Title: Chapter 6 Choosing a Source of Credit: The Costs of Credit Alternatives
1Chapter 6Choosing a Source of Credit The Costs
of Credit Alternatives
6-1
2Learning Objectives - Chapter 6
6-2
- Analyze the major sources of consumer credit.
- Determine the effective cost of borrowing by
considering the quoted rate, the number of
compounding periods, the timing of interest
payments other service charges. - Develop a plan to manage your debt.
- Evaluate various private government sources
that assist consumers with debt problems. - Assess the choices in declaring personal
bankruptcy.
3Learning Objective 1Analyze the major sources
of consumer credit.
6-3
4Sources of Consumer Credit
6-4
- Credit costs money
- Weigh benefits of buying an item on credit versus
waiting until you have saved enough money to pay
cash - Ask yourself
- Do I need a loan?
- Can I afford a loan?
- Can I qualify for a loan?
5Sources of Consumer Credit
6-5
- Inexpensive loans.
- Parents and family members.
- Loans based on assets, such as a GIC.
- Medium-priced loans.
- Chartered banks, trust companies and credit
unions. - Expensive loans.
- Finance companies.
- Retailers such as car or appliance dealers.
- Bank credit cards and cash advances.
6Learning Objective 2Determine the effective
cost of borrowing by considering the quoted rate,
the number of compounding periods, the timing of
interest payments other service charges.
6-6
7The Cost of Credit
6-7
- Effective Annual Interest Rate depends on
- Quoted annual percentage rate
- How frequently interest is compounded
- Interest charged up front
- Other charges such as service charges,
credit-related insurance premiums, and appraisal
fees
8The Cost of Credit
6-8
- The annual percentage rate (APR) is the
percentage cost of credit on a yearly basis. - The APR provides the true rate of interest for
comparison with other sources of credit. This
rate lets you compare like with like when
shopping for rates.
9Annual Percentage Rate (APR)
6-9
R 2 x n x I P (N 1)
- R approximate APR
- n number of payment in one year
- I total dollar cost of credit
- P principal or net amount of loan
- N total number of payments scheduled to pay off
the loan
10Trade-Offs of Financing Choices
6-10
- Term (length of loan) versus interest cost.
- A longer term allows lower monthly payments, but
you pay more in interest. - Lender risk versus interest rate. To reduce the
lenders risk you can... - Accept a variable interest rate.
- Provide collateral to secure the loan.
- Make a large down payment up front.
- Have a shorter loan term.
11Calculating Your Loan Payments
6-11
- Fixed Rate Installment Loan
- Pay off over a pre-determined period of time
- Payment represents blend of interest and
principal - Floating Rate Personal Line of Credit
- Variable interest rate tied to lenders prime
rate - Compounded daily
- Payments not fixed
- At risk if interest rates rise
- Takes longer to repay if only paying minimum
required
12Cost of Carrying Credit Card Balances
6-12
- Adjusted balance method
- The assessment of finance charges after payments
made during the billing period have been
subtracted. - Previous balance method
- Method of computing finance charges that gives no
credit for payments made during the billing
period. - Average daily balance method
- Uses a weighted average of the account balance
throughout the current billing period. If you
carried over a balance new purchases may be
included in your average daily balance
calculation.
13The Cost of Credit
6-13
- Expected Inflation
- borrowers and lenders are concerned about the
goods and services their dollars can buy - its
purchasing power - inflation erodes the purchasing power of money
- the expected rate of inflation is added to the
interest rate charged by lenders to protect their
purchasing power
14The Cost of Credit
6-14
- Avoid the minimum monthly payment trap
- minimum monthly payment is the smallest amount
you can pay and still be a cardholder in good
standing - is not the total amount due
- the longer you take to repay the more interest
you will incur - Credit Insurance
- ensures the repayment of your loan in the event
of death, disability or loss of property - pays lender directly
15Learning Objective 3Develop a plan to manage
your debt.
6-15
16Managing Your Debts
6-16
- A sudden illness or loss of job may make it
impossible to repay your debts - Contact your creditors at once to work out a
modified payment arrangement - Your vehicle can be repossessed if you default on
your payments and you could incur added costs so
it is better to sell yourself and repay the debt - Debt counseling services are available but be
sure to investigate the company
17Warning Signs of Debt Problems
6-17
- Emotional problems such as the need for instant
gratification. - The use of money to punish.
- The expectation of instant comfort among those
who overuse the installment plan to get what they
want now - Keeping up with the Joneses.
- Overindulgence of children.
- Lack of communication among family members.
- The amount of finance charges is too high.
18Warning Signs of Debt Problems
6-18
- You continually go over your credit limit
- You use your credit card as a necessity rather
than a convenience - You borrow money to make it from one pay cheque
to the next - Your wages have been garnished to pay outstanding
debts - You pay only interest or service charges monthly
and dont reduce your total debt - You are pressured or threatened by creditors
- Utility services are cut off for unpaid bills
19The Serious Consequences of Debt
6-19
- Loss of job due to garnishment of wages
- Neglecting health and educational needs of family
members - Alcoholism or drug abuse
- Marital difficulties
- Neglect of children
20Learning Objective 4Evaluate various private
government sources that assist consumers with
debt problems.
6-20
21Consumer Credit Counseling Service
6-21
- If you are having problems paying your bills you
can - contact your creditors and work out a repayment
plan - go to a non-profit financial counseling program
for assistance - Credit counseling activities include
- aiding families by helping them manage their
money, setup a realistic budget and plan for
expenditures - helping people to avoid future debt problems
22Learning Objective 5Assess the choices in
declaring personal bankruptcy.
6-22
23Declaring Personal Bankruptcy
6-23
- Increasing number of bankruptcy filers are
well-educated, middle-class baby boomers with an
overwhelming level of credit card debt - Usually between 40-44 years of age
- Increasingly likely to be female
- In last 9 years bankruptcy has increased almost
8 annually
24Fending off Bankruptcy
6-24
- Consolidation Loans
- advantages are single interest rate on all your
debts and ability to extend them to allow you to
make smaller payments - disadvantages are higher interest rates as you
represent a higher risk to the lender - a longer term means more accumulated interest
25Bankruptcy Insolvency Act
6-26
- A federal law initiated in 1992 and amended in
1997 - Regulates bankruptcy (a straight declaration of
insolvency) and proposal (a wage earner plan)
proceedings - You are allowed to declare insolvency either
through a consumer proposal or through an
assignment in bankruptcy
26Consumer Proposal
6-26
- A consumer proposal is a maximum 5 year plan for
paying creditors all or a portion of a debt owed - must be insolvent and less than 75,000 in debt
(excluding home mortgage) - both court and creditors must approve your
proposal - may save you from bankruptcy
27Bankruptcy
6-27
- First step is the assignment of your assets to a
licensed trustee - Until you are released from your debts by a court
you will be considered a discharged bankrupt - Secured creditors are paid first
- Remaining assets distributed with cost of
bankruptcy administration taking precedence - Once completed court will grant you a discharge
28Effects of Bankruptcy
6-28
- Obtaining future credit will be difficult
- Easier for those who file a consumer proposal and
repay some of their debt than those who make no
effort to repay - A bankruptcy remains on your credit file for 7
years
29Summary of Learning Objectives
6-29
- Analyze the major sources of consumer credit
- Banks, trust companies, credit unions, finance
companies, life insurance companies, family and
friends - Each has unique advantages and disadvantages
- Parents or family members are least expensive
source of loans - May only charge you interest they would have
earned on savings - May complicate family relationships
30Summary of Learning Objectives
6-30
- Determine the cost of credit by calculating
interest using various interest formulas - Determine the effective cost of borrowing by
considering the quoted rate, the number of
compounding periods, the timing of interest
payments and other service charges - Financial institutions quote an annual percentage
rate (APR) on installment loans and lines of
credit - Effective cost of borrowing will rise of
compounded more than once a year or loan is made
on a discount basis with service fees added
31Summary of Learning Objectives
6-31
- Develop a plan to manage your debt
- Serious consequences if debt not properly managed
- Following are common reasons for indebtedness
- Emotional problems
- Use of money to punish
- Expectation of instant comfort
- Keeping up with the Joneses
- Overindulgence of children
- Misunderstanding or lack of communication among
family members - Amount of financial charges
32Summary of Learning Objectives
6-32
- Evaluate various private and government sources
that assist consumers with debt problems - If you cannot meet obligations contact creditors
immediately - Investigate debt consolidation companies
thoroughly before signing up - Or better yet contact a credit counselling
service or other debt counselling organization
33Summary of Learning Objectives
6-33
- Evaluate various private and government sources
that assist consumers with debt problems - Such organizations help people manage money
better by setting up a realistic budget and
planning for expenditures - Also help prevent debt problems by teaching
necessity of family budget planning and providing
education to people of all ages
34Summary of Learning Objectives
6-34
- Assess the choices in declaring personal
bankruptcy - Last resort is to declare bankruptcy
- Consider financial and other costs first
- Can declare insolvency through consumer proposal
or an assignment in bankruptcy - Obtaining credit more difficult after filing
bankruptcy - May be easier because relieved of prior debt or
creditors know they cannot file another case for
a period of time
35Key Formulas
6-35
- Calculating the Effective Annual Interest Rate
- (1 APR/m)m - 1
- Calculating an Installment Loan Payment
- Calculating monthly interest in a line of credit
- Interest B x APR x (n/365)
-