Chapter 5 â Introduction to Consumer Credit
Chapter 5 – Introduction to Consumer Credit What Is Consumer Credit? Credit – arrangement to receive cash, goods, or services now and pay for them in the future -without this, it would make it impossible for many to buy large ticket items (house, car, etc.) Consumer credit- use of credit for personal needs (except a home mortgage) -most consumers have three alternatives in financing current purchases: -draw on their savings -use present earnings -borrow against their expected future income to make current credit purchases Uses and Misuses of Credit -using credit to purchase goods and services may be more efficient or productive or to lead more satisfying lives -‘shopaholics’ and young adults are most vulnerable to misusing credit -if you decide to use credit, make sure the benefits of making the purchase now (increased efficiency or productivity, a more satisfying life) outweigh the costs (financial and psychological) of using credit Advantages of Credit -enables people to enjoy goods and services now (car, home, education), helps in emergencies) and pay for them through payment plans based on future income -consumers with previously approved credit may receive other extras (advance notice of sales, right to order by phone, right to buy on approval)
-many shoppers believe it is easier to return purchases bought on account -credit cards provide convenience and efficiency of paying for several purchases with one monthly payment -safer to use credit since caring large amounts of cash can be dangerous -credit cards are used for identification when cashing cheques and using credit provide you with record of expenses -using credit cards can provide a ’30-day float’—the lag time between when you make the purchase and when the lender deducts the balance from your chequing account when the payment is due -some large companies (Canadian Tire, General Motors Corporation) issue co-branded (affinity/value added) cards or their own Visa or Master Card and offer rebates on purchases -gain good credit rating if you repay your debts in timely manner Disadvantages of Credit -temptation to overspend, especially during periods of inflation (continual overspending can lead to serious trouble) -failure to repay loan may result in loss of income, valuable property, and your good reputation, and can lead to court action and bankruptcy, damage to family relationships and a slowing of progress toward financial goals -credit costs money (due to monthly charges and compounding effect of interest on interest) Types of Credit -two types of consumer credit exist: 1. Consumer loan (instalment loan)- one time loan that borrower repays in specified period of time with predetermined payment schedule -used for specific purpose and involves specified amount -home mortgages, automobile loans, other consumer instalment loans, demand loan -written agreement or contract lists the repayment terms of consumer loans for each credit purchase, number of payments, payment amount and whether the loan rate is floating or fixed 2. Revolving credit- line of credit in which loans are made on continuous basis and borrower is billed periodically for at least partial payment -lines of credit – pre-arranged loan with bank for maximum specified amout -if line of credit is secured (pledged assets against it), you will get lower interest (usually prime) -if line of credit is unsecured, the interest rate (usually prime plus percentage) -usually used for larger purchases and have lower interest rates than credit cards Home equity line of credit-personal line of credit based on current market value of home less amount still owed on the mortgage
-credit cards issued by banks (Visa) or stores (Canadian Tire), charge cards or Travel and Entertainment cards (Dinners Club)
Credit limit- dollar amount, which may or may not be borrowed, that a lender makes available to a borrower Credit Cards -credit cards are most popular type of credit in Canada -students are encouraged to obtain one so they can build credit rating and to make online purchases easy -have a limit (some cards will let you go over limit but will charge fee for doing so) Grace period- period of time between the statement date and the due date -usually you will not be charged interest if you pay the balance in full by the due date -statement gives minimum payment which is the amount you need to pay to prevent account from being in arrears -if balance is not paid in full, interest will be charged for each purchase starting on the date the purchase was made -cash advances made on credit cards always have interest charged starting on the date the advance is made -interest on credit cards is high (low interest rate cards usually have annual fee) Benefits of Credit Cards -short-term, no-interest loan when making a purchase if you pay the balance each month -several reward credit cards that let you earn different types of rewards, rebates or points -Federal law states that you are only responsible for the first $50 of unauthorized charges on your credit card -availability of a credit card in case of emergency Costs Associated With Credit Cards -the major fees charged to customers are for: -late or overdue payments -charges for exceeding credit limit on the card (whether done deliberately or by mistake) –called over limit fees -returned cheque fees or payment fees (phone payment fee) -cash advances and convenience cheques (often 3% of the amount) -transactions in a foreign currency (as much as 3% of the amount) -membership fees (annual or monthly), sometimes a percentage of credit limit When a Credit Card Is Stolen -call toll-free number on your credit card statement and call credit card issuer to tell them your card was stolen -have stolen card cancelled immediately -ask for new account number and new card to be sent to you (can take a couple weeks to get new card) -carefully check future credit card statements for purchases you did not make -if you find any purchases that are not yours, call toll free number again and inform them Signs of Financial Trouble -making only minimum payments -missing credit payments -moving debt around instead of paying it down -depending on overtime to over monthly bills -using cash advances from credit cards -being unaware of total debt
-withdrawing funds from savings/retirement to cover bills -borrowing money from family and friends -maxing out credit cards -applying for almost any offer without reading the terms
Advantages of Credit Character- borrowers attitude toward credit obligations Capacity- borrowers financial ability to meet obligations Capital- borrowers assets or net worth Collateral- valuable asset that is pledged to ensure loan payments Conditions- general economic conditions that can affect borrower’s ability to repay General Rules of Credit Capacity Debt-Payments-To-Income Ratio- calculated by dividing monthly debt payments (not including house payment, which is long term liability) by your net monthly income -experts suggest you spend no more than 20% of your net (after tax) income on consumer credit payments -the lower the ratio the better -to determine whether a lender can afford a mortgage loan, many use:
1. Gross debt service (GDS)- monthly mortgage payment, including principal, interest, heating, and taxes, as percentage of gross monthly income (lender wont let you spend more than 30-32% of gross income on shelter costs) 2. Total Debt Service (-TDS- monthly mortgage payment, including payments on any outstanding debt as percentage of your gross monthly income (lender will let you spend on shelter and non-shelter financial obligations combines should not exceed 40% of gross monthly income)
Consumer Loans Mortgage Loans- probably biggest single debt most individual Canadians will incur Car Loans-second largest investment you probably will make after buying house -Canadian Red Book or Canadian Black Book gives wholesale, retail prices, major options, etc.information Ways to Finance Car Purchase -generally cheaper to buy car with loan than to lease one ●Financing at a Bank- most financial institutions offer instalment loans to purchase an automobile -may require minimum down payment or variable interest rate, for terms ranging from one to five years -payment frequency can be arranged to suit the borrows needs -loan has open prepayment clause (unlike home mortgage) so borrower suffers no penalty for early repayment -lender may offer additional terms (ability to skip regular payment without penalty) ●Financing at the Dealership -factory financing-enables you to get a loan directly from the car manufacturer and you can expect to pay significantly lower interest rates and no down payment on the models they are trying to move ●Leasing – lower monthly payments associated with car leasing has increased its popularity during last decade -you are responsible for insuring the vehicle and maintaining it (may be responsible for paying any ‘unreasonable wear and tear’)
-if you go over maximum number of kilometers you will be charged fee based on extra kilometers -at end of lease, you have option to purchase vehicle -if purchase price is below current market price, likely beneficial to purchase it (even if you resell it) Closed-end lease-leasing company is responsible for residual value of the vehicle at lease-end (can buy vehicle for that price and any other charges or fees stipulated in the contract or return it to leasing company)
-often look better because monthly payments are lower Open-end lease- you are responsible for residual value of vehicle and must pay that amount and any other charges or fees stipulated in the lease at least-end Lease Payments -lease terms usually are from 2 to 5 years -difficult and costly to terminate lease agreement (pay attention to terms of termination) -termination applies to stolen or totaled vehicles (gap insurance will pay lease fees for vehicles stolen or totaled) -based on five factors: 1. cost of the car 2. estimated value of the car at the end of the lease (residual factor) 3. lease or interest rate 4. length of the lease 5. down payment When negotiating lease -ensure price of car and financing rate is identical under the lease and purchase option and any discounts, trade-ins and credits are identical -lease cars that maintain value so residual value used in lease calculation is high (result in lower monthly lease payment) -assess any mileage restrictions and additional front-end charges under a lease -new cars offer three-to-five year warranty (keep lease term within this time frame) Cosigning a Loan -co-signing means your guarantee a debt (if borrower doesn’t/can’t pay, you will have to) -creditor can use same collection methods against you that can be used against borrower (suing you, garnishing wages) -if you do co-sign: -be sure you can afford to pay loan (if you cannot you can be sued and credit rating can be damaged)
-consider that even if you are not asked to repay debt, liability for this loan may keep you from getting other credit you want -before you pledge property (car, furniture) to secure loan, make sure you understand the consequences -check provincial law (some provinces have laws giving you additional rights as cosigner) -request hard copy of overdue-payment notices so that you can take action to protect credit history Building and Maintaining Your Credit Rating -credit experience is major consideration for creditor when applying for credit card, car loan, mortgage, or personal loan -credit experience may affect ability to get a job or buy life insurance -good credit rating is valuable asset that should be nurtured and protected What’s in your credit files: -employer and position -former address -former employer -spouses name, social insurance number, employer -public records and information -cheques returned for insufficient funds Credit Bureau Regulation In Canada Credit bureaus- companies that collect information on personal credit data and sell that information to lenders who are members of credit bureau (collect information from lenders and businesses) -if you rent apartment, your payment history may be transferred to credit bureau -reporting agency that assembles credit and other information about consumers -two main credit bureaus in Canada-Equifax and TransUnion Canada -obtain data from banks, finance companies, merchants, credit card companies, court records and other creditors Credit reporting legislation-Fair Credit Reporting Act–applicable in British Columbia, Ontario, Nova Scotia and PEI -stipulates nature of information that can be used in credit report (distinction made from information and personal data)
-principle concerns of these regulations are the protection of consumer privacy with respect to credit information and the consumers right not to suffer from false credit and personal information FICO and Vantagescore FICO- type of credit score that makes up substantial portion of credit report that lenders use to assess an applicant’s credit risk and whether to extend a loan -calculated based on information contained in your Equifax credit history (score generally between 300-900 and rates how risky borrower is)
-higher the score, less risk you pose to creditors -largest percentage of FICO score (35%) based on payment history (whether payments made on time) -next largest factor (30%) is total amounts owed on outstanding credit (amounts owed on all credit as well as amount of available credit)
-amount of time that credit has maintained makes up 15% of credit score VantageScores- credit rating product offered by two major credit bureaus (Equifac and TransUnion) -uses information contained in credit reports from each of three credit rating companies and calculates it into a three digit score -score ratings range from 501-990 with the higher score representing lowest risk to creditor -calculated primarily on past 24 months activity on credit reports from each other the three credit bureaus -doesn’t take authorized user accounts into consideration when calculating score -payment history (32%) -credit use (23%) -credit balances (15%) -depth of credit (13%) -recent credit (10%) -available (7%)
-assigns consumer credit score a letter grade -901-990 – A --- Super Prime (11% of consumers) -801-900 – B, Prime Plus (29% of consumers) -701-800 – C, Prime (21% of consumers) -601-700 – D, Non-Prime (20% of consumers) -501-600 – F, High Risk (19% of consumers) Credit Rating R0 R1 R2 R3
What It Means Too new to rate, approved but not used Pays (or paid) within 30 days of payment due date or not over one payment past due Pays (or paid) in more than 30 days from payment due date, but not more than 60 days from payment Pays (or paid) in more than 60 days from payment due date, but not more than 90 days or not more than three payments passed due R4 Pays (or paid) in more than 90 days from payment due date but not more than 120 days or four payments past due R5 Account is at least 120 days overdue, but is not rated ‘9’ R7 Making regular payments through a special arrangement to settle your debts R8 Repossession (voluntary or involuntary return of merchandise) R9 Bad debt, placed for collection; moved without giving new address R= revolving credit (includes line of credit, overdraft, credit cards, charge cards, etc.
How To Improve Credit Score -credit score is snapshot of contents of your credit report at the time it is calculated -long term, responsible credit behavior is most effective way to improve future scores -pay bills on time -pay at least minimum payment by due date -don’t go over the credit limit on your credit card -use credit wisely to improve score over time Age -creditor may not, if you are of age to sign binding contract: -turn you down or decrease credit because of age -ignore retirement income in rating application -close your credit account or require you to reapply for it because you reached certain age or retired -deny you credit or close account because credit life insurance or other credit-related insurance is not available to people your age -may not be denied credit because you receive Old Age Security of public assistance
-many shoppers believe it is easier to return purchases bought on account -credit cards provide convenience and efficiency of paying for several purchases with one monthly payment -safer to use credit since caring large amounts of cash can be dangerous -credit cards are used for identification when cashing cheques and using credit provide you with record of expenses -using credit cards can provide a ’30-day float’—the lag time between when you make the purchase and when the lender deducts the balance from your chequing account when the payment is due -some large companies (Canadian Tire, General Motors Corporation) issue co-branded (affinity/value added) cards or their own Visa or Master Card and offer rebates on purchases -gain good credit rating if you repay your debts in timely manner Disadvantages of Credit -temptation to overspend, especially during periods of inflation (continual overspending can lead to serious trouble) -failure to repay loan may result in loss of income, valuable property, and your good reputation, and can lead to court action and bankruptcy, damage to family relationships and a slowing of progress toward financial goals -credit costs money (due to monthly charges and compounding effect of interest on interest) Types of Credit -two types of consumer credit exist: 1. Consumer loan (instalment loan)- one time loan that borrower repays in specified period of time with predetermined payment schedule -used for specific purpose and involves specified amount -home mortgages, automobile loans, other consumer instalment loans, demand loan -written agreement or contract lists the repayment terms of consumer loans for each credit purchase, number of payments, payment amount and whether the loan rate is floating or fixed 2. Revolving credit- line of credit in which loans are made on continuous basis and borrower is billed periodically for at least partial payment -lines of credit – pre-arranged loan with bank for maximum specified amout -if line of credit is secured (pledged assets against it), you will get lower interest (usually prime) -if line of credit is unsecured, the interest rate (usually prime plus percentage) -usually used for larger purchases and have lower interest rates than credit cards Home equity line of credit-personal line of credit based on current market value of home less amount still owed on the mortgage
-credit cards issued by banks (Visa) or stores (Canadian Tire), charge cards or Travel and Entertainment cards (Dinners Club)
Credit limit- dollar amount, which may or may not be borrowed, that a lender makes available to a borrower Credit Cards -credit cards are most popular type of credit in Canada -students are encouraged to obtain one so they can build credit rating and to make online purchases easy -have a limit (some cards will let you go over limit but will charge fee for doing so) Grace period- period of time between the statement date and the due date -usually you will not be charged interest if you pay the balance in full by the due date -statement gives minimum payment which is the amount you need to pay to prevent account from being in arrears -if balance is not paid in full, interest will be charged for each purchase starting on the date the purchase was made -cash advances made on credit cards always have interest charged starting on the date the advance is made -interest on credit cards is high (low interest rate cards usually have annual fee) Benefits of Credit Cards -short-term, no-interest loan when making a purchase if you pay the balance each month -several reward credit cards that let you earn different types of rewards, rebates or points -Federal law states that you are only responsible for the first $50 of unauthorized charges on your credit card -availability of a credit card in case of emergency Costs Associated With Credit Cards -the major fees charged to customers are for: -late or overdue payments -charges for exceeding credit limit on the card (whether done deliberately or by mistake) –called over limit fees -returned cheque fees or payment fees (phone payment fee) -cash advances and convenience cheques (often 3% of the amount) -transactions in a foreign currency (as much as 3% of the amount) -membership fees (annual or monthly), sometimes a percentage of credit limit When a Credit Card Is Stolen -call toll-free number on your credit card statement and call credit card issuer to tell them your card was stolen -have stolen card cancelled immediately -ask for new account number and new card to be sent to you (can take a couple weeks to get new card) -carefully check future credit card statements for purchases you did not make -if you find any purchases that are not yours, call toll free number again and inform them Signs of Financial Trouble -making only minimum payments -missing credit payments -moving debt around instead of paying it down -depending on overtime to over monthly bills -using cash advances from credit cards -being unaware of total debt
-withdrawing funds from savings/retirement to cover bills -borrowing money from family and friends -maxing out credit cards -applying for almost any offer without reading the terms
Advantages of Credit Character- borrowers attitude toward credit obligations Capacity- borrowers financial ability to meet obligations Capital- borrowers assets or net worth Collateral- valuable asset that is pledged to ensure loan payments Conditions- general economic conditions that can affect borrower’s ability to repay General Rules of Credit Capacity Debt-Payments-To-Income Ratio- calculated by dividing monthly debt payments (not including house payment, which is long term liability) by your net monthly income -experts suggest you spend no more than 20% of your net (after tax) income on consumer credit payments -the lower the ratio the better -to determine whether a lender can afford a mortgage loan, many use:
1. Gross debt service (GDS)- monthly mortgage payment, including principal, interest, heating, and taxes, as percentage of gross monthly income (lender wont let you spend more than 30-32% of gross income on shelter costs) 2. Total Debt Service (-TDS- monthly mortgage payment, including payments on any outstanding debt as percentage of your gross monthly income (lender will let you spend on shelter and non-shelter financial obligations combines should not exceed 40% of gross monthly income)
Consumer Loans Mortgage Loans- probably biggest single debt most individual Canadians will incur Car Loans-second largest investment you probably will make after buying house -Canadian Red Book or Canadian Black Book gives wholesale, retail prices, major options, etc.information Ways to Finance Car Purchase -generally cheaper to buy car with loan than to lease one ●Financing at a Bank- most financial institutions offer instalment loans to purchase an automobile -may require minimum down payment or variable interest rate, for terms ranging from one to five years -payment frequency can be arranged to suit the borrows needs -loan has open prepayment clause (unlike home mortgage) so borrower suffers no penalty for early repayment -lender may offer additional terms (ability to skip regular payment without penalty) ●Financing at the Dealership -factory financing-enables you to get a loan directly from the car manufacturer and you can expect to pay significantly lower interest rates and no down payment on the models they are trying to move ●Leasing – lower monthly payments associated with car leasing has increased its popularity during last decade -you are responsible for insuring the vehicle and maintaining it (may be responsible for paying any ‘unreasonable wear and tear’)
-if you go over maximum number of kilometers you will be charged fee based on extra kilometers -at end of lease, you have option to purchase vehicle -if purchase price is below current market price, likely beneficial to purchase it (even if you resell it) Closed-end lease-leasing company is responsible for residual value of the vehicle at lease-end (can buy vehicle for that price and any other charges or fees stipulated in the contract or return it to leasing company)
-often look better because monthly payments are lower Open-end lease- you are responsible for residual value of vehicle and must pay that amount and any other charges or fees stipulated in the lease at least-end Lease Payments -lease terms usually are from 2 to 5 years -difficult and costly to terminate lease agreement (pay attention to terms of termination) -termination applies to stolen or totaled vehicles (gap insurance will pay lease fees for vehicles stolen or totaled) -based on five factors: 1. cost of the car 2. estimated value of the car at the end of the lease (residual factor) 3. lease or interest rate 4. length of the lease 5. down payment When negotiating lease -ensure price of car and financing rate is identical under the lease and purchase option and any discounts, trade-ins and credits are identical -lease cars that maintain value so residual value used in lease calculation is high (result in lower monthly lease payment) -assess any mileage restrictions and additional front-end charges under a lease -new cars offer three-to-five year warranty (keep lease term within this time frame) Cosigning a Loan -co-signing means your guarantee a debt (if borrower doesn’t/can’t pay, you will have to) -creditor can use same collection methods against you that can be used against borrower (suing you, garnishing wages) -if you do co-sign: -be sure you can afford to pay loan (if you cannot you can be sued and credit rating can be damaged)
-consider that even if you are not asked to repay debt, liability for this loan may keep you from getting other credit you want -before you pledge property (car, furniture) to secure loan, make sure you understand the consequences -check provincial law (some provinces have laws giving you additional rights as cosigner) -request hard copy of overdue-payment notices so that you can take action to protect credit history Building and Maintaining Your Credit Rating -credit experience is major consideration for creditor when applying for credit card, car loan, mortgage, or personal loan -credit experience may affect ability to get a job or buy life insurance -good credit rating is valuable asset that should be nurtured and protected What’s in your credit files: -employer and position -former address -former employer -spouses name, social insurance number, employer -public records and information -cheques returned for insufficient funds Credit Bureau Regulation In Canada Credit bureaus- companies that collect information on personal credit data and sell that information to lenders who are members of credit bureau (collect information from lenders and businesses) -if you rent apartment, your payment history may be transferred to credit bureau -reporting agency that assembles credit and other information about consumers -two main credit bureaus in Canada-Equifax and TransUnion Canada -obtain data from banks, finance companies, merchants, credit card companies, court records and other creditors Credit reporting legislation-Fair Credit Reporting Act–applicable in British Columbia, Ontario, Nova Scotia and PEI -stipulates nature of information that can be used in credit report (distinction made from information and personal data)
-principle concerns of these regulations are the protection of consumer privacy with respect to credit information and the consumers right not to suffer from false credit and personal information FICO and Vantagescore FICO- type of credit score that makes up substantial portion of credit report that lenders use to assess an applicant’s credit risk and whether to extend a loan -calculated based on information contained in your Equifax credit history (score generally between 300-900 and rates how risky borrower is)
-higher the score, less risk you pose to creditors -largest percentage of FICO score (35%) based on payment history (whether payments made on time) -next largest factor (30%) is total amounts owed on outstanding credit (amounts owed on all credit as well as amount of available credit)
-amount of time that credit has maintained makes up 15% of credit score VantageScores- credit rating product offered by two major credit bureaus (Equifac and TransUnion) -uses information contained in credit reports from each of three credit rating companies and calculates it into a three digit score -score ratings range from 501-990 with the higher score representing lowest risk to creditor -calculated primarily on past 24 months activity on credit reports from each other the three credit bureaus -doesn’t take authorized user accounts into consideration when calculating score -payment history (32%) -credit use (23%) -credit balances (15%) -depth of credit (13%) -recent credit (10%) -available (7%)
-assigns consumer credit score a letter grade -901-990 – A --- Super Prime (11% of consumers) -801-900 – B, Prime Plus (29% of consumers) -701-800 – C, Prime (21% of consumers) -601-700 – D, Non-Prime (20% of consumers) -501-600 – F, High Risk (19% of consumers) Credit Rating R0 R1 R2 R3
What It Means Too new to rate, approved but not used Pays (or paid) within 30 days of payment due date or not over one payment past due Pays (or paid) in more than 30 days from payment due date, but not more than 60 days from payment Pays (or paid) in more than 60 days from payment due date, but not more than 90 days or not more than three payments passed due R4 Pays (or paid) in more than 90 days from payment due date but not more than 120 days or four payments past due R5 Account is at least 120 days overdue, but is not rated ‘9’ R7 Making regular payments through a special arrangement to settle your debts R8 Repossession (voluntary or involuntary return of merchandise) R9 Bad debt, placed for collection; moved without giving new address R= revolving credit (includes line of credit, overdraft, credit cards, charge cards, etc.
How To Improve Credit Score -credit score is snapshot of contents of your credit report at the time it is calculated -long term, responsible credit behavior is most effective way to improve future scores -pay bills on time -pay at least minimum payment by due date -don’t go over the credit limit on your credit card -use credit wisely to improve score over time Age -creditor may not, if you are of age to sign binding contract: -turn you down or decrease credit because of age -ignore retirement income in rating application -close your credit account or require you to reapply for it because you reached certain age or retired -deny you credit or close account because credit life insurance or other credit-related insurance is not available to people your age -may not be denied credit because you receive Old Age Security of public assistance
