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Chap6.docx6 Building and Maintaining Good Credit
YOU MUST BE KIDDING, RIGHT?
People with no prior credit history or those who show poor repayment patterns in the past often wonder if they will ever be able to get credit, especially during economic times when credit is difficult to obtain. Simply put, will any lender want to trust them? Which of the following is true about the availability of credit for people in such situations?
A. Sadly, they will be doomed to a lifetime of no access to credit.
B. There are a few lenders who will be happy to provide credit to such borrowers.
C. Most of the “big name” banks will grant them credit.
D. Credit will be relatively easy to obtain for such borrowers just about anywhere.
The answer is B. It is difficult for people with poor or no credit to obtain credit from most banks and credit unions. But some lenders do accept such applicants, and they will charge high interest rates. Building and maintaining a good credit history does more than get you access to credit. It will also get you low interest rates!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Explain reasons for and against using credit.
Establish your own debt limit.
Achieve a good credit reputation.
Describe the common sources of consumer credit.
Identify signs of over indebtedness, and describe the options that are available for debt relief.
WHAT DO YOU RECOMMEND?
Hanna Savarin, age 25, is a nurse practitioner with the local health department in Collegedale, Tennessee. She earns $65,000 per year, with about $9000 of her income coming from overtime pay. Her disposable income is about $3800 per month. Her employer provides a qualified tax-sheltered retirement plan to which Hanna contributes 4 percent of her salary and for which she receives an additional 4 percent matching contribution from her employer. (She could contribute up to 6 percent with an equal employer match.) Hanna has $29,000 in outstanding student loans on which she will pay $454 per month over the next five years, and her total credit card debt is $3000 on which she has been paying $120 per month. Otherwise, she is debt free. Hanna would like to purchase a new or late-model used car to replace the car she has been driving since her senior year in high school. She has $2000 to use as a down payment.
What would you recommend to Hanna on the subject of building and maintaining good credit regarding:
1. Factors she should consider regarding her ability to take on additional debt?
2. The impact of her current debt on her ability to obtain a loan to buy a vehicle?
3. Where she might obtain financing for a vehicle loan?
4.The effect of taking on a loan on her overall financial planning?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to building and maintaining good credit:
1. Protect your credit reputation as carefully as you would safeguard your personal reputation.
2. Determine your own debt limit rather than relying on a lender before deciding to take on any debt.
3. Obtain copies of your credit bureau reports regularly for free, and challenge all errors or omissions you find.
4. Use complicated personal ID numbers and login passwords for online credit account management.
5. Always repay your debts in a timely manner.
Your financial success depends heavily on your ability to make the sacrifices necessary to spend less than you earn. This allows you to save money for future uses. Yet, you are likely to use credit to buy housing and vehicles as well as use credit cards . However, paying high interest rates and overuse of credit impedes your financial success.
credit cards Cards that allow repeated use of credit as long as the consumer makes regular monthly payments.
The term credit describes an arrangement in which goods, services, or money is received in exchange for a promise to repay at a future date. Consumer credit usually takes the form of a loan that is repaid in equal payments over a set period of time. You also are likely to use revolving credit, which allows repeated use of credit as long as regular, monthly payments are maintained. Credit cards are an example of revolving credit.
credit An arrangement in which goods, services, or money is received in exchange for a promise to repay at a future date.
loan Consumer credit that is repaid in equal amounts over a set period of time.
There are valid reasons for using credit. You should use credit only when necessary, pay low interest rates, make repayments on time, and repay amounts owed as quickly as possible.
6.1 REASONS FOR AND AGAINST USING CREDIT
Credit represents a form of trust established between a lender and a borrower. If the lender believes that a prospective borrower has both the ability and the willingness to repay money, then credit will be extended. The borrower is expected to live up to that trust by repaying the lender. For the privilege of borrowing, a lender requires that a borrower pay interest and sometimes other charges.
You can distinguish between good and bad uses of credit. Among the good uses are a mortgage loan to buy a home, a loan to open a business, and to finance education expenses. These purposes have benefits because the funds are invested in ways that can have a long-term payoff. Bad uses of credit include using a credit card or student loans money to support a better lifestyle than really needed and loans for extravagant homes and vehicles.
LEARNING OBJECTIVE 1
Explain reasons for and against using credit.
There are good reasons for using credit:
1. For convenience. Using credit cards simplifies the process of making many purchases. Convenience use is justified only if the card balance is paid in full each month, however. You do not want to be paying for today's restaurant meal for months or years in the future.
2. For emergencies. Consumers use credit to pay for unexpected expenses such as emergency medical services and automobile repairs.
3. TO make reservations. Most motels, hotels, and car rental agencies require some form of deposit to hold a reservation. A credit card number can serve as such a deposit, allowing guaranteed reservations to be made over the telephone. In many cases, the hotel will notify the credit card issuer to put a hold on your account for the anticipated total amount of the charge. This common practice is called credit card blocking .
credit card blocking Occurs when hotel or other service providers place a hold on a card holder's account to reflect the anticipated cost of services.
4. TO own expensive products sooner. Buying big ticket items such as a home or automobile on credit allows the consumer to enjoy immediate use of the product. Many expensive items would not be purchased (or would be bought only after several years of saving) without the opportunity to pay for them over time. The expected life of the product should be at least as long as the repayment period on the debt.
5. To take advantage of free credit. Merchants sometimes offer “free” credit for a period of time as an inducement to buy. Free credit, however, should not be used to buy a more expensive item than you can afford. Known as “same as cash” or “interest-free” terms, these programs allow the buyer to pay later without incurring finance charges. The free credit lasts for a defined time period, but interest may be owed for the entire time period if the buyer repays even one day after the allotted free-credit period ends.
6. For protection against rip-offs and frauds. Internet and telephone purchases made on a credit card can be contested with the credit card issuer under the guidelines of the Fair Credit Billing Act (FCBA), as discussed more fully in Chapter 7 . The protections afforded by the FCBA are not available when using a debit card.
7. To obtain an education. The high cost of education has forced many students to use student loans. This may be one of the better uses of credit, as the borrower is investing in himself or herself to raise the quality of life and/or income in the future. The amount borrowed should be compared to the projected extra income provided by the education to be obtained.
Debt Has Enormous Opportunity Costs
When people take on debt they often neglect to save or invest. Taking on too much debt early in life, instead of saving and investing, can compromise your goal of being financially successful.
Despite its benefits, the use of credit has significant negatives.
1. Credit reduces your financial flexibility and buying power. The greatest disadvantage of credit use comes from the loss of financial flexibility in personal money management. As the old proverb states, “He who borrows sells his freedom.” The money that you pay each month on your debt is money you could have spent elsewhere on other opportunities. Also, credit can be seen as a promise for you to “work for the creditor” in the future to pay off your debt. People rarely go through life without taking on debt from time to time, but repaying debt for years and years is not a smart move. Mortgage debt reduces significantly the flexibility you will need at that time in your life, so make paying off your home before retirement an important financial priority.
2. interest itself is costly. Interest represents the price of credit. It is the “rent” you pay while you use someone else's money. When stated in dollars, interest makes up the finance charge , which is the total dollar amount paid to use credit (including interest and any other required charges such as a loan application fee). The Truth in Lending Act requires lenders to state the finance charge both in dollars and as an annual percentage rate (APR) . The APR expresses the cost of credit on a yearly basis as a percentage rate. For example, a one-year, single-payment loan for $1000 with a finance charge of $140 has a 14 percent APR.
interest In this context, interest is the “rent” you pay for using credit.
finance charge Total dollar amount paid to use credit.
annual percentage rate (APR) Expresses the cost of credit on a yearly basis as a percentage rate.
3. It is tempting to spend more money. A major disadvantage of credit is that its use can lead to overspending. Using a credit card to buy $425 worth of new clothes and paying off $25 per month over 20 months costs and extra $75 in interest (20 × $25 = $500 − $425) may seem less painful than paying cash or spending less money, perhaps only $300, on clothing. This tendency to spend more is why sellers promote buying on credit so heavily.
4. Overindebtedness is a real possibility. Consumers with monthly nonmortgage debt repayments amounting to 15 percent of monthly take-home pay or more are considered to be precariously in debt. They teeter on the brink of disaster. If they begin missing payments, they run a high risk of a poor credit reputation, damage to employment prospects, an increase in rates paid for insurance, difficulty in renting or buying a home, and the possible repossession of some purchased items.
CONCEPT CHECK 6.1
1. Which two good uses of credit seem most reasonable to you? Which do not?
2. Explain the two downsides of credit that would be most worrisome for you.
3. Distinguish between the APR and the finance charge on a debt.
LEARNING OBJECTIVE 2
Establish your own debt limit.
You should set your debt limit , which is the overall maximum you believe you should owe based on your ability to meet the repayment obligations. Most people's debt limit is and should be lower than what lenders are willing to offer. Lenders are willing to take chances that some borrowers will not repay, knowing that some of the interest paid by other borrowers will cover the unpaid debts. There are four methods to determine your debt limit.
debt limit Overall maximum you believe you should owe based on your ability to meet repayment obligations.
6.2a Method 1: Debt-to-Income Method
The debt-to-income method (DTI) was introduced in Chapter 3 on page 78. Using the debt-to-income method your monthly debt repayments (including your prospective mortgage, and any other loan or alimony payments you must make) are divided by your gross monthly income (your income before taxes) and multiplied by 100. A ratio of 36 percent or less is desirable. Home loan seekers may not exceed 43 percent to obtain a qualified residential mortgage (details in Chapter 9 ).
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6.2b Method 2: Debt Payments-to-Disposable Income Method
The debt payments-to-disposable income method uses the debt-payments-to-disposable income ratio also introduced in Chapter 3 on page 78. Recall that this ratio excludes the first mortgage loan on a home and credit card charges that are paid in full each month. Disposable income is the amount of your income remaining after taxes and withholding for such purposes as insurance and union dues. Note that the debt payments-to-disposable income method focuses on the amount of monthly debt repayment—not the total debt. As a result, it also would be wise to consider the length of time that the severe financial situation caused by high debt payments might last. You could get yourself into financial trouble for many years.
debt payments-to-disposable income method Percentage of disposable personal income available for regular debt repayments aside from set obligations.
disposable income Amount of income remaining after taxes and withholding for such purposes as insurance and union dues.
Table 6-1 shows some monthly debt-payment limits expressed as a percentage of disposable personal income. As the table indicates, with monthly payments representing 15 to 18 percent of monthly disposable personal income, a borrower is precariously overindebted and fully extended; taking on additional debt would be unwise.
Table 6-2 shows the effects on a budget of increasing one's level of debt. In the table, after deductions, disposable personal income amounts to $2200 per month. Current budgeted expenses (totaling the full $2200) are allocated in a sample distribution throughout the various categories. As you can see, increasing debt payments to 25 percent of disposable income ($550 per month; perhaps to buy a new automobile) has dramatic effects on this budget.
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Table 6-1 Debt-Payment Limits as a Percentage of Disposable Personal Income*
Where would you make reductions as debt load grows? Spending a few minutes changing the figures in Table 6-2 will give you an idea of your priorities and the size of the debt limit that you might establish.
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Table 6-2 Effects of Increasing Debt Payments on a Budget*
Bias Toward Overconfidence
People engaged in building and maintaining good credit have a bias toward certain behaviors that can be harmful, such as a tendency toward overconfidence. Examples are young adults who take on heavy student loan debt and people who finance large sums to buy a large new home or expensive vehicle. What to do? Calculate your current debt load ratios before taking on new debt and also calculate what they will be with the new debt; then, if necessary, adjust the borrowed amount down appropriately.
6.2c Method 3: Compare Debt-to-Equity
Are You Worried About Your Debts?
If you are worried about your debts, then you should be. Your own gut feeling is often the best indicator of carrying too much debt.
Another method for determining your debt limit involves calculating the ratio of your consumer debt to your assets. The debt-to-equity ratio compares the equity in a person's assets (the amount by which the value of those assets exceeds debts) with amounts owed. This ratio excludes first mortgage assets and debt because the total amount of mortgage debt usually does not get people into trouble; it is the payments themselves that do so. The ratio of debt-to-equity method provides a quick idea of one's financial solvency. A ratio in excess of 0.33 is considered high.
debt-to-equity ratio Ratio of your consumer debt to the equity in your assets.
6.2d Method 4: Continuous-Debt Method
Another approach for determining your debt limit is the continuous-debt method. If you are unable to get completely out of debt every four years (except for a mortgage loan), you probably lean on debt too heavily. You could be developing a credit lifestyle in which you will never eliminate debt and will continuously pay out substantial amounts of income for finance charges—likely $1200 or more per year, and that is like throwing away $100 every month!
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6.2e Dual-Earner Households Should Set a Lower Debt Limit
Having two incomes in a household has its benefits. Two people, each of whom earns $42,000 per year, will gross $84,000, with a disposable personal income of around $63,000, or $5250 monthly. It may seem that the couple can afford a much higher level of debt than before the incomes were combined, but beware.
How to Manage Student Loan Debt
Total student loan debt outstanding now exceeds $1 trillion, more than that owed on all credit cards combined. Two-thirds of students borrow for school costs, and the average student with such debt owes more than $27,000 at graduation; this is double what it was 20 years ago. Such student loan debt makes it very difficult to buy a vehicle, a home, and save for retirement. While in school, strive to keep your student debt down. Here are some tips for managing the student debt:
1. Always know your outstanding debt and required monthly payment . Both while in school and after graduation you should fully understand how much you owe and your future or current payment based on a ten-year payoff. The payment can calculated at www.bankrate.com/calculators/managing-debt/loan-calculator.aspx . If you do not know your interest rate, ask your loan servicer or use 5 percent as an estimate.
2. Choose your most advantageous repayment pattern allowed . The standard repayment plan for student loan debt calls for equal monthly installments paid over ten years, but to pay the debt off faster, you can establish a graduated repayment plan whereby the payments are lower in the early years but then increase in later years.
3. Make your repayments on time, every time . In some programs, if you make the first 48 payments on time, the interest rate will be reduced by 2 percentage points. Failing to repay in a timely manner can have dire consequences, including forfeiture of federal and state income tax refunds, as well as Social Security and veterans' benefits.
4. Pay electronically . Make arrangements to have the monthly payment transferred electronically out of a checking account and you can receive a small reduction in the interest rate.
5. Consolidate your student loans . Consolidating your education loans means that all your existing loans are paid off and one new loan is created. This strategy may allow for a much more convenient repayment schedule. The interest rate may be lower, and the amount of time for repayment may be longer, resulting in a lower monthly payment under the new loan. Loans can be consolidated through a private bank or through one of two government programs: Sallie Mae ( www.salliemae.com ) or Federal Direct Consolidation Loans ( www.loanconsolidation.ed.gov ).
6. If desired, sign up for the Federal government's income-based repayment plan . If your student loan debt is very high compared to your salary, you may qualify for a plan that has low payments and the remaining debt is forgiven after 25 years if you have made payments consistently up to that point. See www.studentaid.ed.gov/ . You may also qualify for reduced payments if you work in a public-service job, in an underserved profession, or for a national service organization such as AmeriCorps. Go to www.finaid.org/loans/forgiveness.phtml .
Two incomes should not mean a doubled debt limit.
Many young couples adopt a lifestyle based on two incomes. Their spending grows in tandem with their rising incomes. After a while, they are spending and borrowing to the limit. This situation cannot go on forever, of course. Eventually they may begin to feel financially stressed and wonder, “How can we be so broke when we make so much money?” When a child comes along or one partner loses a job or overtime pay, they may quickly get into deep financial trouble as debts that had been manageable with two incomes quickly become overwhelming.
Couples would be wise to set a debt limit based on the higher of their two incomes and use the second income to build savings accounts and make investments early in their lives together. That will truly protect their future financial security. This is one of the smartest financial actions a couple can make—save and invest extra money early in a relationship.
CONCEPT CHECK 6.2
1. Distinguish among the debt payments-to-disposable income, debt-service-to-income, debt-to-equity ratios, and continuous-debt methods for setting your debt limit.
2. What are the threshold levels for both the debt payments-to-disposable income, debt-service-to-income and ratio of debt-to-equity ratios that would indicate that a person is carrying too much debt?
3. Discuss how dual-earner households should consider their ability to carry additional debt.
Tips for keeping Student Loan Debt Down
You should try to limit your total student loan debt to no more than the average of your projected annual take-home pay over the first ten years after you graduate. That way, you can repay your loan in ten years by using about 10 percent of your income each year.
Here's how you can keep student debt from becoming too much to handle:
1. Work part-time or increase your work hours to lower the amount you must borrow.
2. Set aside funds to pay down the debt as soon as you graduate.
6.3 OBTAINING CREDIT AND BUILDING A GOOD CREDIT REPUTATION
LEARNING OBJECTIVE 3
Achieve a good credit reputation.
Credit is widely and readily available to most of us today. It is not unusual for a customer to walk into a retail store such as Target or Home Depot and be offered a credit card account that can be used immediately. However, if the applicant has not used credit previously (no credit), or has bounced a lot of checks, or has failed to honor credit agreements in the past (bad credit), the offer may be withdrawn or changed after the credit check to a much higher interest rate. Your success in obtaining credit at a low interest rate depends on an understanding of the credit approval process and having a good credit reputation.
6.3a The Credit Approval Process
To obtain credit, you must first complete a credit application. Based on the information in this application, the lender will investigate your credit history. The information is then evaluated (sometimes instantly via computer), and the lender decides whether to extend credit. When an application is approved, the rules of the account are established.
Turn Bad Habits into Good Ones
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Do You Do This? |
Do This Instead! |
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Ignore the list of transactions in your credit card account statements |
Inspect your statements for errors and signs of identity theft |
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Assume your credit bureau files are correct and up to date |
Check your file for free with one of the three credit bureaus alternating every four months |
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Borrow from your own bank when you need new credit |
Shop at various lenders for the best credit terms and lowest APR |
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Assume you are doing fine if you can make your monthly debt payments |
At least once a year, calculate your debt limit using appropriate ratios |
What to Do Before You Apply for Credit
To get the lowest interest rates possible, you should make sure that your credit bureau file is accurate before filling out a credit application. If possible, you should do this at least three months in advance to allow time for you to correct any errors or omissions in your file.
You Apply for Credit A credit application is a form or an interview that requests information that sheds light on your ability and willingness to repay debts. This information helps lenders make informed decisions about whether they will be repaid by borrowers. Answering questions completely and honestly both on an application form and during an interview (if any) is important. If inconsistencies arise during the lender's subsequent investigation of the applicant's credit history, the lender could refuse the request for credit or charge a higher interest rate. At the time of application, ask for a copy of the rules governing the account, including the APR and repayment terms. However, the offered terms are not final and can change when the actual decision to lend is made. This is one reason why you should read all credit contracts before signing.
credit application Form or interview that provides information about your ability and willingness to repay debts.
The Lender Obtains Your Credit Report Upon receiving your completed credit application, the lender conducts a credit investigation and compares the findings with the information on your application. The goal of the investigation is to assess the applicant's creditworthiness. Lenders want to know the applicant's prior credit usage and repayment patterns, income, length of employment, and home ownership status.
To conduct its investigation, the lender obtains a credit report from a credit bureau that keeps records of many borrowers' credit histories. Credit bureaus compile information from merchants, utility companies, banks, court records, and creditors. There are three major national credit-reporting bureaus: Experian, TransUnion, and Equifax. A lender may consult one or all of the bureaus when you apply for credit.
credit report Information compiled by a credit bureau from merchants, utility companies, banks, court records, and creditors about your payment history.
credit bureau Firm that collects and keeps records of many borrowers' credit histories.
The Lender Also Obtains Your Credit Score Lenders use a credit score (also known as a risk score ) in which a statistical measure is used to rate applicants on the basis of various factors deemed relevant to creditworthiness and the likelihood of repayment. All three of the major credit reporting bureaus also calculate and report credit scores to lenders and there are more than 50 versions of the scores from the three credit bureaus.
credit score (risk score) Statistical measure used to rate applicants based on various factors deemed relevant to creditworthiness and the likelihood of repayment.
The most well-known score is the FICO score developed by Fair Isaac Corporation. The generic FICO score ranges from 300 to 850. FICO and other brand credit scores have been developed for many specific uses such as vehicle loans, mortgages, and credit cards, and the range of scores differs somewhat on each. Lenders are free to use whatever scoring system they prefer. So the odds are slim that the score you obtain on your own will be the exact score the lender will use. It is a good idea when you have applied for credit to ask the lender for the score it used as well as the source.
The Lender Decides Whether to Accept the Application and Under What Terms The approval or rejection of credit is based on the lender's judgment of the willingness and ability of the applicant to repay the debt. If the application is accepted, a contract is created that outlines the rules governing the account. For credit cards, this contract is called a credit agreement . For loans, the contract is called a promissory note (or simply, the note ).
credit agreement Contract that stipulates repayment terms for credit cards.
promissory note (note) Contract that stipulates repayment terms for a loan.
Approximately 15 percent of all people who apply for credit are denied. Half of the unsuccessful applicants have no established credit history (a continuing record of a person's credit usage and repayment of debts) or their credit history contains negative information. The other half have low credit scores or are attempting to take on too much debt.
credit history Continuing record of a person's credit usage and repayment of debts.
Credit scoring simply allows lenders to categorize credit users according to the perceived level of risk. Under the concept of tiered pricing, lenders may offer lower interest rates to applicants with the highest credit scores while charging steeper rates to more risky applicants. The difference in rates is modest except for those with scores below 620. People with such low credit scores can often find some lender that will say yes. However, the interest rates will be higher. The lender (not a credit bureau) always makes the decision about whether to grant credit.
Making Sense of Credit Scores
Although the credit-scoring systems in use today go by a number of brand names, the most widely known is the generic FICO score developed by Fair Isaac Corporation ( www.myfico.com ). Because your credit file and the method of calculating the score may differ at each of the three major credit bureaus, your credit score at each may differ as well. (See “Access Your Credit Bureau File for Free” on page 180.) Under the Fair and Accurate Credit Transactions Act, credit bureaus must provide consumers with their credit scores upon request. A nominal fee of about $20 is charged for a credit score report. However, if you are denied credit altogether or at less than favorable rates you must be told why, and if the reason was your credit score you may request a credit score report at no charge.
Credit scores are produced via complex statistical models that correlate certain borrower characteristics with the likelihood of repayment. The exact methodologies employed in the models, though similar, are closely held secrets. The factors used in the FICO score system are shared openly by Fair Isaac Corporation on the company's website:
1. Payment history . Are you late with your payments? How late? How often? On how many of your accounts?
2. Amounts owed . What is the balance on each of your credit obligations? (Even if you pay in full each month, there might be a balance on a given date.) How do the amounts owed vary on various types of accounts, such as credit cards versus loans? How many accounts have balances? Are you maxed out or nearly so on your cards, regardless of the dollar amount of your balances? (Credit scores are negatively affected if you have a balance on any card in excess of 30 percent of the credit limit on that card.) On loans, how much of the original loan is still owed?
3. Length of credit history . How long have you had each account? How long has it been since you used the accounts?
4. Taking on more debt . How many new accounts do you have? How long has it been since you opened a new account? How many recent inquiries have been made by lenders to which you have made application? If you had a period of poor credit usage in the past, for how long have you been in good standing?
5. Types of credit used . Do you have a good mix of credit usage, with reliance on multiple types depending on the purpose of the credit (for example, not using a credit card to buy a boat)? How many accounts in total do you have?
The median FICO score is about 736. About one-fourth of consumers have a FICO score below 620, making it nearly impossible to get a loan from all but the most expensive types of lenders. The FICO website provides suggestions on how to improve your FICO score. For example, if you are maxed out on two cards and have low balances on others, you might shift some of the large balances to other cards so that you owe no more than 30 percent of the debt limit on any of your cards. This percentage, known as the credit utilization ratio, contributes almost one-third of the weight of your credit score. The chart above indicates the relative importance of each of the five factors in the development of FICO scores.
The information about you that is contained in credit bureau files is one of the most important aspects of your financial life. It is used not only when lenders decide whether to approve your applications for credit but also when you apply for a job, insurance, and rent or buy housing. Thus, it is important that you build a good credit reputation and ensure that the information in your file is as accurate as possible and up to date.
Unfair Credit Discrimination Is Unlawful
The Equal Credit Opportunity Act (ECOA) prohibits certain types of unfair discrimination (making distinctions among individuals based on unfair criteria) when granting credit. Under this law, a lender must notify an applicant within 30 days about the lender's acceptance or rejection of a credit application.
The ECOA also requires the creditor to provide the applicant with a written statement, if requested, detailing the reasons for refusing credit. Rejecting a credit application due to poor credit history is legal. Conversely, it is illegal to reject applicants on the basis of gender, race, age, national origin, religion, marital status, or receipt of Social Security income, child-bearing plans, or public assistance. (Applicants may offer such information voluntarily, however.) Always request that a lender who turns you down for credit provide you with the credit score it used in the decision and the name of the credit bureau that provided the score.
A creditor cannot require an applicant to disclose income from alimony, separate maintenance payments, or child support payments. If the borrower wants this income to be counted during the lender's evaluation of the application, the creditor can consider whether that income stream is received consistently. Information about a spouse or former spouse may not be requested unless the spouse will use the account, it is a joint account, or repayment of debts will rely on the spouse's income or other financial support. The law requires that credit granted in both spouses' names be used to build a credit history for the parties as a couple as well as for each individual spouse.
Closing Accounts Does Not Help Your Credit Score
Many people incorrectly think that closing some existing credit card accounts will help raise their credit score. This is not usually the case unless you have a very large number of accounts that you do not use. When accounts are closed, it reduces the ratio between what you owe to the total amount of credit available on all credit cards, and that smaller window of credit available is what reduces your credit score. Also, credit scores are higher when accounts have been open for longer periods of time. Therefore, if you feel you must close accounts, close your newest accounts, not the oldest. Also take care to ensure that closing accounts does not raise your credit utilization ratio above 30 percent.
Build a Strong Credit History Some people who are new to the world of credit wonder whether they will ever get credit when they need it. They will if they establish a good credit history. This is what is meant when someone is said to have “good credit.” The following steps can help you build a strong credit history:
1. Establish both a checking account and a savings account. Lenders see people who can handle these accounts as being more likely to manage credit usage properly.
2. Have your cell phone and utilities billed in your name. The fact that you can maintain a good payment pattern on your utility bills indicates that you can manage your money wisely and will do the same with your credit repayments.
3. Request, acquire, and use a retail credit card. These cards are relatively easy to obtain. Use the credit sparingly, and the entire balance in full and on time each month as these card have high APRs.
4. Apply for a bank credit card. Your own bank is the best place to start your search for a credit card. If not successful there, you usually can find some bank that will issue you a card (search at www.bankrate.com ). The credit limit may be low (perhaps $1000) and the APR high (perhaps 27 percent), but at least the opportunity exists to establish a credit history. Later, you can request an increase in the credit limit and a lower APR.
5. Ask a bank for a small, short-term cash loan. Putting these borrowed funds into a savings account at the bank will almost guarantee that you will make the required three or four monthly payments. In addition, the interest charges on the loan will be partially offset by the interest earned on the savings.
6. stay current on your student loans. Many young adults have their first exposure to credit through the student loans. Making payments on time and paying off these loans quickly will show prospective lenders that you are a responsible borrower.
Access Your Credit Bureau File for Free Federal law requires credit bureaus to provide consumers with their credit reports upon request. You can obtain one report for free each year from each of the national credit bureaus. In addition, consumers must be notified if merchants report negative information to a credit bureau. You should request a report periodically (certainly every year) and whenever you move, have a change in family status (marry, get divorced, or become widowed), or after resolving any credit billing errors or disputes.
Only One Website Is Truly Free To obtain a free credit report, simply contact www.annualcreditreport.com . This is the only site that links you directly to the mechanism for obtaining a free report.
For a free credit report, visit www.annualcreditreport.com .
Credit Monitoring Is Costly and Unnecessary
If you go to websites other than annualcreditreport.com to obtain a copy of your credit report for a “free” credit score you will be enticed to sign up for a credit-monitoring service. Such services allow you to access your report as often as daily and perhaps even obtain a generic personal credit score, supposedly for free for a month or two. However, these offers always are negative option plans. Thus you will be automatically signed up for a plan costing as much as $100 or more per year and your membership will renew automatically unless you notify them that you want to renew at the end of the free period. This is a bad deal, especially when you can obtain the information in your files for free.
Actually, You Can Obtain a Free Report Every Four Months The free annual credit report law allows you to check your credit for free every four months. How? By staggering your requests across the three national bureaus. For example, in January you can request a report from Experian through www.annualcreditreport.com . Then, in May you can order a report from TransUnion. In September you can request a report from Equifax. Then in January, it's back to Experian. Because the bureaus all gather information from essentially the same sources, you can have some confidence that what appears on one file will be present in the others. If you find an error, contact all three to make the correction. The major credit bureaus often sell lists of consumer names in their files (but not each consumer's specific credit history information) for credit card marketing purposes. To have your name withheld for two years from this practice, call (888) 567–8688 or go online at www.optoutprescreen.com .
Guard Your Privacy
Identity theft is a form of stealing someone's identity in which someone pretends to be someone else by assuming that person's identity, usually as a method to gain access to resources or obtain credit and other benefits in that person's name. It is the fastest growing crime in America. Over 17 million Americans each year fall victim to identity theft and lose over $25 billion. Fortunately, a vigilant watch over personal documents can greatly reduce the risk of becoming a victim of identity theft.
Identify theft thieves can take bills and account information out of mailboxes, steal wallets, memorize debit card information from watching victims at ATMs, and piece together bills and bank account statements found in the trash. With a Social Security number, they can steal from already established bank and credit accounts, open new credit accounts, rent or buy housing, obtain a new driver's license or passport, obtain a tax refund, and utilize medical services. All this can saddle the victim with thousands of dollars in legal fees to restore their identity.
YOU SHOULD NEVER:
• Carry anything in your wallet that contains your Social Security number.
• Write your Social Security number or other identifying information like a credit card number on a check, and realize that merchants are prohibited from recording such information on a check.
• Keep Social Security numbers, bank account, medical insurance, or other sensitive information on hard drives, tablets, or cell phones, because even a so-so hacker can obtain quick access to the sensitive information.
• Give your credit card or bank information numbers over the telephone unless you initiated the contact with the merchant.
• Respond to emails claiming that your bank or a government agency is trying to reach you.
YOU SHOULD ALWAYS:
• Use hard to crack PINs and passwords and make sure that no two accounts share the same PIN number or password.
• Consider using “password generating software” to create unique passwords.
• Ask insurance companies (and others) to assign each customer a randomly generated “ID” instead of using Social Security numbers.
• Ask financial institutions for “two-factor authentication” for online transactions, which makes hacking into accounts more difficult.
• Shred sensitive documents before recycling or throwing them away.
• Consider using automatic bank deposits, filing income taxes electronically, and paying bills online to minimize opportunities for thieves.
• Consider placing a security freeze on your credit report, which for a small fee is an effective way to prevent unauthorized credit accounts from being opened in your name. With a freeze, you tell the credit bureaus not to release your financial records to anyone without specifically obtaining your written consent.
• Remember the Federal Trade Commission's “Identity Theft” website www.consumer.ftc.gov/articles/0277-create-identity-theft-report/ .
Holly Hunts
Montana State University
Here's How to Fix Errors in Your Report When you obtain your report, you should thoroughly inspect it for accuracy. If you find an error, the Fair Credit Reporting Act (FCRA) allows you to challenge the error as it requires that reports contain accurate information. It also requires that only bona fide users be permitted to review your file for approved purposes. The FCRA governs both lenders and credit bureaus.
Fair Credit Reporting Act (FCRA) Requires that credit reports contain only accurate relevant information and allows consumers to challenge errors or omissions of information in their reports.
If you find an error or omission in a credit report from a particular credit bureau, you should immediately take steps to correct the information since the FCRA is partially enforced by consumers and also by the Consumer Financial Protection Bureau (CFPB) Here is how to assert your rights:
1. Simultaneously notify both the credit bureau and the original lender of the error and ask the original lender for confirmation of the debt. State that you wish to exercise your right to a reinvestigation under FCRA. Specifically, you should ask the bureau to “reaffirm” the item or delete it.
2. The bureau and lender must reinvestigate the information within 45 days. If the bureau cannot complete its investigation within 45 days, it must drop the information from your credit file.
3. If the information was erroneous, it must be corrected. If a report containing the error was sent to a creditor investigating your application within the past six months, a corrected report must be sent to that creditor.
4. If the credit bureau refuses to make a correction (perhaps because the information was “technically correct”), you may wish to provide your version of the disputed information (in 100 words or less) by adding a consumer statement to your credit bureau file. This statement will be included with any credit reports by that bureau.
consumer statement Your version of disputed information in your credit report when the credit bureau refuses to remove the disputed item.
5. Also obtain a report from the other two bureaus to ensure that the error does not also appear in their files. If an error appears, correct it beginning at step #2.
6. If you have trouble getting erroneous information removed, contact the CFPB.
The Effects of Divorce on Your Credit
The breakup of a marriage affects the creditworthiness of both partners. The Federal Trade Commission offers the following suggestions for individuals seeking a divorce.
Pay careful attention to credit accounts held jointly, including mortgages, second mortgages, and credit cards. The behavior of one divorcing spouse will continue to affect the other individual as long as the accounts are held in both names. One party could make credit card charges, for example, and refuse to pay the debt, leaving the financial burden on the other party. Ask creditors to close joint accounts. Then, if possible reopen them as individual accounts. Never accept a creditor's verbal assurance, either over the telephone or in person, that an account has been closed. Always insist on written confirmation, including the effective date of the account closure.
When debts were accumulated in both names, a divorce decree has no legal effect on who technically owes the debts. Creditors can legally collect from either of the divorcing parties when the accounts were held jointly. If the person absolved of responsibility for the debt under the divorce decree is forced by a creditor to pay off the account, he or she must then go to court to seek enforcement of the divorce decree and collect reimbursement from the former spouse.
Both before and after a divorce, get copies of your credit report from all three credit bureaus. Check them for accuracy and challenge any problem areas, such as accounts, that continue to be shown in both names.
CONCEPT CHECK 6.3
1. Summarize the basic steps that occur when someone applies for credit.
2. What is a credit history, and what role do credit bureaus play in the development of your credit history?
3. What is a credit score, and what five major factors go into its calculation?
4. Identify five actions you can take to build a good credit reputation.
5. Summarize the protections provided under the Fair Credit Reporting Act.
LEARNING OBJECTIVE 4
Describe the common sources of consumer credit.
Today's consumers have many sources of consumer loans from which to choose. Most lending to consumers occurs through depository institutions and sales finance companies. Other sources include consumer finance companies, stockbrokers, and insurance companies. Table 6-3 shows the interest rates charged and example payment amounts and finance charges were you to borrow $1,000 from these various sources of consumer loans.
6.4a Depository Institutions Lend Money to Their Customers
Depository institutions include commercial banks, mutual savings banks, savings banks, and credit unions (see Chapter 5 on pages 140 and 141 for more-detailed descriptions of these institutions). They tend to make loans to their own customers and to noncustomers with good credit histories. Depository institutions offer highly competitive rates, partly because the funds loaned are obtained primarily from their depositors. The interest rate commonly ranges from 4 to 18 percent. Research indicates that many people who go elsewhere for loans actually meet the qualifications for depository institution lending and as a result end up paying a higher interest rate than necessary.
6.4b Sales Finance Companies Lend Money to Purchasers of Consumer Products
A sales finance company is a seller-related lender (such as Ally Financial for General Motors and Ford Credit for Ford vehicles) whose primary business is financing the sales of its parent company. Such state licensed firms specialize in making purchase loans, often with the item being bought serving as the collateral for the loan. Because the seller often works in close association with the sales finance company, credit can be approved on the spot.
sales finance company Seller-related lender whose primary business is financing sales for its parent company.
Table 6-3 Estimating What It Costs to Borrow Money ($1,000)
Compare APRs Not Lenders
Knowing the APR simplifies making comparisons among credit arrangements. The lower the APR the lower the true cost of the credit. The APR can be used to compare credit contracts from different sources, with different time periods, finance charges, repayment schedules, and amounts borrowed.
All states have usury laws (sometimes called small loan laws) that establish the maximum loan amounts, interest rates, and credit-related fees for different types of loans from various sources. These maximum rates may vary from 18 percent to as much as 54 percent. These laws also apply to bank credit card fees, such as annual fee and late payment fees.
Sales finance companies require collateral and deal only with customers who are considered medium to good risks. Thus, their interest rates are often competitive with those offered by depository institutions. Their interest rates may be even lower than those offered by other sources when the seller subsidizes the rate to encourage sales—as with the special low-APR financing often offered on new cars, for example. Most new-car loans today are made by sales finance companies.
6.4c Consumer Finance Companies Make Small Cash Loans
A consumer finance company specializes in making relatively small loans and is, therefore, also known as a small-loan company . These state licensed lenders range from the well-recognized large corporations to many local neighborhood lenders. Such companies make both secured and unsecured loans at relatively high interest rates and require repayment on a monthly installment basis. They focus mainly on the subprime lending market. This market focuses on lending to people who have FICO scores of less than 620 and normally would not qualify for any credit elsewhere.
consumer finance company/small-loan company Firm that specializes in making relatively small secured or unsecured loans that require monthly installment payments.
Alternative Lenders offer High-Priced Credit
High-priced credit can come from alternative lenders such as payday lenders, rent-to-own stores, and pawnshops.
Payday lenders (which are illegal in some states) are businesses that grant credit when they honor a personal check but agree not to deposit the check for a week or longer. The fees for check cashing are often 20 percent or more of the amount of the check, pushing the annual percentage rate from 20 to 300 to 700 percent. Eighty percent of payday borrowers either roll over their loans or take out larger loans further escalating the cost of borrowing.
A rent-to-own program offered through a rent-to-own store provides a mechanism for buying an item with little or no down payment by renting it for a period of time, after which it is owned. Furniture, appliances, and electronic entertainment items are commonly sold via the rent-to-own approach.
These programs have two big drawbacks for consumers. First, the renter does not own the item until the final payment is made. Paying late or stopping payments will cause the products to be seized with no allowance being made for the previous “rental” payments. Second, the actual cost for renting items is often exorbitantly high. For example, a TV worth $1000 might be rented for $39 per week for one year, producing a finance charge of $1028 [(52 × $39) − $1000].
A pawnshop is a business that offers secured loans to people, with items of personal property used as collateral that the borrower turns over to the pawnshop. The lender offers single-payment loans, often ranging from $100 to $500, for short time periods (typically two to six months). The dollar amount loaned is typically equal to one-third or less of the value of the item pawned. In most states, to get the cash a borrower need merely turn over the item, present identification, and sign on the dotted line.
The pawnshop owner can legally sell the item if the borrower fails to redeem the property by paying the amount due, plus interest, within the time period specified. The pawnshop commonly charges an interest rate of about 5 percent per month plus a 2 percent monthly storage fee; thus, the annual combined “interest” amounts to 84 percent [(5 + 2) × 12].
Approximately one-fifth of all loans granted by consumer finance companies are for the purpose of debt consolidation. Here the borrowed takes out one new loan to pay off many others. This is often done to secure a lower interest rate, secure a fixed interest rate or for the convenience of servicing only one loan. Other common uses of such loans are for travel, vacations, education, automobiles, and home furnishings. Some small-loan companies specialize in making loans by mail. They advertise on the Internet as well as in newspapers and magazines to attract borrowers, who complete a credit application and receive approval via e-mail or mail.
6.4d Stockbrokers and Employers Lend Money to Their Clients
People build significant assets in investment accounts that may be earmarked for their children's college education, their own retirement, or other purposes. If you have a margin account (see Chapter 14 ), you can borrow from your stockbroker using your investments as collateral. Although many people prefer not to tap into these investment funds directly, it is possible to borrow from these accounts.
Also, it usually is possible to borrow from one's employer-sponsored, tax-sheltered retirement account (see Chapter 17 ), depending on the rules of the plan. Care must be taken to ensure that the loan plus interest is repaid so that the savings goal can still be met. Serious consequences may arise if one changes employers or the retirement account loan is not repaid. (See Chapter 17 for details.)
6.4e Insurance Companies Lend Money to Their Policyholders
Insurance companies, such as State Farm or Allstate, offer credit cards to their policyholders. Policyholders who have cash-value life insurance policies also can obtain loans based on the cash values built up in their policies. An advantage to borrowing on a cash-value life insurance policy is that the interest rates are low, ranging from 4 to 9 percent even though the policy-holders actually are borrowing their own money. Many people fail to pay back such loans because no fixed schedule of repayment is established and insurance companies do not pressure borrowers to repay the debt. If the insured person dies before repaying the loan, the life insurance company will deduct the amount of the loan from the amount that would otherwise be paid on the policy.
6.4f Choose Your Source of Credit Wisely
Figure 6-1 provides a representation of various lenders with those with the highest standards at the top of the pyramid and those with the lowest standards at the bottom. Try to borrow from lenders as high on the pyramid as possible.
Money Websites for Building and Maintaining Good Credit
Informative websites for building and maintaining good credit, including credit scores are:
Bankrate.com ( www.bankrate.com/debt-management.aspx )
Center for Responsible Lending ( www.responsiblelending.org/ )
Consumer Financial Protection Bureau ( www.consumerfinance.gov/ )
Federal Reserve Board ( www.federalreserve.gov/creditreports/default.htm )
Federal Trade Commission ( www.consumer.ftc.gov/topics/money-credit )
FICO ( www.myfico.com )
MyMoney.gov ( www.mymoney.gov/borrow/Pages/borrow.aspx )
National Foundation for Credit Counseling ( www.nfcc.org/ )
NOLO ( www.nolo.com/legal-encyclopedia/collection-agencies )
Sallie Mae ( www.salliemae.com/ )
Figure 6-1 The Credit Pyramid
CONCEPT CHECK 6.4
1. List the types of depository institutions that are sources of credit for consumers.
2. Distinguish between a sales finance company and a consumer finance company.
3. Summarize how stockbrokers and insurance companies serve as sources of consumer credit.
4. Explain where you would go to obtain credit at the lowest cost.
6.5 DEALING WITH OVERINDEBTEDNESS
LEARNING OBJECTIVE 5
Identify signs of overindebtedness, and describe the options that are available for debt relief.
People become overindebted when their excessive personal debts make repayment difficult and cause financial distress.
overindebted When one's excessive personal debts make repayment difficult and cause financial distress.
6.5a Ten Signs of Overindebtedness
1. Not knowing how much you owe. Have you lost track of how much you owe? Do you avoid reality by not adding up the total? Are you afraid to add up how much debt you have?
2. Running out of money. Are you using credit cards on occasions when you previously used cash? Are you borrowing to pay insurance premiums, taxes, or other large, predictable bills? Are you borrowing to pay for regular expenses such as food or gasoline? Do you try to borrow from friends and relatives to carry you through the month?
Sean's Success Story
Sean's success as a personal financial manager is reflected in his debt situation. While in college, Sean worked part-time for his living expenses and only used student loans to pay for his tuition and fees. He had a credit card that provided cash-back rewards. He used the card for most of his expenses and paid the balance due in full each month. He used the cash-back amount each year to help pay for a road trip during spring break. During his senior year, Sean checked his credit report with all three national bureaus. He found one or two mistakes in each and had the errors corrected. He now checks one of the files every four months. Sean has been considering the purchase of a new vehicle so he purchased his FICO score and was pleased to see that the score was above 800, indicating that he would qualify for a loan at the lowest possible rates. He plans to seek preapproval from at least three sources including his credit union before visiting a dealership. Sean's approach to building and maintaining good credit will benefit him for years to come.
3. Paying only the minimum amount due. Do you pay the minimum payment— or just a little more than the minimum—on your credit cards instead of making large payments to more quickly reduce the balance owed?
4. Exceeding debt limits and credit limits. Are you spending 15 percent or more of your take-home pay on nonmortgage credit repayments? Do you sometimes reach the maximum approved credit limits on your credit cards?
5. Requesting new credit cards and increases in credit limits. Have you applied for additional credit cards to increase your borrowing capacity? Have you asked for increases in credit limits on your current credit cards?
6. Using cash advances to pay other credit cards. Have you obtained a cash advance on one credit card to make a payment due on another card? Have you used a cash advance to pay other bills?
7. Paying late or skipping credit payments. Are you late once or more a year in paying your mortgage, rent, vehicle loan or lease, or utility bills? Do you sometimes pay late charges? Are you juggling bills to pay the utilities, rent, or mortgage? Are creditors sending overdue notices?
8. Taking add-on loans. Taking add-on loans, also called flipping, occurs when you refinance or rewrite a loan for an even larger amount before it has been completely repaid. Suppose that a loan of $1000 has been repaid down to $400. You decide to refinance the debt balance of $400 by borrowing $2000 and using the additional $1600 ($2000 − $400) for other purposes.
9. Using debt-consolidation loans. Are you borrowing, perhaps from a new source, to pay off old debts? Such action may temporarily reduce pressure on your budget, but it also indicates that you are overly indebted.
10. Experiencing garnishment. Garnishment is a court-sanctioned procedure by which a portion of the debtor's wages are set aside by the debtor's employer to pay money owed. Wages and salary income, including that of military personnel, can be garnished. The Truth in Lending Act prohibits more than two garnishments of one person's paycheck. The total amount garnished cannot represent more than 25 percent of a person's disposable income for the pay period or more than the amount by which the weekly disposable income exceeds 30 times the federal minimum wage (whichever is less). In addition, the law prohibits garnishment from being used as grounds for employment discharge.
garnishment Court-sanctioned procedure by which a portion of debtors' wages are set aside by their employers to pay debts.
11. Experiencing repossession or foreclosure. Repossession is a legal proceeding by which the lender seizes an asset (called foreclosure , if the property is a home) for nonpayment of a loan. When a lender repossesses property, the borrower may still owe some money on the debt. A deficiency balance occurs when the sum of money raised by the sale of the repossessed collateral fails to cover the amount owed on the debt plus any repossession expenses (collection, attorney, and court costs) paid by the creditor.
repossession/foreclosure Legal proceeding by which the lender seizes an asset.
deficiency balance Occurs when money raised by the sale of repossessed collateral doesn't cover the amount owed on the debt plus any repossession expenses.
Old Debts May Never Die
It is not uncommon for a credit collector to contact someone who thought a debt was written off by a lender and demand repayment. This may occur years later. A single dollar of repayment by you will start the clock ticking again, because if you make a partial payment you “reaffirm” the debt as valid; thus you will owe the whole balance all over again.
To illustrate this point, consider what happened to Maria Peterson, a staff sergeant in the army from San Diego, California, whose husband lost his civilian job. In an attempt to reduce expenditures, Maria voluntarily turned her Chevrolet Malibu back to the finance company while still owing $11,000 on the debt. A month later, she was notified that the vehicle had been sold at auction for $7800; the proceeds were reduced to only $7100, however, due to collection and selling costs of $500 and attorney fees of $200. Maria was billed for a deficiency balance of $3900 ($11,000 − $7100). She would have been much better off had she sold the vehicle herself, as vehicles at auction usually sell for much less than their book values.
6.5b Federal Law Regulates Debt Collection Practices
The federal Fair Debt Collection Practices Act (FDCPA) prohibits third-party debt collection agencies from using abusive, deceptive, and unfair practices in the legitimate effort to collect past-due debts. Debt ( or credit) collection agencies are firms that specialize in making collections that could not be obtained by the original lender. In some cases, they assist the original lender (for a fee); in other cases, they take over (purchase) the debt and become a new creditor. When a debtor offers to make payment for several debts, the FDCPA requires that the amount paid must be applied to whichever debts the debtor desires. Banks, dentists, lawyers, and others who conduct their own collections (second-party collectors) are exempt from the provisions of the FDCPA. Nevertheless, many states have enacted similar laws that govern these second-party collectors.
Fair Debt Collection Practices Act (FDCPA) Prohibits third-party debt collection agencies from using abusive, deceptive, or unfair practices to collect past-due debts.
debt collection agency Firm that specializes in collecting debts that the original lender could not collect.
Collection agencies are prohibited from telephoning the debtor at unusual hours, making numerous repeated telephone calls during the day, not applying payments to amounts under dispute, using deceptive practices (such as falsely claiming that their representatives are attorneys or government officials), making threats, or using abusive language. They also cannot telephone a debtor's employer.
Even with these limitations, collection agencies can be irritatingly persistent when collecting past-due accounts. If the collection effort is not successful, the creditor may take the debtor to court to seek a legal judgment against the debtor; this judgment may be collected by repossessing some of the debtor's property or garnishing wages. More than one third of Americans have been reported to collection agencies for unpaid bills.
6.5c Steps to Take to Get Out from Under Excessive Debt
Even the most well-meaning credit user can become overextended as a result of illness, unemployment, or divorce. What should you do if you realize that you are overly indebted?
1. Determine your account balances and the payments required. Find out exactly what it would take to pay off your balances today. This amount is not the same as the total of your remaining payments and very likely includes additional fees, penalties and late charges if you have been late in your payments.
2. Focus your budget on debt reduction. Calculate the percentage of your budget necessary to make the payments on your debts, and then add 5 percent. Use this extra money to help pay your creditors by applying the extra money to the debt with the highest APR. Paying off small debts might give a psychological boost but it is the high APR largest debts that are the most expensive. And remember, paying off debts provides a higher “rate of return” than money in savings and investments, so “invest” your money in debt repayment first.
3. Contact your creditors. Try to work out a new payment plan with your creditors. Many lenders, including those that finance vehicles, may let you skip a payment. They want to see you solve your financial problems so you can avoid bankruptcy. Creditors are more likely to work with borrowers who come to them first rather than after collection efforts begin.
4. Take on no new credit. Return your credit cards to the issuer or lock them up so that you cannot use them. Disciplined action to reduce debt should show results in only a few months. If progress does not occur, seek professional help.
5. Refinance. Determine whether some loans can be refinanced to obtain a lower interest rate, especially mortgage loans. (See Chapter 9 for details.) Even if you refinance, keep making the same payment so you will pay the new loan off more quickly. Consumers who have difficulty making credit repayments may resort to a debt-consolidation loan , through which the debtor exchanges several smaller debts with varying due dates and interest rates for a single large loan. You should avoid the temptation to use this strategy simply to lower your total monthly payments.
DO IT IN CLASS
debt-consolidation loan A loan taken out to pay off several smaller debts.
6. Avoid credit repair and debt settlement companies. Many companies claim that they want to help people in debt. A credit repair company (also known as a credit clinic ) is a firm that offers to help improve or clean up a person's credit history for a fee. Experts say that none are reputable. The Credit Repair Organization Act (CROA) makes it illegal for credit repair companies to lie about what they can do for you, and to charge you before they've performed their services. The CROA is enforced by the Federal Trade Commission and requires credit repair companies to explain your legal rights in a written contract. The contract must specify the cost, services they will perform, how long it will take to get results, and explain your three-day right to cancel without any change.
credit repair company (credit clinic) Firm that offers to help improve or fix a person's credit history for a (usually hefty) fee.
In reality, no company can remove or “fix” accurate but negative information in anyone's credit history. You can improve your future credit history by making on-time repayments. And you can correct errors in your credit bureau files on your own for free with little effort.
Debt settlement companies also are to be avoided. These firms promise to reduce your debt by negotiating with your creditor. Debt settlement programs typically are offered by for-profit companies and involve the company negotiating with your creditors to allow you to pay a “settlement” to resolve your debt. The settlement is another word for a lump sum that is less than the full amount you owe. To make that lump sum payment, the company asks that you stop making monthly payments to your creditors. Instead you are supposed to set aside a specific amount of money every month in a savings account and you are to transfer this amount every month into an escrow-like account to accumulate enough savings to pay off a settlement that is reached eventually.
One of your problems is that those creditors will have reported late payments to the credit bureaus, which will stay on your credit file for up to seven years. Also, no “paid in full” notations will be in your credit report, and the IRS may assess you for income taxes due on the debts cancelled.
7. Find good help. You may be able to obtain free budget and credit advice from your employer, credit union, or labor union. Also, many banks and consumer finance companies offer advice to help financially distressed debtors, as do nonprofit credit counseling agencies (CCAs) . Such an agency can make arrangements with unsecured creditors to collect payments from overly indebted consumers to repay debts, and it can provide individuals with credit counseling, assistance with financial problems, educational materials on credit and budgeting, and a debt management plan (DMP) .
credit counseling agency (CCA) Agency that can arrange payment schedules with unsecured creditors for overly indebted consumers and can provide individuals with credit counseling.
debt management plan (DMP) Arrangement whereby the consumer provides one monthly payment (usually somewhat smaller than the total of previous credit payments) that is distributed to all creditors.
A DMP is an arrangement whereby the consumer provides one monthly payment (usually somewhat smaller than the total of previous credit payments) that is distributed to all creditors. Creditor concessions, such as reduced interest rates, may also allow debtors to repay what they owe more quickly than would otherwise be possible.
Credit counseling services are provided at a nominal cost on a face-to-face basis, online, or via the telephone. Seek a non profit agency that will do a full budget review for you. Make sure the agency is a member of the Association of Independent Consumer Credit Counseling Agencies ([866] 703–8788; www.aiccca.org ) or the National Foundation for Credit Counseling ([800] 388–2227; www.nfcc.org ). Contact the Better Business Bureau for a reputation report as well.
Debt Management Plans Do Not Impact Your Credit Score
Entering into a debt management plan with a nonprofit credit counseling company will not lower your credit score. A future lender may look at debt management plans unfavorably and either deny credit or charge a higher APR for a DMP participant.
6.5d Bankruptcy as a Last Resort
When debts are so overbearing that life seems really bleak—a situation that may be aggravated by recent unemployment, illness, hospital bills, disability, death in the family, divorce, or small-business failure—many people consider filing a petition in federal court to declare bankruptcy. Bankruptcy is a constitutionally guaranteed right that permits people (and businesses) to ask a court to find them officially unable to meet their debts.
bankruptcy Constitutionally guaranteed right that permits people (and businesses) to ask a court to wipe out all their debts.
The court will designate some debts as discharged debts that are excused. Some debts are never excused through bankruptcy. These include education loans that have come due within the previous seven years, fines, alimony, child support, income taxes for the most recent three years, and debts for causing injury while driving under the influence of alcohol or drugs. Bankruptcy is not a do-it-yourself project. Use a lawyer who specializes in consumer bankruptcies.
discharged debts Debts (or portions thereof) that are excused as a result of a bankruptcy.
Before you can file for bankruptcy, you must complete credit counseling with an agency approved by the United States Bankruptcy Trustee's office. The purpose of this counseling is to give you an idea of whether you really need to file for bankruptcy or whether an informal repayment plan could get you back on your feet financially. Also, you will have to attend another counseling session, this time to learn more about the fundamentals of personal financial management. Only after you submit proof to the court that you have fulfilled this requirement can your attorney request a bankruptcy discharge wiping out many of your debts.
Chapter 13 —Regular Income Plan Chapter 13 of the Bankruptcy Act (also known as the wage earner or the regular income plan ) is designed for individuals with regular incomes who might be able to pay off some or all of their debts given certain protections of the court. Under this plan, the debtor submits a debt repayment plan to the court that is designed to repay as much of the debt as possible, typically in three to five years. After the debtor files a petition for bankruptcy, the court issues an automatic stay—a court order that temporarily prevents all creditors from recovering claims arising from before the start of the bankruptcy proceeding. This action protects the debtor from collection efforts by creditors, including garnishments. Typically, no assets may be sold by the debtor or repossessed by the lender after a stay is granted.
Chapter 13 of the Bankruptcy Act (wage earner or regular income plan) Bankruptcy plan designed for individuals with regular incomes who might be able to pay off some or all of their debts given certain court protections.
After the court notifies all creditors of the petition for bankruptcy, a hearing is scheduled. With the help of a bankruptcy trustee (an agent of the bankruptcy court), who verifies the accuracy of a bankruptcy petition at a hearing and who distributes the assets according to a court-approved plan, the proposed repayment plan is reviewed (and modified, if necessary) and finally approved by the court. The debtor must then follow a strict budget while repaying the obligations. During this time, the bankrupt person cannot obtain any new credit without the permission of the trustee. If the debtor makes all scheduled payments, he or she is discharged of any remaining amounts due that could not be repaid within the repayment period.
Your Worst Financial Blunders in Building and Maintaining Good Credit
Based on others' financial woes, you will make mistakes in personal finance when you:
1. Fail to regularly check the accuracy of your credit bureau files.
2. Let a lender's willingness to grant credit be an indicator that you can afford to repay the debt.
3. Pay more than 14 percent of your disposable income toward nonmortgage debt payments.
Chapter 7 —Immediate Liquidation Plan Chapter 7 of the Bankruptcy Act , also called straight bankruptcy , provides for an immediate liquidation of assets and discharge of debts. This option is permitted when it would be highly unlikely that substantial repayment could ever be made. Petitioners seeking to file Chapter 7 must pass a “means test.” Those who fail this test because their income is too high must file Chapter 13 instead.
Chapter 7 of the Bankruptcy Act (straight bankruptcy) Provides for the liquidation of assets with proceeds applied to paying off excusable debts to the degree possible.
Don't Wait Too Long to Declare Bankruptcy
The thought of declaring bankruptcy is so onerous for many that some people wait too long to seek its protection. Both Chapter 7 and 13 bankruptcies allow debtors to keep a portion of their assets. For example, 401(k) retirement accounts are 100 percent protected from creditors in bankruptcy. If a debtor begins taking money out of a retirement plan when faced with mounting debt and ultimately declares bankruptcy, the debtor would have used up an asset that could have been fully protected had he or she filed sooner. If the only way you can pay your debts or home mortgage is to tap your retirement plan, you should consult a lawyer about whether the time already has come to seek bankruptcy protection.
When Chapter 7 is allowed, most of the bankrupt person's assets are given over to the bankruptcy trustee. Any assets that serve as collateral for loans are turned over to the appropriate secured creditors. Most of the remaining assets are sold, and the proceeds of the sales are distributed to the unsecured creditors of the bankrupt person.
A debtor may choose to sign a reaffirmation agreement and become legally obligated again to pay all or a portion of a debt that would have been discharged in the bankruptcy case, such as for a vehicle. Any leftover debt is usually discharged by the court when the debtor emerges from bankruptcy.
State and federal laws govern what assets the debtor can keep. In general, bankrupt people are allowed to keep a small amount of equity in their homes, an inexpensive vehicle, and limited personal property. Discharged debtors usually emerge with little, if any, debt and a much improved net worth and, of course, a lower credit score.
Bankruptcy should be used as a last resort rather than as a quick fix or cure-all for overuse of credit. Bankruptcy remains on one's credit record for ten years. People who have declared bankruptcy typically face years of trouble when renting housing, obtaining home loans, buying insurance, obtaining employment, and getting new credit cards. They also cannot use Chapter 7 bankruptcy again for at least six years. Therefore, some creditors will lend to such individuals, but at much higher interest rates than usual.
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Obtaining a free copy of your credit report ( www.annualcreditreport.com ) from one of the three national credit bureaus.
2. Confirming the accuracy of the report and, if there are errors or omissions, challenging them.
3. Repeating step two every four months, staggering the bureaus to ensure that each request is free.
CONCEPT CHECK 6.5
1. Identify four signs of overindebtedness.
2. List the major provisions of the Fair Debt Collection Practices Act.
3. What services are provided by a credit counseling agency, and how might a debt management plan work to provide relief for someone who is having debt problems?
4. Distinguish between Chapter 7 and Chapter 13 bankruptcy, and explain who might be forced to use Chapter 13 rather than Chapter 7 .
WHAT DO YOU RECOMMEND NOW?
Now that you have read this chapter on building and maintaining good credit, what would you recommend to Hanna Savarin regarding:
1. Factors she should consider regarding her ability to take on additional debt?
2. The impact of her current debt on her ability to obtain a loan to buy a vehicle?
3. Where she might obtain financing for a vehicle loan?
4. The effect of taking on a loan on her overall financial planning?
BIG PICTURE SUMMARY OF LEARNING OBJECTIVES
L01 Explain reasons for and against using credit.
People borrow for a variety of reasons—for example, to deal with financial emergencies, to have goods immediately, and to obtain discounts in the future. Perhaps the greatest disadvantage of using credit is the ensuing loss of financial flexibility in personal money management. The annual percentage rate (APR) provides the best approximation of the true cost of credit.
L02 Establish your own debt limit.
It is important to establish your own debt limit. There are three approaches you can take to do this. One, you can compare debt payments to income. Two, you can compare debt load to your assets. Three, you can determine how long it should take for you to get out of all your debts other than your home mortgage.
L03 Achieve a good credit reputation.
In the process of opening a credit account, the lender investigates your credit history, obtains a credit score (such as a FICO score) from a credit bureau, and then determines whether to grant credit and under what conditions.
L04 Describe the common sources of consumer credit.
Major sources of consumer loans include depository institutions (commercial banks, savings and loan associations, and credit unions), sales finance companies, and consumer finance companies. Loans are also available through insurance companies and stockbrokers. Depository institutions typically offer the lowest interest rates, although sales finance companies sometimes offer very low rates to increase sales of the products being financed. Only those people with high credit scores qualify for the best rates from any source.
L05 Identify signs of overindebtedness, and describe the options that are available for debt relief.
Among the signals of being overly indebted are exceeding credit-limit guidelines and running out of money too often. People experiencing serious financial difficulties can obtain professional assistance through nonprofit credit counseling agencies or by contacting an attorney about bankruptcy.
LET'S TALK ABOUT IT
1. Good Versus Bad Debt. If there is such a thing as good debt, what types of debt do you consider to be “good”? What types do you consider to be “bad”?
2. Your Creditworthiness. What aspects of your financial life make you creditworthy? What aspects would make it difficult for you to obtain credit?
3. Assessing Your Debt Load. How might students judge whether they are taking on too high a level of student loan debt?
4. Managing Student Loan Debt. Use the information on pages 174 and 175 to discuss how best to deal with student loan debt.
5. Sources to Borrow for a Vehicle. If you wanted to borrow money to buy a new or used car, where would you turn? Why?
6. Your Privacy. Are you concerned that the major national credit bureaus may have files containing information about you? What do you think about the process required to correct errors in those files?
7. Easy Credit. Is it too easy for college students to get credit cards? Who do you know who has gotten into financial difficulty because of overuse of credit cards?
8. Feelings About Bankruptcy. How do you feel about bankruptcy? When might bankruptcy be justified in your opinion? When might it not be justified?
DO THE MATH
1. Taking Out a Motorcycle Loan. Kevin Jones is single and recently graduated from law school. He earns $9000 per month, an awesome salary for someone only 26 years old. He also has $1400 withheld for federal income tax, $540 for state income taxes, $688 for Medicare and Social Security taxes, and $230 for health insurance every month. Kevin has outstanding student loans of almost $80,000 on which he pays about $900 per month and a 0% auto loan payment of $300 on a Ford Fusion Hybrid he purchased new during law school. He is considering taking out a loan to buy a Kawasaki motorcycle.
(a) What is Kevin's debt payments-to-disposable income ratio?
(b) Based on your answer to (a), how would you advise Kevin about his plan?
DO IT IN CLASS PAGE 172
2. Buying a Vacation Home. Carmen and Juan Montoya have just finished putting their three daughters through college. As empty-nesters, they are considering purchasing a vacation home on a nearby lake because prices have dropped in recent years. The house might also serve as a retirement home once they retire in 12 years. The Montoyas' net worth is $283,000 including their home worth about $265,000 on which they currently owe $143,000 for their first mortgage. Their outstanding debts in addition to their mortgage include $12,500 on one car loan, $13,700 on a second car loan, and a $25,500 second mortgage on their home taken out to help pay for college expenses.
(a) Calculate the Montoyas' debt-to-equity ratio.
(b) Advise them as to the wisdom of borrowing for a vacation home at this time.
DO IT IN CLASS PAGE 174
3. A Recent Graduate's Debt Status. Chelsea Menken recently graduated with a degree in food science and now works for a major consumer foods company earning $20K per year with about $36,000 in take-home pay. She rents an apartment for $1040 per month. While in school, she accumulated about $38,000 in student loan debt on which she pays $385 per month. During her last fall semester in school, she had an internship in a city about 100 miles from her campus. She used her credit card for her extra expenses and has a current debt on the account of $8000. She has been making the minimum payment on the account of about $320. She has assets of $14,000.
(a) Calculate Chelsea's debt payment-to-disposable income and debt-service-to-income ratios.
(b) Calculate Chelsea's debt-to-equity ratio.
(c) Comment on Chelsea's debt situation and her use of student loans and credit cards while in college.
DO IT IN CLASS PAGES 172 AND 174
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Attempt to Resolve Their Credit and Cash-Flow Problems
Harry and Belinda have a substantial annual joint income—more than $95,000, in fact. Nevertheless, they expect to experience some cash-flow deficits during several months of the upcoming year (see Tables 3-6 and 3-7 on pages 87–88).
To resolve this difficulty, the couple is considering opening a credit card account and using it exclusively for those expenditures that will cause the deficits they face. They could also open a line of credit that would allow them to borrow money by simply going online and having money placed in their checking account.
(a) What are the advantages and disadvantages of the Johnsons opening these accounts?
(b) What financial calculations should Harry and Belinda undertake to see whether they could afford to borrow more money at this time?
(c) What might Harry and Belinda do before applying for credit to ensure that they will pay the lowest interest rate possible?
CASE 2
Victor and Maria Advise Their Niece
Victor and Maria have always enjoyed a close relationship with Maria's niece Teresa, who graduated from college with a pharmacy degree. Teresa recently asked Maria for some assistance with her finances now that her education debts are coming due. She owes $19,000 in student loans and earns $44,000 per year in disposable income. Teresa would like to take on additional debt to furnish her apartment and buy a better car.
(a) What advice might Maria give Teresa about managing her student loan debt?
(b) If next year Teresa were to consolidate her loans into one loan at 6 percent interest, what advice might Maria give regarding Teresa's overall debt limit using both the debt payments-to-disposable income method and the continuous-debt method? (Hint: Use Table 6-3 on page 183 or visit the Garman/Forgue companion website to calculate monthly payments for various time periods.)
CASE 3
Julia Price Thinks About a Loan to Buy a Ski Boat
Julia has been thinking about the purchase of a boat. As a teenager, she was an avid water skier at her parents' summer home. Now that she has moved away, she wants to renew her hobby at a lake nearby. Julia recently received a raise of $200 per month and plans to visit a dealership nearby to see what kind of boat she can buy with that level of payment. Based on the information in this chapter, including Table 6-3 on page 183, offer your opinions about her thinking.
CASE 4
Reducing Expenses to Buy a New Car
Courtney Bennett recently graduated from college and accepted a position in Manhattan, Kansas, as an assistant librarian in the public library. Courtney has no debts, and her budget is shown in the first column (no debt) of Table 6-2 on page 173. She now faces the question of whether to trade in her old car for a new one requiring a monthly payment of $330. Taking the role of a good friend of Courtney, suggest how Courtney might cut back on her expenses so that she can afford the vehicle.
(a) What areas might be cut back?
(b) How much in each area might be cut back?
(c) After finishing your analysis, what advice (and possibly alternatives) would you offer Courtney about buying the new car?
DO IT IN CLASS PAGE 173
CASE 5
Cousins Discuss Their Debt Situations
Melinda Dennis from Troy, New York, just graduated from college and is concerned about her student loan debts. While at her graduation party she got to talking with three of her cousins, Kyle, Mariah, and Hadrian who have been out of school for several years and found they each have had somewhat different pattern with using credit and carrying debt. Kyle, who had taken a personal finance class, said he felt good about his credit management and mentioned he has a debt payments-to-disposable income ratio of 7 percent. None of the other three cousins even knew what such ratio was. Kyle offered to do the calculations for the other three cousins. After doing so, he found ratios of 20 percent for Melinda due to her student loan debt, 12 percent for Mariah due primarily to a car loan, and 16 percent for Hadrian due to both a car loan and credit card debt. The cousins are planning to get together next week and discuss what Kyle has found. What assessment and advice should Kyle give to his cousins?
DO IT IN CLASS PAGE 172
CASE 6
Preparation of a Credit-Related Speech
Jacob Marchese of Auburn, Alabama, is the credit manager for a regional chain of department stores. He has been asked to join a panel of community members and make a ten-minute speech to graduating high-school seniors on the topic “Using Credit Wisely.” In the following outline that Jacob has prepared, provide him with some suggested comments.
(a) What is consumer credit?
(b) Why might graduates use credit?
(c) How can graduates use credit wisely?
CASE 7
Debt Consolidation as a Debt Reduction Strategy
Justin Granovsky, an assistant manager at a small retail shop in Lubbock, Texas, had an unusual amount of debt. He owed $5400 to one bank, $1800 to a clothing store, $2700 to his credit union, and several hundred dollars to other stores and individuals. Justin was paying more than $460 per month on the three major obligations to pay them off when due in two years. He realized that his take-home pay of slightly more than $2100 per month did not leave him with much excess cash. Justin discussed a different way of handling his major payments with his bank's loan officer. The officer suggested that he pool all of his debts and take out an $11,000 debt-consolidation loan for seven years at 21 percent. As a result, he would pay only $250 per month for all his debts. Justin seemed ecstatic over the idea.
(a) Is Justin's enthusiasm over the idea of a debt-consolidation loan justified? Why or why not?
(b) Why can the bank offer such a “good deal” to Justin?
(c) What compromise would Justin make to remit payments of only $250 as compared with $460?
(d) How much total interest would Justin pay over the seven years, and what would be a justification for this added cost?
DO IT IN CLASS PAGE 189
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Your Credit Report. Visit the website for obtaining a free credit report at www.annualcreditreport.com to order a copy of your credit report. Check the accuracy of the report and follow the directions provided to correct any errors. If no report is available on you, it should be because you have never used credit. If you have used credit and there is no report, you should notify the credit bureaus of this error and ask them to create a file on you.
2. Set Your Debt Limit. Based on your personal balance sheet and cash-flow statement, calculate your debt payments-to-disposable income and debt-to-equity ratios. Do you feel that you are overly indebted by these measures? Also consider the continuous-debt method in your considerations. Use Worksheet 25: The Effect of Taking on Additional Debt on My Financial Ratios from “My Personal Financial Planner” to determine if you could take on any debt at this time.
3. List Your Outstanding Installment Loans. Make an inventory of your installment loans including each loan's purpose, to whom the debt was owed, payoff date, monthly payment, and monthly due date using Worksheet 26: My Installment Loan Inventory from “My Personal Financial Planner.”
4. Protect Your Privacy. A lost or stolen debit or credit card can cost you money and time. Using your credit report and other information from various billing statements, compile a list of all your debit and credit accounts including the telephone number and address of where to send notification if the card is lost or stolen.
5. List Your Student Loans. Make an inventory of your student loans including source, amounts currently owed, current APR, when payments must begin, approximate monthly payment, and the maximum number of years you will have to repay the loan using Worksheet 27: My Student Loan Inventory from “My Personal Financial Planner.”
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Visit the website for the Federal Reserve Board at www.gulletttitle.com/Forms/FRB_CHB_YourCredit.pdf . Locate its online copy of the Consumer Handbook on Credit Protection Laws. Identify one additional protection not discussed in this book that is provided by each of the following laws: the Fair Credit Billing Act, the Equal Credit Opportunity Act, and the Fair Credit Reporting Act.
2. Visit the website for Fair Isaac Corporation at www.myfico.com/crediteducation/articles/ . Read up on how credit scoring works. Identify three actions you could take to improve your credit score.
3. Visit the website for the Center for Responsible Lending at www.responsiblelending.org/ . Read about the various ways that lenders design onerous credit products and efforts to reign in those products.
ACTION INVOLVEMENT PROJECTS
1. Understanding Credit Applications. Visit a local bank or credit union and ask for an application for a credit card. Read through the items of information that are requested in the application. Why do you think that the lender asks for the information requested? Do you think the lender would view the information that you would provide positively?
2. Good Uses of Credit. Survey five of your friends about their perceptions of when it is appropriate to use credit. Compare their views to your own.
3. The Downside of Credit. Survey five of your friends about their three most negative aspects of using credit. Compare their three aspects to your own views and those listed in this chapter.
4. Perceptions of Bankruptcy. Survey five of your friends about their feelings about and understanding of bankruptcy. Do their feelings conflict with yours? Is their understanding of bankruptcy accurate?
Visit the Garman/Forgue companion website at www.cengagebrain.com .
