Chapter 6

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 6th Ed., Prentice Hall Inc.

Personal Finance:An Integrated Planning Approach

Winger & Frasca

Chapter 6Short-term Credit Management

http://www.prenhall.com/winger/


Major TopicsMajor Topics

Arranging and Using Credit Sales Credit Cash Credit Obtaining Credit and Resolving Credit

Problems


Reasons for Using CreditReasons for Using Credit

As a Shopping Convenience To Increase Total Consumption As an Inflation Hedge As a Source of Emergency Funds


Disadvantages of Using CreditDisadvantages of Using Credit

Temptation to overspend Credit costs Less flexibility with future budgets


How to Get CreditHow to Get Credit

Consider what the lender looks for. Begin a credit record. Review your credit report. Repair a bad credit record.


What Lenders Look ForWhat Lenders Look For

The Three C’s of Credit Character

– Have you met your previous obligations? Capital

– Have you sufficient financial assets? Capacity

– Can you meet your future obligations?


Begin a Credit RecordBegin a Credit Record

Open savings and checking accounts. Open a retail charge account. Qualify for a small installment loan. Make sure your credit records follow you. Have a telephone installed.


Special Concerns for SpousesSpecial Concerns for SpousesEstablishing CreditEstablishing Credit

Make sure your credit history is in your name. Don’t use a social title

– ex., Mrs... Edward Hall Inform creditors that you wish to maintain

your own credit history. Know the difference between a joint and

individual credit account.


Credit AccountsCredit Accounts

Joint Credit Account– Both spouses responsible for debt.– Divorced or separated spouses should cancel

joint accounts. Individual Credit Account

– Only you are responsible for debt.– Account will appear only on you credit report.


The Role of the Credit BureauThe Role of the Credit Bureau

Does not decide who receives credit. Stores information on past use of credit Stores information on legal actions against

you. Sells credit reports to lenders.


Contents of a Credit ReportContents of a Credit Report

Existing credit accounts Information on each credit account includes

– credit limit, loan amount and account balance– who is responsible for paying the account

Public record information– bankruptcies, tax liens and monetary judgments

Who has obtained a copy


Credit ReportCredit Report

View a Credit Report

You must have an Internet connection for the above link to work.


If You are Denied CreditIf You are Denied Credit

Obtain a copy of your report. Correct any mistakes. Submit your own statement on disputed

claims. Have adverse information that is old removed

from report. Have those who received report notified of

any incorrect entries.


Sales CreditSales Credit

Kinds of Accounts Major Issuers of Credit Cards Selecting a Credit Card


Sales Credit AccountsSales Credit Accounts

Regular charge account– billed for purchases at end of month

Open-end account– revolving credit account– agreement continues as long as account is open

Closed-end account– separate installment contract for each purchase


Revolving Charge AccountRevolving Charge Account

Credit limit determined by credit record and net worth.

Partial payment must be made each month. Interest charged on unpaid balance. Account may never actually be paid off.


Required Information on Required Information on Revolving Charge AccountRevolving Charge Account

Truth in Lending ActTruth in Lending Act Annual percentage rate (APR) applied to

balance. Method for calculating interest. Grace period, if any. Minimum monthly payment, and penalties

for late payment. Permission to investigate credit history.


Interest Computation MethodsInterest Computation Methods

Previous balance method Adjusted balance method Average daily balance method

– including current purchases– excluding current purchases

Two-cycle average daily balance method


Previous Balance MethodPrevious Balance Method

Rate applied to balance at end of previous month. Example

Previous balance = $215

Monthly interest rate = 1.65%

Interest charge:

1.65% x $215 = $3.55


Equal to the previous balance less any payments or returns made during the current billing cycle

Example

Previous balance $215

Less current payment 20

Interest charge = $190 x 1.65% = $3.22

Adjusted Balance MethodAdjusted Balance Method


Average Daily Balance MethodAverage Daily Balance Method(including current purchases)(including current purchases)

Period Daysa

Balanceb a x b

7/1-7/4 4 215.00 $ 860.007/5-7/9 5 253.15 1,265.757/10-7/11 2 233.15 payment 466.307/12/-7/19 8 265.65 2,125.207/20-7/31 12 283.29 3,399.48

31 Weighted sum = $8,116.73


Average Daily Balance Method(including current purchases)

Average Daily Balance = Weighted sum Days

$8,116.73 = $261.83 31

Interest charged = $261.83 x 1.65% = $4.32


Average Daily Balance Method(excluding current purchases)

Period Daysa

Balanceb a x b

7/1-7/9 10 215.00 $2,150.007/10-7/31 21 215 - 20 = 195 4,095.00

(payment)31 Weighted sum = $6,245.00


Average Daily Balance Method(excluding current purchases)

Average Daily Balance = Weighted sum Days

$6,245 = $201.45 31

Interest charged = $201.45 x 1.65% = $3.32


Interest Charges on BalancesInterest Charges on Balances

Text IllustrationText IllustrationPrevious Balance Method $3.55

Adjusted Balance Method $3.22

Average Daily Balance Method

– including current purchases $4.32

– excluding current purchases $3.32


Two-cycle Two-cycle Average Daily Balance MethodAverage Daily Balance Method

Eliminates a grace period in the previous month when you fail to completely pay off the balance in the present month.

Can go back two periods to collect interest on unpaid balance.


Major Issuers of Credit CardsMajor Issuers of Credit Cards

Bank Credit CardsDiscover MasterCard Visa

Travel & Entertainment Cards– American Express

Other Cards– Department store chains– Major gasoline retailers


Credit Card Cost ComparisonCredit Card Cost Comparison

Annual membership fee

Variable rate information

Balance computation method

Late payment fee Return check charge Copy charge

Annual percentage rate

Grace period Cash advance fee Over-the-limit penalty Replacement fee Fees for optional

services


Credit Card Benefit ComparisonCredit Card Benefit Comparison

Credit limit Disability insurance Accident insurance Rental car collision

insurance Warranty protection Merchandise loss

protection

Credit life Rebates & discounts Frequent flyer miles Credit card registry Purchase price

protection


Payback PeriodPayback Period$3,000 Credit Balance @ 19% APR$3,000 Credit Balance @ 19% APR

Monthly Payment

Months Total Interest

$6075100125

100644231

$2,9911,7901,102804


Protect Against Credit Card FraudProtect Against Credit Card Fraud

Record card numbers, expiration dates and phone number for card company.

Destroy old bills, receipts and credit cards. Check sales receipt and compare with credit

card statement. Be careful giving out your card number. Report lost and stolen cards immediately.


Correcting Credit MistakesCorrecting Credit Mistakes

Notify the creditor in writing within 60 days after bill was mailed.

Pay parts of the bill that are not in dispute. Creditor will notify you within 30 days of its

decision.


Correcting Credit MistakesCorrecting Credit Mistakes

If no error is found, you must pay or you will be reported as delinquent.

If you still challenge in writing the creditor must report that information.

Provide credit bureau with your explanation of the dispute.


Other Credit TermsOther Credit Terms

Chargeback– a disputed amount charged back to the

merchant by the credit card company. Credit blocking

– a reduced credit limit based upon an expected purchase


Debit CardsDebit Cards

Bank deposit is immediately reduced

You do not have the protections afforded credit card purchases


Debit CardsDebit Cards

Lost or stolen credit cards are covered by the Electronic Funds Transfer Act– you can lose up to $500 if you fail to notify

issuer within two days after learning of theft– if you wait 60 days your losses may be

unlimited


Cash CreditCash Credit

Credit extended in the form of cash. Elements of a retail installment contract

– Promissory note• A contract binding a borrower to future

repayment of the amount borrowed.

– Security agreement• Establishes the creditor’s security interest in the

good for which the credit was extended


Simple Interest Method– percentage rate applied to outstanding loan

balance Discount Method

– interest deducted from credit extended you Add-on Method

– interest added to amount borrowed at beginning of loan

Methods for Charging InterestMethods for Charging Interest


Figure 6.6 A 12-month installment loan with Figure 6.6 A 12-month installment loan with annual simple interest of 12 percentannual simple interest of 12 percent

Monthly OutstandingBalance

MonthlyPayment

FinanceCharge

LoanRepayment

1 $1,000.00 $88.85 $10.00 $78.85

2 921.15 88.85 9.21 79.85.... ... ... ... ...

11 175.07 88.85 1.75 87.10

12 87.97 88.85 0.88 87.97

Total $1,066.19 $66.19 $1,000


Discount MethodDiscount Method

Total paymentson discount loan

amount financed

1 - (discount rate x t )

=

$1,000

1 - (0.12 x t )$1,136.36 =


Add-on MethodAdd-on Method

Total payments on add-on loan

amount financed x [1 + (add-on rate x t ) ]

=

$1,000 x [1 + (0.12 x t ) ]$1,120 =


Figure 6.7 Comparative interest on credit of $1,000 Figure 6.7 Comparative interest on credit of $1,000 to be repaid in 12 equal monthly installmentsto be repaid in 12 equal monthly installments

Simple Discount Add-on

12%12%12%

InterestMethod

ContractRate

APR

12.00%24.28%21.46%

MonthlyPayment

$88.8594.7293.33

Total Interest

Paid

$ 66.19136.36120.00


Annual Percentage Rate (APR)Annual Percentage Rate (APR)

Same as annual simple interest. In the absence of other loan fees it is the

rate charged on the outstanding loan balance.

The ratio of the finance charge to the average amount of credit over the term of the loan expressed as a percentage rate.


Rule of 78Rule of 78

Rule for determining how interest accrues on a loan.

Pushes interest earned by creditor to front of loan.

Pushes your repayment of principal to back of loan.

Early loan prepayment may be costly.


Consumer Loan ClausesConsumer Loan Clauses

Acceleration clause– Late payment entitles the lender to demand that

the entire unpaid balance be paid immediately. Add-on clause

– Lender can repossess all goods financed under the agreement in the event of a missed payment.


Consumer Loan ClausesConsumer Loan Clauses

Balloon payment– Lump-sum payment at end of loan.


Sources of CreditSources of Credit

Banking Institutions– Overdraft protection credit line– Unsecured personal credit line– Home equity loan

Consumer Finance Companies


Sources of CreditSources of Credit

Other– Life insurance policies– Margin accounts on stocks and bonds– Pawnbroker


A Credit Management StrategyA Credit Management Strategy

Use the grace period. Avoid expensive credit on revolving charge

accounts. Take a broad view of credit sources. Carefully consider the use of variable rate

loans.


BankruptcyBankruptcy

Straight Bankruptcy Wage Earner Plan


Straight BankruptcyStraight Bankruptcy

Primary form of bankruptcy. Discharges all debts and provides a fresh

start. Homeowner’s equity and some personal

assets may be partially protected. Cannot file again for 6 years. Record remains on credit report for 10 years.


Wage Earner PlanWage Earner Plan

Repayment schedule established by court. Debtor may retain property. Lenders receive partial or total repayment

over 3-5 year period. Remains on credit report for 7 years.


AppendixAppendix

Rule of 78


Calculating Loan Prepayment Under Calculating Loan Prepayment Under Rule of 78Rule of 78

Determine monthly interest factor for each month.

Multiply each month’s interest factor by total interest due on loan.

Result is amount earned by lender each month.


Calculating Loan Prepayment Under Calculating Loan Prepayment Under Rule of 78Rule of 78

Add interest earned by lender to original principal.

Subtract previous monthly payments to determine loan payoff.


Elements of Rule of 78Elements of Rule of 78

Sum of Digits (SD) = N

N + 1

2( Monthly interest factor = Month in reverse order

Sum of Digits


Figure 4.6 A 12 month installment loan Figure 4.6 A 12 month installment loan with annual add-on interest of 12 percent,with annual add-on interest of 12 percent,

Total Interest = $120Total Interest = $120

123

$ 93.3393.3393.33

Month Payment MonthlyInterestFactor

12/7811/7810/78

MonthlyInterestEarned

$18.4616.9215.38

Total InterestEarned

$18.4635.3850.77

InterestRefund

$101.5484.6269.23


NextNextChapter 7Chapter 7

Consumer Durables Consumer Durables

Chapter 6

Documents

credit history

credit costs

credit temptation

credit bureau

credit problems

credit reports

credit records

individual credit account