12 consumer credit - why business?thssbusiness.com/business-10/chapter-12.pdf · • explain the...

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12 Consumer Credit

S p e c i f i c E x p e c t a t i o n s

After studying this chapter, you will be able to

• explain the advantages and disadvantages of consumer credit

• describe the process of establishing a personal credit rating andapplying for and obtaining credit

• calculate the total cost of credit on a variety of loans

In chapter 12, we investigate consumer credit, when to use and avoid it, how much

it costs, and how it can either help or ruin a financial plan. Credit can help you achieve

your financial goals if you use it to acquire assets that you can afford, based on your

income. Credit can also help you build wealth if you use it to acquire training that

improves your income or assets that increase in value. However, credit can create

misfortune for those who try to “charge” a lifestyle that their income cannot pay for.

In this chapter, you will learn how to establish a credit rating and how to maintain a

good credit rating. You will also learn about the real costs of different types of loans.

C H A P T E R 1 2 Consumer Credit • MHR 323

The Wheels of FortuneBobby and Lawrence had stopped for lunch after drywalling Lawrence’sbasement apartment on a rainy Saturday morning. Burt, Lawrence’s friend,had dropped over to see how they were doing because he was going torent the apartment. Bobby began talking about buying a truck.

“My business teacher says that if you are self-employed and use atruck in your business, part of the expense is borne by the business. Yousubtract the business truck expenses from the business’s gross income.Only my personal use of the truck would be a personal expense. If I getthis weekend basement renovation business going, I can afford a truck.”

“In fact, if you work for homeowners, you have to have a truck,” saidLawrence. “It’s not like working at DelMarco. You have to provide every-thing for the customer. But you charge the customer for that too. Justmake sure you research all the costs and set your prices right.”

“For sure. I’m working on a business plan in one of my classes. WhatI’d like is an F250 pickup with ...”

“Hey, Bobby, choosing a truck is the easy part! Me, I’d like a ChevyS10 with a crew cab. That’s what I’m aiming for when I buy, maybe threeyears from now. Once I have paid my mortgage down a bit and paid offmy reno loan, I can afford a little consumer debt.”

“A crew cab? Wow! Are you planning to get married and start a family?”

B U S I N E S SP R O F I L E

Figure 12-1 A big purchase like a truckrequires a carefully thoughtout financial strategy.

“For your information, Bobby, a four-seater is really handy when fourguys go fishing.”

Burt listened, but did not have much to say. He was thinking aboutfinances too, but he had big problems. His status car, which cost $43 000when he bought it, had cost him a lot recently. It was beautiful, the envy ofall his friends. But it was expensive to maintain and insure, and he hadn’teven finished paying for it. When he got short on cash a while back, he hadbegun using his three credit cards for as many expenses as he could, think-ing he could deal with them later.

As an administrative assistant, he had an adequate salary, but notenough for the lifestyle he was living. It was years since he had paid off abalance on his charge cards. The compound daily interest was making thebalance rise much more rapidly.

He was trying to get control. He stopped putting so many frivolousexpenses on the cards. No more restaurant bills. Just necessities and reg-ular car expenses. But then a big car repair expense put him over the limiton one of his cards.

Right now, he was negotiating a bank loan to clear the charge carddebt. The bank would only charge him 10 percent interest, compared tothe average of 16 percent interest on his cards. But that same bank gaveLawrence a mortgage loan at only 6.25 percent! Why the big difference?

Burt did not feel like sharing his problem with Lawrence and Bobby,because he was so embarrassed. To try reducing his debt, he haddecided to work a lot of overtime. He knew he had to do somethingbecause the bank manager wasn’t sure about giving him the loan. Sheexpressed surprise that he was nearly 30 and had no assets.

“Don’t you count the car?” he asked.“Well, because it’s four years old, it has a bit less than $16 000 value

left,” she explained. “Cars aren’t like houses. They lose value every yearyou drive them. We bankers say that the asset depreciates. What youneed are assets that appreciate — for example, investments that earninterest every year. Burt, you are on the wrong side of compound interest.Let’s get on the right side!”

Burt promised to think about it.What does the bank manager mean when she says that Burt is on the

“wrong side” of compound interest? As you read the chapter, note how thesame compound interest that increases the value of investments can workin reverse and empty bank accounts. Will getting a bank loan be enoughfor Burt? What other steps may he need to take?

324 MHR • U N I T 3 Personal Finance

Consumer CreditOver the past 30 years, Canadian consumers have been using credit agreat deal (see Figure 12-2 below). Is this a bad thing?

The answer is not a simple yes or no. If being in debt were always abad thing, Lawrence would be much worse off than Burt. Lawrence owesover $176 000 on his house. Burt is only about $30 000 in debt becauseof his car and credit card expenses. But the bank manager thought thatBurt, not Lawrence, was in big trouble. Why do you think that is?

Here is how the bank manager sees it: Lawrence’s house will prob-ably keep its value. In fact, its value will rise if more people move tohis community. By putting in a legal basement apartment, Lawrence isfurther increasing the house’s value, and will earn money from it. Whenhe has paid off the house he can live there inexpensively and still col-lect rent. So, the house is a smart investment. The mortgage loan is anecessary expense for the investment. The bank manager was happy tolend Lawrence the money at 6.25 percent.

But what about Burt’s car? It is a big expense to him. It does notearn him any money. Its value goes down every year. True, he needs acar to get to work, but a much less expensive car would provide thesame service. Although the bank manager might lend money to Burtbecause he has a steady job, she wants a much higher interest rate.Burt’s car was not a smart investment. Spending more money on theproblem is not a good idea.

An important question to ask about debt is this: Will borrowingeventually create income or savings, or will it simply create more debt?

What I s ConsumerCred i t ?

When consumers borrow money formortgages and personal loans, and whenthey pay for purchases with credit cards,they are using consumer credit.Lawrence has used two types of con-sumer credit for his house: a mortgageand a personal renovation loan. Burt alsohas two kinds of credit: a car loan and


$180,000$160,000 $140,000$120,000$100,000

$80,000$60,000$40,000$20,000

$0

(milli

ons

of d

olla

rs)

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998

Outstanding Consumer Credit, 1971 – 1998

Figure 12-2 What factors in our society encourage people to buy on credit? Which of these factors is most important?

Who uses credit?According to StatisticsCanada, 50% of house-holds in which the mainincome earner isbetween 25 and 34 owemoney on credit cardsor installment plans.

credit card debt. Credit card debt, almost without exception, carries thehighest interest rate.

Generally, apart from emergencies, you should borrow money onlyto acquire something that will do one of two things: • appreciate (go up in value) • earn income.You should not borrow for things that • depreciate (go down in value) or • run up a lot of extra expenses.

Lawrence’s house, for example, was likely to appreciateand earn money. Burt’s car was certain to depreciate

and run up a lot of extra expenses.This does not mean that a house is always a

good investment or that a car is always a bad one.A poorly chosen house can depreciate. Borrowing

money for a car can be smart. Burt, for example,would have been smart to borrow money for a mod-

est car when he got his job. A car that he could affordwould be a good investment because it would help him get

to work to earn income and would not put him into serious debt.

Advantages o f Consumer Cred i t

Credit can help you achieve your financial goals if you use it wisely. Forexample, assume Lawrence tried to save up all the money to buy ahouse. He might be an old man before he reached his goal. He wouldhave the expense of paying rent and would not have the income froman apartment. House prices in his area might even rise faster than hecould save. For him, consumer credit was a wise choice, based on afinancial plan and a budget.

You will recall from Chapter 11 that Lawrence also took a personalloan of $5000 for the renovation. He would have been better off to takea larger mortgage, because the mortgage interest rate was lower (10percent for the renovation loan vs. 6.25 percent for the mortgage). Butin general, he hasn’t made a big mistake. After all, the “borrowed”money meant he was able to buy inexpensive building materials. Also,he used the loan for a capital improvement. That is, he used it tobuild something—an apartment—which adds value to the house(causes it to appreciate).


WebnectConnC

On their Web sites, the Canadian AutomobileAssociation and Rogers Media have excellent

information on owning a car in Canada.

http://www.mcgrawhill.ca/links/exploringbiz


A student who needs to go into debt for tuition faces similar deci-sions. The student needs to ask whether the training, certificate, diploma,or degree will lead to a job or another type of benefit that will justify theloan’s expense.

The fact that credit card debt carries the highest interest rate doesn’tmean that credit cards provide no advantages. Misuse of credit cards isthe problem. A credit card comes in handy for a wise purchase whenyou don’t have cash. It is very valuable if you find yourself strandedsomewhere. However, as you learned in Chapter 10, you should pay offyour credit card balance as soon as you receive your statement in the mail.Carrying a balance costs a lot because credit card interest is very high.

Disadvantages o f Consumer Cred i t

The greatest disadvantage of consumer credit isthat you may be tempted to borrow money tofinance purchases that depreciate, and to live alifestyle whose expenses your income cannot payfor. You won’t be building wealth because youhave to pay off purchases with high interest rates.

For example, Burt’s financial future is threat-ened by unwise use of consumer credit. Hereally could not afford the car of his dreams. ButLawrence and Bobby, who manage their finan-cial affairs wisely, will buy vehicles they wantwithout sacrificing their income and credit rating.Each of them has a plan for managing consumercredit to his advantage. Lawrence will wait till hisassets are high and indebtedness is low. Bobbywill use the vehicle largely in his business, whichmeans that most of the expense for his truck is abusiness expense and is subtracted from what heearns before his income tax is calculated. He willalso have the personal use of the vehicle. Youwill recall from Chapter 8 that the business entityprinciple of accounting requires that the businessbear its own share of the vehicle’s expenses.

F igure 12-3 Thedebtors’ prison. For manycenturies, failure to paydebts was a crime, punish-able by imprisonment. Theestablishment of the moderncredit system in the19thcentury ended imprisonmentfor debt.

Note that you are responsible for using credit to youradvantage. The financial institutions that let you havecredit cards or lend you money do not have to do yourfinancial planning for you. Because Burt had a steadyjob, financial institutions lent him the money for the sta-tus car and let him pile debt on his credit cards. The factthat he was not getting ahead financially was his prob-lem, not theirs. They will only refuse him money if theythink he cannot ever pay them back.

K n o w l e d g e / U n d e r s t a n d i n g

1 What is appreciation of an asset?2 What is depreciation of an asset?

T h i n k i n g / I n q u i r y

3 Give an example of an asset that will probably appreciate. Find one that isnot in the text.

4 Give an example of an asset that will probably depreciate. Find one that isnot in the text.

C o m m u n i c a t i o n

5 Anna would like to take the four-year registered nursing course at a localuniversity. Her math and science marks are good. She could live at home,but she must go into debt for tuition. Her mother thinks she should take atwo-year health care aide course instead. A friend took such a course andis now making $18 per hour. “You say you could make $30 per hour as anurse,” her mother says, “But you might not get a job. And you will have amuch bigger debt. You can’t afford to take risks like that!”

Write a note to Anna giving your perspective. Use what you have learnedin Chapter 9 on the factors that determine income and what you havelearned in this section on consumer credit. (a) How big a risk is Anna tak-ing? (b) Are there risks that her mother is not considering? (c) What do youthink these risks might be?


Check Your UnderstandingFigure 12-4

Many factors canincrease our desire toshop; attractive surround-ings are one. The designof Toronto Eaton Centre,which opened in 1979,has been widely imitatedbecause it lures creditcards out of wallets. Howdo shopping plazas inyour area do this?

S k i l l sA p p e n d i x

critical thinkingbuilding an argument


A p p l i c a t i o n

6 Bobby plans to write off the business portion of the cost and operatingexpenses of his truck. List the types of expenses that Bobby shouldexpect. If you are unsure, ask people you know who own a motor vehicle.

Establishing a PersonalCredit RatingYour credit rating is your reputation for paying back money you owe.A good credit rating is important for managing personal finances. Afterhigh school, you will likely need a good credit rating if you want to rentan apartment or borrow money to buy a car. Protecting your good rep-utation with money is important.

Apply ing for Cred i t

Credit ratings pose the same problem for students as job experience: Youmust earn a credit rating—but how can you earn it if people won’t give youcredit? Many young people start to earn a credit rating by getting a phonein their own name while living away from home, perhaps at college.

Credi t CardsAnother way that students develop a good credit rating is by getting astudent credit card that they use sparingly and pay off every month.They may be invited to apply for a card at a display set up by a finan-cial institution during registration. Or they fill out the application andhand it in at the financial institution. A young person who has a steadyjob is also eligible for credit in most cases.

Most first-time credit cards have a low limit. A limit is the amount ofmoney the financial institution that sponsors the card is willing to allowyou to charge to it. If you pay your balance promptly, they may give youa higher limit. If you develop a very good credit rating and have a highincome, your limit might reach $10 000. Most cardholders would notwant a higher limit than this, in case their card was stolen. As a rule, theywould not need a higher limit because, as you learned, a different formof credit is used for very large purchases such as homes or cars.

How did credit cards getstarted? In the late1940s, several U.S.banks started giving theircustomers speciallyissued paper that couldbe used like cash in localstores. The successor,credit cards, are nowwidely used and availablethroughout the world.Each year, they accountfor well over a trillion dol-lars worth of purchases.

Interest rates vary a lot oncards. The interest charged by abank can be as low as 10 percent.But many retail stores and outlets,such as The Bay, Canadian Tire,or Petro Canada, issue their owncards, known as retail cards. Theycan charge as much as 30 percentper year on their cards. Somecards also charge an annual fee,usually between $10 and $100 peryear. Others charge a monthly feefor services such as insurance incase the card is stolen. When youare offered a credit card, askabout all charges before youaccept the offer.

When you apply for a creditcard, the financial institution mayask you to find a person whoalready has a good credit rating to

co-sign your application. The co-signer agrees to pay your debt if youdon’t live up to your responsibilities.

You must keep within your credit limit and make the minimumpayment each month, usually 5 percent of the total outstanding balance,by the due date. If you don’t, further purchases or cash advances maybe declined (turned down). This can be very embarrassing in a restau-rant or a busy store.

Keep in mind that when you use a credit card, the financial institu-tion is advancing money to the owner of the business for your debt.Once the business deposits the charge slip to get the money, you owethe money to the financial institution. If you don’t pay, the financialinstitution will stop paying your debts, and may take other actions, asdiscussed below.

Are credit cards a bad thing? In 2000, over half of Canadian creditcard holders paid the entire outstanding balance each month on theircredit cards. For them, the credit card was a short-term, zero-interestloan. The other half did not pay off the balance. For them, the creditcard became a very high-interest loan. That’s what happened to Burt(see Figure 12-5).


CHARGE WORLDINCORPORATED

STATEMENT DATE

01 02 01

CREDIT LIMIT BALANCE ON LAST STATEMENT

ANNUAL INTERESTRATE

DAILY INTERESTRATE

6000

18.5% .05068

PAYMENT DUE DATE PAST DUE/OVER LIMIT

01 28 01 120.00

2089.45 - + + =

+ =

TOTAL CREDITS

0

TOTAL DEBITS

4875.47

TOTAL INTEREST NEW BALANCE

MINIMUM PAYMENT DUECURRENT DUE

29.12 6964.92

472.98352.98

1 800 123-4567 1314 1516 1718 1920

01 02 01 Gifts for the Whole Family Christmas Shoppe

01 04 01 Gov't of Ontario Motor Vehicle Plate Fee - 2 yrs

01 07 01 PetroCanada 2 Orangeville

01 11 01 Groceries on the Go Delivery Stoufville

01 16 01 Pamper's Car Care Service

01 19 01 Fab! Fabrics Dry Cleaning

01 21 01 PetroCanada 2 Orangeville

01 24 01 Groceries on the Go Delivery Stouffville

01 29 01 Hank's Import Auto Service Markham

805.72

148.00

28.29

57.01

197.00

29.00

27.42

72.01

3511.02

Orangeville ONACCOUNT NUMBER

M D Y

F igure 12-5 This is the statement for Burt’s highest interest chargecard, and he forgot to make a payment last month. He charged the autoservice on this one because the others were already near their limit. Whichof the types of expenses on this card could Burt reduce? Eliminate?


The Cred i t Rat ingSome people who can’t pay their credit card bill try to get new cards fromother financial institutions. Do they succeed? To try to prevent this, insti-tutions use the services of credit bureaus. Credit bureaus are companiesthat gather and provide information on the credit history of potential cus-tomers. Credit history is the history of paying back debts. Financial insti-tutions provide this information to the credit bureau, which in turn sharesit with other financial institutions for a fee.

Credit bureaus keep a record of your credit rating for the last sevenyears. A lender or property owner who wants to do business with you maypay to find out your credit rating. They want to know if you are a “latepayer” or, worse, in default. Default means that a debt has gone unpaidfor so long that the creditor wonders if the money will ever be paid.

A reputation as a bad credit risk can be very serious—you could bedenied a loan for a car, for example, even if you need it to get to a newjob. Property owners may refuse to rent to you. Stores may insist on cash.

Burt was in serious danger of developing a bad credit rating. Afterseveral years, he could barely pay the interest on his charge cards, letalone pay down the principal. Luckily, he realized that his situation sig-nalled a serious financial problem (see Figure 12-6).

Why Burt’s Debts Were Becoming Unmanageable

1997 1998 1999 2000

Bert’s net pay $40 000.00 $42 000.00 $45 000.00 $45 000.00

Car payments/year 10 860.96 10 860.96 10 860.96 10 860.96

Total charge card 1 000.00 5 000.00 11 000.00 17 000.00balances (3 cards)/year

Rent/year 14 400.00 15 120.00 15 877.80 16 672.80

Other expenses/year 10 000.00 10 000.00 11 500.00 8 000.00

Surplus savings/(shortfall) $3 739.04 $1 019.04 –$4 238.46 –$7 533.76

F igure12-6 These expenses show why Burt’s debts were becoming unmanageable by 2001.He has three credit cards, each with a high limit, and no budget. A luxury apartment, a luxury car,and a matching lifestyle meant hardly any savings or investments. Burt put many expenses, includ-ing car-related ones, on his credit cards and often carried balances from month to month. He forgotto make a payment last month, and a big, unexpected expense put him over the limit. Can you seewhy the bank manager told him he was on the “wrong side” of compound interest?


Credi t Counse l l ing

After receiving the statement shown in Figure 12-5 for one of his creditcards, Burt sought confidential advice from a local credit counsellingservice. The not-for-profit agency, which is supported by financial insti-tutions, is one of a network of organizations across Canada that helpspeople deal with debt problems. The counsellor did not lecture Burtabout his lifestyle, but did help him understand the significance of thefigures shown in Figure 12-6. Then he helped him develop a realisticbudget to reduce his debt.

One option was for the agency to contact the financial institutionsand arrange a payment plan that let Burt take longer than usual to payoff his debt. Burt would pay the money to the agency, and they in turnwould pay it to the creditors. Meanwhile, the creditors would promisenot to send threatening letters or try embarrassing tactics like phoningBurt at his work.

But this payment plan was not necessary. Burtaccepted that, on his salary, he could not afford a

luxury car, or the lifestyle that went with it.Because he needed a car to get to work, he soldhis luxury car and got a much cheaper one. Burtacted before he could no longer afford to make

payments on the status car, so he ensured that hecould still get a loan for the new one. He decided to

consolidate (put together) the remaining credit card debt(which averaged 16 percent in interest) and took out the personal

loan at 10 percent to pay it off. The bank manager was willing to lendhim the money once he had lowered his living costs.

Obta in ing Cred i t

You should use a credit card only for expenses that you expect to payoff within a month. For longer-term debts, many other types of con-sumer credit—loans for a variety of purposes at a variety of interestrates—are available. Usually, the interest rates are lower. The managerat the financial institution decides whether the borrower qualifies forthe loan. You have already learned basic facts about mortgage loans inChapters 10 and 11. The following are some other major varieties ofconsumer credit.

WebnectConnC

Take a look at the different rates charged by creditcard companies in Canada, and decide which card

would be the most economical to use.

http://www.mcgrawhill.ca/links/exploringbiz

Three tips from theCanadian BankersAssociation on buildinga good credit rating: • Pay your bills promptly,

especially credit cards.• Borrow only what you

need, and what youcan afford.

• Try to pay off loanson time, and as quicklyas possible. Not onlydoes it help your creditrating, you also savevaluable interest costs.


Persona l LoanIf you are a qualified borrower, a financial institution may allow youto take out a personal loan for almost anything: a computer, a holiday,home renovations, or an investment. The financial institution is notconcerned with whether your purchase is a good idea, only withwhether you can afford the monthly payments, given your sources ofincome and your level of debt and assets. Personal loans must berepaid in equal monthly payments for the term of the loan—usuallybetween one and five years.

Car LoanThe interest rate for a car loan is often less than the rate for a personalloan. But financial institutions usually restrict these loans to the pur-chase of new cars. This is because a new car has several features thatassist financial calculations:• a generally agreed value• marketability at or near the agreed value • a warranty against serious defects, which would significantly reduce

its value (usually three years or 60 000 km).Thus, the car itself is collateral against the loan. By contrast, the

value of older used cars (more than three years old) can vary signifi-cantly, depending on where, how, and how much they were driven.For a used car, the bank may insist on the higher “personal loan” rate.So, when deciding between new and used, the customer needs toweigh differing interest rates and performance guarantees against thevehicle’s price.

Car loan customers are wise to get pre-authorization from the bankbefore they go shopping. Pre-authorization is the bank’s guaranteethat it will advance the customer an agreed amount of money; it isbased on the customer’s income and other debts. Recall that Lawrencegot pre-authorization for a mortgage loan. Pre-authorization assures youand the seller that you can afford the purchase. It reduces the risk ofsigning an agreement for which you cannot raise the funds.

Persona l L ine o f Cred i tA personal line of credit is a permanent offer of a loan from a finan-cial institution. If you have a personal line of credit, for example, youcan write a cheque for more than your chequing account balance andthe financial institution will advance you the amount required to make

up the total. The amount that is advanced becomes a personal loan.Similarly, the personal line of credit would ensure that funds wereadvanced to meet an automatic monthly payment. The interest on theseloans is lower than on credit cards, but only customers with very goodcredit ratings are eligible for this type of loan.

Ins ta l lment P lanAn installment plan is a loan granted either by or through a retailerfor an expensive purchase such as a TV. Or a fuel gas company, forexample, may offer financing for energy-saving renovations that will bepaid for on the fuel bill. The fuel company already knows whether thecustomer is reliable. The item is delivered or installed immediately, andthe loan is paid off monthly thereafter. To qualify for these types ofloans, the customer must choose a product offered by or through theretailer or provider.

Interest rates for installment plans match retail credit card rates orhome renovation loan rates. But sometimes the creditor offers lowerrates to get business. Items may even be sold on “interest free” install-ment plans—in other words, the retailer pays the interest costs of theloan. “Interest-free” offers usually require the installment loan to bepaid within one year.

Are installment plans good or bad for the customer? It depends onthe alternatives. An installment plan for fuel-saving renovations mightbe smarter than trying to save the money while paying higher fuel costs.However, with TVs, the company may be trying to clear outdated orunpopular stock by offering bargain financing. Another problem is that,lured by an offer of “no money down,” you may buy a more expensiveitem than you can afford.

Deal ing w i th Cred i t You Cannot Af ford

Fa i lure to Make PaymentsWhen a customer does not make payments on credit cards or personalloans, after a few reminders by phone or mail, the financial institutionmay use a collection agency. A collection agency is a company hiredto collect overdue accounts from customers. The agency may resort toannoying, persistent, embarrassing calls and letters to get action.


Don’t shop for a largepurchase alone—takea skeptical, neutral friend.Do not sign anythingon the sales floor. Breakfor a snack with yourfriend, talk it over, con-sider other options, andthen decide.


Collection agencies must operate according to rules established by law:• They may contact you at home or at work to try to collect a debt

but only between 7:00 am and 10:00 pm. • They cannot call you or your family so often that the number of

calls could be considered harassment.• Collection agencies can only discuss the details of your debt with

you and the creditor.• Collection agencies cannot contact your friends, neighbours, family,

or employer except to have the employer verify employment, or getyour address or phone number.When customers do not pay regularly on an installment plan or car

loan, the purchase may be repossessed (taken back) and the customer’scredit rating will be damaged. A bank may take money from bankaccounts to pay outstanding debts. Wages can also be garnisheed—money is removed from the pay cheque at the same time as income taxand mandatory government deductions.

Persona l BankruptcyThe customer who simply cannot pay debts faces personal bankruptcy.This disastrous outcome is happening to increasing numbers ofCanadians who use credit unwisely. The conditions for bankruptcy arethat the person must• owe at least $1 000• be unable to meet regular payments• owe more than his or her assets are worth.

Personal bankruptcy is devastating—you must sell all assets other thanclothing, furniture, and personal items. You cannot get credit for sevenyears. Fortunately, the use of a budget and financial plan make bank-ruptcy a very unlikely event.

F igure 12-7 Do youthink that credit problemscould cause stress in reallife (as opposed to the life ofa cartoon character)? Whatkinds of stress?


1 Suggest two ways you can establish a credit rating.2 What does co-signing for a loan mean? Would you co-sign a loan for some-

one? Explain your decision.


3 No Money Down! No Payments Till Next Year! Do these claims in adssound too good to be true? Obtain flyers offering these incentives andread the fine print regarding the terms and conditions. What did you learn?Could the merchandise end up costing more than a straightforward creditpurchase? If the offer is good only on “selected merchandise,” could therebe hidden pitfalls? Explain.


4 Debate the following statement: Society would be a better place if finan-cial institutions stopped people from getting into high credit card debtbefore they reach a crisis.


5 Must a good time be an expensive time? Assume an unexpected expensehas cut deeply into your savings. Explain how you would handle the follow-ing situations:• You promised to treat a friend to a birthday dinner and movie. You can

spend $20.00. Research reduced-price nights and two-for-one deals andpresent the best local deal to a group or the class.

• You need to buy holiday gifts for five family members, including an eld-erly man, a middle-aged woman, a teen (girl or boy), a seven-year-oldgirl or boy, and a baby. You can spend $50.00. (Note: You can offerservices instead of money, as long as they have a financial value.) Listwhat you would do and why.


Check Your Understanding


analysing media


brainstorming


Calculating the Cost of CreditAs you know, when banks lend money, they calculate the interest rateusing a number of factors:• credit risk• inflation• term• profit for the bankAs a result, interest rates can range from a low of 5 percent per year fora mortgage to 16 percent per year or more for a personal loan.

Burt’s car loan, at 10 percent, is costing him a lot. The status car cost $42 085, which included taxes, air conditioning, and delivery, Take alook at Figure 12-8 to see just how this breaks out.

If Burt had researched and negotiated different loan conditions,would he be better off? Figure 12-9 takes a look at available options.

Different loan conditions would have reduced Burt’s indebtedness,but he still could not really afford a status car. After he had drawn up afinancial plan, Burt sold his status car and bought a Honda Civic coupe.The trade-in price for the four-year-old car was less than $16 000. Thisalmost covered the cost of the two-door Civic, including all taxes. Burtwas smart enough to search for a two-year-old car, still on warranty, withvery low mileage.

Burt, Lawrence, and Bobby had a steak barbecue to celebrate Burt’scar-loan and credit-card freedom day. Burt cut up two of his threecards. “Sure, I miss the luxuries,” he said, “but I don’t miss the sleeplessnights. Last year, my heart was racing more often from opening my billsthan from driving a beautiful car.”

Burt’s current car loan:Facts FiguresSticker price of car 4 years ago $35 900.00Add in taxes, delivery costs, etc. $42 085.00Monthly payment $905.08Term 5 yearsDown payment $2000.00Annual interest rate 10%Gross cost of car including interest costs $56 304.90Trade-in value after term (5 years) $12 137.79Net cost of car $44 167.11

F igure 12-8

Bear in mind that Burt willalso spend over $5 000 ayear to operate the vehicle,including fuel, insurance,fees, and repairs not cov-ered by warranty.


Once he had sorted out his car problems, Burt arranged to pay off thecredit card companies. Remember that the bank manager had given him apersonal loan to consolidate them. Why is that an advantage? You’ll recallfrom Figure 12-6 that Burt had amassed a whopping $17 000 balance onhis three credit cards. The balance compounded daily, with an averageyearly interest rate of 16 percent. But the $17 000 personal loan has only a10 percent interest rate. Also, the loan will compound monthly, whereasthe charge card balances compounded daily. Have a look at Figure 12-10to see how much difference this consolidation will make to Burt.

Consumer credit is not good or bad in itself any more than the inter-est rate is good or bad in itself. The smart personal financial managerdevelops a good credit rating, and then treats credit as a financial instru-ment to be used—or set aside—as part of a plan for building wealth.

Car Loan Options Available to BurtIf Bert Sticker Add-in Monthly Term Down Annual Gross Cost Trade in Net costchanged price of taxes, payment payment interest of vehicle at end of of vehicleloan car – 4 delivery. rate including term (Grossconditions: years costs, etc interest cost minus

ago costs trade-in)

Change term $35 900.00 $42 085.00 $1 080.40 4 years 2 000.00 10% $53 858.98 $15 577.01 $38 281.97to 4 years

Change term $35 900.00 $42 085.00 $1 374.52 3 years $2 000.00 10% $51 482.64 $19 604.99 $31 877.65to 3 years

Change term $35 900.00 $42 085.00 $1 334.87 3 years $2 000.00 8% $50 055.19 $19 604.99 $30 450.20to 3 years and negotiate 8%interest rate

Change term $35 900.00 $42 085.00 $1 146.85 3 years $8 000.00 8% $49 286.54 $19 604.99 $29 681.55to 3 years

and negotiate8% interest rateand increasedown paymentto $8 000.00

F igure 12-9

If Burt had researched andplanned his car purchasemore carefully, the overallcost at the endof the loan term wouldhave changed greatly.

Saving on Interest Debt$17,000.00 Monthly Total Total Time toDebt Payment Interest Interest & Pay Off

PrincipalCharge Cards 16% $450.00 $6 802.00 $23 802.00 4 years and 5 months

Consolidated $450.00 $3 503.97 $20 503.97 3 years and 10 monthsLoan 10%

F igure 12-10 Withthe same monthly pay-ment, Burt will pay off hisconsolidated loan soonerand with less interest thanhe could pay off the creditcards. How much will Burtsave in interest?


Check Your Understanding


1 Identify two factors that determine the final cost of borrowing $5000.


2 Kim Seong’s father will buy her a computer system for up to $1500 on credit. He has asked her to research financing options. Byte Shoppewants $1200 for a suitable system. Kim has identified the followingoptions: a) Bank loan at 9% interest compounded monthly for one year. b) Zed Computer Store’s installment plan—a zero-interest loan for one

year, repayable in 12 equal monthly installments. However, Kim mustpay $1365 for an identical system.

c) Byte Shoppe’s once-a-year Midnite Madness sale happens tonight. At10:00 p.m., Kim and her father can get the same system for $1150.Because of the rush, her father can finance the purchase only by get-ting a Byte Shoppe credit card at 22% interest, compounded daily. Hecan afford to pay off the cost as follows: $250 before the due date;$400 on the next monthly statement, and $500 on the one thereafter.

Which offer results in the lowest overall cost to Kim’s father? Ignore taxesand delivery when computing your answer.


3 Prepare a chart that Kim can use to demonstrate to her father whichoption costs least. Include figures for all three options.


4 Assume that after the sale the Byte Shoppe agrees to hold an unsold com-puter system for Kim for two weeks, for a firm price of $1150. This givesKim’s father time to obtain a credit card sponsored by a financial institu-tion. Research the best rate available to him. Can you find a rate lowerthan the personal loan rate?


researching


Socia l Respons ib i l i ty

Postsecondary Education: A Challenge to Your Credit Management Skills

Your high school education is funded by localproperty taxes and provincial grants. Once yougraduate from high school, you must finance fur-ther education yourself. The first big credit deci-sion many Ontario students make is how tofinance postsecondary education. Your school’sguidance office provides many resources on thissubject. Consider the following options:

Financial assistance as a gift (not a loan). First,research any assistance you need not repay:

This includes scholarships (financial rewardfor academic achievement), bursaries (awardbased on need), and grants (money awarded bygovernment under a specific program). Also findout whether a union or religious or cultural organ-ization of which your parent or guardian is amember offers financial assistance to students.

Ontario Student Assistance Plan (OSAP). OSAP isa loan program sponsored by the Ontario govern-ment. If you must borrow to get postsecondaryeducation, the government pays the interest onyour loan while you are studying. You do not startto pay back the principal or interest until sixmonths after you graduate. The payment-freeperiod gives you time to find a job.

However, you must ask, will my degree,diploma, or certificate lead to a job? By law, uni-versities, community colleges, and vocational

schools that participate in OSAP must tell you howmany students graduated, how many graduatesgot jobs, and how many defaulted on loans. Thisinformation is available through the OntarioStudent Assistance Plan.

Registered Education Savings Plan (RESP). AnRESP is a tax shelter, like the RRSP you havelearned about in this unit. An eligible adult caninvest money for your education before taxes arecalculated. This is the most economical way thatan adult who has a taxable income can assist you.A manager at a financial institution can help toarrange an RESP.

Personal savings. While personal savings will notlikely pay the whole cost of your education, theycan help you deal with unexpected problems. Forexample, suppose a payment from a fundingsource is delayed. Personal savings let you payyour bills. You can focus on your education, noton urgent financial worries.

Research university co-op programs. To earn whileyou learn, a co-op program may be your wisestchoice. Your education will take a year or twolonger, but you gain valuable work experience—and may get a job with a co-op employer. Over 35 000 Ontario postsecondary students partici-pated in co-op programs in 2001.

A C T I V I T I E S

1 List five sources of income for postsecondary students in Ontario.2 Explain how the student can benefit from the requirement that a program eligible for

OSAP must say how many graduating students got jobs.3 John’s guardian is worried about John going into debt for postsecondary education.

What if he can’t get a job in today’s economy? Using facts you have learned aboutemployment, education, and credit, give your own view.

4 Find the Web site for Schoolfinder and make a point form list of the types of informa-tion aimed at a student who is investigating postsecondary education.


C h a p t e r R e v i e w

P o i n t s t o R e m e m b e r• An advantage of consumer credit is that it can be used to purchase assets

with a high financial value. A disadvantage is that consumers may financeexpenses they cannot afford.

• Some assets appreciate in value, and others depreciate in value.

• For future success, it is important to get and keep a good credit rating.

• Interest is charged on credit card purchases only if the balance is not paid bya certain date.

• Credit counselling agencies assist consumers who cannot manage their debt.

• Pre-authorization means a bank agrees in advance to lend the customer aspecific sum of money.

• An installment plan is a loan, offered by a business, that allows customers topurchase an item and pay part of the cost on a regular basis over a specificperiod of time.

• A car loan is generally available for new cars. A personal loan is available forused cars and for a variety of other purposes.

• A consumer may save money on interest charges by consolidating debts intoone loan with a lower interest rate.

A c t i v i t i e sKnowledge/Unders tand ing

1 What four factors affect the way banks determine the interest rate atwhich they will lend to an individual? Which of these factors does theBank of Canada affect?

2 Explain specific steps a young person can take to establish a goodcredit rating.

3 What three factors lower the net cost of a car loan?

4 Which types of loans have the lowest and highest interest rates? Why?


Th ink ing/ Inqu i ry

1 Could you live using credit only (no cash)? As you go through a day,list the financial transactions that you could have put on a credit card.Also, list those that required cash. Treat debit card transactions as cashtransactions. What types of transactions require cash? What types permitcredit? If possible, compare notes with other students.

2 Working in a small group, investigate the student loan offers ofCanada’s six chartered banks. Note important features of each type ofloan, including interest rate and rules about when and how the moneyis paid back. As a group, vote on which you think is the best package.

Communicat ion

1 Write and present a short monologue called “A Day on Credit.” Explainhow a typical day in your life would change if you could not use cashor a debit card. Assume that you are legally entitled to a credit card.How would you adapt? Some research will be needed. After you walkyour audience through your all-credit day, tell them what aspect of cashyou would miss the most.

2 Working with a group, prepare a flip chart presentation on the key fea-tures of student loans. Base your presentation on what your grouplearned while investigating these loans in Thinking/Inquiry Activity 2.

Appl icat ion

1 You saw from Figure 12-10 that changing the loan conditions affectedthe net cost of Burt’s car. This principle applies to mortgages as well.The chart below shows Lawrence’s present mortgage costs and thecosts he would face if interest rates were higher.

Interest on $176 000.00 Monthly Paid off Interest paidmortgage. (This interest payment each year, in over life ofrate is fixed for five years, addition to 5-year compounding semi-annually. monthly payment mortgage.

each year Assume 25years to pay offwhole amount

@ 6.25% $1 170.00 $5 000.00 $74 297.00

@ 10.00% $1 378.00 $5 000.00 $117 760.00

@ 12.00% $1 589.13 $5 000.00 $138 772.00


researching,working in groups


oral presentations


Note the difference in monthly payments between the 6.25% and 12.00%.Looking back at Lawrence’s budget in Figure 11-15, calculate the effecton his savings. If he had a 12.00% mortgage, could he pay off $5 000 ayear on the principal? (Assume no other expenses change.) Would a 12%mortgage rate affect his credit when he went to the bank for the renova-tion loan? Explain. (Note: Canada Mortgage and Housing Corporationdoes not recommend more than a 32% ratio of mortgage, taxes, andheating to one’s total income. And no more than 40% total debt.)

2 Looking back at Lawrence’s budget (Figure 11-15,), answer the following questions. Assume that Lawrence heats his home with natural gas.• Does Lawrence really need the income from the basement apart-

ment? That is, what difference does it make to his total debt serviceratio? Is it a critical difference?

• When Lawrence has paid off the capital improvement loan for thebasement apartment, how will the ratio change? Will not having thatdebt make a significant difference?

• Assume Lawrence can buy and operate a truck for $800.00 permonth. Can he do it, within the current budget situation? Explain,using ratios, and assuming that $340.00 of the expense is debt.

3 For the following question, assume that Lawrence is allowed to raiseBurt’s rent by 4% per year. Can Lawrence afford the truck after the ren-ovation loan is paid off in three years’ time? Explain.

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