Sources of Loans and Credit
I. Types of financial institutions
A. Commercial Banks (example: Bank of America) –
1. accept deposits,
2. lend $$
3. transfer funds among banks, individuals and
businesses
B. Savings and Loan Associations (S&L… also known as
a ‘thrift’) = building societies
C. Savings Banks
1. savings accounts
2. Home loans
D. Credit Unions
1. Owned and operated by its members to provide savings
accounts and low-interest loans to its members
2. Not for profit
E. Finance Companies
1. take over contracts for installment debts from stores and
adds a fee for collecting the debt
F. Consumer Finance Company
1. Makes loans directly to consumers
at HIGH RATES OF INTEREST
II. Charge Accounts – allows customers to buy goods and services
from a particular company and pay for them later
A. Regular charge account = 30 day charge;
1. entire amount must be paid
2. no interest
3. credit limit
B. Revolving Charge account – allowed to make additional
purchases from a store even if previous bill not PIF
C. Installment Charge account = equal payments over time
III. Credit and Debit Cards
A. Credit card = purchases without cash
1. used in many stores
2. usually high interest
3. first credit cards in the 1950s – Diners Club and
American Express
B. Debit card – NOT CREDIT = cashless purchase directly from
bank account
IV. Finance Charges and Annual Percentage Rates (APR)
A. Finance charges = cost of credit expressed in dollars and cents
1. includes membership fees
B. Annual Percentage Rates = cost of credit expressed as a yearly
percentage; includes membership fees
V. Determining Credit Worthiness
A. Credit History
1. Credit Bureau – private business that runs credit checks
2. Credit Check – investigation of a person’s income, current
debts, details about personal life, how well debts have
been repaid
3. Credit Rating – rating of the risk involved in lending $$ to
a person or business
B. Three other credit check factors
1. Capacity to pay
2. Character
3. Collateral
C. Loans
1. Secured Loans – loan backed by collateral
2. Unsecured loans – loan without collateral
3. Cosigner – person who signs a loan contract with the
borrower and promises to repay the loan if the borrower
does not
VI. Responsibilities as a borrower
A. Pay on time
B. Keep accurate records
Credit Cards
•Americans charged more than $886 billion on their bank
credit cards in 2010. Record high = $975 billion in Sept. 2008.
By the end of 2011 expected to reach $1.177 trillion!
•The average credit card holder has more than four credit cards.
•One third of Americans do not own a credit card
•The average American credit card debt in 1990 = $2,966
•The average American had about $10,679 in credit card debt
at the end of 2008, with a typical average interest rate of
19% in March of 2007.
•Anchorage, Alaska has the highest credit card debt and Lincoln,
Nebraska has the lowest
Costs of Credit Cards
•Costs more if unpaid balance is not paid monthly
•Ties up future income
•Tempts one to overspend… impulse buying
•Reduces comparison shopping if you only shop in stores
extending credit
•Decreases future buying power
•Poor credit use can harm credit
ratings and make future
credit more expensive
Benefits of Credit Cards
•Earlier consumption; use of goods while paying for them
•Convenience
•Use for emergencies
•Establishment of a good credit history
•Consolidation of debts
Opportunity Cost = value of whatever is given up when credit
card is used
• Future income and $$ spent on interest payment
Collective Cost = if balance is unpaid each month then finance
charges on total unpaid balance begin to add up – thus increasing
the original cost
Purchasing consumable and durable goods with credit =
* Consumable – not wise UNLESS paid off each month
* Durable – better off with loans versus credit card on these purchases
due to lower interest rate and installment pay off rates with loans
The Four C’s of Credit
Capacity:
* Ability to pay
Collateral:
* Assets used as a guide to determine your ability to
repay debt
Character:
* Reputation as a reliable and trustworthy person
Credit History:
* Previous financial record… are you a good risk??
Methods of Calculating Credit Card Interest
Assume an APR of 18.9% and a daily interest rate of .05476% (.0005476)
For these examples the number of days in the cycle is 30, and only payments
have been included.
An actual active account with purchases or cash advances would be
more involved.
April 1 Opening Balance = $1,000
April 15 Payment
=
400
April 30 Closing Balance =
600
Average Daily Balance, Adjusted Balance, Previous Balance are the
three most common methods of calculating credit card interest.
Average Daily Balance:
You pay interest on the average balance owed during the billing cycle. The creditor
Figures the balance in your account each day of the billing cycle, then adds together
these amounts and divides by the number of days in the billing cycle.
Average balance = $1,000 x 15 days x .0005476 = $8.21
$ 600 x 15 days x .0005476 = 4.93
$13.14
Adjusted Balance:
You pay interest on the opening balance after subtracting the payment or returns made
during the month.
Opening Balance = $1,000
Payment
= 400
Interest calculated on 600 x 30 x .0005476 = $9.86
Previous Balance:
You pay interest on the opening balance, regardless of payments made during the month.
Opening Balance = $1,000 x 30 x .0005476 = $16.43
Interest Rates on Loans and Savings Accounts
Interest rate is the percentage amount of payment by borrowers
to the lender. An annual interest rate of 5% on a $100 loan
would translate differently depending upon how the interest
was calculated.
With a SIMPLE interest rate, interest is determined annually with
the original loan amount.
5% = .05
5% ($100)=(.05)(100)=$5.00 + $100 = $105.00
In the second year, interest would again be $5, so a person would
Owe $105 + $5 = $110.
With a SIMPLE interest rate, interest is determined annually with
the original loan amount.
5% = .05
5% ($100)=(.05)(100)=$5.00 + $100
= $105.00
In the second year, interest would again be $5, so a person would
Owe $105 + $5 = $110.
With COMPOUND interest, future interest is determined with the
existing amount owed. In the second year of a compound debt,
interest would be:
.
5%($105) = (.05)(105) = $5.25
$105 + $5.25 = $110.25
Bottom line….
Compound interest rates are greater than simple interest
rates.
In this example, the current difference is only $.25, but
compound interest over time can build up.
This is:
•good for savings accounts, but
•bad for those whose interest on debt is calculated by
compounding.
Budget Bombs…
ways to break your budget
1. Cut out all the fun stuff –
*Allow for about 5% of budget to go toward entertainment
2. Be hit or miss with savings –
*MAKE deposits consistent; pay yourself first
3. Overuse debit card –
*Use cash only instead
4. Pay only the minimum on credit card debt –
*Only charge what you can pay off each month
5. Live without emergency savings –
*Should have between three and six months of savings in a
liquid interest bearing account; the self-employed should
have a years worth of savings
6. Spend more than you earn
*Live within your means
Schwartz, Shelly K. Schwartz (2007). Six Budget Bombs. Retrieved October 2008, from
http://www.bankrate.com
Savings Accounts and Investing Accounts
Savings Accounts – offer easy availability of funds, money may
be withdrawn w/o a penalty, and there is no minimum balance.
•Trade-off = interest paid on these accounts is LOW
•Passbook (regular) savings account – customer must present
passbook to make transactions
•Statement savings account – same as passbook, but depositor
receives monthly statement
•Called “share accounts” at credit unions
Money Market Deposit Account (MMDA) – relatively high
rates of interest and immediate access to money
•Trade-off = minimum balance of $1,000 to $2,500 required
•May withdraw in person at any time
•Can only write a few checks a month against the account
Time Deposits – saver is required to leave funds in the account
for a specific period of time, called maturity
•Offer higher interest rates than savings accounts… the longer
the maturity the higher the rate
•Certificates of Deposit (CDs) – usually require minimum
deposit $250 to $100,000 – interest rates and maturity dates
vary
•Called “share certificates” at credit unions
Stocks and Bonds
Stocks (also called equities) represent ownership shares in
a corporation.
•Ownership by stock can be risky… there is no guarantee of
a return on the investment
Bonds – a formal contract to repay borrowed $$ and interest
on the borrowed $$ at regular future intervals
•Corporate Bonds = can be risky… “junk” bonds
•Municipal Bonds (munis) = issued by state and local governments.
Generally safe and tax exempt (gov. does not tax the interest paid)
•Government Savings Bonds = low denomination, nontransferable
from $50 to $10,000; have virtually no risk.