Chapter 6 Choosing a Source of Credit: The Costs of Credit Alternatives

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Chapter 6Choosing a Source of Credit The Costs
of Credit Alternatives
6-1
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Learning Objectives - Chapter 6
6-2

1. Analyze the major sources of consumer credit.
2. Determine the effective cost of borrowing by
   considering the quoted rate, the number of
   compounding periods, the timing of interest
   payments other service charges.
3. Develop a plan to manage your debt.
4. Evaluate various private government sources
   that assist consumers with debt problems.
5. Assess the choices in declaring personal
   bankruptcy.

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Learning Objective 1Analyze the major sources
of consumer credit.
6-3
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Sources of Consumer Credit
6-4

• Credit costs money
• Weigh benefits of buying an item on credit versus
  waiting until you have saved enough money to pay
  cash
• Ask yourself
• Do I need a loan?
• Can I afford a loan?
• Can I qualify for a loan?

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Sources of Consumer Credit
6-5

• Inexpensive loans.
• Parents and family members.
• Loans based on assets, such as a GIC.
• Medium-priced loans.
• Chartered banks, trust companies and credit
  unions.
• Expensive loans.
• Finance companies.
• Retailers such as car or appliance dealers.
• Bank credit cards and cash advances.

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Learning Objective 2Determine the effective
cost of borrowing by considering the quoted rate,
the number of compounding periods, the timing of
interest payments other service charges.
6-6
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The Cost of Credit
6-7

• Effective Annual Interest Rate depends on
• Quoted annual percentage rate
• How frequently interest is compounded
• Interest charged up front
• Other charges such as service charges,
  credit-related insurance premiums, and appraisal
  fees

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The Cost of Credit
6-8

• The annual percentage rate (APR) is the
  percentage cost of credit on a yearly basis.
• The APR provides the true rate of interest for
  comparison with other sources of credit. This
  rate lets you compare like with like when
  shopping for rates.

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Annual Percentage Rate (APR)
6-9
R 2 x n x I P (N 1)

• R approximate APR
• n number of payment in one year
• I total dollar cost of credit
• P principal or net amount of loan
• N total number of payments scheduled to pay off
  the loan

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Trade-Offs of Financing Choices
6-10

• Term (length of loan) versus interest cost.
• A longer term allows lower monthly payments, but
  you pay more in interest.
• Lender risk versus interest rate. To reduce the
  lenders risk you can...
• Accept a variable interest rate.
• Provide collateral to secure the loan.
• Make a large down payment up front.
• Have a shorter loan term.

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Calculating Your Loan Payments
6-11

• Fixed Rate Installment Loan
• Pay off over a pre-determined period of time
• Payment represents blend of interest and
  principal
• Floating Rate Personal Line of Credit
• Variable interest rate tied to lenders prime
  rate
• Compounded daily
• Payments not fixed
• At risk if interest rates rise
• Takes longer to repay if only paying minimum
  required

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Cost of Carrying Credit Card Balances
6-12

• Adjusted balance method
• The assessment of finance charges after payments
  made during the billing period have been
  subtracted.
• Previous balance method
• Method of computing finance charges that gives no
  credit for payments made during the billing
  period.
• Average daily balance method
• Uses a weighted average of the account balance
  throughout the current billing period. If you
  carried over a balance new purchases may be
  included in your average daily balance
  calculation.

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The Cost of Credit
6-13

• Expected Inflation
• borrowers and lenders are concerned about the
  goods and services their dollars can buy - its
  purchasing power
• inflation erodes the purchasing power of money
• the expected rate of inflation is added to the
  interest rate charged by lenders to protect their
  purchasing power

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The Cost of Credit
6-14

• Avoid the minimum monthly payment trap
• minimum monthly payment is the smallest amount
  you can pay and still be a cardholder in good
  standing
• is not the total amount due
• the longer you take to repay the more interest
  you will incur
• Credit Insurance
• ensures the repayment of your loan in the event
  of death, disability or loss of property
• pays lender directly

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Learning Objective 3Develop a plan to manage
your debt.
6-15
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Managing Your Debts
6-16

• A sudden illness or loss of job may make it
  impossible to repay your debts
• Contact your creditors at once to work out a
  modified payment arrangement
• Your vehicle can be repossessed if you default on
  your payments and you could incur added costs so
  it is better to sell yourself and repay the debt
• Debt counseling services are available but be
  sure to investigate the company

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Warning Signs of Debt Problems
6-17

• Emotional problems such as the need for instant
  gratification.
• The use of money to punish.
• The expectation of instant comfort among those
  who overuse the installment plan to get what they
  want now
• Keeping up with the Joneses.
• Overindulgence of children.
• Lack of communication among family members.
• The amount of finance charges is too high.

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Warning Signs of Debt Problems
6-18

• You continually go over your credit limit
• You use your credit card as a necessity rather
  than a convenience
• You borrow money to make it from one pay cheque
  to the next
• Your wages have been garnished to pay outstanding
  debts
• You pay only interest or service charges monthly
  and dont reduce your total debt
• You are pressured or threatened by creditors
• Utility services are cut off for unpaid bills

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The Serious Consequences of Debt
6-19

• Loss of job due to garnishment of wages
• Neglecting health and educational needs of family
  members
• Alcoholism or drug abuse
• Marital difficulties
• Neglect of children

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Learning Objective 4Evaluate various private
government sources that assist consumers with
debt problems.
6-20
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Consumer Credit Counseling Service
6-21

• If you are having problems paying your bills you
  can
• contact your creditors and work out a repayment
  plan
• go to a non-profit financial counseling program
  for assistance
• Credit counseling activities include
• aiding families by helping them manage their
  money, setup a realistic budget and plan for
  expenditures
• helping people to avoid future debt problems

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Learning Objective 5Assess the choices in
declaring personal bankruptcy.
6-22
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Declaring Personal Bankruptcy
6-23

• Increasing number of bankruptcy filers are
  well-educated, middle-class baby boomers with an
  overwhelming level of credit card debt
• Usually between 40-44 years of age
• Increasingly likely to be female
• In last 9 years bankruptcy has increased almost
  8 annually

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Fending off Bankruptcy
6-24

• Consolidation Loans
• advantages are single interest rate on all your
  debts and ability to extend them to allow you to
  make smaller payments
• disadvantages are higher interest rates as you
  represent a higher risk to the lender
• a longer term means more accumulated interest

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Bankruptcy Insolvency Act
6-26

• A federal law initiated in 1992 and amended in
  1997
• Regulates bankruptcy (a straight declaration of
  insolvency) and proposal (a wage earner plan)
  proceedings
• You are allowed to declare insolvency either
  through a consumer proposal or through an
  assignment in bankruptcy

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Consumer Proposal
6-26

• A consumer proposal is a maximum 5 year plan for
  paying creditors all or a portion of a debt owed
• must be insolvent and less than 75,000 in debt
  (excluding home mortgage)
• both court and creditors must approve your
  proposal
• may save you from bankruptcy

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Bankruptcy
6-27

• First step is the assignment of your assets to a
  licensed trustee
• Until you are released from your debts by a court
  you will be considered a discharged bankrupt
• Secured creditors are paid first
• Remaining assets distributed with cost of
  bankruptcy administration taking precedence
• Once completed court will grant you a discharge

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Effects of Bankruptcy
6-28

• Obtaining future credit will be difficult
• Easier for those who file a consumer proposal and
  repay some of their debt than those who make no
  effort to repay
• A bankruptcy remains on your credit file for 7
  years

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Summary of Learning Objectives
6-29

• Analyze the major sources of consumer credit
• Banks, trust companies, credit unions, finance
  companies, life insurance companies, family and
  friends
• Each has unique advantages and disadvantages
• Parents or family members are least expensive
  source of loans
• May only charge you interest they would have
  earned on savings
• May complicate family relationships

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Summary of Learning Objectives
6-30

• Determine the cost of credit by calculating
  interest using various interest formulas
• Determine the effective cost of borrowing by
  considering the quoted rate, the number of
  compounding periods, the timing of interest
  payments and other service charges
• Financial institutions quote an annual percentage
  rate (APR) on installment loans and lines of
  credit
• Effective cost of borrowing will rise of
  compounded more than once a year or loan is made
  on a discount basis with service fees added

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Summary of Learning Objectives
6-31

• Develop a plan to manage your debt
• Serious consequences if debt not properly managed
  
• Following are common reasons for indebtedness
• Emotional problems
• Use of money to punish
• Expectation of instant comfort
• Keeping up with the Joneses
• Overindulgence of children
• Misunderstanding or lack of communication among
  family members
• Amount of financial charges

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Summary of Learning Objectives
6-32

• Evaluate various private and government sources
  that assist consumers with debt problems
• If you cannot meet obligations contact creditors
  immediately
• Investigate debt consolidation companies
  thoroughly before signing up
• Or better yet contact a credit counselling
  service or other debt counselling organization

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Summary of Learning Objectives
6-33

• Evaluate various private and government sources
  that assist consumers with debt problems
• Such organizations help people manage money
  better by setting up a realistic budget and
  planning for expenditures
• Also help prevent debt problems by teaching
  necessity of family budget planning and providing
  education to people of all ages

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Summary of Learning Objectives
6-34

• Assess the choices in declaring personal
  bankruptcy
• Last resort is to declare bankruptcy
• Consider financial and other costs first
• Can declare insolvency through consumer proposal
  or an assignment in bankruptcy
• Obtaining credit more difficult after filing
  bankruptcy
• May be easier because relieved of prior debt or
  creditors know they cannot file another case for
  a period of time

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Key Formulas
6-35

• Calculating the Effective Annual Interest Rate
• (1 APR/m)m - 1
• Calculating an Installment Loan Payment
• Calculating monthly interest in a line of credit
• Interest B x APR x (n/365)