Mr. Mohamed Aljamri
Tel: 39636632
Chapter 6: Using Credit
1. Why We Use Credit:
- People use credit when they can't afford to pay for goods and services with their current
income.
- To avoid paying cash for large purchases: Credit allows people to pay for large purchases
over time, making them more affordable.
- To meet a financial emergency: Credit can be used to cover unexpected expenses or
emergencies.
- For convenience: Credit can be used for convenience, such as with credit cards.
- For investment purposes: Credit can be used for investment purposes, by borrowing
funds to invest in various opportunities.
2.
-
Improper Uses of Credit:
Some people use consumer credit to live beyond their means.
Overspending can become a habit and is a significant danger of borrowing.
Consumer credit is often used to meet basic living expenses.
Consumer credit is also used for impulse purchases and buying non-durable goods.
3. Establishing Credit
- Lenders assess creditworthiness based on various factors, such as current earnings, net
worth, debt position, and credit history.
- Building a strong credit rating is important to get approved for credit.
- Steps to build a good credit history include opening checking and savings accounts,
getting one card and making small purchases, fulfilling all credit terms, paying on time,
notifying creditors if unable to pay, and being truthful.
How Much Credit Can You Stand?
- It's important to have an idea of how much credit you can comfortably handle.
- To avoid repayment problems, limit the use of credit to your ability to repay the debt.
- A useful credit guideline is to ensure that your monthly repayment burden doesn't exceed
20% of your monthly take-home pay.
- Experts recommend debt safety ratios closer to 15% or 10% instead of the maximum
20%.
Note that the monthly repayment burden here does include payments on your credit cards, but it
excludes your monthly mortgage obligation
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Mr. Mohamed Aljamri
Tel: 39636632
Example:
consider someone who takes home $2,500 a month. Using a 20% ratio, what should she have
monthly consumer credit payments?
monthly consumer credit payments = $2,500 * 0.20 = $500.
4. CREDIT CARDS AND OTHER TYPES OF OPEN ACCOUNT CREDIT
- Open account credit is a form of credit extended to a consumer in advance of any
transactions.
- Consumers can buy up to a specified credit limit and must make payments according to
the terms.
- Open account credit is offered by retailers and financial institutions and includes monthly
credit statements.
- Consumers can avoid interest charges by paying their balance in full.
- Open account credit is available from financial institutions and retail stores/merchants.
- Debit cards and revolving lines of credit are also forms of credit that consumers can use.
Note: Revolving lines of credit are a form of credit that allows borrowers to draw funds up
to a certain limit, repay the borrowed amount, and then draw again.
Bank Credit Cards
- Bank credit cards, such as Visa and MasterCard, are a popular form of open account
credit.
- Line of Credit: The credit limit for a bank credit card is set by the issuer and is the
maximum amount the cardholder can owe at any time. The credit limit is determined
based on the applicant's credit and financial status.
- Cash advances can be obtained from participating banks using a bank credit card, but
interest begins to accrue immediately.
- Bank credit cards also allow for balance transfers, which is the ability to transfer balances
from one or more old cards to a new card.
Interest Rates and other fees
• Annual fees
• Transaction fees
• Late-payment fees
• Over-the-limit fees
• Balance transfer fees
• Foreign transaction fees
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Mr. Mohamed Aljamri
Tel: 39636632
5. Special Types of Bank Credit Cards
1. Reward Cards
Reward credit cards are a fast-growing segment that combines traditional credit card features
with incentives such as cash, merchandise rebates, airline tickets, or investments. Frequent flyer
programs, automobile rebate programs, and other merchandise rebates are common types of
reward programs offered by credit card companies. Major oil companies and regional phone
companies also offer rebate cards.
2. Affinity cards are credit cards issued in conjunction with a sponsoring group, such as a
charitable or political organization, which receives a share of the profits.
3. Secured credit cards require collateral in order to get the card and are targeted at people with
no credit or bad credit histories.
4. Student credit cards are targeted at college and high-school students and often come with
special promotional programs.
5. Retail charge cards are issued by merchants such as department stores, oil companies, and car
rental agencies. These cards are popular with both consumers and merchants due to their
convenience and ability to build consumer loyalty. They come with a preset credit limit that
varies based on the creditworthiness of the cardholder.
6. Debit cards work like a check by accessing a checking account and do not provide a line of
credit.
They look like credit cards but have greater liability exposure if fraudulently used.
Unlike credit cards, cardholders are liable for any fraudulent charges made with their debit card,
and they have limited protection if their debit card is lost or stolen. The maximum liability is $50
up to a maximum of $500, depending on the circumstances of the loss, although most banks
provide the same level of protection for debit cards as for credit cards.
7. Revolving credit lines are offered by financial institutions and are accessed by writing checks
on regular checking accounts or designated credit line accounts.
- They provide access to borrowed money through revolving lines of credit.
- These credit lines offer more credit and can be less expensive than credit cards.
- There may even be a tax advantage to using these other kinds of credit.
- The three major forms of open credit are overdraft protection lines, unsecured personal
lines of credit, and home equity credit lines.
A. Overdraft protection is a line of credit linked to a checking account that allows depositors
to overdraw their account up to a predetermined limit.
B. Unsecured personal lines of credit make a line of credit available to individuals on an asneeded basis without the hassle of setting up a new loan.
C. Home Equity Credit Lines Such lines are much like unsecured personal credit lines
except that they’re secured with a second mortgage on the home.
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Mr. Mohamed Aljamri
Tel: 39636632
6. OBTAINING AND MANAGING OPEN FORMS OF CREDIT
Opening an Account
Steps in opening an account:
1. Credit card application
2. Credit investigation
3. Credit bureau
The Credit Application
The Credit Investigation
- Once the credit application has been completed and returned to the establishment issuing
the card, it is subject to a credit investigation. The purpose is to evaluate the kind of credit
risk you pose to the lender.
The Credit Bureau
- A credit bureau is a type of reporting agency that gathers and sells information about
individual borrowers. If, as is often the case, the lender doesn’t know you personally, it
must rely on a cost-effective way of verifying your employment and credit history.
Managing Your Credit Cards
• Review statements monthly to verify entries
• Pay by due date
– minimum monthly payment
– entire amount to avoid finance charges
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Mr. Mohamed Aljamri
Tel: 39636632
Computing Finance Charges
Example:
Assume that you have a FirstBank Visa card with a monthly interest rate of 1.5%. Your statement
for the billing period extending from October 10, 2010, through November 10, 2010—a total of
31 days—shows that your beginning balance was $1,582, you made purchases of $750 on
October 15 and $400 on October 22, and you made a $275 payment on November 6.
Calculate the following:
1. The Average daily balance
2. The Finance charges
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Mr. Mohamed Aljamri
Tel: 39636632
Problems
Problem 1:
Zainab has a job with monthly take-home pay of $3,500. Using the suggested maximum debt
safety ratio, what maximum debt burden per month can she assume? (Show all work.)
Problem 2:
Ted and Karen have a combined take-home income of $4,500. Their total monthly payments on
consumer debt are $875. What is their debt safety ratio? Are they exhibiting any sign of
approaching credit problems?
Problem 3:
You have a $926 balance on your credit card account. The minimum payment on your account is
2 percent of the latest balance or $20, whichever is greater. What will be the minimum payment
this month?
Problem 4:
The APR on this account is 18%. Assuming the $926 does not include any interest charge, how
much of your minimum payment will be used for interest?
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Mr. Mohamed Aljamri
Tel: 39636632
Problem 5:
The market value of your house is $175,000 and you have a first mortgage balance of $100,000.
If a lender requires a 80% loan-to-market value ratio, how large could your home equity loan be?
Problem 6:
Denise (a single taxpayer) contributes $6,000 annually to her church. In addition, she owns a
home in which she has $20,000 equity, and she itemizes deductions. If she pays $1,000 interest
on credit cards, $6,000 interest on her home equity loan, and is in the 26% marginal tax bracket,
calculate Denise's tax savings from these interest payments.
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Mr. Mohamed Aljamri
Tel: 39636632
Problem 7:
Clare's gross salary is $36,000 annually and her after-tax income is $28,800. What is Clare's
maximum recommended monthly consumer credit payment?
Problem 8:
If your monthly before-tax income is $2,000 and your monthly take-home pay is $1,500, what is
your maximum monthly consumer credit payments?
Problem 9:
Sheldon has a home valued at $108,000 and an outstanding mortgage of $70,000. If his lender is
willing to provide a home equity loan of up to 80% of market value, how much could Sheldon
borrow using a home equity loan?
Problem 10:
Russ and Lois have a home valued at $96,000 and an outstanding mortgage of $60,000. If their
lender is willing to provide a home equity loan of up to 75% of market value, how much could
they borrow using a home equity loan?
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