Cost of Credit Ch. 7.4 Banking Services

U.S. Economy Runs on Credit Credit is the foundation of banking income.

U.S. Economy Runs on Credit Credit is the engine that makes possible growth & development through the economy. Ex) Septic Tank installation at center

Credit can be Dangerous if Misused Revolving Credit – a line of credit that has a maximum limit. It can be used on an ongoing basis until that limit is reached. Ex) Credit cards, & lines of credit

Dangers of Credit Easy access to credit allowed many consumers to accumulate more debt than they can manage. Whenever in a financial pinch, they add more debt to cover the shortfall. Eventually leading to disaster!

Informed Consumers It is the bank’s best interest & the consumer’s best interest if the consumer is informed about the cost of using credit, and the dangers involved. Banks want to lend money to make money, but... The bank doesn’t want to struggle to collect money owed to them.

Annual Percentage Rate (APR) The amount of interest charged on the loan principal expressed as a yearly figure. Does not include: ◦ Annual fees ◦ Transaction fees ◦ Penalties ◦ Loan origination fees ◦ Etc.

Different Ways Interest is Charged Sum-of-Digits Method Previous Balance Method Adjusted Balance Method Average Daily Balance Method

Sum-of-Digits Method Interest gets paid first Paying ahead doesn’t save you any $ Has built in prepayment penalties, which may be fixed charges or may be based on the Sum-of-Digits Methods

Sum-of-Digits Method Sum-of-Digits Method – method of calculating finance charges that takes the total finance charge, divides it by the number of months in the loan term, and assigns a higher ratio of interest to the early payments.

Example of Sum-of-Digits Method Consider a 12 month loan. Add so on The sum of the digits 1 through 12 = 78 1 st month of the loan, 12/78 ths of the payment goes towards interest 2 nd month of the loan, 11/78 ths of the payment goes towards interest Although the total cost to the consumer is the same, there is no advantage to paying early, because the interest is front-loaded.

Example of Sum-of-Digits payments Look at example on page 208 Read paragraphs explaining savings differences

House Payment Example Mortgage payment history

“Rule of 78” A method of calculating payments The name derives from how the denominator sums for a 1-year period

Sum-of-Digits Method Can work for loans of any duration The denominator used is always the sum of the total months Ex) a 15-month loan would have a denominator of 120.

Previous Balance Method The amount owed at the beginning of the billing cycle with calculated interest on that figure, regardless of payments or charges Used with open-ended credit

Adjusted Balance Method Payments made are subtracted during the billing cycle, however new purchases are not included. Used with open-ended credit

Average Daily Balance Method Most common method The balances for each day of the billing cycle are added and then divided by the number of days in the billing cycle to yield an average figure on which the finance charge is calculated.

Minimum Payments Most credit cards require a minimum payment of about 4% of the unpaid balance every month Used to be only 2% but that only paid the interest, and the credit card companies could keep indebted to them forever

Term Term – the length of the loan (ex: 60 months, 48 months, etc) The length of the term affects the finance charge The longer the term, the more $ paid back See example on page 210

Overextension Happens when you take on more debt than you can afford Some consumers mistakenly believe that just because someone approves them for credit, that must mean they can afford it. Ex) they take on 3, 4, or 5 credit cards, but then they can only afford to make minimum payments

Overextension can be Disastrous! If you’re overextended, and an emergency arises, or a situation changes, such as a job loss, you are in major trouble! A snowball effect may occur as late charges, penalty interest rates, & other fees apply

Consequences of overextension Ruined credit rating Missed opportunities on great deals Important things may have to be passed over (orthodontics for kids, etc) If all your money is already going out to make debt payments, when gas prices go up, your entire budget may collapse!

The Role of Banks Regarding Credit Predatory Lending – occurs when lenders create problems for consumers by making credit too easily available without regard to the borrower’s ability to pay. Not really in the bank’s best interest Banks need creditworthy customers Collecting debt is expensive, & almost impossible on loans in default

Credit Counseling Counseling agencies (some are for-profit, some are non-profit) Help you reorganize your debts & sometime negotiate terms Banks will often accept such arrangements rather than lose their money altogether.

Be Careful with Credit Counseling Some credit-counseling companies are simply looking for ways to offer more subprime loans or to make a profit by doing stuff that you could do on your own

Bankruptcy is the last option Only in extreme cases Has long-term consequences Seek professional legal advice 1 st !

Book Work: “Checkpoints” ◦ Pg. 211 ◦ Pg Assessment ◦ Pg. 213 #1-4