At the conclusion of this lesson you should be able to:
1. Identify and compare the different kinds of credit.
2. Identify the sources and institutions that lend money.
3. Evaluate the terms and cost of a loan.
4. Understand the use of credit.

In this lesson we will brefly explore the subject of using credit. You will learn about the different kinds of credit and identify some sources of credit and institutions that lend money. You will also find important information about how to evaluate the terms and cost of a loan.

INTRODUCTION

Credit is using tomorrow’s money to pay for something you get today. Because our society is becoming more and more credit-based, it is important that you understand how to use credit properly so that you will always have access to the most affordable terms of financing for all of the things that you may need to pay for over time.

On the other hand, some of you may never want to use credit again! However, chances are you’ll probably need some type of loan in the future. If so, then it will be important to make sure that you are educated about the wise use of credit so that you will be able to make the wisest choices, such as:

• Do you really need credit?
• If so, what kind of credit do you need?
• Who will you get credit from?
• Will you be able to pay for it?
• How much is too much?
• Will buying an item on credit make you happy if you don’t need it and can’t afford it?

WHAT IS CREDIT?

Credit is a promise to repay a debt for goods or services after you have received them. With credit, you receive the goods or services now but pay for them later. Between the time you receive the goods or services and the time you pay for them, you owe a debt. Your promise to pay the debt is usually stated in a contract which is enforceable in a court of law.

Before you get involved with credit again, take the time to review some of the basics.

KINDS OF CREDIT

Long Term Credit
Mortgages, car loans, and other installment loans which are repaid over months or years are generally considered long-term debts. How much the loan will cost you over the long-term is based on the terms of the loan.

Short Term Credit
One type of short-term credit (called single-payment credit) is used to purchase items or services that are to be paid for in a single payment within a given period of time, usually with no interest charge. If the full balance isn’t paid within the given time period, you are charged a fee or interest on the balance. Utility bills are examples of this kind of credit.

Other short-term credit is usually paid for in installments of equal payments that include the original amount you borrowed plus interest. Short-term credit may have terms ranging from six months to five years.

Secured Credit
Secured debt requires something of value to be pledged to the lender if the debt is not repaid (this is called collateral). Home mortgages and car loans are examples of secured debt. They are also examples of what is known as closed–end credit, which calls for a payment of a fixed amount for a predetermined period of time. The interest rate may be “fixed” or “variable.” (Refer to Part I, Lesson 1, “The Basics of Chapter 7 Bankruptcy,”, for information about how secured credit is affected in bankruptcy.)

Unsecured Credit
Unsecured debt is based solely on the trustworthiness of the borrower. If nothing of value is pledged as collateral for the debt, the lender depends on the borrower to repay. The lender’s risk is greater if an unsecured loan is not repaid because no collateral was pledged for the loan. Therefore, these debts carry a higher interest rate.

Most credit card debts are unsecured. Credit card debt is a type of “open-end” credit and the cost of the credit may vary depending on the Annual Percentage Rate (APR) and other finance charges.

With a revolving account such as a credit card account, additional credit is extended to pay for the cost of items and services until the borrower’s limit or maximum dollar amount has been reached. A minimum payment is required each month to be paid on the balance owing. The difference between your credit limit and the actual amount you owe is your “available credit.”

TYPES OF LOANS

Most loans come under one of the categories we just discussed, but the fact that they have unique names indicates that each loan is slightly different from all the rest.

Business loans
Real estate loans
Lines of credit
Service loans
Government guaranteed student loans
Government guaranteed Small Business Administration loans

Personal or signature loans
Debt consolidation loans
Interim financing
Life insurance loans
Retirement loans
Margin loans
Government guaranteed FHA home mortgage loans

If you must use credit, be sure you use the type of credit that best fits your purpose.

Read the fine print. Make sure that you understand what kind of credit is being offered to you. If you don’t understand all of the terms of your credit agreement — how long you have to repay, when your payments are due and for exactly how much, whether you have pledged collateral or not in return for the credit — don’t sign the agreement. Don’t be afraid to ask the
loan officer as many questions as you need until you completely understand the loan terms and what is expected of you.

BORROWING STRATEGIES

Consider these important factors when borrowing money.

• Identify a variety of sources and institutions which lend money.
• Evaluate the terms of a loan.
• Know how to calculate the cost of credit.
• Determine your own debt limit.

Where Can I Borrow Money?

Most consumer credit comes from banks, savings and loan institutions, credit unions, finance companies, and credit card companies.

In addition, people often borrow from relatives or other individuals who may or may not be good credit sources. Often, individuals who loan money but don’t have a permanent place of business may offer you loans that charge more than the legal interest rate. BEWARE! Wherever you borrow money, be sure to get a signed contract and, always read the fine print.

COST OF CREDIT

WHAT ARE THE TERMS OF THE LOAN?

Down payment
How much cash up front is required?

Term
How long do you have to repay the loan?

Interest rate
What are the finance or additional charges? The interest rate (the APR) is the percentage cost of credit on a yearly basis. This is key to comparing costs. The Truth In Lending Act doesn’t set interest rates or other charges, but it does require that the lender disclose the terms of the credit plan so that you can “comparison shop” for credit. Other charges such as annual membership fees, points, and transaction charges are not included in the APR.

Interest Rate Example
Suppose you borrow $100 for one year and pay a finance charge of $10. If you can keep the entire $100 for a whole year and then pay back $110 at the end of the year, you are paying an APR of 10%. But if you repay the $100 and finance charge (a total of $110) in twelve equal monthly installments, you don’t really get to use $100 for the whole year. In fact, you get to use less and less of that $100 each month. In this case, the $10 charge for credit amounts
to an APR of 18%.

Finance Charge
The finance charge is the total dollar amount you pay to use credit. In addition to the charges imposed based on a periodic rate, it includes other costs such as interest fees, service charges, annual fees, late charges, and some credit-related insurance premiums.

Finance Charge Example
Borrowing $100 for a year might cost you $10 in interest. If there was also a service charge of $1, the total finance charge would be $11.

METHODS USED TO CALCULATE FINANCE CHARGES

The method used to calculate the balance on which you pay a finance charge makes a difference in the cost of credit.

Adjusted Balance
The adjusted balance method takes the amount you owed at the beginning of the billing period and subtracts any credits and any payments made by you during the period. New purchases are not counted.

Average Daily Balance
The average daily balance — one of the most common methods — adds your balances for each day in the billing period and divides that total by the number of days in the period. Payments and credits made during the period are subtracted and new purchases may or may not be included.

Two-Cycle Average Daily Balance
The two-cycle average daily balance method uses the average daily balances for two billing periods to calculate the finance charge. Payments and credits made will be accounted for and new purchases may or may not be included.

Previous Balance
The previous balance method bases the finance charge on the amount owed at the end of the previous billing period. In open-ended credit such as credit cards or gasoline cards, it is critical that we consider the method used to calculate our finance charges because the method will cause the amount of the finance charge to vary considerably. It’s difficult to figure out the finance charges once you start using a card regularly and carry a balance on it.

SOUND CREDIT CARD ADVICE

Pay off your credit cards each month. If you can’t afford to pay off your credit cards each month, make the largest payment you can afford and pay the card off before you make another purchase.

The example below illustrates the value of this concept.

Example: Different Methods of Credit

Let’s look at an example of how the different methods used to calculate finance charges can affect the cost of credit. Bankcard Holders of America (BHA) calculated the finance charges on one account four different ways. The account started with a zero balance the first month. The account holder then charged $1000 and made the minimum payment. The next month, the account holder charged another $1000 and paid off the balance due. The account’s interest rate is 19.8%. The calculations resulted in these figures:

Method	Include New Purchases?	Payment
Average Daily Balance	Yes	$33.00
Average Daily Balance	No	$16.50
Two-Cycle Avg. Balance	Yes	$49.05
Two-Cycle Avg. Balance	No	$32.80

You can see by this example that the calculation method can cause the balance to vary widely. Since your finance charges are based upon your balance, you can end up paying a lot more for your credit — not because you get greater value in what you purchased, but because the calculation method takes more money OUT of your pocket.

WHAT IS THE REAL COST OF CREDIT?

Credit costs money. Shop for it just like you would for any other commodity. Sometimes people are surprised to learn how expensive credit actually is. You understand the terms (you think) but you still can’t see the difference in dollars that different terms make.

Example: Buying a Car

This example looks at the cost of a $7,500 car with $1,500 down. We’re going to borrow $6,000 over time. There are several factors to consider. Here are some ways to calculate the cost of credit. The lowest cost is available from Creditor A at an APR of 14% over 3 years. If you were looking for lower monthly payments, you could get them by paying the loan off over a longer period of time, but then you would pay more in total costs. The same loan from creditor B at 14% but for 4 years will add $488 to your finance charge. If the same four year loan were available only from Creditor C, the 15% APR charge would add approximately $145 to your finance charges as compared with Creditor B.

Creditor or Financed	APR	Length of Loan	Monthly Payment	Total Finance Charge	Total Cost of Purchase
Creditor A	14%	3 Years	$205.07	$1,383.52	$7,382.00
Creditor B	14%	4 Years	$163.96	$1,870.08	$7,870.00
Creditor C	15%	4 Years	$166.98	$2,015.00	$8,015.00

But wait! I only owed $6,000 on the car! So why am I paying $8,015 plus my $1,500 down payment for this car that is only worth $7,500? Answer: I want the car now! And what will it be worth at the end of four years when I finally pay off that note? A whole lot less than $9,515 ($8,015 plus the $1,500 down payment)! So you can see why it’s important to shop for the best credit you can find.

Let’s look at some more extreme examples, just to amplify the point.

Total Amount Financed	APR	Length of Loan	Monthly Payment	Total Finance Charge	Total Cost of Purchase
$15,000.00	25%	60	$406.25	$9,375.00	$24,375.00
$15,000.00	10%	60	$312.50	$3,750.00	$18,750.00
$12,000.00	25%	60	$325.50	$7,500.00	$19,500.00
$12,000.00	10%	60	$250.00	$3,000.00	$15,000.00
$10,000.00	25%	60	$270.83	$6,250.00	$16,250.00
$10,000.00	10%	60	$208.33	$2,500.00	$12,500.00

What a difference! Consider all the terms before you make a choice!

YOUR TOTAL DEBT LOAD

What is a “debt load?” What is a safe amount of credit for you to carry? How do
creditors find out what a person’s debt load is? How do I know my own debt load?

DEBT/INCOME RATIO

Before extending credit to you, lenders analyze your income and your outgo to decide for themselves whether you have too much debt. This debt/income ratio is figured with monthly amounts and reveals how good (or bad) your total financial picture is. To figure this ratio for yourself, add all of your non-housing monthly payments except for your utilities or taxes. Then compare that total with your total gross annual wages divided by 12. If you don’t have fixed monthly payments on revolving debts such as credit cards, estimate your monthly payments at 4% of the total amount you owe.

When you divide your monthly debt payments by your total monthly income, you will get your monthly non-housing debt/income ratio. It’s usually expressed as a percentage so move the decimal point 2 places to the right and add the “%” sign.

Example: Dori’s Home Loan

Dori is applying for a short-term, unsecured loan. Her gross monthly income is $2,000. Her monthly debt (excluding her housing payments) is $500. That means that her credit cards, gasoline cards and car payments amount to 25% of her income. And the mortgage payment hasn’t been added to that.

Debt $ 500
Income $2,000

If Dori decided to apply for a home loan, her lender would look at both her non-housing debt and her total monthly debt which includes her housing payments. They call these her “ratios.” Her income is $2,000, her non-housing debt is $500, and she is applying for a mortgage loan that would cost her $350/month. This makes her total debt $850, including housing payments. Now her housing plus other debt ratio is 42.5%. This debt is generally too high for most mortgage loans, and Dori will have to pay off some of her other debts to qualify for a mortgage loan.

Debt $ 850
Income $2,000

Rules of Thumb

A conservative rule of thumb for consumer credit is the “20-10 Rule.” This means that total household debt including your housing payments shouldn’t exceed 20% of your net household income. Remember your net income is how much you “bring home” in your paycheck and monthly payments on the debt shouldn’t exceed 10% of net monthly income. Another conservative rule of thumb for mortgage debt is the “28/36” rule. This means that your non-housing debt shouldn’t exceed 28% of your gross (your total) income, and your total debt — consumer debt plus housing debt — shouldn’t exceed 36% of your gross income.

Other Considerations

In determining your own debt load limit you can use rules of thumb such as those previously mentioned, but you must also consider:
• The stability of your income
• Your other regular expenses
• Your need for cash from month to month
• All of your personal needs and wants.
• The “smell test:” Are you comfortable with this amount of debt?
• The changes in your cash needs as you and your household grow older

CONCLUSION

You may need to use credit in the future. Remember, every time you borrow money — even to buy something you think is a bargain — the cost of the item that you purchase with credit goes up. It also means that unless you pay off that credit quickly, you will have less money to spend in the future than you do today. Ask yourself if it’s really worth it.

The cheapest way to pay is with cash. But that means planning ahead. If you set your goals to spend money on things that mean the most to you and you develop a realistic plan to buy that item or service, then you can start today to save for that goal. It may take longer to achieve, but it will cost you less in terms of both stress and dollars. That means that you will also have more money to spend on other goals that you have set for yourself.

Lesson 6 >>



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