Chapter 6
Building and
Maintaining Good Credit
Learning Objectives
1. Explain reasons for and against using credit.
2. Establish your own debt limit.
3. Achieve a good credit reputation.
4. Describe common sources of consumer credit.
5. Identify signs of over-indebtedness and
describe options available for debt relief.
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Reasons For and
Against Using Credit
• Credit is any arrangement in which goods,
services or money is received in exchange for a
promise to repay at a later date.
• Good uses of credit include emergencies,
reservations, convenience, owning expensive
items sooner, earning a college education, etc.
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Reasons For and
Against Using Credit
• The downside of credit:
– Use of credit reduces financial flexibility
– It is tempting to overspend
– It can be difficult to get out of debt
– Interest is costly
• Interest, Finance Charge, Annual Percentage
Rate (or APR)
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Debt Payments-to-Disposable Income
• Maximum 14% limit of monthly debt payment as percent of disposable income
• A Monthly payment (mortgage not included) of 15% to 18% as percent of
disposable income is precariously over-indebted and should NOT aquire more
debt.
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Setting Debt Limits
• Ratio of debt-to-equity method uses your
Debt-to-Equity Ratio: Ratio of your
consumer debt to your assets.
– Equity: Amount by which the value of a
person’s assets exceeds debts.
– Example: Assume a household has $9,120
monetary assets, $20,500 tangible assets and
$167,000 investment assets for total assets of
$196,620. If total household debt is $9,365, the
equity is $187,255 ($196,620 - $9,365) and the
debt-to-equity ratio is 5% ($9,365/$187,255)
– A ratio of 33% or higher is excessive.
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Managing Student Loan Debt
• When possible, choose grants, scholarships first
• Choose the most advantageous repayment
pattern allowed.
• Pay electronically.
• Make your repayments on time, every time.
• Consolidate your student loans.
• If necessary, sign up for the Federal
government’s income-based repayment plan.
• Go to http://studentaid.edu.gov/ and select
“Repay Your Loans” then “Repayment Plans”
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Credit Approval Process
1. You apply for credit.
• Credit Application – ability to pay debt
• Credit History – record of credit usage
2. The lender conducts a credit investigation.
• Credit Rating – evaluation of credit worthy
• Credit Report – Info about payment history
• Credit Bureau – Firm that collects history
• Credit Scoring (or Risk Scoring) System –
rates credit worthiness & likelihood of
repayment
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Credit Approval Process
3. The lender decides whether to accept the
application.
• Credit Agreement – loan on credit card
• Promissory Note
• Tiered Pricing
- Interest rate charged
based upon level
of risk
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Making Sense of Your
FICO Credit Scores
• Percent indicates weight of characteristic used when determining credit score
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Your Credit Reputation
• Building credit history: Ways to establish Credit:
– Establish both a checking account and a
savings account.
– Have your telephone and other utilities billed
in your name.
– Request, acquire, and use an oil-company
credit card.
– Apply for a bank credit card.
– Ask a bank for a small short-term cash loan.
– Pay off student loans.
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Your Credit Reputation
• Managing your credit bureau file for free
• Fair Credit Reporting Act (FCRA) – Requires
that credit reports contain accurate, relevant,
and recent information and access is restricted
for approved purposes.
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Sources of Consumer Loans
•
Depository institutions such as commercial banks, mutual savings
banks, savings banks and credit unions loan money to their banking
customers. – Wells Fargo, First National Bank, Centris Federal, etc.
•
Sales finance companies loan money to buy consumer products.
GMAC Financial Services, Ford Motor Credit
•
Consumer finance companies make small cash loans. CitiFinancial,
Beneficial Finance Corp, HSBC, Household Finance, etc.
•
Stockbrokers loan money to their clients. Charles Schwab, Fidelity
Investments, A.G. Edwards, etc.
•
Insurance companies loan money to their policyholders. Allstate,
State Farm, Farmers Insurance
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What it Costs to Borrow Money
• Above payment schedule based upon $1,000 Loan over two and five year periods
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10 Signs of Overindebtedness
•
Exceeding debt limits and credit limits
•
Not knowing how much you owe
•
Running out of money
•
Paying only the minimum amount due
•
Requesting new credit cards and increases
in credit limits
•
Paying late or skipping credit payments
•
Using debt-consolidation loans
•
Taking add-on loans
•
Experiencing garnishment
•
Experiencing repossession or foreclosure
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Debt Collection
• Federal law regulates debt collection practices.
• Federal Fair Debt Collection Practices Act
(FDCPA)
– Prohibits third-party debt collection agencies from
using abusive, deceptive and unfair practices to
collect past due debts.
• Debt collection agencies
– Specialize in making collections that could not be
obtained by the original lender for a fee.
– Prohibited from calling at unusual hours, numerous
calls, false claims, contacting employer and abusive
tactics
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Steps to Take to
Get Out from Under Excessive Debt
• Determine your account balances and the
payments required.
• Focus your budget on debt reduction.
• Contact your creditors.
• Do not take on new credit.
• Refinance.
• Find good help.
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Bankruptcy
• Bankruptcy is a last resort.
• Discharged debts
• Chapter 13 of the Bankruptcy Act:
Wage earner or regular income plan – Reorganization
plan to repay debts in 3-5 years
– Stay – prevents creditors from recovering claims
temporarily before court proceedings
• Chapter 7 of the Bankruptcy Act:
Straight bankruptcy – liquidation (sale) of assets to repay
creditors and remains on record for 10 years
– May result in future problems when credit requested for home or
car purchase
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The Top 3 Financial Challenges in
Building and Maintaining Good Credit
People experience difficulty in building and
maintaining good credit when they do the
following:
1. Make late payments on credit cards.
2. Pay more than 14 percent of disposable
income toward nonmortgage debt payments.
3. Fail to regularly check the accuracy of credit
bureau files.
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Good Money Habits in Building
and Maintaining Good Credit
• Protect your credit reputation just as you would
guard your personal reputation.
• Calculate your own debt limits before taking on
any credit.
• Obtain copies of your credit bureau reports
regularly, and challenge all errors or omissions
on them.
• Never cosign a loan for anyone, including
relatives.
• Always repay your debts in a timely manner.
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Questions ?
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