Case study
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Chap7.docx7 Credit Cards and Consumer Loans
YOU MUST BE KIDDING, RIGHT?
College students have an average debt of about $3000 at graduation. If they maintain that level of debt for ten years, how much total interest will they pay over that decade?
A. $3000
B. $4500
C. $5400
D. $8400
The answer is C. A credit card with an 18 percent APR translates to a 1.5 percent rate per month (18 ÷ 12). The $3000 debt multiplied by this rate equals $45 ($3000 × 0.015) per month in interest. And $45 multiplied by 120 months equals $5400. You must pay more than the required minimum monthly amount plus any new charges in order to reduce a credit card debt. Otherwise you will pay many thousands of dollars in interest and be in debt for years and years!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Compare the common types of consumer credit, including credit cards and installment loans.
Describe the types and features of credit card accounts.
Manage your credit card accounts to avoid fees and finance charges.
Describe the important features of consumer installment loans.
Calculate the interest and annual percentage rate on consumer loans.
WHAT DO YOU RECOMMEND?
Zachary Cochrane, a 31-year-old food scientist in Jackson, Tennessee, made $62,000 last year. Zachary avoided using credit and credit cards until he was 28 years old, when he missed three months of work due to a water-skiing accident. He made ends meet by obtaining two bank credit cards that, because of his lack of a credit history, carry 19.6 and 24 percent annual percentage rates (APRs). Zachary now has 11 credit card accounts open: five bank cards and six retail store cards. He uses them regularly, presenting whatever card a store will honor. He owes $13,000 on the 24 percent APR card and $4400 on the 19.6 percent APR card. His other three bank cards carry APRs of 11 percent, 12 percent, and 15 percent, and he owes $500 to $700 on each one. For the past year, Zachary has been making only the minimum payments on his bank cards. His retail cards all carry APRs in excess of 21 percent. Although he has managed to keep from running a balance on those cards during most months, occasionally these accounts have balances as well.
What would you recommend to Zachary on the subject of credit cards and consumer loans regarding:
1. His approach to using credit cards, including the number of cards he has?
2. Estimating the credit card interest charges he is paying each month?
3. How he might lower his interest expense each month?
4. Consolidating his credit card debts into one installment loan?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to credit cards and consumer loans:
1. Pay all your credit card balances in full each month, or certainly no longer than two or three months later.
2. Move credit card balances you do carry to lower-interest accounts and never make convenience purchases on the accounts on which you carry a balance.
3. Use only credit cards with chip and pin technology as soon as they become available.
4. Use student loans for direct education expenses only rather than to maintain a better lifestyle.
5. Choose installment loans based on the lowest annual percentage rate (APR) rather than monthly payment and years to repay.
You cannot borrow your way to financial success. Using credit requires deliberate thinking and planning so you do not become overextended. You need to first consider whether the reason you are borrowing is sound and then decide in advance how you will repay the debt. This is especially true for credit cards. Credit card usage can be managed so that you pay no interest at all. This occurs if you pay your balance in full every month, and more than 4 in 10 cardholders do it. Also, to succeed in personal finance you might consider leading a life so that you avoid getting into the situation that the average household credit card holder face: over $7,000 in credit card debt.
Planning how to repay an installment loan is also important because you commit to making a series of monthly payments for one to seven or more years. Smart borrowers understand the mathematics behind the calculation of the finance charges on these installment loans. They always focus on the annual percentage rate (APR) when comparing among various sources of credit. The APR is the cost of credit on a yearly basis stated as a percentage rate.
Consumer credit is nonbusiness debt used by consumers for expenditures other than home mortgages. (Borrowing for housing has investment aspects that result in a separate classification and is discussed in Chapter 9 .)
There are two types of consumer credit: installment credit and noninstallment credit.
• With installment credit (also called closed-end credit ), the borrower must repay the amount owed plus interest in a specific number of equal payments, usually monthly. For example, an $18,000 used vehicle loan might require monthly payments of $356 for 60 months at 7 percent interest.
installment credit (closed-end credit) Credit arrangement in which the borrower must repay the amount owed plus interest in a specific number of equal payments.
• Noninstallment credit includes single-payment, open-ended credit, and service credit. Single-payment loans are the easiest of the three to understand. As an example, a borrower might take out a loan of $2000 at 12 percent interest for one year. If so, a single payment of $2240 ($2000 + $240 interest; $2000 × 0.12) would be due at the end of one year.
LEARNING OBJECTIVE 1
Compare the common types of consumer credit, including credit cards and installment loans.
Credit cards are an example of open-ended credit. With open-ended credit (also called revolving credit ), credit is extended in advance of any transaction so that the borrower does not need to reapply each time credit is desired. Any amounts owed will be repaid in full in a single payment or via a series of equal or unequal payments, usually made monthly. The borrower can use the account as long as the total owed does not exceed his or her credit limit . This credit limit amount is set by the lender and is the maximum outstanding debt allowed on the credit account. Credit limits vary with the perceived creditworthiness of the borrower.
open-ended (revolving) credit Arrangement in which credit is extended in advance of any transaction so that borrowers do not need to reapply each time they need to use credit.
credit limit Maximum outstanding debt that a lender will allow on an open-ended credit account.
Open-ended credit can be used to make purchases and, in some cases, to obtain cash advances. It is the most convenient type of credit, and it is also the most abused. Many open-ended accounts—but not all—use a credit card. A credit (or charge) card is a plastic card identifying the holder as a participant in the charge account plan of a lender, such as a retailer or financial institution.
A charge card charges no interest but requires the user to pay his/her balance in full upon receipt of the statement, usually on a monthly basis. The major benefit offered by a charge card is that it has much higher, often unlimited, spending limits. Travel and entertainment (T&E) cards are charge cards and are often used by businesspeople for food and lodging expenses while traveling; however, they are not accepted at as many outlets as bank credit cards. Applicants must have higher-than-average incomes to qualify, and applicants must pay an annual membership fee of $90+ annually. Examples are American Express and Diner's Club.
How to Avoid Using Credit Cards in College
Those who use credit card debt sometimes find that its use can quickly spiral out of control. Instead some college students plan ahead and find other ways to manage money. Consider using the following: prepaid cards, a no-fee checking account, a charge card, and gift cards.
Cash advances may be obtained at any financial institution that issues the type of card (e.g., Visa, MasterCard, Discover) being used. A cash advance is a cash loan from a credit card account. The borrower can receive a cash advance from an ATM or the funds may be transferred electronically into the cardholder's checking account.
A personal line of credit is a form of open-ended credit that allows the borrower access to a prearranged revolving line of credit provided by the lender (usually a commercial bank, savings bank, credit union, or brokerage firm). Like credit card accounts, a personal line of credit includes a credit limit and a flexible repayment schedule. The essence of a line of credit is that borrowers can obtain a cash advance when needed and not have to reapply for a loan each time they need money. Some people use the equity in their home as collateral for a line of credit. This arrangement is referred to as a home-equity line of credit.
Service credit is granted to consumers by public utilities, physicians, dentists, and other service providers that do not require full payment when services are rendered. For example, your electric company allows you to use electricity all month and then sends you a bill that may not be due for 10 to 15 days. Service credit usually carries no interest, although penalty charges and interest may apply if payments are made late. Service may be cut off for continued slow payment or nonpayment of the debt.
CONCEPT CHECK 7.1
1. Distinguish between installment credit and open-ended credit.
2. Explain the basic features of revolving credit.
3. Describe how someone might use a personal line of credit.
7.2 CREDIT CARD ACCOUNTS PROVIDE INSTANT ACCESS TO CREDIT
Once a credit card account is opened, it can be used at any time. Credit card accounts allow the borrower to pay the balance in full at any time or carry over a balance owed from month to month (travel and entertainment cards are an exception). If a balance is carried over, a minimum payment must be made each month to cover interest and a small payment on the amount owed (the principal). If at least the minimum payment amount is not received by the payment due date (the specific day by which the credit card company should receive payment from you), the cardholder must pay a late payment fee and may be declared in default . Default occurs when a borrower has failed to make a payment of principal or interest when due or failed to meet any other requirement of a credit agreement. Credit card companies often cancel the accounts of customers who are delinquent or in default.
minimum payment Payment that must be made to a credit account each month to cover interest and a portion of the amount owed.
default Occurs when a borrow fails to make a payment when due or fails to meet other requirements of the credit agreement (contract).
LEARNING OBJECTIVE 2
Describe the types and features of credit card accounts.
Cash Advances Are Very Expensive
Obtaining money via a credit card cash advance may seem easy. It is also very expensive. It starts with a transaction fee. It is usually a percentage of the amount taken (3 to 5 percent is common), but there is often a minimum amount that makes the percentage much higher on small advances. Then there is the interest that begins to accrue immediately even if you are not carrying a balance on the card. Plus, the interest rate on cash advances is always higher than for purchases.
7.2a Who Pays How Much Every Month?
Credit cards are the primary source of consumer credit other than home mortgages. About two-thirds of American adults have a credit card account. About 18 percent repay the minimum amount due each month and 40 percent pay a partial amount but more than the minimum payment due. About 42 percent pay their monthly balances in full. Those who never pay off the balance can do so for years, even as other charges and interest are added to the account. As long as the total debt remains below the credit limit, the user may continue to make charges on the account. A credit card borrower may also ask a creditor to increase his or her credit limit.
A bank credit card is a credit card issued by a financial institution that allows the cardholder to pay for goods and services based on the holder's promise to pay for them. The issuer of the card creates a revolving account and grants a line of credit to the user for use in making purchases or to obtain a cash advance.
Bank credit card account Open-ended credit account with a financial institution that allows the holder to make purchases almost anywhere.
Visa, MasterCard, Discover, and Optima are the most commonly recognized bank card names. However, the actual lender is the bank, savings bank, or credit union through which the card is offered. Visa and MasterCard are service providers that maintain the electronic network through which transactions are communicated.
Participating merchants pay fees that average 2 percent to these companies based on the dollar amounts charged, although they can be as high as 6 percent. Virtually all financial institutions offer bank credit cards as do a number of consumer products companies, such as AT&T, Allstate Insurance, and Verizon. These companies contract with Visa, MasterCard, and a bank to offer these cobranded credit cards.
Many bank credit card issuers periodically send cash advance (or convenience ) checks to their cardholders. These instruments are not genuine checks but simply a check-equivalent way to take a cash advance. Customers can use these “checks” to make payments to others or themselves. If you receive convenience checks but do not want to use them, either put them in a safe place or destroy them immediately because they easily could be used fraudulently by someone else.
cash advance (or convenience) checks A check-equivalent way to take a cash advance on a credit card.
7.2c Retail Credit Card Accounts
A retail credit card allows a customer to make purchases on credit at any of the outlets of a particular retailer or retail chain. Examples of credit card accounts at retail stores include those offered by Kohl's, REI, and Shell Oil. Many retailers have alliances with a financial institution to offer a bank credit card that carries the retailer's logo and can also be used anywhere the bank credit card can be used.
retail credit cards Allow customers to make purchases on credit at any of the outlets of a particular retailer.
Some smaller retail establishments offer open-ended accounts that do not use a credit card as the vehicle for using the account. With these retail credit accounts, customers simply ask to have the purchase put on their account for repayment at a later date. Repayment may be required in full monthly or allowed to be spread over time.
Federal Rule for Credit Card Applicants Age 18 to 20
Under the Credit Card Accountability, Responsibility and Disclosure (CARD) Act, when a person age 18 to 20 applies for a credit card, the lender must verify that the person has sufficient independent income or require a cosigner.
7.2d Common (But Not Always Beneficial) Aspects of Credit Card Accounts
Federal law requires credit card lenders to disclose all the rules governing the account to borrowers before they sign up for any card. Some of that information must be displayed in a uniform manner, as illustrated in the sample credit card disclosure box in Figure 7-1 . The remainder of the information appears in the credit card agreement (contract).
Credit Card Security Chip Update
The increasing frequency of cases where hackers have stolen consumers' credit card data from retailers and others has sped up efforts to introduce “Chip and PIN technology” in the United States. The standards leader is EMV, which is an abbreviation for Europay, MasterCard, and Visa. Cards with this technology cannot be counterfeited and are more secure than magnetic stripe credit cards because personal data is encrypted on the card rather than in a retailer's database and are accessible only with a PIN.
Figure 7-1 Sample Credit Card Disclosure Box Federal law requires that key pieces of information be disclosed in direct-mail advertising and when applying for credit cards and any time the rules of an account are changed. To search for the best offers on credit cards, you can visit www.bankrate.com or www.cardtrack.com.
Credit Card Offers Often Come “Preapproved” Credit card companies often send applications to consumers who have been preapproved. It is important to understand that being preapproved means only that you will be granted credit. Both the credit card debt limit and APR will be determined after you apply for an account.
How to Close a Credit Card Account Wisely
Credit card accounts can remain open for decades even if you never use the card or stopped using it at some point. Accounts are not closed if you cut up the cards. The lender must be formally notified of your request before the account will be officially closed. Here's what to do:
1. Pay off your balance in full. Accounts cannot be truly closed until they are paid off. You can, however, ask an issuer to stop honoring a card.
2. Obtain the customer service telephone number for the lender from your most recent monthly statement. If you do not have a recent bill, obtain a free copy of your credit report, which will list the contact information for the lender.
3. Contact the lender to request the address to which you should send your cancellation request. It will not be the same address to which you send your monthly payment. Confirm that there is no longer a balance owed as sometimes a very small amount of interest may still be owed for the last month when an account is paid off.
4. Send a written request to close the account and request that the creditor send a confirmation that the account is, indeed, closed.
5. Obtain a copy of your credit report , after 90 days, from one of the three national credit bureaus (pay if necessary). If the account shows as closed, obtain free copies from the other two bureaus as confirmation at the next opportunity. If the account shows as still open at any of the bureaus use the procedures outlined in Chapter 6 on page 182 to correct the error.
Annual and Transaction Fees Can Be Avoided Some bank credit card lenders assess annual fees ranging from $25 to $100+. In addition, lenders may charge a transaction fee (a small charge levied each time certain types of transactions occur). The card illustrated in Figure 7-1 assesses transaction fees for cash advances and balance transfers , which are full- or partial-payments on one credit card by using a cash advance from another. Some lenders even charge a fee for printing the monthly credit bill. As you can see, an apparently low-rate card may turn into a higher-cost card when all fees are considered.
annual fees Charges levied against cardholders for the privilege of having an open account but that are not included in the advertised APR.
transaction fee A small charge levied each time certain types of transactions occur, such as for cash advances and balance transfers.
balance transfer Full or partial payment on the balance of one credit card using a cash advance from another.
Liability for Lost or Stolen Cards Is Limited The Truth in Lending Act limits a cardholder's credit card liability for lost or stolen credit cards. Under the law, if you notify the card issuer within two days of a loss or theft, you are not legally responsible for any fraudulent usage of the card. After two days, your maximum liability for fraudulent usage of the card prior to your notification is $50.
Although your financial liability is low, many companies nevertheless sell credit card insurance (for an annual premium ranging from $15 to $49) that will cover the first $50 of unauthorized use of an insured person's lost or stolen credit cards. Such insurance is profitable for the sellers but a wasteful expense for you. If you are insistent and talk with a credit card company supervisor, she/he will waive the $50 fee for unauthorized use as a gesture of goodwill to keep you as a good credit card customer. Also you should know that most homeowner's and renter's insurance policies will pay the $50 fee you might be charged for unauthorized use of a lost or stolen credit card.
Late-Payment, Bounced-Check, and Over-the-Limit Fees Are Very Costly The fees assessed by credit card issuers can be expensive. Late-payment fees are limited by law to $25 in most cases. Card issuers also assess fees if you write a bad check when making your monthly payment or you exceed your credit limit. This latter fee can only be assessed if the cardholder agrees to allow the lender to accept over-the-limit usage. If this agreement has not been given, over-the-limit usage will be blocked. Each of these fees is much higher than necessary in terms of the actual cost to the lender for these rule violations. Indeed, they represent a significant source of profits for credit card issuers. The account illustrated in Figure 7-1 assesses a maximum fee of $25 for each of these offenses.
opt out to Avoid Unwanted Credit Card offers
Federal law states that consumers have the right to opt out of receiving unsolicited credit card offers. To put a stop to such mailings using the official system, call (888) 5-OPT-OUT or visit www.optoutprescreen.com .
Credit Card Rules Can Change at Any Time
When you open a credit card account, the account rules and interest rate are determined based on two groups of factors. The first consists of your credit history and information in your application form. The second group relates to conditions in the economy as a whole and the policies of the issuer of the card.
Over time, these sets of information can change, and as a result, the card issuer may wish to make amendments to the interest rate, credit limit, and other card rules or features. The law requires card holders be given 45 days of advance notice. However, interest rates cannot be changed on existing balances. Therefore, the issuer must give you the option of rejecting or accepting a change in interest rates. If you reject the change, the card will be blocked for further usage, and you may repay any balance according to the old rules. once you have repaid the balance owed, your card is cancelled. If you accept the changes, they will take effect 45 days after notification.
Teaser Interest Rates May Be Appealing Some cards carry a temporarily low teaser rate (introductory rate) to entice borrowers to apply for an account. Teaser rates must stay in effect for six months after the account is opened unless the cardholder violates a rule of the account such as being late with a payment by more than 60 days. Teaser APRs of 0 to 3.9 percent are common. In Figure 7-1 , the teaser rate is 2.9 percent for purchases and 0.0 percent for cash advances. The APR typically reverts to a much higher fixed or variable interest rate (19.2% in the example in Figure 7-1 ) after the introductory period ends. Some credit card borrowers take advantage of teaser rates by opening new accounts regularly and transferring the balances from other accounts to the new account to take advantage of the low introductory rate despite any high balance transfer fee that might exist.
Higher Penalty APRs Can Be Assessed A serious downside to many credit card accounts is the assessment of a penalty APR that can be 8 to 10 percentage points higher that the normal APR. The penalty APR is assessed whenever a borrower fails to uphold certain rules of the account, such as being more than 60 days late on the minimum payments or making a payment by check that is returned for insufficient funds. The disclosure notice in Figure 7-1 indicates a penalty APR of 28.99 percent for violation of the listed rules. By law, penalty rates must be reviewed after six months and rescinded if all payments have been made on time in that period. Some credit card issuers simply cancel the account when the rules are violated rather than assess the penalty APR.
Variable Interest Rates Can Easily Go Up Credit card accounts (and installment loans) carry either fixed or variable interest rates. Variable interest rates go up and down, usually monthly or annually, often according to changes in interest rates in the economy as a whole. The example in Figure 7-1 has a variable interest rate with the prime rate used as a base rate. The prime rate is a key measure of interest rates in the economy, and its fluctuations drive the changes in rates for all types of variable-rate credit. In recent years, the prime rate has ranged from 3 to 4 percent. As indicated in Figure 7-1 , the card company uses the prime rate as published in The Wall Street Journal to determine interest rates for purchases, cash advances, and balance transfers on the card.
variable interest rates Interest rates that change monthly or annually according to general interest rate changes in the economy as a whole.
Paying Cash Instead of Using a Credit Card Might Save You 2 or 3 Percent
The Federal Reserve says that merchants are allowed to give discounts for those who pay cash or use a debit card rather than use a credit card. If the availability of such a discount is not obvious, just ask. You might save 2 to 3 percent on a purchase, such as for gasoline purchases.
Be Smart When Using a Rewards Credit Card
Credit cards that provide airline miles or cash-back bonuses can be a good idea. However, the benefits will be lost if the card has a high APR and/or substantial fees. And it absolutely makes no sense to use a rewards card if you are going to carry a balance on the card.
Extremely low APRs are usually temporary. Read the rules of your account carefully
Credit Card Insurance Is Overpriced Many lenders encourage borrowers to sign up for credit life insurance that pays the unpaid balance of a loan—to the lender—in the event of the borrower's death. Credit life insurance is grossly overpriced (and very profitable) and is a cost that can be avoided. The same can be said for credit disability insurance, which repays the outstanding loan balance if the borrower becomes disabled (with “disability” usually being very narrowly defined). The companies also sell unneeded credit unemployment insurance.
7.2e Prestige and Affinity Cards
Some bank credit cards are a form of prestige card, often with a precious metal in the brand name such as “gold,” “silver,” or “platinum.” These accounts require that the user probably possess high credit qualifications and they offer enhancements such as higher credit limits. Prestige cards sometimes carry higher annual fees.
Some Visa and MasterCard credit cards are identified as affinity cards— that is, they are standard bank cards but with the logo of a sponsoring organization imprinted on the face of the card. The issuing financial institution often donates a portion of the annual fee and a small percentage of the amounts charged (perhaps 0.25, 0.5, or 1 percent) to the sponsoring organization. Sponsors may include charitable, political, sports, or other organized groups, such as the Sierra Club or Mothers Against Drunk Driving. Supporters of the sponsoring organization may be motivated to use an affinity card because the organization receives money from each transaction. Creditors rightly calculate that fewer delinquencies will occur among the particular group of people, so they can afford to transfer some income to the named organization.
Prepaid Cards Are Mainstream
Prepaid cards (or reloadable cards) are stored value cards that are used like credit cards. These were once marketed to low-income consumers but today they are mainstream. You choose the dollar amount to put on the card and as you spend, your purchases are deducted from the total balance. When the balance gets low, you can reload with more money. People without banking or a standard credit card account and those with little or no credit history often choose to use prepaid cards as an alternative to cash.
Since prepaid cards are associated with one of the major card networks, such as Visa, MasterCard, and Discover, they can be used anywhere those cards are accepted. They can be used to purchase groceries, buy merchandise on eBay, pay bills online, and withdraw cash from an ATM machine. Almost all of them come with FDIC insurance as well as the full theft and loss protections of the Fair Credit Billing Act. High fees can be avoided if you shop carefully online for the best accounts.
CONCEPT CHECK 7.2
1. Distinguish among bank credit cards, retail credit cards, and travel and entertainment cards.
2. What are the differences and similarities between a cash advance and a balance transfer using a bank credit card?
3. Describe the positive and negative aspects of having a variable interest rate on a credit card.
4. Briefly describe five common fees assessed on credit card accounts and how they can be avoided.
7.3 YOU MUST MANAGE YOUR CREDIT CARDS WISELY
Credit cards can be a positive tool in personal financial management—but only when used appropriately. To do so, you must understand and monitor your credit statements, correct any billing errors quickly, and verify the computation of any finance charges. Your goal should be to use the credit card in a manner that avoids all fees, including finance charges. This means paying your balance in full every month. Otherwise, credit card debt likely will be your most expensive form of debt. As one personal finance expert observed, “You want to earn a 21% risk-free return on your money? Pay off your credit cards.”
If you do not manage your credit cards wisely, you will unnecessarily pay hundreds or even thousands of dollars every year in interest, penalties, and fees to credit card companies. You also may mess up your credit rating and, as a result, will wind up paying higher interest rates than normal for all your credit transactions including rented and owned housing, vehicle purchases, and insurance. You might even miss out on a job opportunity because employers sometimes turn down applicants who have poor credit histories.
LEARNING OBJECTIVE 3
Manage your credit card accounts to avoid fees and finance charges.
Active charge account holders receive a monthly credit statement (also called a periodic statement ) that summarizes the charges, payments, finance charges, and other activity on the account. Figure 7-2 shows an example monthly statement for a credit card.
credit (or periodic) statement The monthly bill on a credit card account showing the charges and payments made, minimum payment required, and due date among other information.
Statement Date The statement date (sometimes called the billing date or closing date ) is the last day of the month for which any transactions are reported on the statement. Any transactions or payments made after this date will be recorded on the following month's credit statement. The statement is mailed to the cardholder a day or so after the statement date. It is generally the same day of each month, and the time period between statement dates is referred to as the billing cycle.
statement/billing/closing date The last day of the month for which any transactions are reported on the credit statement.
Bias Toward an Easy Solution
People engaged in credit cards and consumer loans have a bias toward certain behaviors that can be harmful, such as a tendency toward taking the easiest solution. People who owe on multiple credit cards often want to pay off the card with the lowest balance first regardless of the APR. What to do? Repay just the minimum repayment amounts on the cards with the lowest APR and pay as much as possible on the highest APR card.
Get Rid of Your Credit Card Debt
If your credit card debt rises to a hard-to-manage level, consider the following suggestions:
1. Immediately stop using your credit cards. And avoid the temptation to open new credit card accounts or accept any new offers.
2. Get organized. Gather your more recent outstanding credit card statements. Using Excel, or other financial software, list each credit card's balance with its interest rate, in order from highest interest rate to lowest. Then calculate the total balance owed on all cards and the total monthly payment required.
3. Set a goal and stick with it. Determine a reasonable pay-off date. Calculate the monthly payment you will need to pay off the debt. You may visit www.bankrate.com/calculators/credit-cards/credit-card-payoff-calculator.aspx or similar online tools for calculators.
4. Develop a new budget. Evaluate all of your budgeted expenditures and streamline your new budget so you can repay the largest possible amounts toward paying off your credit card balances. Now, it is time to take action!
5. Create a plan of action. You may use one or more of the following options:
a. Pay the minimum amount due on the card with the lowest interest rate and pay as much as possible on the card with the highest interest rate until it is paid in full. Repeat the process in the same manner for additional cards and continue until all of the credit card debts are paid in full.
b. Consider transferring existing balances on high interest rate accounts to an account with a lower interest rate. Pay attention to brief introductory periods, transaction fees, and penalties that may eliminate the potential savings.
c. Work overtime or take another job. Devote any extra income, such as overtime pay, a tax refund, or a bonus toward paying down the credit card debt.
d. Consider seeking professional assistance from a reputable nonprofit credit counseling agency. They may be able to negotiate with your creditors to lower payments, interest rates, and reduce or eliminate late fees and over-the-limit charges. You may do this at any time during the process. (See Chapter 6 .)
e. Make timely payments to prevent fees and penalties. You can do it and you will.
Steve Holcombe and Feliccia Smith
North Greenville University, Tigerville, South Carolina
Payment Due Date The payment due date is the specific day by which the credit card company should receive payment from you. Federal law states that bills must be mailed to cardholders at least 21 days before payments are due. Your payment due date must be the same each month, and if it falls on a weekend or holiday, you have until the following business day to pay. Payments received by 5 p.m. on the due date are considered to be on time.
Consider Using Two Credit Cards
It is a smart financial move to use one credit card for convenience items that are paid in full each month and another credit card for items for which paying off the balance each month is impossible. use a no-annual-fee card for the convenience purchases and a low-APR card for purchases for which you carry a balance.
Transaction and Posting Dates The date on which a credit cardholder makes a purchase (or receives a credit, as described later in this chapter) is known as the transaction date (“Trans Date” in Figure 7-2 ). Any interest is usually charged from the posting date (“Post Date” in Figure 7-2 ).
Grace Period A grace period is the time period between the posting date of a transaction and the due date, within which any new credit card purchases made during the billing cycle will avoid finance charges. Grace periods are offered only if the previous month's total balance was paid in full and on time. In Figure 7-2 , the cardholder has a previous unpaid balance, $535.07, and was charged interest on the unpaid balance as well as on the new charges made within the billing cycle, starting from the date they were posted to the account. Thus, this example lacks a grace period because of the unpaid balance on the card.
Figure 7-2 Sample Statement for a Bank Credit Card Account
Secured Credit Cards Are Usually a Very Bad Deal
A secured credit card (or collateralized credit card) is a type of credit card that requires a fee to open, and it is backed by a savings account used as collateral on the credit available with the card. Money is deposited and held in the account backing the card. The limit, often $500 to $1000, will be based on both your previous credit history and the amount deposited in the account. The limit as a percent of the deposit tends to range between 50 and 100 percent. Most people do not need a secured credit card, but those who have no alternative should consider obtaining one from a reputable institution, as scams abound in this market.
Minimum Payment Due To meet their obligations, borrowers must make a minimum payment due monthly that is no smaller than the amount required by the creditor. In Figure 7-2 , the cardholder has two options: pay the total amount due, known as the “new balance,” of $1798.14 or make at least the minimum payment of $53. If the borrower pays the total amount due, finance charges on new purchases in the next billing cycle generally can be avoided. If a partial payment, such as $53, is made, additional finance charges will be assessed and will be payable the following month.
minimum payment Lowest allowable monthly payment required by the lender.
The Credit Card Accountability, Responsibility and Disclosure Act requires that your credit card statement include the number of months it will take to pay off your card balance if you make only the minimum payment with no additional charges. In the example, it would take ten years to pay off the balance making only the minimum payments, resulting in estimated total payments of $3284.
Transaction Fees Credit card companies usually charge transaction fees whenever the card is used for a balance transfer or cash advance.
Credit for Merchandise Returns and Errors If you return merchandise bought on credit, the merchant will issue you a credit receipt — written evidence of the items returned that notes the specific amount of the transaction. In essence, the amount of the merchandise credit is charged back to the credit card company and eventually to the merchant. A credit may also be granted by the card issuer when a billing error has been made and when an unauthorized transaction appears. Credits obtained in the current month should appear on the next monthly statement as a reduction of the total amount owed.
credit receipt Written evidence of any items returned that notes the specific amount and date of the transaction.
Computation of Finance Charges Companies that issue credit cards must tell consumers the APR applied as well as the method used to compute the finance charges. Mathematically the APR translates into a periodic rate, which is the APR for a charge account divided by the number of billing cycles per year (usually 12). For example, a periodic rate of 1½ percent per month would result from an APR of approximately 18 percent (actually a bit higher because of compounding); both figures must be disclosed.
The finance charge is typically calculated by first computing the average daily balance —the sum of the outstanding balances owed each day during the billing period divided by the number of days in the period. The periodic rate is then applied against that balance. For example, a card with an 18 percent APR, a 1½ percent periodic rate, and an average daily balance of $1000 would have a finance charge for the month of $15 ($1000 × 0.015). As shown at the bottom on the statement in Figure 7-2 , differing APRs apply for purchases, balance transfers, and cash advances.
average daily balance Sum of the outstanding balances owed each day during the billing period divided by the number of days in the period.
Money Websites for Credit Cards and Consumer Loans
Informative websites for credit cards and consumer loans, including how to correct billing errors are:
Center for Responsible Lending ( www.responsiblelending.org/ )
Consumer Financial Protection Bureau ( www.consumerfinance.gov/ )
Bankrate.com ( www.bankrate.com/credit-cards.aspx )
NOLO ( www.nolo.com/legal-encyclopedia/credit-cards )
Federal Reserve Board ( www.federalreserve.gov/consumerinfo/default.htm )
Federal Trade Commission ( www.consumer.ftc.gov/topics/money-credit )
MyMoney.gov ( www.mymoney.gov/borrow/Pages/borrow.aspx )
Bankrate.com ( www.bankrate.com/calculators/index-of-credit-card-calculators.aspx )
How Your Credit Card Payment Is Applied
Under the Credit Card Accountability, Responsibility and Disclosure (CARD) Act, whenever you make more than a minimum payment on your credit card account, the lender must apply any excess above the minimum payment to the portion of the card debt that carries the highest APR, and this is usually for cash advances.
7.3b How Credit Card Average Daily Balances Are Calculated
Three methods can be used to calculate the average daily balance on a credit card billing statement.
1. Average daily balance including new purchases with a grace period. The balance calculation includes the balance from the previous month and any new charges made during the billing cycle. The grace period allows for the exclusion of new charges made during the billing cycle only if the balance from the previous billing cycle was zero. This is the most commonly used method.
2. Average daily balance excluding new purchases. The cardholder pays interest only on any balance left over from the previous month. Good for consumers.
3. Average daily balance including new purchases with no grace period. The balance from the previous month and any new charges made during the billing cycle are included in the balance calculation, even if the previous month's balance was paid in full. This is the worst method for consumers.
DO IT IN CLASS
Avoid the Minimum Payment Trap
Do you currently have balances outstanding on your credit cards? If so, how long have you carried those balances? If you open an account in college and already have an unpaid balance of $2500 upon your graduation, you may find that the balance owed will not drop below $2500 for many years. This situation occurs when you continue to make purchases with the card but continue to pay only the amounts charged each month. If $2500 is still owed on the account years later, then you have “permanent debt.” In essence, you have never repaid the college charges. With an 18 percent APR, the finance charges on a debt principal of $2500 for 15 years will total $6750 (0.18 × $2500 × 15), almost three times as much as the debt itself!
The outlook is similarly bleak if you discontinue using the card for new purchases but still remit only the required minimum repayment amount. Credit card issuers often require a minimum monthly payment as low as 3 to 5 percent of the outstanding balance. This small payment requirement is mathematically guaranteed to keep the user in debt for many years. To illustrate, a minimum payment of $75 (3 percent) on an outstanding balance of $2500 with a 1½ percent monthly periodic rate results in only one-half of the payment ($37.50 = $2500 × 0.015) going to reduce the actual debt (the principal). The other $37.50 is used to pay the monthly interest. At this rate of repayment, it will take more than six years to repay the $2500.
A ploy that card issuers frequently use is to allow cardholders to “skip a payment”—in essence, to make “a zero-dollar minimum payment.” Interest will continue to accrue for the month during which no payment is made and the unpaid interest simply adds to the unpaid balance.
To avoid paying credit card charges for six to ten years, or even longer, you must make much larger monthly payments that go toward retiring your credit card balances more quickly.
Jonathan J. Fox
Iowa State University
How to Correct Errors on Your Credit Card Billing Statement The Fair Credit Billing Act (FCBA) helps people who wish to dispute billing errors on revolving credit accounts. In effect, the FCBA permits a chargeback ; that is, the amount of the transaction is charged back to the business where the transaction originated.
Fair Credit Billing Act (FCBA) Helps people who wish to dispute billing errors on revolving credit accounts and permits chargebacks.
chargeback The amount of the transaction is charged back to the business where the transaction originated in the case of a dispute or challenge by the cardholder.
Withholding payment to a credit card company is permitted when the cardholder alleges an error. For example, a mathematical error has been made in a billing statement or when fraudulent use of the card appears to have occurred. Also when (within certain reasonable limitations) a goods and services dispute asserts that the charges were for faulty, damaged, shoddy, defective, or poor-quality goods and services and you made a good-faith effort to try to correct the problem with the merchant. For goods and services disputes, the FCBA applies only to charges of more than $50 made in your home state or within 100 miles of your current mailing address. Most lenders apply the spirit of the FCBA to any goods and services disputes, regardless of the geographic distances involved.
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Your Time Limits You must make your billing error complaint within 60 days after the date on which the first bill containing the error was mailed to you. The lender then has 30 days to acknowledge your notification and, within 90 days, must either correct the error permanently, return any overpayment (if requested), or provide evidence of why it believes the bill to be correct (such as a copy of a charge slip you supposedly signed).
Lender Responsibilities While the dispute is being investigated, creditors cannot assess interest on or apply penalties for nonpayment of the disputed amount, send dunning letters (notices that make insistent demands for repayment), or send negative information about your account to a credit bureau without stating that “some items are in dispute.” A lender that does not follow the procedures correctly cannot collect the first $50 of the questioned amount, even if the bill was correct. Back interest and penalties may be charged if the disputed item is shown to be legitimately owed.
dunning letters Notices that make insistent demands for repayment.
Your Action Steps Take several actions when disputing an item on a billing statement:
1. Notify the merchant involved of the error. Although the FCBA does not apply to merchants, it is often the merchant that caused the error and who is in the best position to clear up the error. Be sure to tell the merchant that you also are asserting your rights under the FCBA with the card issuer.
2. Send a written notice of the error to the credit card issuer. The notice must be in writing to qualify for the protections provided under the FCBA. Instead of sending the notice to the same address where repayments are normally remitted, examine the billing statement thoroughly, looking for an address under the heading “Send Inquiries to” or something similar. If the error is an “unauthorized use,” make sure you indicate this as these disputes have added protections.
3. Provide photocopies (not originals) of any necessary documentation. Keep the originals to challenge any finding by the company that no error occurred.
4. Withhold payment for disputed items. If possible, pay the remaining amount owed in full to isolate a disputed item. Under the provisions of the FCBA, the card company must immediately credit your account for the amount in dispute.
5. Review your credit bureau file after the dispute has been settled to ensure that it does not include information regarding your refusal to repay the disputed amount.
Shoppers frequently rely on purchase loans when buying big ticket items such as furniture and TVs.
CONCEPT CHECK 7.3
1. Describe how the finance charge is typically calculated on a credit card account.
2. What is the major benefit of having a credit card with a grace period?
3. Briefly summarize the steps you should take if you find an error on your credit card account billing statement.
7.4 UNDERSTANDING CONSUMER INSTALLMENT LOANS
Consumers obtain installment credit in two ways. With a cash loan, the borrower receives cash and then uses it to make purchases, pay off other loans, or make investments. With a purchase loan (also called sales credit), the consumer makes a purchase on credit with no cash transferring from the lender to the borrower. Instead, the funds go directly from the lender to the seller. For example, a car buyer might obtain a purchase loan from the Ford Credit to buy a new Ford Fiesta. With some purchase loans, the seller is also the lender. For all consumer loans, the borrower will sign a formal promissory note (a written installment loan contract) that spells out the terms of the loan.
promissory note Written installment loan contract that spells out the terms of the loan.
LEARNING OBJECTIVE 4
Describe the important features of consumer installment loans.
7.4a Installment Loans Can Be Unsecured or Secured
Credit can either be unsecured or secured. An unsecured loan is granted solely based on the good credit character of the borrower. Sometimes unsecured loans are called signature loans because they are backed up by only the borrower's signature. Because unsecured loans carry higher risk than secured debts, the interest rate charged on them is substantially higher.
unsecured loan/signature loan Loan granted based solely on borrower's good creditworthiness.
A secured loan requires a cosigner or collateral. A cosigner agrees to pay the debt if the original borrower fails to do so. Being a cosigner is a major responsibility because a cosigner has the same legal obligations for repayment as the original borrower does. In case of default, a lender will go after the party—either the borrower or the cosigner—from whom it is more likely to collect the funds. Remember that when people require a cosigner, it means that the lender feels that the borrower is not creditworthy on his or her own, and that judgment is usually quite correct. A good rule in life is to never cosign for a loan, even for relatives.
secured loan Loan that is backed by collateral or a cosigner.
Sean's Success Story
Sean has been very careful about his use of credit since he graduated and began working full time for a marketing firm. He purchased a two-year-old used car soon after taking his job. He shopped thoroughly for the lowest APR and, so far, has made all of his payments on time. He also has three credit cards. one is a rewards card that he uses for most of his day-to-day spending, and he pays the card balance off in full every month. He has used his rewards bonuses to buy some cameras that he uses in his photography hobby. Sean has a second card that he uses when he travels on business.
This is also a rewards card, and it provides air miles that he has used for personal travel. He pays this card off with his travel reimbursement checks from his employer. He doesn't use his third card very often as it is used to charge items that he figures he might not be able to pay in full when the monthly bill is received. Sean is careful to make certain that he pays off the card balance before using it again for another purchase. He also does not carry this card with him so that he must return home before fully deciding to take on more debt that he cannot repay in full when the bill is received.
A loan secured with collateral means that the lender has a security interest in the property that is pledged as collateral. For example, the vehicle itself is the collateral on an automobile loan. The item of collateral does not necessarily need to be the property purchased with the loan. Typically, the lender records a lien in the county courthouse to make the security interest known to the public. A lien is a legal right to seize and dispose of (usually sell) property to obtain payment of a claim. When the loan is repaid, the lien will be removed. The borrower should double check to make sure this removal occurs.
lien A legal right to seize and dispose of (usually sell) property to obtain payment of a claim. Once the loan is paid, the lien is removed.
In the event that the borrower fails to repay a loan, the creditor can exercise the lien and seize the collateral through repossession, sometimes without notice. Almost all credit contracts contain an acceleration clause stating that after a specific number of payments are unpaid (often just one), the loan is considered in default and all remaining installments are due and payable upon demand of the creditor. These clauses protect the lender's interest but can prove very difficult for borrowers. Don't be fooled if you miss a payment and the lender does not exercise the acceleration clause immediately. It can do so at any time after default occurs. Therefore, never ignore a warning letter from a creditor!
acceleration clause Part of a credit contract stating that after a specific number of payments are unpaid (often just one), the loan is considered in default, and all remaining installments are due and payable upon demand of the creditor.
4b Purchase Loan Installment Contracts
Two kinds of contracts are used when purchasing goods with an installment loan:
• Installment purchase agreements (also called collateral installment loans or chattel mortgage loans), in which the title of the property passes to the buyer when the contract is signed. An installment purchase agreement provides a measure of protection for the borrower, as the creditor must follow all legal procedures required by state law when repossessing the property. Some state laws permit the lender to take secured property back as soon as the buyer falls behind in payments, possibly by seizing a car right from a person's driveway.
• Conditional sales contracts (also known as financing leases), in which the title does not pass to the buyer until the last installment payment has been paid. Thus it may be repossessed as soon as any payment is missed.
CONCEPT CHECK 7.4
1. Describe how a cash loan and a purchase loan differ.
2. Distinguish between a secured and an unsecured loan.
3. Describe when a lender might enforce an acceleration clause on a loan, and explain the impact of such an action by the lender.
4. Differentiate between an installment purchase agreement and a conditional sales contract.
7.5 CALCULATING INTEREST ON CONSUMER LOANS
The federal Truth in Lending Act (TIL) requires lenders to disclose to credit applicants both the interest rate expressed as an APR and the finance charge. Always inquire about the APR if it is not readily apparent, and use it to compare rates from other lenders to obtain the best deal. The finance charge is the cost of credit expressed in dollars. The finance charge plus the original amount borrowed must be paid.
Truth in Lending Act (TIL) Requires lenders to disclose to credit applicants both the interest rate expressed as an annual percentage rate (APR) and the finance charge.
LEARNING OBJECTIVE 5
Calculate the interest and annual percentage rate on consumer loans.
7.5a Calculating an Installment Loan Payment
Installment credit typically comes with a fixed interest rate, meaning that the rate will not change over the life of the loan. Lenders may offer variable-rate loans (also called adjustable-rate loans ) to borrowers. When the loan rate varies, the monthly payment will go up or down, allowing the loan to be paid off by the same date as originally established in the contract.
variable-rate (adjustable-rate) loans Loans for which the interest rate varies with the monthly payment going up or down, allowing the loan to be paid off by the original end date.
Table 7-1 Monthly Installment Payment (Principal and Interest) Required to Repay $1000*
To help you figure out the required monthly payment for different loan amounts, Table 7-1 shows various monthly installment payments used to repay a $1000 loan at commonly seen APR interest rates and time periods. For loans of other dollar amounts, divide the borrowed amount by 1000 and multiply the result by the appropriate figure from the table. For example, an automobile loan for $12,000, financed at 10 percent interest, might be repaid in 36 equal monthly payments of $387.24 ($32.27 × 12). A loan for $3550 at 16 percent for 24 months will require monthly payments of $173.81 ($48.96 × 3.550).
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The finance charge must include all mandatory charges to be paid by the borrower. In addition to interest, lenders may charge fees for a credit investigation; a loan application; or credit life, credit disability, or credit unemployment insurance. When fees are required, the lender must include them in the finance charge in dollars and as part of the APR calculations. When the borrower elects these options voluntarily, the fees are not included in the finance charge and APR calculations, even though they raise the actual cost of borrowing.
It is easy to calculate the finance charge on a consumer loan. First, multiply the monthly payment by the number of months and subtract the original amount borrowed. In the 36-month automobile loan example given earlier, the finance charge would be $1940.64 [($387.24 × 36) − $12,000]. Second, add any other mandatory charges.
7.5b Calculation of the Finance Charges and APR for Installment Loans
Interest accounts for the greatest portion of the finance charge. Three methods are used to calculate interest on installment and noninstallment credit: the declining-balance (sometimes called the simple-interest) method, the add-on interest method, and the discount method. The declining-balance method is widely used by credit unions to calculate interest on all loans, and it is always used for credit cards and home mortgages. The add-on method predominates on installment loans at banks, savings banks, and consumer finance companies when financing automobiles, furniture, electronics, and other credit requiring collateral. The following discussion illustrates the calculation of the APR for installment loans using each of the three methods.
1. The Declining-Balance Method Is Fair to Both Lender and Borrower With the declining-balance method , the interest assessed during each payment period (usually each month) is based on the current outstanding balance of the installment loan. The lender initially calculates a schedule (such as that given in Table 7-2 ) to have the balance repaid in full after a certain number of months. The borrower may vary the rate of repayment by making payments larger than those scheduled or may repay the loan in full at any time.
declining-balance method Interest calculation method in which interest is assessed during each billing period (usually each month) based on the outstanding balance of the installment loan that billing period.
Here is an illustration of the declining-balance method for an installment loan. As shown in Table 7-2 , at the end of the first month, a periodic interest rate (the monthly rate applied to the outstanding balance of a loan) of 1½ percent (18 percent annually divided by 12 months) is applied to the beginning balance of $1000, giving an interest charge of $15. Of the first monthly installment of $91.68, $15 goes toward the payment of interest and $76.68 ($91.68 ;− $15.00) goes toward payment of the principal.
periodic interest rate The monthly rate applied to the outstanding balance of a loan.
For the second month, the outstanding balance is reduced to $923.32 ($1000 ;− $76.68). Since the balance is $78.68 lower, the interest portion of the payment drops to $13.85 (0.015 × $923.32). Because the declining-balance method applies the periodic interest rate to the outstanding loan balance, the APR and the simple interest rate will differ only if fees (such as an application fee) boost the finance charge. (This method of paying off a loan, called amortization , is also discussed in Chapter 9 when we examine home mortgage loans.) Note that declining-balance loans carry no prepayment penalties.
amortization Loan repayment method in which part of the payment goes to pay interest and part goes to repay principal. Extra payments toward principal shorten the life of the loan and decrease the total amount of interest paid.
Table 7-2 Sample Repayment Schedule for $1000 Principal Plus Interest Using the Declining-Balance Method (1½ Percent per Month)
2. The Add-On Method Favors the Lender The add-on method is also widely used for computing interest on installment loans. With this method, the interest is calculated and added to the amount borrowed to determine the total amount to be repaid. Equation (7.1) is used to calculate the dollar amount of interest. Note that the interest rate used in this equation for the add-on method is an add-on rate and should not be confused with the APR.
With the add-on interest method , interest is calculated by applying an interest rate to the amount borrowed times the number of years. The add-on interest formula given in Equation (7.1) is used as follows:
add-on interest method Interest is calculated by applying an interest rate to the amount borrowed times the number of years to arrive at the total interest to be charged.
where
I = Interest or finance charges
P = Principal amount borrowed
R = Rate of interest (simple, add-on, or discount rate)
T = Time of loan in years
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For example, assume that Graciela Lopez of New York City borrows $2000 for two years at 9 percent add-on interest to be repaid in monthly installments. Using Equation (7.1), her finance charge in dollars is $360 ($2000 × 0.09 × 2). Adding the finance charge ($360) to the amount borrowed ($2000) gives a total amount of $2360 to be repaid. When this amount is divided by the total number of scheduled payments (24), we find that Graciela must make 24 monthly payments of $98.33.
Calculating the APR When the Add-On Method Is Used Add-on rates and APRs are not equivalent. This is because the add-on calculation assumes the original debt is owed for the entire period of the loan. But of course the debt does go down as the debt is repaid. In the example just given, Graciela does not have use of the total amount borrowed for the full two years. Equation (7.2) shows the n-ratio method of estimating the APR on her add-on loan.
Where
APR = Annual percentage rate
Y = Number of payments in one year
F = Finance charge in dollars (dollar cost of credit)
D = Debt (amount borrowed or proceeds)
P = Total number of scheduled payments
Using Equation (7.2), the APR is 16.4 percent. Note that the APR is approximately double the add-on rate because, on average, Graciela has use of only half of the borrowed money during the entire loan period.
Your Worst Financial Blunders in Credit Cards and Consumer Loans
Based on others' financial woes, you will make mistakes in personal finance when you:
1. Fail to shop for the lowest APR on credit cards and consumer loans.
2. Regularly carry balances on credit card accounts.
3. Use a credit card rather than lower interest rate installment loans to make expensive purchases.
Turn Bad Habits into Good Ones
Do You Do This?
Skim read your credit card billing statements
Pay with whatever card you pull out first from your wallet or purse
Make only the minimum payment on your credit card
Ignore the potential to earn rewards on your credit cards
Focus on the size of the monthly payment when you take out loans
Do This Instead!
Read each statement for completeness and accuracy
Avoid making purchases that you plan to pay off with a credit card on which you carry a balance
Set a date for paying off that card balance in full and make the payments required to meet your goal
Open an account that provides rewards and make day-to-day purchases paying balances in full when billed
Focus on the annual percentage rate and length of loan
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Making a list of all your debts currently outstanding, the amounts owed, to whom, and at what interest rates.
2. Projecting any money you might borrow between now and graduation.
3. Using the calculator at finance .yahoo.com/calculator/loans/det03/ to determine your monthly payments if you were to pay off your total debt owed at graduation within 3 years, 5 years, and 10 years.
The Rule of 78s Determines the Prepayment Penalty When an Add-On Loan Is Repaid Early Most installment loan contracts that use the add-on method include a prepayment penalty —a special charge assessed to the borrower for paying off a loan early. Prepayment penalties take into consideration the reality that borrowers should pay more in interest early in the loan period when they have the use of more money and increasingly less interest as the debt shrinks over time. With an add-on method loan, however, the interest is spread evenly across all payments rather than declining as the loan balance falls. If an add-on method loan is paid off early, the lender will use some penalty method to compensate for the lower interest component applied in the early months.
prepayment penalty Special charge assessed to the borrower for paying off a loan early.
The rule of 78s method (also called the sum of the digits method ) is the most widely used method of calculating a prepayment penalty. Its name derives from the fact that, for a one-year loan, the numbers between 1 and 12 for each month add up to 78 (12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1). For a two-year loan, the numbers between 1 and 24 would be added, and so on for loans with longer time periods.
rule of 78s method/sum of the digits method A common method of calculating the prepayment penalty on a loan that uses the add-on method for calculating the interest.
To illustrate the use of the rule of 78s method, consider the case of Devin Grigsby from West Lafayette, Indiana. He borrowed $500 for 12 months plus an additional $80 finance charge and is scheduled to pay equal monthly installments of $48.33 ($580 ÷ 12). Assume Devin wants to pay the loan off after only six months. He might assume—incorrectly—that he would owe only $250 more because after six months he had paid $250 (one-half) of the $500 borrowed and $40 (one-half) of the finance charge, for a total of $290 in payments ($48.33 × 6). Actually, Devin still owes $268.46, including a prepayment penalty of $18.46. To calculate this amount using the rule of 78s method, the lender adds together all of the numbers between 12 and 7 (12 for the first month, 11 for the second, and so on for six months): 12 + 11 + 10 + 9 + 8 + 7 = 57. The lender assumes that during the first six months $58.46 [(57 ÷ 78) × $80]—not $40—of the finance charges was received from the $290 in payments Devin had made on the loan. *
Consequently, only $231.54 ($290.00 − $58.46) was paid on the $500 borrowed, leaving $268.46 ($500.00 − $231.54) still owed, for a prepayment penalty of $18.46 ($268.46 − $250.00).
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3. With the Discount Method, Interest Is Paid Up Front The discount method is sometimes used by creditors to compute the interest on an installment loan. Here the interest is calculated based on a discount rate that is multiplied times the amount borrowed and multiplied by the number of years to repay. The interest is then subtracted from the amount of the loan, and only the difference is given to the borrower. Thus, the interest is paid up front.
discount method Interest is calculated based on a discount rate multiplied by the amount borrowed and by the number of years to repay. Interest is then subtracted from the amount of the loan and the difference is given to the borrower. In this method, interest is paid up front before any part of the payment is applied to the principal.
When this method is applied to our earlier example involving Graciela Lopez, she would receive only $1640 [$2000 − ($2000 × 2 × 9%)] at the beginning of the loan period. Her monthly payment would be $83.33 ($2000 ÷ 24). Using Equation (7.2), the APR would be 19.8 percent (the APR rises because only $1640 is obtained while $2000 is repaid).
CONCEPT CHECK 7.5
1. Explain how the interest is calculated on a consumer loan that uses the declining-balance method.
2. Summarize how interest is calculated on a consumer loan that uses the add-on method.
3. What is the effect of the rule of 78s when a borrower repays an add-on method loan early?
4. Explain how the interest is calculated on a consumer loan that uses the discount method.
WHAT DO YOU RECOMMEND NOW?
Now that you have read this chapter on credit cards and consumer loans, what would you recommend to Zachary Cochrane regarding:
1. His approach to using credit cards, including the number of cards he has?
2. Estimating the credit card interest charges he is paying each month?
3. How he might lower his interest expense each month?
4. Consolidating his credit card debts into one installment loan?
BIG PICTURE SUMMARY QF LEARNING OBJECTIVES
LO1 Compare the common types of consumer credit, including credit cards and installment loans.
Borrowers can use both installment and noninstallment credit. Open-ended credit is an example of noninstallment credit. It permits the customer to gain repeated access to credit without having to fill out a new application each time one borrows money. The consumer may choose either to repay the debt in a single payment or to make a series of payments of varying amounts. Bank credit cards and travel and entertainment credit cards are the most commonly used open-ended credit accounts.
LO2 Describe the types and features of credit card accounts.
Credit card borrowers must adhere to all the rules of the account or risk being charged a number of fees such as late-payment and bounced-check fees.
LO3 Manage your credit card accounts to avoid fees and finance charges.
Credit card statements provide a monthly summary of account activity, the calculation of any finance charges, and how long it will take to pay off the card balance if you only pay the minimum payment required. Credit card issuers compute finance charges by multiplying the average daily balance by the periodic interest rate.
LO4 Describe the important features of consumer installment loans.
Consumer loans, also called installment loans, have several features that distinguish them from credit card accounts. Loans usually have a fixed payment for a fixed number of months. Once the loan is paid off, the account is closed and a new account would need to be opened if the person wanted to take out another loan.
LO5 Calculate the interest and annual percentage rate on consumer loans.
Both the declining-balance and add-on methods are used to calculate the interest on installment loans, although the annual percentage rate (APR) formula gives the correct rate in all cases. With declining-balance loans, the dollar amount of interest incorporated in each monthly payment declines as the loan balance declines.
LET'S TALK ABOUT IT
1. Learning More About Credit. Most young adults form their opinions about credit and debt from what they see in their parents' experiences. How has your perception of carrying credit card debt, student loans, and other borrowing changed as a result of reading Chapters 6 and 7 ?
2. What Type of Borrowing Might Be Best? If you wanted to borrow money to study abroad for a semester and could pay it back within two years after returning, would you prefer a single-payment loan, an installment loan, or a cash advance on a credit card? Why?
3. Are Rewards Cards a Good Idea? Some credit cards offer rewards points or a 1 percent or higher cash back reward for all purchases made on the card. How would you feel about using such a card to get those rewards with the intention of paying the balance off in full each month?
4. The Declining-Balance Method. How do you feel about the fact that interest costs are higher in the early months of a declining-balance loan than they are in the later months?
5. The Rule of 78s. Are prepayment penalties such as that applied with the rule of 78s justified? Why or why not?
DO THE MATH
1. Monthly Payments and Finance Charges or an Add-on Rate Loan. Zachary Porter of Highland Heights, Kentucky, is contemplating borrowing $10,000 from his bank. The bank could use add-on rates of 6.5 percent for 3 years, 7 percent for 4 years, and 8 percent for 5 years. Use Equation 7.1 to calculate the finance charge and monthly payment for these three options.
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2. Monthly Payments and Finance Charges. Kimberly Jensen of Griffin, Georgia, wants to buy some living room furniture for her new apartment. A local store offered credit at an APR of 16 percent, with a maximum term of four years. The furniture she wishes to purchase costs $2800, with no down payment required. Using Table 7-1 or the Garman/Forgue companion website, make the following calculations:
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(a) What is the amount of the monthly payment if she borrowed for four years?
(b) What are the total finance charges over that four-year period?
(c) How would the payment change if Kimberly reduced the loan term to three years?
(d) What are the total finance charges over that three-year period?
(e) How would the payment change if she could afford a down payment of $500 with four years of financing?
(f) What are the total finance charges over that four-year period given the $500 down payment?
3. Average Daily Balance and Finance Charges. Kayla Sampson, an antiques dealer from Great Bend, Kansas, received her monthly billing statement for April for her MasterCard account. The statement indicated that she had a beginning balance of $600, on day 5 she charged $150, on day 12 she charged $300, and on day 15 she made a $200 payment. Out of curiosity, Kayla wanted to confirm that the finance charge for the billing cycle was correct.
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(a) What was Kayla's average daily balance for April without new purchases?
(b) What was her finance charge on the balance in part (a) if her APR is 19.2 percent?
(c) What was her average daily balance for April with new purchases?
(d) What was her finance charge on the balance in part (c) if her APR is 19.2 percent?
4. Average Daily Balance. Alexis Monroe, a biologist from Storm Lake, Iowa, is curious about the accuracy of the interest charges shown on her most recent credit card billing statement, which appears in Figure 7-2 on page 207. Use the average daily balances provided to recalculate the interest charges, and compare the result with the amount shown on the statement.
5. Comparing APRs. James Sprater of Conway, South Carolina, has been shopping for a loan to buy a new car. He wants to borrow $18,000 for four or five years. James's credit union offers a declining-balance loan at 9.1 percent for 48 months, resulting in a monthly payment of $448.78. The credit union does not offer five-year auto loans for amounts less than $20,000, however. If James borrowed $18,000, this payment would strain his budget. A local bank offered current depositors a five-year loan at a 9.34 percent APR, with a monthly payment of $376.62. This credit would not be a declining-balance loan. Because James is not a depositor in the bank, he would also be charged a $25 credit check fee and a $45 application fee. James likes the lower payment but knows that the APR is the true cost of credit, so he decided to confirm the APRs for both loans before making his decision.
(a) What is the APR for the credit union loan?
(b) Use the n-ratio formula to confirm the APR on the bank loan as quoted for depositors.
(c) What is the add-on interest rate for the bank loan?
(d) What would be the true APR on the bank loan if James did not open an account to avoid the credit check and application fees?
6. Rule of 78s. Miguel Perez of Norfolk, Nebraska, obtained a two-year installment loan for $1500 to buy some furniture eight months ago. The loan had a 12.6 percent APR and a finance charge of $204.72. His monthly payment is $71.03. Miguel has made eight monthly payments and now wants to pay off the remainder of the loan. The lender will use the rule of 78s method to calculate a prepayment penalty.
(a) How much will Miguel need to give the lender to pay off the loan?
(b) What is the dollar amount of the prepayment penalty on this loan?
DO IT IN CLASS PAGE 217
FINANCIAL PLANNING CASES
CASE 1
The Johnsons' Credit Questions
Harry and Belinda need some questions answered regarding credit. Their three-year-old car has been experiencing mechanical problems lately. Instead of buying a new set of tires, as planned for in March, they are considering trading the car in for a newer used vehicle so that Harry can have dependable transportation for commuting to work. The couple still owes $3600 to the bank for their current car, or $285 per month for the remaining 18 months of the 48-month loan. The trade-in value of this car plus $1000 that Harry earned from a freelance interior design job should allow the couple to pay off the auto loan and leave $1250 for a down payment on the newer car. The Johnsons have agreed on a sales price for the newer car of $14,250. The money planned for tires will be spent for other incidental taxes and fees associated with the purchase.
(a) Make recommendations to Harry and Belinda regarding where to seek financing and what APR to expect.
(b) Using the Garman/Forgue companion website or the information in Table 7-1 , calculate the monthly payment for a loan period of three, four, and five years at 8 percent APR. Describe the relationship between the loan period and the payment amount.
(c) Harry and Belinda have a cash-flow deficit projected for several months this year (see Table 3-6 and Table 3-7 on pages 87–88). Suggest how, when, and where they might finance the shortages by borrowing.
CASE 2
Victor and Maria Have a Billing Dispute
Maria Hernandez was reviewing her recent bank credit card account statement when she found two charges that she and Victor could not have made. The charges were for rental of a hotel room and purchase of a meal on the same day in a distant city. These charges totaled $219.49 out of the couple's $367.89 balance for the month.
(a) What payment should Maria make on the account?
(b) How should she notify her credit card issuer about the unauthorized use?
(c) Once the matter is resolved, what should Maria do to ensure that her credit history is not negatively affected by this error?
CASE 3
Julia Price Thinks About Her Use of Credit Cards
Julia has been thinking about how she uses credit cards. She has two bank cards and three store cards. The APRs on the cards range from 10.5 to 24.9 percent, with the store cards being among the highest. She uses the cards often and picks whatever card she comes to first in her wallet. Most months she pays the balance off in full. However, sometimes she is unable to pay the balance on one or more of the cards, and so she only pays the minimum balance. Julia feels she is doing her best on managing her cards but wants to do better. She is thinking about using just one of her bank cards for any purchases that she thinks she will be unable to pay at the end of the month. Offer your opinions about her thinking.
CASE 4
A Delayed Report of a Stolen Credit Card
Jia Li Sun, took her sister-in-law Ah-Iam Johnson out for an expensive lunch. When it came for the time to pay the bill, Jia Li noticed that her Visa credit card was missing, so she paid the bill with her MasterCard. While driving home, Jia Li remembered that she had last used the Visa card about a week earlier. She became concerned that a sales clerk or someone else could have taken it and might be fraudulently charging purchases on her card.
(a) Summarize Jia Li's legal rights in this situation.
(b) Discuss the likelihood that Jia Li must pay Visa for any illegal charges to the account.
DO IT IN CLASS PAGE 210
CASE 5
Clauses in a Car Purchase Contract
Lauren Rowland is a dentist in Saint Charles, Missouri, who recently entered into a contract to buy a new auto-mobile. After signing to finance $18,000, she hurriedly left the office of the sales finance company with her copy of the contract. Later that evening, Lauren read the contract and noticed several clauses—an acceleration clause, a repossession clause, and a rule of 78s clause. When she signed the contract, Lauren was told these standard clauses should not concern her.
(a) Should Lauren be concerned about these clauses? Why or why not?
(b) Considering the rule of 78s clause, what will happen if Lauren pays off the loan before the regular due date?
(c) If Lauren had financed the $18,000 for four years at 7 percent APR, what would her monthly payment be, using the information in Table 7-1 or on the Garman/Forgue companion website?
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. List Your Credit Card Accounts. Complete Worksheet 28: My Credit Card Inventory from “My Personal Financial Planner,” which asks you to make an inventory of your credit cards including the name of the card (Visa, Discover, etc.); issuer (bank, retailer, etc.); account number; the current APRs for purchases, balance transfers, and cash advances; outstanding balance, if any; usual due dates; and phone numbers to use if the card is lost/stolen or there is a billing error.
2. Shop for a New Credit Card. Complete Worksheet 29: Comparing My Credit Card Offers from “My Personal Financial Planner,” which asks you to shop for a new credit card from two different sources. If you already have a credit card, include the information on that card in the third column in the worksheet. Determine whether your current card is the best of the three, or if you have no current card, choose among the two you have researched.
3. Monitor Your Credit Card Statements. Review your most recent credit card statements for accuracy. List the steps you would take if you found an error in the statement.
4. Compare Hypothetical Vehicle Loans. Assume you have decided to buy a used car by borrowing $6000 and you have offers for loans at 6, 8, and 10 percent and each can be for 3, 4, or 5 years. Complete Worksheet 30: Monthly Installment Loan Payment Calculator from “My Personal Financial Planner” to determine the monthly payment for each of the six loan arrangements. Which loan is most attractive to you and why?
QN THE NET
Go to the Web pages indicated to complete these exercises.
1. Review Current Market Interest Rates. Visit the website for Bankrate.com at www.bankrate.com/credit-cards.aspx , where you will find information on bank credit card interest rates around the United States. View the information for the lenders in a large city nearest your home. How does the information compare with the interest rates charged on your own credit card account(s)? How do the rates in the city you selected compare with those found elsewhere in the United States?
2. Explore the Impact of Varying Interest Rates and Time Periods on a Loan Payment Amount. Visit the website for Interest.com at www.interest.com/auto/calculators/auto-loan-calculator/ . There you will find an auto loan calculator that determines the monthly payment for any declining-balance loan given a specified time period, interest rate, and loan amount. Assume you wish to borrow $12,000 to buy a car. Vary the time period and interest rate of the loan to see how these variations affect your monthly payment.
3. How Long Will It Take to Pay off Your Credit Card? Do you owe money on one or more credit cards? Visit the Bankrate.com website at www.bankrate.com and click on “Calculators” to find a calculator that will tell you how long it will take to pay off your balances given various monthly payment amounts.
ACTIQN INVQLVEMENT PRQJECTS
1. Comparing Credit Card offers. Select two local retailers, a local bank, and a local credit card and request credit card applications from all four. Compare the applications for the types of information they require. Compare the APRs offered among the cards and others that you may already hold. Make a table that summarizes your findings and write some brief reactions to what you found.
2. Credit Card Repayment Patterns. Survey five of your friends about their patterns of using their credit card accounts including their choice to make the minimum payment rather than pay off the balance in full each month. Compare what they do to your own pattern, and write a summary of your findings.
3. Credit Card Billing Errors. Survey five of your friends about experiences they have had concerning a billing error on their credit cards. Compare the steps they took to resolve the error(s) with those recommended in this chapter. Write a summary of your findings.
4. Installment Loan Interest Methods. Visit a bank and a credit union in your community and your own bankers. Tell them that you are considering taking out a loan to purchase a vehicle. Inquire whether they offer declining-balance or add-on method loans and which approach they would recommend. Compare the responses to the information provided in this chapter, and write a summary of your findings.
Visit the Garman/Forgue companion website at www.cengagebrain.com .
* Calculations involving Equation (7.1) and (7.2) can be found on the Garman/Forgue companion website.
* If the loan was paid off after one month, the amount of interest paid is assumed to be 12/78 of the $80 finance charge, or $12.31. For a loan paid in full after two months, the amount of interest paid is assumed to be 23/78 of the total (12/78 for month 1 plus 11/78 for month 2), or $23.59.
