Personal and Family Financial Planning will address many critical personal financial management topics in order to help you learn prudent habits both while in school and throughout your lifetime.
Credit Basics and Debt Management
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Personal & Family Financial Planning
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Building and Maintaining Good Credit
Credit basics.
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Michael S. Gutter, Ph.D.Professor
Family, Youth & Community Science
Hi!
In today's presentation, we're going to talk about credit basics and
understanding a little bit more about how we manage our debt burdens.
So what is credit?
Let's think about that for a moment.
Credit is really this interesting phenomenon.
What we're actually doing with credit is saying,
I'm going to borrow money from the future.
So that I can spend it today.
Now that's kind of an interesting thing.
In other words, we can get goods or
services that we want to have access to, and pay for them later.
Now, that may seem like a win-win situation,
but remember, you're not going to get to borrow that money for free.
With credit, there's going to be two principle types of credit that we're
going to discuss.
Installments and revolving as well.
Now why do we want to use credit, why don't we want to use credit?
Well, the pros tend to be relatively obvious to us,
we can use credit to obtain things we don't have the cash for right now.
Maybe they're strategic in value,
maybe they're something that's really important to us.
They're certainly convenient.
Without question, they're convenient if we don't have cash,
don't have access to an ATM machine, in between paychecks of course.
And convenient too for
things like online purchases, online shopping that we might be doing.
And certainly in case of an emergency.
Your car breaks down and
you really need to get the tires fixed, you really need to get a new battery.
So there's plenty of times when we may use credit, and it makes a lot of sense to.
But, there's some disadvantages to using credit too.
Number one, is you're going to have to pay it back.
So you're going to have to continue to make payments for this.
And when we have access to credit.
We can be tempted to buy things when we're not really sure when we can pay them off.
That's a concern that we're going to have as well.
We certainly know that if making we're making payments to our credit,
remember we've gotta pay it back after we've borrowed it.
We're going to have a challenge then also balancing those repayments.
With savings. And,
savings is going to be kind of important, as we know, down the road.
Credit's not cheap.
Right? We know that the average rate on
a credit card can be as high as 18%.
And, they can go actually substantially higher if you actually miss a payment.
30% is not uncommon for people who may have missed a payment.
Or who have a lower credit score.
So a few other types of things there, right, is that the more and more we
use credit, the harder it can be for us to have emergencies, accumulate savings.
We can have challenges purchasing basic needs that we might have.
We talked about savings and investing.
It can certainly inhibit our planning for the future and
doing some basic family functions.
And even can make it challenging if we've been using our credit, then we
potentially don't have access to it when we actually need it in an emergency.
And lastly, completely non-financial, but
very financial at the same time, is it creates stress.
Many of us are stressed out when we owe someone something.
And so as we kind of put those pieces together, we think.
Wow.
There's good.
There's bad. So credit
can directly add to the budget concern.
Number one, right?
We can have challenges where if we get our credit limits lowered, it can make it
challenging for us to make expenses that we were planning to use our credit for.
That can be problematic.
Or interest rates may vary on some of our credit.
And bear in mind we're not just talking about credit cards,
this includes thing like mortgages or car loan, or other debts,
which may have a variable rate, a rate that fluctuates with time.
And so as a result, that can be challenging from a budgeting stand point.
We certainly can have our credit go up, if we've actually missed a payment and
there can be fees we might encounter.
If we're late, we're going to get charged a fee,.
If we go over our credit limit, which we have to authorize, but
many people still do, we're going to be charged a fee.
If we take a cash advance, we're going to be charged a fee, and
have a higher interest rate.
So all of these pieces and the most basic fact that you now have a payment you
have to make every month for something that you've already got.
So you continue to pay on something sometimes for years, right even
though right you've already obtained a while ago, now there's two majors types of
credit that we're going to discuss, the first is called revolving credit and
the most common example for this is simply a credit card revolving credit says
that the company is going to give you a line of credits that you can use.
And you can use this almost anywhere that that line of credit is available.
So most company,
many stores, different services take almost any number of credit card brands.
And right, that's your revolving credit.
You have a limit.
You can spend up to that limit.
You pay it down.
You can charge it up, you can pay it down, you can charge it up.
What the way those work are is that there's going to be a minimum payment that
you have to make each month.
This is typically 2% of the balance.
Hot most of the time.
And your interest rate can as I said before,
may be fixed where it's the same no matter what, unless you miss a payment, or
it's flexible where it varies actually with the overall state of the economy.
If the overall interest rate goes up, so does your credit card interest rate.
If the overall interest for the economies go down.
Credit card interest rate may go down.
Installment debt is a little different.
Right, this is going to be something that you get typically for a specific item,
a specific purchase.
So, common examples of installment credit are car loans, student loans,
so we'll get something,
we'll get the money, we'll use it to make a purchase and then we'll pay that back.
Typically periodically, almost commonly, every month, so car loans again
being a great example of this, you get a set limit and a set payoff time.
So when we make payments and we're reducing our balance,
we don't then get to go charge up more, like we put on a credit card.
It was really that one time use type of purchase.
And as with revolving.
The APR can be both fixed or it can vary.
So, there's a few types of things we want to think about.
Calculating the cost of credit is one.
Here we have the Truth in Lending Act as a great example in this.
I generally refer to this as TIL, but
we'll call it the Truth in Lending Act for today's purposes.
So the Truth in Lending Act requires a few things that need to
be disclosed to anyone.
In other words, what the Truth in Lending Act says is we need to make sure people
can compare across different types of credit.
So it requires that everybody disclose the rate that you're going to be
charged interest and the particular form with all the annual percentage rate.
And this accounts for all of the different elements that can go
into what we're charged on a annualized basis for our credit.
It also accounts for the finance charge that we'll have in dollars.
So in other words on an installment loan if you pay as agreed,
how much will you pay in interest over the life of that loan?
Now when we talk about that finance charge, there's a few different ways that
that'll be calculated, there's single payment loans, right, where we're
charged simple interest, or the discount method, and we'll describe those, and then
there's these installment loans, where we might have simple interest, right?
And again, that's just interest that's charged, added on.
We have the add-on methods as well.
And then we have the discount method.
And we'll define each of these in a little bit more detail.
So a single payment, single int, simple interest.
Interest is computed on the principal only, with no compounding.
So all that time value of money we learned,
we don't need with single payment, simple interest.
In other words,
the amount of interest is simply based on the principle, or the amount we borrowed,
times the rate that we're charged interest, times the time.
The APR for this is going to be the average annual finance charge, then,
divided by the average outstanding loan balance.
So in other words, in a single payment, simple interest loan.
The APR actually is equal to the stated interest rate that makes comparing
things pretty easy for us, so suppose you borrow $500 for two years using
a single payment loan and an interest rate of 12%, our I equals PRT formula, $120.
So our APR in this case would be $60 divided by the 500 that we borrowed, or
12%, so we can see in this case the APR in the state of
interest rate would be the same.
Now the single payment discount method interest is paid up front,
and then subtracted from the amount of the loan,.
The APR formula looks the same but what's going to be different right is that
the amount that's borrowed changes because right we're saying it goes down, so
here we still have I equals 120 same calculation but
the amount borrowed changes right APR equals sixty divided by 380 or 15.8%.
Now 380 is because the loan was 500 but with the discount method we
actually are only borrowing the amount of the loan minus the interest or
the finance charge that we'll be paying.
Now installment with simple interest.
Interest is charged on the outstanding balance using what we
call a periodic rate.
You'll hear this term a lot when we talk about credit.
The periodic rate in most times is simply whatever the annual interest rate is
put into monthly terms.
So if you have a 12% annual interest rate,
the periodic rate monthly is going to be 1%.
So in this case APR and simple interest will differ if there are fees.
As part of what you're paying for, having this particular loan.
With add-on interest, we add, right again, we take I equals PRT, so
we keep using that approach, that basic formula.
And we add that amount to the principal.
The monthly payments then equal the interest plus the principal,
divided by the number of payments.
With multiple payments in this case.
Right? The APR is
typically going to be greater than the stated interest rate.
And that's really because you don't actually have the full amount borrowed for
the use of the loan period because you're paying it back over time.
So here, we call this a, this is a really fun formula here, right?
So the APR in this case which we call the n ratio formula.
Where the APR in this case is the annual percentage rate.
Y is going to be equal to the number of payments in one year.
F is the finance charge in dollars, right, we learned how to calculate that,
D is the debt or amount borrowed, and P equals the total number of payments.
So if Kurt Angle borrows $1500 for three years at an interest rate of 7% using
a loan that applies the add-on method.
What's his APR?
So, the finance charge, right again same thing I=PRT $315.
The monthly payments in this case 1500 plus 315 divided by 36 is $50.42.
Right? Then, if we take a look here,
the APR in this case, do all of this mess, we end up with 12.84%.
Now that's something we want to kind of think about then, right?
So remember, the different calculations for
how interest factors in, will actually affect this annualized cost of credit.
Now you may think, do I have to memorize all these, Dr. G?
No, but what you have to be aware about, not always memorizing the equations, but
understanding the implications of the fact that interest does
not always computed the same way.
And so when we're pricing loans, or
comparison shopping for borrowing for something like a car,.
This type, the calculation that the company uses, is very important.
So you want to remember, when the time comes, to check that out and
see, is this approach the right approach?
Is this approach going to cost me more than what someone else was offering to
charge me for?
Then on the ins, discount method,
the only difference would actually be in the amount that was borrowed.
So here right, if we take a look at this the kind of fun
about this one is that we can actually take a look and
use our financial calculators again for this, you may think well how
is that Doctor Rover well the amount that we borrow on a loan is very comparable to,
stop me if you heard this one the present value of an annuity.
Right? We get this lump sum today,
were going to be making payments over time.
So to our financial calculators, or even our algebra if we love that,
the math is the same, so you borrow it then you make payments to pay it back, so
if you have monthly payments, the big trick on your financial calculator is to
make sure that you set your payments per year, equal to 12.
So that's the important thing that you're going to want to keep track off
again as you're trying to do the math, so what would my payment be,
well on your calculator set P per Y or payments per year to 12.
Present value's the amount we borrowed.
The future value is zero.
Why? You're going to pay the loan off in
the future it has no value then.
The I per year is the APR and then we have the number of years and
we want to make sure that we convert that to monthly terms.
So Jack and Diane, right, finance their new home theater.
They borrowed $3200 for two years with an APR of 11.5%,
what's their monthly payment, well let's explore that little ditty further.
So we set the payments per year equal to 12, future value of zero,
$3200 present value, 11.5 was the interest rate, 2 second N,
that puts it into 24 payments for us, with a payment then of roughly $150.
As always, when we have examples, check them out on your own calculator whether
it's online, on your phone, a calculator your hold in your hands.
Make sure you can get the same answer as I do.
Why does interest matter?
I mean we talk about this an we say, gosh Dr.
Gutter, this really, really a big deal?
Here's why this matters, How long do we want to pay on our debt?
Always the big question we have.
If it's installment, we know how long we're going to pay on it.
With revolving debt, the question I get a lot of times is, when will I be debt free?
That's a moving target if it's revolving debt,
especially if you don't, if you don't stop charging.
Let's take a simple look.
Let's say that you have an average daily balance on your credit card of $2,000.
You may think, I would never have that.
The average American has about $8500 as an average daily balance on their
credit cards.
The annual percentage rate, let's say 18%.
What's the periodic rate?
1.5.
The finance charge, remember, is calculated on the periodic rate.
The minimum payment here is going to be 2% of the balance,
very typical for credit cards.
That's $40. So, let's kind of keep going where we're
going with this.
The finance charge is $30.
Now, you'll start seeing why
credit card companies are required on statements to disclose how long will you
have to pay on this debt if you only make the minimum payment?
Let's take a simple look at this example.
$2,000, right, for our minimum payment.
That's $40.
If we make that payment every month, let's say next month we pay $40.
$30 of that is just paying the finance charge that we accrued that month,
so that means $2,000 minus $10 is the amount that went to principle.
That's $1,990. The following month we'll see
that this pattern keeps going on.
Right? I mean we can see that we
will be paying on this debt for well over a decade if we keep this pattern up.
And I always ask everybody,
when you go to charge something, ask yourself, is that sweater so darn nice,
that you'll be happy you're still paying a couple pennies on the dollar for it.
10 years from now, because that's what happens if we carry a balance and
only make the minimum payments.
So we certainly want to think about that.
It's going to take years to pay off, a lot of years and that, remember when we
talked about that cash flow burn then that credit can create for us, it'll go on, and
on, and on, and nag you just when you're trying to do other things in your life.
This is just a little bit of a pattern then, right.
If we make a minimum payment along these lines it could take you up to 30 years.
Not the process we want to be in.
Fortunately most of the time minimum payments don't go much below $10.
So you'll find that even as your balance would require a lower minimum payment from
the the 2% rule.
Most of the time you're still required to pay a minimum of $10,
which will cut back on that a little bit,
now I want to touch base on the rules of borrowing if we could as well.
Four several major rules we want to talk about.
The Truth in Lending Act, the Equal Credit opportunity Act,
the Fair Credit Reporting Act,
the Fact Act and the Fair Debt Collection Practices Act.
So truth in lending.
We talked about this briefly when we put a few more pieces on it.
Creditors are required to state the costs of borrowing, in specific terms right?
What was that term?
The APR.
Two main components, fees that may be one time, annual, or
monthly, whatever they are, they need to be bundled in,.
And of course then that actual interest rate that we're going to be paying.
So companies are required to disclose this.
That's important.
Ecoa or the Equal Credit Opportunity Act.
This simply says that only certain things can be
considered when you ask someone for credit.
In other words they can't ask you your race.
Color, age, gender, marital status.
If you're married, they may ask you if your spouse is equally applying with you,
going to be jointly held on the debt.
But they can't ask these questions upfront.
It's not fair.
Shouldn't matter in whether or not you're paying your debt off or not.
And in fact, if you're denied credit.
Not only is it your right, but it is your responsibility to ask why.
Call them on it. Why was I denied?
You may get a copy of your credit report and your credit score.
And see, okay.
I wasn't living up to what it was that they wanted me to have.
My score wasn't high enough.
That's a reasonable.
Rationale for why you were denied.
But you want something to be articulated in a way that's permissible by the law.
The Fair Credit Billing Act which says that if there's a mistake made on your
bill, a charge made that you didn't make, maybe they didn't credit you for a payment
you had, there's a lot of little things that can kind of go wrong sometimes.
There's human error unfortunately.
So, this says that there has to be prompt correction of
billing mistakes, number one.
Number two, you can refuse payments for defective goods, so if you get
something that you have paid for, and it wasn't what you thought it was refuse it.
Credit payments are made properly, so when you make your payments and they perceived
and your check shows it's posted or processed already through your bank.
You should be seeing that reduced in your balance.
Why?
Remember, your finance charge is based on your average daily balance, so
every day that your balance doesn't reflect a payment that you've made,
the higher your finance charges will be.
If there's any of these mistakes that are there, you need to notify the creditor
within 60 days of receiving that statement and say I've got a problem with my bill.
You can often call them, but you will find creating that paper trial of emails or
letters that you're writing is very beneficial.
Now here's the other thing, too,
if they do realize there was a mistake and that amount is taken off your balance,
the interest that might have been accrued for that amount.
Also needs to be taken.
You shouldn't be paying any interest on something you weren't supposed to be
paying for in the first place.
And also that there should be prompt replies to your query.
You may say I called them five minutes ago.
They haven't gotten back to me yet.
Prompt is a purposely vague term.
We should certainly expect a response in short order to let us know that
they're working on our situation, doing some research and getting back to us.
Typically I say, if you don't hear back from them within 24 hours,
that's when I start to want to ask questions, call them again, and
keep pursuing that particular line of, of, of proof.
So, let's take a brief look, then, at what a credit statement is going to look like.
Here, right, we can see some simple things.
In this first box, summary of the account activity.
What was the previous balance?
What were the payments made?
What were the other credit items that were had there?
We can see things under the payment information.
New balance.
Minimum payment due.
Payment due date.
So, what do these things look like?
And even giving you the warning.
Remember we said, your interest rate can shoot up on your credit card.
If you fail to make payments on time.
So here they're telling you, if you miss a payment, what's going to happen to you?
So, and we can continue to get some of that information as well.
All of these pieces then continue to be kind of interesting for us.
We want to keep reflecting on.
Of course, there can be changes in our interest rates that may have happened,
that can be a result of change in the company status,
change in our credit status.
If we have a variable credit rate.
Then again, it could simply be that the economy's changed and
our credit has changed as a result of it as well.
And one of the other pieces that's still in
there is going to be the Schumer box, which was
recently part of new legislation that says exactly what we talked about before.
If you make the minimum payment,
here's how long it's going to take you to pay off this debt.
That's a wake up call for a lot of consumers, who really never put a lot of
thought, or understood the math enough, to say, wow, I would take ten years to
pay off this credit card if I just keep making that minimum payment.
Because a lot of us will do our budget around that minimum payment.
And then forget to make extra amounts too.
The Fair Debt Collection Practices Act should get you into trouble,
should somebody say you owe us money we want you to repay us,
you may be sent to collections.
The Fair Debt Collection Practices Act actually goes to
the credit collections agencies, not the lenders themselves.
So what this says is that collection agencies must send a written notice within
five days of calling and you have the right to dispute their claim.
If you don't dispute it, then you need to start negotiating or make arrangements to
pay it, you can just ignore them, that's the first thing that I tell everybody.
Don't ignore the collection agencies.
That just makes them less and less willing to work with your the more and
more they're ignored.
Deal with them.
Try and work out a plan.
They're often, remember, they just typically want to get paid back.
If they know you're working on it and you have good faith, they're
going to probably try and work with you if you are proactive and talk to them.
So, what's a good use of credit?
What's not so good use of credit?
What are strategic reasons why we have it?
What are not strategic reasons why we have it?
So these are kind of some interesting questions that we have.
Right? When does it make sense?
What do you guys think?
What is a good reason to use it?
What's not?
Is it a good reason to use credit to go out to dinner,
to go out to a fancy restaurant?
Is it a good reason to use credit to invest in your education?
So there's strategic rationales for
credit and there's ones that are more impulsive in nature.
So you'll find I'm not going to answer this and tell you what's good, what's bad.
Sometimes our lives aren't that simple.
In an emergency situation,
credit is a way of avoiding a lot of other potential hardships that may be there,
even if it's for purchases that we ordinarily wouldn't want to make it for.
So, we try and avoid using credit for everyday expenses, but
on the other hand, if you're paying it off every month.
Right, you'll see that there's not one simple answer to this question.
But if you're carrying a balance and you continue to use payments for
everyday expenses, that's going to be a challenging pattern to break.
So how do you build credit?
Number one question I get, compared to some of the others.
You're going to have to have some sort of account.
That's the biggest thing.
Here's what's really important.
In general, if people say put utilities in your name,
most utilities don't regularly report your on-time payments to a credit card company,
if you're sent to collections from the utility company,
that will be reported to your credit report.
Probably not the type of building credit you were after.
So, we're going to typically have to make some kind of on time payments that we're
going to need to make.
So, a secured credit card can be one way to do
this through a financial institution.
You put money on deposit with them, and
then you take a credit card that borrows against it.
This is different than a debit card.
Because, you're not actually spending the money in that account.
That money is simply there as a guarantee for what you're borrowing.
Now, that can help because if you're going to be late you can potentially avoid
some of the negative hits on your credit by making those payments.
But whatever you choose to do, and the younger you are the more I say you need to
talk to your parents about this because they can potentially help shed some light.
Even if they didn't make all the best choices themselves.
You can learn from their mistakes, or learn from their good patterns.
Either way, it's usually not something we say to make on your own.
Talk to an older relative whenever possible, or maybe a trusted adviser.
But again, make sure you're making your payments on time.
If you're worried about temptation, right?
Some, this is something students kind of fall into, they get their first credit
card and somebody gives them a thousand dollars credit limit.
So what do they do?
They hit Best Buy, they hit the mall.
We don't want that, because remember, what happens when you charge it?
You gotta pay it back.
So requesting a low limit to start off with is prudent.
On my first credit card, I refused to let them raise it.
Every time they said, you're eligible for an increase in your credit line.
Until I finished college I never wanted a higher credit limit than $250.
I just didn't see how it could benefit me.
I didn't want to buy my books on it, I just want it in
case of a few emergencies or a few little things I had to do.
You can potentially, if your parents are open for it,
get one that has your parents name on it too.
Will be in your name,.
But your parents get the bill as, at the same time as you do.
And that'll keep you from making some frivolous purchases, I assure you.
And, of course, consider sticking with a secured card was one of the other things.
Now a few little rules and we'll get into credit reports next time,
but don't apply for too many cards at once.
Don't be desperate, right?
Think of the person that asks five people to the prom the week of the prom.
Nobody said yes in that circumstance.
You ask five people for
a credit card in one week, you're going to get pretty much the same response.
So, and we'll talk more about things like,
what about the applications you get in the mail?
Right, those may be a good place to at least consider,
you're on somebody's marketing list.
But they haven't actually approved you for anything yet,
when you get those letters in the mail.
You're just literally on someone's marketing.
Establishing a credit history is something that is important though and
take some time.
Establishing checking and savings accounts is good.
Maintaining utilities in your name isn't a bad idea, But,
even though they're probably in most cases not going to report to your credit to your
credit agencies, it gets you use to making payments on time.
That's something you want to think about too.
Obtain an easy to get card.
So, one of my friends started off his college career,
the only credit card his parents would let him get, is a gas station credit card.
Now needless to say,
a few snacks wound up on that card as well, but the limit was low.
He could only use it at that particular gas station.
So to be honest, it really limited his ability to get himself into trouble.
Once you get something like a gas station credit card, and
you're successful with that, once you've been successful making regular payments to
something, then think about going for a bigger card, a bank card in particular.
People would say, what about the retail store cards.
Again, probably not the first choice to go to because impulse purchasing that we
can often do, right, for clothing or other sundries.
And lastly, if you have student loans, pay them off.
Your student loans will absolutely, for some of us,
are the first form of credit we have, because they are installment loans.
If you're making your payments.
They will be reported to credit reporting agencies.
So that information will be tracked for you, and it's important that we want to
make sure that people are aware that those are loans in every shape of the form.
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