of credit.  Greater liability exposure in event of fraudulent use.  Prepaid card is a debit card with fixed amount available—does not access your checking account.

6-12 When Losing a Credit Card or Debit Card…  Credit card –Card holder not liable for fraudulent charges if loss is reported before the card is used –If reported after the card is used, maximum liability is $50  Debit card –If stolen, the thief could wipe out your checking account! –Check with your bank regarding policies on lost or stolen cards

6-13 Revolving Credit Lines:  Open account credit offered by banks and other financial institutions.  Usually offer higher credit lines and lower interest rates than credit cards!  Money accessed by writing checks.

6-14 Forms of revolving credit:  Overdraft protection lines –A line of credit linked to a checking account –Enables a depositor to overdraw the account up to a predetermined limit –Usually with limits between $500 to $1000  Unsecured personal credit lines –Available on an as-needed basis –Money is accessed by writing checks –Repayment is set up on a monthly installment basis

6-15 Forms of revolving credit:  Home equity credit lines –Secured by the equity in owner’s home –Interest tax deductible up to $100,000 (if you itemize deductions) –Lenders usually set the maximum credit line at 75%-80% of the market value of the home –Example: A couple buys a home for $85,000, ten years later, it’s worth $165,000. Mortgage balance is $45,000. Using 75% loan-to-market value ratio, how much can they borrow? –Answer: 0.75*165,000-45,000 = $78,750.

6-16 Obtaining and Managing Open Account Credit Steps in opening an account: 1. Complete and submit application. 2. Lender investigates creditworthiness. 3. Lender obtains credit bureau report. 4. Lender makes credit decision; may use credit scoring.

6-17 The Credit Application Applicant submits information on income, marital status, employment history, existing accounts, etc.

6-18 The Credit Application Applicant submits information on income, marital status, employment history, existing accounts, etc. The Lender Verifies application; turns it over to the Credit Bureau.

6-19 The Credit Bureau The Credit Application Applicant submits information on income, marital status, employment history, existing accounts, etc. The Lender Verifies application; turns it over to the Credit Bureau. Reporting agency that gathers and sells info about people. Gets information from: subscribing creditors creditors you use as reference public documents

6-20 The Credit Bureau The Credit Application Applicant submits information on income, marital status, employment history, existing accounts, etc. The Lender Verifies application; turns it over to the Credit Bureau. Credit Bureau submits report back to lender; lender then makes Reporting agency that gathers and sells info about people. Gets information from: subscribing creditors creditors you use as reference public documents The Credit Decision

6-21 Computing Finance Charges  Lenders must disclose –Annual percentage rate (APR), the true rate of interest paid over life of loan. –Method used in computing finance charges.  Balance to which interest rate applied generally determined using one of four variations of the Average Daily Balance (ADB) method.

6-22  ADB excluding new purchases The most consumer friendly!  ADB including new purchases Most frequently used—no grace period on new purchases if you carry a balance.  Two-cycle ADB excluding new purchases Calculated using last 2 billing cycles.  Two-cycle ADB including new purchases Least consumer friendly method!

6-23 Example: Calculate the finance charges on a credit card account which has an annual interest rate of 18% (or 1.5% per month) and uses the average daily balance method including new purchases. (Refer to Exhibit 6.8 in text.)

6-24 5$582$ 2, , , ,844 Total: 31$28,068 ADB = $28,068  31 = $ Monthly APR =.18  12 =.015 Finance charge = $ x.015 = $13.58 ADB Including New Purchases: # of Days BalanceWeighted (1) (2)Balance (1x2)

6-25 Refer to Exhibit 6.7 in text— What a difference the balance method makes! Examples shown below all have:  Same stated rate of 19.8%  Same account activity Method Finance Charges ADB including new purchases $ ADB excluding new purchases Two-cycle ADB including new purchases Two-cycle ADB excluding new purchases

6-26 Managing Your Credit Cards  Review statements promptly each month and verify each entry.  Pay at least the minimum monthly payment by due date.  Returned merchandise credited to your account.

6-27 Using Credit Wisely  Shop around, comparing: –Annual fees & other fees –APR –Length of grace period –Balance method

Short, interest-free loan + Simplified record keeping + Easier resolution to unsatisfactory purchases + Convenience and emergencies  Disadvantages of Credit Cards – Easy to overspend – High interest costs  Advantages of Credit Cards

6-29 Avoid credit problems by:  Using discipline when purchasing.  Reducing the number of cards you carry.  Being selective in accepting preapproved credit offers.  Not making new charges.  Paying more than the minimum.  Paying off cards with highest finance charges first.  Transferring balances to card with low introductory rate and paying off quickly.

6-30 Important Consumer Credit Legislation  Key legislation deals with –Credit discrimination. –Disclosure of credit information. –Billing procedures, errors, complaints, and recourse on unsatisfactory purchases. –Disclosure of finance charges, other fees, credit terms, and loss of credit card. –Protection against collector harassment.

6-31 Credit Card Fraud  Never give account number to someone who calls you—you must initiate the call.  Use only secure Internet sites.  Never put credit card info on checks or personal info on charge slips.  Keep your eye on your card!  Draw line through blank spaces on slip.  Destroy old cards and shred old statements and slips.  Report lost or stolen cards immediately!

6-32 Options if you’re getting into trouble...  File Bankruptcy –Wage Earner Plan (Chapter 13—debt restructuring). Viable for one with a steady income and a reasonable amount of debt A majority of the creditors must agree to the plan Interest charges and late-payment penalties are waived for the repayment period Account for less than 30% of all bankruptcies –Straight bankruptcy (Chapter 7—wipe the slate clean). Debtor must make certain tax payments and keep up alimony and child-support payments Debtor is allowed to retain certain payments from Social Security, retirement, veteran’s, and disability benefits Debtor may retain the equity in a home, a car, and other personal assets to a certain limit.

6-33 Options if you’re getting into trouble...  Other bankruptcy options –Chapter 20: allow individual to wipe out unsecured debt, as per Chapter 7; then use Chapter 13 to restructure their secured debt, including mortgages, home equity loans, and other non-dischargeable debts.  Try credit counselors –Help you prepare a budget and repayment schedule. –Deal with creditors to possibly reduce some interest & fees.