Unit 5 Introduction to Consumer Credit Introduction Spending future income: an introduction to consumer credit. Survey data from 2014 found that 89% of Canadian adults had at least one credit card (creditcard.com, data from Canadian Bankers Association, 2015). Why is consumer credit so popular? In this unit you will study the fundamentals of consumer credit. Credit ratings, credit scores and credit files are part of the picture, as well as interest rates, credit card options, lines of credit and repayment. How can we avoid problems when using credit? Where do we find reliable information to help with problems related to credit? Units 5 and 6 focus on the ins and outs of credit and its related topic, debt. Learning Objectives By the end of this unit student will be able to: 1. 2. 3. 4. 5. Describe why people use credit. Identify different forms and sources of credit. Understand how interest and fees are applied to balances owing. Describe basic facts about consumer protection and credit regulation in Canada. Identify commercial and non-commercial sources of information on credit products and legislation. Learning Objectives – Consumer Credit and Loans LO1. Explain some of the trends in the use of consumer credit. LO2. Formulate generalizations that apply at the household level about relations between the following variables: income and the probability of having consumer debt; income and average consumer debt; stage in the life cycle and incidence of consumer debt and age and average consumer debt. LO3. Examine four major reasons for using credit LO4. Distinguish between enforcement of security and other ways of collecting debts. LO5. Explain how a promissory note, wage assignment, chattel mortgage, and lien differ from one another and identify a situation where each might be used. LO6. Ascertain the following by examining a chattel mortgage: the security pledged, the repayment conditions, the penalties for late payments, and the conditions under which a creditor may enforce security and the means that may be used. LO7. Compare the costs of various types of consumer loans and suggest reasons for the interest rate spread. LO8. Distinguish among debit cards, charge cards, credit cars, conditional sales contracts/agreements, and chattel mortgages. LO9. Explain the main provisions of the legislation regarding the following matters: disclosure of information about credit transactions; supervision of itinerant seller repossession of good when the borrower defaults; advertising credit; and unsolicited credit cards and unsolicited goods. Summary – Consumer Credit and Loans Consumer debt is the personal debt of households excluding mortgages. Mortgage debt is any debt secured by real property. The sum of consumer and mortgage debt is referred to as the total debt. Total consumer credit outstanding equals reported outstanding debt to lending institutions by consumers Current dollars are the value of recorded debt by lenders. Constant dollars are current dollars corrected for inflation, estimating constant prices. Debt burden is the ratio of debt to income. Personal disposable income is the total income received by people after income tax is paid. Real income reflects income after adjustment for inflation. Discretionary income is the amount of income left over after paying for food, clothing, and shelter. Consumer loans are usually obtained from a financial institution. Point of sale credit is usually obtained through credit cards, charge cards, or a conditional sales contract. Spread is the difference between the amount paid for deposits and loans. Living trusts are established while the donor is alive; testamentary trusts are established by a will. Credit unions are financial co operatives owned by their members. By definition, the members of a credit union are bound together by a common bond, such as a place of employment. Terms of the loan include amounts, rate, security, and length of time for repayment. In contrast, term of the loan is the maximum length of time the loan is to be outstanding. The maturity date is the day by which the loan is to be fully repaid. The prime rate is the lowest interest rate that financial institutions charge. A loan that is fully secured is one that has collateral equal to the value of the loan. A loan is partly secured when the collateral is less than the amount of the loan. A promissory note is an unconditional promise to repay the loan. A co-signer (guarantor) agrees to repay the loan should the borrower fail to do so. Wage assignment is an agreement that the lender may collect a portion of the borrower’s wages to repay the loan. Tangible assets pledged to secure a loan are referred to as collateral. Movable goods are called chattel. A chattel mortgage (security interest) transfers ownership of the asset to the lender. Lien is a claim registered against the property of the borrower. A borrower is in arrears (delinquent) when he or she does not adhere to the terms of the repayment schedule, and in default when the payments are delinquent and there is no success in obtaining payment. To enforce security is to realize on the collateral pledged. Debit cards directly access the bank accounts of the holder. Charge cards generally require payment in full each month. Credit cards require minimum repayment each month. A credit card permitting continued use providing a minimum payment is regularly received is called a revolving charge account or variable credit. The grace period is the time permitted for the borrower to pay his or her credit off without interest charges applying. A conditional sales contract (agreement) permits the vendor to retain title of the asset until the asset is paid for. Residual interest is the amount of interest charged from a second statement date till payment is received. An acceleration clause in the conditional sales contract permits the lender to speed up repayment of the loan. An executory contract is another technical term for a conditional sales contract. Unit 5 Slideshow – Introduction to Credit Consumer Credit – Lending arrangements between consumers and financial institutions 1. 2. 3. 4. 5. 6. Credit cards – 80% of Canadians have one, you have to be 18+ Car loans Personal loans Lines of credit – a combination of features of a credit card and a personal loan Payday loans Home equity loans The cost of these vary. Loans from family or friends tend to be cheaper (no interest) than loans from financial institutions. Consumer debt is the debt related to all the different forms of loan products above. Mortgage debt and consumer debt equal total debt. What are some concerns related to using credit? Purchases can be more expensive (fees, interest) Temptation to overspend Ties up future income, introducing uncertainty in finances Possible financial difficulties Possible damage to family relationships Can slow progress towards financial goals Advantages of Credit 1. Immediacy - Permit purchase even when funds are low. To “bridge the gap” - Can be used to cover financial emergencies - To pay for large purchases over time 2. Convenience - More secure than carrying cash - Easy to use for online purchases 3. Benefits - Points or rewards can be accrued - Insurance or other premium perks for using credit Types of Credit 1. Installment Loan - One time loan that the borrower pays back in a specified period of time with a pre-determined payment schedule - Most home mortgages, car or household furnishing loans 2. Revolving Credit (open ended) - A line of credit in which loans are made on a continuous basis and the borrower is billed periodically for at least partial pay payments - Tend to have a maximum you can borrow - Department store or bank credit cards Unit 5 Slideshow – Borrowing and Lending How do lenders decide who can borrow money? 1. Character attitude towards money, specifically look at past repayment behaviours by asking for a copy of a credit file from the credit bureau 2. Capital or Collateral some loans may need to be secured with collateral, they look at our assets to see our position as a potential borrower, sometimes will also look at present economic conditions 3. Capacity involves looking at the person’s future income and their capacity to repay the loan Lenders may qualify you for more credit than you can comfortably repay 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑡𝑜 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑁𝑒𝑡 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑐𝑜𝑚𝑒 Experts recommend that the maximum ratio to consider is 20%. (The ratio does not include housing). If the lender cannot qualify someone for a loan, they may permit a co signer A co signer becomes the joint borrower and is equally liable for the loan and fees. Should you ever co-sign a loan for a friend or family member? It depends. When young people look for apartments, they may ask for a co signer for the rent payments. Effective use of credit involves staying within capacity and knowing how the credit product works Some examples of credit terms and conditions to know: Credit cards with perks often charge an annual fee The term of a car loan is determined at the time of application A cash advance on a credit card begins accruing interest immediately You must report lost credit cards as soon as possible to avoid charges A student loan or line of credit may require a minimum course load per term Credit File/Credit Report The Credit Bureau is a reporting agency that collects and sells credit related information about consumers You can receive a copy of your credit file free from one of the credit bureaus in Canada - It lists your employer (s) and credit history, generally for the last 3-7 years - To find credit scores, you are usually charged a fee Not all creditors report payments to the bureaus Some financial institutions provide a service to help you monitor your credit information Financial literacy: 1. 2. 3. 4. What is the current spread (difference between interest on loans and interest on deposits)? Have there been any recent changes to credit and loan legislation in my province? What credit products are available today? How does one order a copy of their credit file?