credit cards and other forms of credit © 2010 pearson education, inc. all rights reserved chapter...

Credit Cards and Other Forms of Credit

© 2010 Pearson Education, Inc.All rights reserved

Chapter 11

Math for Personal Finance

• Jose just made a $532 credit sale in his uncle’s electronics store. The customer paid with a Visa card. Assume Jose’s uncle receives 98 percent of the sale after paying a 2 percent fee.

• How much will he actually receive from the sale?

© 2010 Pearson Education, Inc. All rights reserved 0-2

What are your financial Math Skills Problem 1


• Solution: Jose’s uncle will get .98 x $532 = $521.36



• Reese charged a pizza on her MasterCard. When she got her bill she was shocked. The pizza was only $11.39, but the charge put her over her credit limit. Assume the company charges her a $30 overdraft charge.

• How much did the pizza actually cost Reese?




• Solution: the pizza cost Reese $11.39 + $30 = $41.39. However, don’t forget that she probably incurred interest charges related to this purchase, since overdraft often triggers a higher interest rate on the balance she carries



• Twila used her credit card to get a $40 cash advance at a local ATM. She intended to pay the balance in full when the bill came in. Twila paid the $40 advance back and also paid $4 in fees ($2 for the ATM and $2 for the credit card company) when the credit card statement arrived 20 days later.

• What is the approximate annual interest rate that Twila paid for this advance?




• Solution: The $40 advance cost her $4 for 20 days. This amounts to 4/40 or 10 percent for 20 days use of the money. Assuming there are 18 twenty-day periods in a year, Twila would be paying 18 x 10 percent = 180 percent a year in interest if she did this same withdrawal every 20 days.


Learning Objectives

• Explain how credit cards work

• Describe different credit card features

• Explain how to use a credit card correctly

• Describe other risky credit arrangements


11-1 How Credit Cards Work

• Credit cards provide people with revolving open-end credit, which they can draw from repeatedly up to some preset limit

• Credit provider – such as a bank, agrees to make a certain amount of credit available to the cardholder

• A credit card can be a very useful financial tool

• Credit card are used at places of business that accept the credit card

• The cardholder receives a monthly bill listing all of the credit card purchases


How Credit Cards Work

• The cardholder can use the card until reaching the credit limit

• A credit card can be very easy to abuse

• Pay off the balance every month or you could find yourself in financial trouble


Ease of Availability and Use

• The easiest way to establish credit is to apply for a credit card

• You can receive credit card offers in the mail or apply for a card at a bank or website

• People use credit cards for lower priced convenience purchases such as gasoline, clothing, and air travel

• Take a look at Figure 11.1 for an example of a credit card statement


Figure 11.1


Ease and Availability of Use

• Billing takes place monthly

• The credit card statement identifies purchases you made during the period

• The statement gives the total amount borrowed and the minimum payment you have to make


Ease and Availability of Use

• Credit cards offer three advantages1. You can purchase products and services

without carrying a large amount of cash or checkbook

2. If you pay the balance in full at the end of each billing cycle, you do not incur any interest charges

3. You receive a monthly statement that contains a list of your purchases for that month


Applying for a Credit Card

• To get a credit card, you must apply for it

• Applying for a credit card is like applying for a loan or other form of credit

• Your potential creditor will obtain personal information from you, such as cash inflows and current cash outflows.

• Refer to figure 11.2 for a sample credit card application


Figure 11.2


Applying for a Credit Card

• credit check is when creditors assess your credit report in order to examine your credit history and determine your ability to repay

• Potential creditors will perform a credit check

• Your credit report summarizes your existing lines of credit and past credit

• Creditors will be more likely to extend credit to people with high levels of cash inflows, low levels of cash outflows, and a good credit history


Types of Credit Cards

• Credit cards are recognized and accepted by most merchants in the United States and globally

• Credit cards help merchants, but they also cost them money

• Credit card companies receive a percentage of the purchase price in return for their services


Types of Credit Cards

• Many financial institutions issue MasterCard and Visa credit cards to individuals.

• There are also numerous retail cards available.

• Retail stores such as Target and Sears issue cards


Check Your Financial IQ

• What can a consumer do with a credit card?



• A consumer can purchase goods and pay for them later—even over time


11-2 Credit Card Features

• Become familiar with credit cards different features and options

• The next few slides discuss some of the more common features and options


Credit Limit

• Credit card companies will establish an individual credit limit for you

• The total amount of your outstanding debt to the credit card company cannot exceed the credit limit

• Creditors monitor how much of your limit you keep charged up.

• Keeping your card charged near the limit will negatively impact your credit score


Overdraft Protection

• Overdraft protection is a credit card feature that allows you to “overdraw,” or exceed your credit limit

• Some credit cards have overdraft protection

• This will prevent you from attempting to use your credit card and having the charge denied because you are over the limit

• Only use this feature in emergency situations

• Overdraft often triggers higher interest rates on any balances you are carrying


Annual Fee

• Annual fee a fee credit card companies charge you for using their card

• Most credit card companies charge an annual fee of $20 to $70

• Companies often waive the fees for people with good credit history and use their card frequently

• Other cards advertise charging no fee at all

• Read all offers carefully


Incentives to Use the Card

• Some credit cards offer bonus incentives to encourage people to use their credit cards such as:– Cash-back bonuses– Airline miles– Gifts

• Incentives can be valuable for people who use of their credit cards often


Prestige Cards

• Financial institutions often issue prestige cards

• These cards are often called platinum or gold cards

• These cards provide additional benefits to cardholders, such as special warranties on purchased products or insurance on travel


Grace Periods

• Grace period is when you are not charged interest on your purchases

• Credit cards typically allow a grace period

• Grace periods are 20 days from the time the statement is “closed”

• If you pay the bill within the grace period, you will pay no interest on the amount borrowed.

• This is, in effect, a short-term free line of credit (see figure 11.3)


Figure 11.3


Cash Advances

• A cash advance is when you can use your card to get cash rather than just purchasing a good or service

• Many credit cards allow cash advances at banks or ATMs

• Most credit cards charge special transaction fees for this service and higher interest rates

• Cash advances do not have grace periods


Financing or Interest Charges

• Most credit cards interest rates range between 15 and 22 percent

• Cardholders who make late payments may have late fees

• Many credit card companies make more money from late fees and other charges than they do from interest charges


Financing or Interest Charges

• Credit card companies sometimes offer low teaser rates

• These rates last for three to six months and encourage people to make charges and carry balances

• When teaser rates expire, the cards revert to the typical high interest rates

• Using a credit card as a type of financing can be convenient but it is also expensive with how high interest can be


Prepaid Cash Cards

• Some companies allow you to purchase a card that you can “load” with cash.

• The purchase price is deducted from the amount the card was for when you use the card

• You can use the card until the amount is gone

• Other common prepaid cards are gift cards



• Identify five key features of a credit card.



• Features include: – the credit limit– overdraft protection– annual fee, incentives– prestige cards– grace periods– cash advances– finance or interest charges


11-3 Tips on Using Credit Cards

• Credit cards are popular, widely available, and risky

• The Federal Reserve has a lot of information on credit cards.

• Go to www.federalreserve.gov and click “Consumer Help” to find out information


Use a Credit Card Only if You Can Cover the Bill

• Use a credit card only for convenience and not as a source of financing

• The cost of borrowing money beyond the grace period with a credit card is too high

• Save up for major purchases instead of using a credit card


Impose a Tight Credit Limit on Yourself

• Impose a strict standard on your own spending

• Your self-imposed maximum should equal the amount you can repay every month

• This will prevent carrying balances on your card

• For example, you may have a $5000 credit limit

• If you don’t have enough cash inflow to use that amount, you shouldn’t use it.


Pay Credit Card Bills First

• Pay off credit card balances as soon as possible

• Pay credit card balances before paying off less costly debt

• Pay off credit card debt rather than putting money into savings or investments


Use Savings if Necessary

• Pay credit card debt with you savings if you need to

• You can replenish your savings later

• Credit card debt is costing you 15 to 22 percent

• Your money is much more wisely used to reduce that debt (see figure 11.4)


Figure 11.4


If You Experience Credit Card Debt Problems

• Steps can be taken to deal with credit card debt

• Try to negotiate new terms.

• Credit card companies often lower interest rates or work out more favorable repayment terms

• Credit card companies prefer this type of arrangement to bankruptcy or default



• Credit counseling agencies are another source of help for credit card debt

• They can help you negotiate better terms with your creditors

• As you try to lower your rates, limit your spending

• Take steps to increase cash inflow



• Debt consolidation means combining several small accounts into a one larger account that you may be able to finance at a lower rate at the bank

• Debt consolidation may be an option for credit card debt

• This option works best when you have assets you can pledge as collateral against the loan



• For example, many people take a loan from a bank using the equity in their home as collateral

• This is a so-called home equity loan

• You replace the smaller loans with one larger loan and make one larger payment

• If the larger loan is at a lower rate, it can reduce the overall cost of your borrowing



• There are risks with debt consolidation

• Too many people pay off their credit card debt with a home equity loan—and then run their credit card balances higher again

• Failure to pay off a home equity loan could have disastrous consequences—the loss of the home



• Bankruptcy is the process in which the courts provide protection for a person who is unable to pay off his or her debts

• Personal bankruptcy is the last resort for credit card debt

• Most bankruptcy debt workouts involve a three to five year repayment plan

• Bankruptcy is reported to the credit bureau

• It is listed on the person’s credit report for seven years



• What is the main rule for using credit cards wisely?



• Do not borrow more than you will be able to pay off at the end of the billing period.


11-4 Other Risky Credit Arrangements

• There are other types of risky credit arrangements

• Among them are: payday lending, tax refund loans, and pawn shops

• It is important to understand the characteristics these credit options


Payday Lending

• Payday lending is when a lender provides cash advances at a high cost to customers who provide a check dated for some time in the future

• Payday lending is a new form of credit

• Payday lenders charge a very high fee for their service

• Loans are small and last for 7 to 14 days

• The fees amount to an interest rate that is equivalent to several hundred percent per year


Payday Lending

• Payday lending has other dangers too

• If the money you are expecting is delayed, the check to the payday lender will bounce

• The bounced check will result in additional fees

• It may also damage your credit report

• Go to www.paydayloaninfo.org/ to find out other dangers of payday lending


Tax Refund Loans

• People take short-term loans and plan on using their income tax refund to repay what they borrowed. This is called a tax anticipation loan

• A number of income-tax preparers offer this option during tax season

• When people use this service, the tax preparer may offer an instant refund based on the calculated income tax refund


Tax Refund Loans

• The typical fees for these loans are high

• They can be equal to an annual interest rate of over 100 percent

• Another danger is that some people find their refunds to be lower than expected

• In such a situation , the borrower would have a debt that is larger than the refund he or she receives


Tax Refund Loans

• Consumers need to be cautious of scams linked to tax refund advance lending

• In one common scam, victims receive a call offering to speed up their tax refund for a fee charged to their credit card

• The con artist uses the card to the available credit limit and the victim is left with a serious identity theft problem


Pawn Shops

• Pawnbroker is a pawn shop representative that receives and holds items in exchange for loans that run for 30 days to as much

as three months

• Pawn shops used to be a popular source of short-term loans

• In many regions of the country, pawn shops still service this particular role

• Commonly pawned items are firearms, jewelry, and vehicles


Pawn Shops

• Pawned items serve as collateral for the loan

• The customer signs an agreement that allows the pawnbroker to sell the item if the customer does not repay the loan

• Customers may redeem their item if they repay the loan prior to the due date

• The cost of a pawnshop loan can be very high


Cell Phone Leases

• Most cell phone providers require you to sign a 12-month lease

• This is a binding agreement to pay for one year’s service

• Plans typically charge a monthly fee ranging from $39.99 to $200 or more

• These plans vary based on the number of minutes you use, the services you have available, and on calling regions


Cell Phone Leases

• In most cases, per-minute charges apply if you use the phone more than the plan allows

• Some plans charge higher rates for other features such as text messages and interest access

• If you default on the payment, the service provider will report it to the credit bureaus



• What are some examples of other risky types of credit?



• Payday lending, pawn broking, tax refund lending, and even cell phone plans are risky types of credit


Summary

• Credit cards provide people with convenient and easy-to-use credit

• They are also easy to apply for and obtain

• A disadvantage of credit is that it is easier to obtain than to repay


Summary

• Key credit card features include:– the credit limit

– the annual fee

– the interest rate a grace period the availability of cash advances

• Cards may offer “prestige” versions and also have incentives

• Some have overdraft protection


Summary

• Credit cards should be used with discipline

• Impose your own credit limits rather than spend up to the limit granted by the card

• Attempt to avoid financing costs

• Deal with any problems quickly


Summary

• There are several other examples of credit arrangements that meet a similar need to credit cards and carry similar risks

• These include:– Payday lending– Tax refund loans– Pawnbroking– Cell phone leases


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