Managing Your Credit C H A P T E R 7 regularly, he did not buy a house. When it came time to buy his third car, he wanted to finance part of the cost. After applying for credit, Rick was treated to a rude awakening. The finance company used a three-tier credit rating system. An A-level credit rating was the best and received an 11 percent rate. The B- level buyer received a 13 percent rate. Rick only qualified for the C-level, at a 15 percent rate. Rick was stunned. How could he have such a low rating when he had never had to borrow before? Everything he had ever bought was paid for with cash. He had never been late paying any bills. For 15 years, Rick avoided using credit. He paid cash for everything, including two cars. Since he was in the armed forces and moved As it turns out, having no credit history looks as bad to a credit rating agency as having a bad credit history. You might think that not having to borrow for 15 years would demonstrate fiscal responsibility. Not so to a credit rating bureau. 185
186 M A N A G I N G Y O U R C R E D I T This chapter focuses on obtaining and effectively using credit. You ll see that a good credit history is built by the proper use and control of credit, not by the absence of credit. While the proper use of credit can prepare you to take on larger credit debt, the improper use of credit can harm your financial situation. Taking on too much debt, not paying the minimum required payments, or routinely being late with debt payments lowers your credit rating. A poor credit rating leads to denial of future credit or perhaps an increased rate of interest on new debt. This chapter covers the basics of credit use and provides tips on using credit cards. The objectives of this chapter are to: provide a background on credit, explain the key characteristics of credit cards, and offer tips on using credit cards. credit Funds provided by a creditor to a borrower that will be repaid by the borrower in the future with interest. BACKGROUND ON CREDIT Credit represents funds a creditor provides to a borrower that the borrower will repay in the future with interest. The funds borrowed are sometimes referred to as the principal, so we segment repayment of credit into interest and principal payments. Credit is frequently extended to borrowers as a loan with set terms such as the amount of credit provided and the maturity date when the credit will be repaid. For most types of loans, interest payments are made periodically (such as every quarter or year), and the principal payment is made at the maturity date, when the loan is to be terminated. This chapter focuses on the use of credit (which is often extended through credit cards), while other types of loans for large purchases such as a car or home are discussed in the next two chapters. ADVANTAGES OF USING CREDIT Individuals borrow funds when the dollar amount of their purchases exceeds the amount of their available cash. Many individuals use borrowed funds to purchase a home or car or to pay their tuition fees, while others use credit (such as a credit card) for convenience when making day-to-day purchases. DISADVANTAGES OF USING CREDIT There can be a high cost to using credit. If you borrow too much money, you may have difficulty making your credit card payments. It is easier to obtain credit than to pay it back. And having a credit line can tempt you to make impulse purchases that you cannot afford. College students are carrying credit cards in record numbers. Eighty-three percent of all students have at least one credit card, and the average credit card balance is $2,327. Many students make
BACKGROUND ON CREDIT 187 minimum payments on their credit cards while in school with the expectation that they will be able to pay off their balance once they graduate and are working full-time. Yet the accumulating interest fees catch many by surprise, and the debt can quickly become difficult to manage. Today s graduating students have an average of $20,402 in combined education loan and credit card balances. If you are unable to repay the credit you receive, you may not be able to obtain credit again or will have to pay a very high interest rate to obtain it. Your ability to save money will also be reduced if you have large credit payments, as illustrated in Exhibit 7.1. If your spending and credit card payments exceed your net cash flows, you will need to withdraw savings to cover the deficiency. Warren Buffett, a successful billionaire investor, recently offered financial advice to some students. He told them that they will not make financial progress if they are borrowing money at 18 percent (a typical interest rate on credit cards). In recent years, more than 1 million people in the United States have filed for bankruptcy each year. A primary reason for these bankruptcies is that the individuals obtained more credit than they could repay. Even if obtaining credit at a high interest rate does not cause personal bankruptcy, it limits the potential increase in personal wealth. ESTABLISH A CREDIT HISTORY You receive credit when you use utilities such as water, electric power, and telephone services. The utility company extends credit by providing a service, and you are billed at the end of a period (such as one month). In this way, utility companies provide a form of short-term credit. To obtain this credit, you normally must make an initial deposit at the time the account is created. When you have accounts with utility companies, you develop a credit history that documents how timely you are in paying your bills. You can establish a favorable Exhibit 7.1 Impact of Credit Payments on Saving USE OF CREDIT NO USE OF CREDIT Net Cash Flows Saving Payments on Credit Saving Net Cash Flows Spending Spending
188 M A N A G I N G Y O U R C R E D I T 7.1 Financial Planning Online: Personal Credit Counseling Go to: http://www.phil.frb.org/ consumers/establish.html This Web site provides: information on how to establish, use, and protect credit. credit history by paying your utility bills on or before the due date. Doing so indicates to potential creditors that you may also repay other credit in a timely manner. simple interest rate The percentage of credit that must be paid as interest on an annual basis. IMPACT OF THE INTEREST RATE ON CREDIT PAYMENTS When you borrow funds, you are charged an interest rate. The simple interest rate is the percentage of the credit that you must pay as interest on an annual basis. EXAMPLE If you borrow $10,000 and are charged a simple interest rate of 12 percent, the amount of interest you pay each year is: Amount of Interest Amount Borrowed Simple Interest Rate $10,000.12 $1,200. Exhibit 7.2 shows the amount of interest you would pay per year on a $10,000 loan at various simple interest rates, as well as the total amount of interest that would be paid over a four-year period. Notice how much larger the interest payments are when you pay a higher interest rate. When obtaining credit, it is important to seek out the lowest interest rate possible.
CREDIT CARDS 189 Exhibit 7.2 How Interest Payments Are Influenced by Interest Rates Simple Interest Total Simple Interest Simple Interest Rate Payment per Year Payments over Four Years 6% $600 $2,400 8 800 3,200 10 1,000 4,000 12 1,200 4,800 14 1,400 5,600 16 1,600 6,400 18 1,800 7,200 20 2,000 8,000 Interest Payments ($) 10,000 9,000 Total Interest Payments over Four Years Annual Interest Payment 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 6% 8% 10% 12% 14% 16% 18% 20% Simple Interest Rate (%) annual percentage rate (APR) The simple interest rate including any fees charged by the creditor. The annual percentage rate (APR) on credit is the simple interest rate after including any fees (such as an application processing fee) imposed by the creditor. The APR is useful because it allows you to easily compare financing costs among various possible creditors. CREDIT CARDS The easiest way to establish credit is to apply for a credit card. There is no shortage of credit card companies eager to extend you credit. A credit card allows you to purchase products on credit wherever that card is honored. You
190 M A N A G I N G Y O U R C R E D I T receive a monthly statement that identifies the purchases you made with the credit card during that period. Normally, credit cards are not used for very large expenditures such as cars or homes, but they are very convenient for smaller purchases, such as meals at restaurants, gasoline, clothing, car repairs, and even groceries. Credit cards offer three advantages. First, you can purchase products and services without carrying a large amount of cash or a checkbook. Second, as long as you pay off your balance each month, you receive free financing until the due date on your credit card statement. Third, you receive a monthly statement that contains a consolidated list of the purchases you made with the credit card, which enables you to keep track of your spending. In some cases, you receive an annual statement as well, detailing expenses by category, which can be useful in preparing your income tax return. APPLYING FOR A CREDIT CARD When you apply for a credit card, potential creditors obtain information from you, from credit bureaus, and about the economy so that they can assess your ability to repay credit. Personal Information. When you apply for credit, you are asked to complete an application that typically requests the following information: Cash inflows: What is your monthly income? Cash outflows: How much do you spend per month? Credit history: Have you borrowed funds in the past? Did you repay any previous loans in a timely manner? Capital: Do you have any funds in the form of savings or stocks that can be used if necessary to cover future debt payments? Collateral: Do you have any assets that can be used as collateral to secure the borrowed funds? (If you could not repay your debt, you could sell these assets to obtain the funds needed to repay the loans.) Creditors generally prefer that you have a high level of cash inflows, a low level of cash outflows, a large amount of capital and collateral, and a good credit history. Nevertheless, they commonly extend credit to individuals who do not have all of these attributes. For example, although creditors recognize that college students may not earn much income, they may still provide a limited amount of credit if they believe that the students are likely to repay it. Some creditors also extend credit at higher interest rates to individuals who have a higher risk of defaulting. Credit Check. When you apply for credit, a credit card issuer typically conducts a credit check as part of the application review process. It can obtain a
CREDIT CARDS 191 credit report A statement of creditworthiness based on information such as whether you have made late payments, and any unpaid current bills. credit report that indicates your creditworthiness, based on information such as whether you have made late payments, and any unpaid current bills. A credit report also contains general information such as your social security number, address, birth date, employer, and marital status. Most importantly, it contains your credit history, which summarizes credit repayment with banks, retailers, credit card issuers, and other lenders. Credit problems remain on a credit bureau s report for seven years. If you claim bankruptcy, this information normally remains on a credit bureau s report for ten years. Credit Bureaus. A credit report is prepared by a credit bureau, which collects financial information about individuals. The three primary credit bureaus are Equifax, Experian, and Trans Union. Credit bureaus receive their information from utility companies, retail firms, and other credit card issuers. All bureaus consider the same type of information to determine your credit rating. In particular, they evaluate whether you make late payments on credit. They also consider your level of outstanding debt, and the number of years you have been using credit. Credit Scoring. Each credit bureau uses its own system for credit scoring, so the weighting of each characteristic may vary among bureaus. One bureau may assign more weight to your repayment of credit in the last few years, while another bureau may assign a higher weight to the number of years you have been using credit. The bureaus use the same rating scale, which ranges from 375 to 900. One bureau may rate you as a 700, while another may rate you as a 720. The credit rating is critical in determining whether you are approved for credit and the terms of your credit, including the credit limit and interest rate. Interpreting Credit Ratings. Very high credit ratings (such as over 700) will normally allow you to have easy approval for credit. Ratings in the 600 to 700 range may cause some creditors to reject your application. Other creditors may 2003 Peter Steiner from cartoonbank.com. All Rights Reserved.
192 M A N A G I N G Y O U R C R E D I T 7.2 Financial Planning Online: Your Credit Card Report Go to: http://loan.yahoo.com/c/ index.html This Web site provides: a credit report that assesses your creditworthiness. The report is available to you online for a small fee. be willing to extend credit in this range but may charge a higher interest rate. Individuals with ratings in the 500 to 600 range will have difficulty obtaining credit. FOCUS ON ETHICS: GUARDING YOUR FINANCIAL INFORMATION Are you surprised that credit bureaus have so much of your personal financial information on hand? Financial institutions and credit bureaus use your personal financial information to offer you additional services and introduce you to new products. This means that your financial information ends up in the hands of marketers who make unsolicited offers and extend promotions. The Fair Reporting Act limits the sharing of credit information to firms that certify that they have a purpose permitted by law to evaluate this information. For example, if the firms are evaluating your application for credit, insurance, or employment, they are eligible to request credit information from credit bureaus. While the sharing of financial information may ease your application process, it also allows firms to access more information than you would like to disclose. Financial institutions must provide customers privacy policies that detail what information they collect and intend to share. For example, a bank that receives a credit card application from you may intend to pass this financial information to an affiliate that can market their financial services to you. Don't overlook these notices, which are often tucked in with your monthly statement or bill. The privacy notices also give you the opportunity to limit some of that sharing by opting out, which typically involves calling a phone number that is provided or filling out a form.
CREDIT CARDS 193 Evaluating Your Credit Report. Check to make sure that a credit bureau has accurate information about you by requesting an online report from a credit bureau, such as Equifax Credit Information Services (www.equifax.com) or Experian (www.experian.com). If you find any errors in your credit history, you can contact the bureaus to request that the errors be corrected. The credit bureau will not charge you for the correction. Other Information Creditors Evaluate. Some creditors also request that the applicant disclose income and existing debt level so that they can assess the existing debt level as a percentage of income. If an applicant s debt level is only a small fraction of his or her income, creditors are more willing to provide credit. In addition to information about the applicant, creditors also consider existing economic conditions when they evaluate credit applications. If economic conditions weaken, and you lose your job, you may be unable to repay your loan. Thus, creditors are less willing to extend credit when the economy is weak. The Credit Decision. When applying for credit, you should receive an answer within 30 days. If you are rejected, the creditor must provide an explanation. If the rejection is due to a specific credit report, the creditor must identify that report. You can access the credit report to ensure that the report s credit history is correct. While income and credit history can be used by creditors when deciding whether to grant credit, characteristics such as race and gender cannot be used. Laws protect individuals from being discriminated against because of race or gender. In addition, criminal records, political preferences, and religion cannot be used. retail (or proprietary) credit card A credit card that is honored only by a specific retail establishment. TYPES OF CREDIT CARDS The most popular credit cards are MasterCard, Visa, and American Express. MasterCard and Visa allow your payments to be financed, but American Express requires that the balance be paid in full each month. These three types of cards are especially convenient because they are accepted by so many merchants. The merchants honor credit cards because they recognize that many consumers will make purchases only if they can use their credit cards. A credit card company receives a percentage (commonly between 2 and 4 percent) of the payments made to merchants with its credit card. For example, when you use your MasterCard to pay for a $100 car repair at a Shell Oil station, Shell will pay MasterCard a percentage, perhaps $3. Many financial institutions issue MasterCard and Visa credit cards to individuals. Each financial institution makes its own arrangements with credit card companies to do the billing and financing when necessary. The institution provides financing for individuals who choose not to pay their balance in full when they receive a billing statement. The financial institutions benefit by providing financing because they typically earn a high rate of interest on the credit extended. Some universities and charitable organizations also issue MasterCard and Visa credit cards and also provide financing if needed. Retail Credit Cards. An alternative to MasterCard, Visa, and American Express credit cards is a retail (or proprietary) credit card that is issued for use at a spe-
194 M A N A G I N G Y O U R C R E D I T cific retail establishment. For example, many retail stores (such as J.C. Penney and Macy s) and gas stations (such as Shell Oil and Exxon Mobil) issue their own credit card. If you use a Shell Oil credit card to pay for gas at a Shell station, Shell does not have to pay a small percentage of the proceeds to Master- Card or any other credit card company. You can usually obtain an application for a proprietary card when you are paying for products or services. You may be given instant credit when you complete the application. With most retail credit cards, you can pay a small portion of the balance owed each month, which means that the merchant finances your purchase. The interest rate you are charged when financing with retail credit cards is normally 18 percent or higher. One disadvantage of a proprietary credit card is that it limits your purchases to a single merchant. You may find that the limit is an advantage if you are trying to restrict your use of credit so that you do not spend beyond your means. For example, you could use a Shell credit card to pay for gasoline and car repairs, but not to buy CDs, clothing, and many other products. Another disadvantage is that using many proprietary cards means you will have several credit card bills to pay each month; using one card for all purchases allows you to write only one check to cover all the credit card payments. CREDIT LIMIT Credit card companies set a credit limit, which specifies the maximum amount of credit allowed. The credit limit varies among individuals. It may be a relatively small amount (such as $300) for individuals who have a low income. The credit limit can usually be increased for individuals who prove that they are 7.3 Financial Planning Online: Planning to Eliminate Debt Go to: http://cgi.money.cnn.com/ tools/debtplanner/ debtplanner.jsp This Web site provides: estimates of your future credit card payments based on your credit card balance, the interest rate you are charged, and the desired time in which you want it paid.
CREDIT CARDS 195 creditworthy by paying their credit card bills on time. Some credit card companies may allow a large limit (such as $10,000 or more) to households that have made their credit payments on a consistent basis and have higher incomes. ANNUAL FEE Many credit card companies charge an annual fee, such as $50 or $70, for the privilege of using their card. The fee is sometimes waived for individuals who use their credit cards frequently and pay their credit card bills in a timely manner. INCENTIVES TO USE THE CARD Some credit card companies offer a bonus to cardholders. For example, they may award a point toward a free trip on an airline for every dollar spent. After accumulating 20,000 points, you receive a coupon for a free flight anywhere in the United States. If you spend $20,000 over the year on purchases and use this particular credit card for all of them, you will accumulate enough points by the end of the year to earn a free round-trip on a designated airline to any destination in the United States. Some airlines issue their own credit cards, which provide similar benefits. prestige cards Credit cards, such as gold cards or platinum cards, issued by a financial institution to individuals who have an exceptional credit standing. PRESTIGE CARDS Financial institutions may issue prestige cards to individuals who have an exceptional credit standing. These cards, sometimes referred to as gold cards or platinum cards, provide extra benefits to cardholders. For example, the card may provide insurance on rental cars and special warranties on purchases. Many cardholders receive an upgrade to a gold card or platinum card after they prove that they are creditworthy by making their payments on time. GRACE PERIOD Credit cards typically allow a grace period in which you are not charged any interest on your purchases. The grace period is usually about 20 days from the time the credit card statement is closed (any purchases after that date are put on the next month s bill) and the time the bill is due. The credit card issuer essentially provides you with free credit from the time you made the purchase until the bill is due. EXAMPLE On June 1, Stephanie Spratt paid a car repair bill of $200 with her credit card. The closing date for that month s billing statement is June 30, and the bill is due around July 20. In this case, Stephanie receives about 50 days of free credit. On June 20, she purchased some clothing with her credit card. For that purchase, which is also on the billing statement, she receives about 30 days of free credit. On July 10, she purchased concert tickets with her credit card. This purchase occurs after the closing date of the billing statement and therefore will be listed on the next billing statement, which is due on about August 20. For this purchase, credit is extended for about 40 days.
196 M A N A G I N G Y O U R C R E D I T CASH ADVANCES Many credit cards also allow cash advances at automated teller machines (ATMs). Since a cash advance represents credit extended by the sponsoring financial institution, interest is charged on this transaction. A transaction fee of 1 or 2 percent of the advance may also be charged. Credit card companies also provide checks that you can use to make purchases that cannot be made by credit card. The interest rate applied to cash advances is often higher than the interest rate charged on credit extended for specific credit card purchases. The interest rate is applied at the time of the cash advance; the grace period that applies to purchases with a credit card does not apply to cash advances. So, although cash advances are convenient, they can also be extremely costly. finance charge The interest that you must pay as a result of using credit INTEREST RATE Some individuals use credit cards as a means of financing their purchases. That is, they pay only a portion of the credit card bill at the end of the month, and the sponsoring financial institution extends credit for the remainder and charges an interest rate. The interest rate charged on credit is commonly between 15 and 20 percent on an annualized basis and does not vary much over time. Although financing is convenient for individuals who are short of funds, it is expensive and should be avoided if possible. Many credit cards advertise a very low teaser interest rate, which is normally applicable for the first three or six months. Some people transfer their balances from one credit card to another as soon as the period of low interest rates has ended. Keep in mind that the issuer of the first credit card may charge a fee when transferring the balance to a new credit card with the low teaser rate. The finance charge represents the interest that you must pay as a result of using credit. It is usually determined using either the previous balance method, the average daily balance method, or the adjusted balance method, which are described in the appendix to this chapter. For all methods, purchases after the statement closing date are not normally considered when determining the finance charge because of the grace period. These purchases will appear on your next monthly statement. The finance charge applies only to balances that were not paid in full before their due date in the current billing period. However, some credit card companies add any new purchases when determining the average daily balance if there is an outstanding balance in the previous period. CREDIT CARD STATEMENT Individuals typically receive a credit card bill at the end of their billing cycle. This bill lists all the purchases that were made with that credit card during that period, as well as any balance carried over from the previous statement. A credit card statement includes the following information: Previous balance: The amount carried over from the previous credit card statement. Purchases: The amount of credit used this month to make purchases.
CREDIT CARDS 197 Cash advances: The amount of credit used this month by writing checks against the credit card account or making ATM withdrawals. Payments: The payments that you made to the sponsoring financial institution this billing cycle. Finance charge: The finance charge that is applied to any credit that exceeds the grace period or to any cash advances. New balance: The amount that you owe the financial institution as of now. Minimum payment: The minimum amount that you must pay. The credit card statement details why your new balance differs from the balance shown on your statement in the previous month. The difference between the previous balance and the new balance results from any new purchases, cash advances, or finance charges, which increase your balance, versus any payments, which reduce your balance. The statement also shows the method of calculating finance charges. EXAMPLE Suppose you have a credit card balance of $700 because of purchases you made last month that you did not pay off. During that billing period, you send in $200 to pay off part of your outstanding balance. You also use the credit card for $100 of new purchases. Since you relied on the sponsoring financial institution to pay $500 of last month s bill, you owe a finance charge. Assuming the institution imposes a finance charge of 1.5 percent per month and uses the adjusted balance method to determine the finance charge (which results in a finance charge of $7.50 as described in the chapter appendix), your credit card statement is as follows: Previous Balance $700.00 New Purchases 100.00 Cash Advances 0 Payments 200.00 Finance Charges 7.50 New Balance $607.50 If you had paid the full amount of the previous balance ($700) during the billing period, the statement would have been as follows: Previous Balance $700 New Purchases 100 Cash Advances 0 Payments 700 Finance Charges 0 New Balance $100
198 M A N A G I N G Y O U R C R E D I T 7.4 Financial Planning Online: Your Rights When Using Credit Go to: http://www.chicagofed.com /consumer_information/ personal_finance_ information.cfm Click on: credit guide. This Web site provides: information about various laws that protect your rights when using credit. Thus, if you had paid $700 instead of $200, you would not have borrowed from the sponsoring financial institution and would not have incurred a finance charge. The new balance at the end of this billing period would simply be the amount of purchases that occurred over this period. When you receive your account statement, you should always scrutinize it for errors. There may be a math error, a double charge for a purchase, or an incorrect amount on a purchase. Under consumer protection laws, you have the right to dispute possible errors. COMPARING CREDIT CARDS Some individuals have numerous credit cards, which can complicate record keeping and increase the probability of losing one or more credit cards. You can consolidate your bills by using just one credit card to cover your purchases. If you decide to use only one credit card, the following criteria will help you determine which card is most desirable. Acceptance by Merchants. You should make sure that your card is accepted by the types of merchants where you typically make your purchases. Master- Card and Visa are accepted by more merchants than other credit cards. Annual Fee. Shop around for a credit card that does not charge an annual fee.
TIPS ON USING CREDIT CARDS 199 7.5 Financial Planning Online: The Best Credit Card for You Go to: http://www.bankrate.com /brm/rate/cc_home.asp This Web site provides: links to help you get the best overall credit card rate, the lowest introductory rate, frequent flier credit cards, and other special features. Interest Rate. The interest rate varies among financial institutions that provide financing on credit cards. Shop around for the lowest rate. As mentioned earlier, some credit cards offer a low teaser rate to entice you to apply for that card. Be aware, however, that this rate is likely to be available only for a short time before the normal interest rate is charged. Maximum Limit. Some credit cards allow a higher maximum limit on monthly purchases than others. A very high maximum may not be necessary, and may tempt you to spend excessively. Make sure that the maximum limit is high enough to cover any necessary monthly purchases, but not so high that it encourages you to spend beyond what you can afford. TIPS ON USING CREDIT CARDS Since you are likely to have one or more credit cards, consider the following tips to enjoy their use without incurring excessive costs. USE A CREDIT CARD ONLY IF YOU CAN COVER THE BILL Treat a credit card as a means of convenience, not a source of funds. Use a credit card only if you will have the cash to cover the payment when you receive your credit card statement. The use of this self-imposed credit limit is illustrated in Exhibit 7.3. The difference between your expected cash inflows and your
200 M A N A G I N G Y O U R C R E D I T Exhibit 7.3 Self-Imposed Credit Limit Based on Monthly Cash Inflows Expected cash inflows this month Maximum credit to use this month Expected spending to be paid by cash or check expenses paid by check (such as rent) or by cash is the maximum amount of credit that you can use and still ensure full payment of the credit card balance. IMPOSE A TIGHT CREDIT LIMIT You may consider imposing a tighter credit limit as part of your budgeting process so that you can save or invest a specific amount every month. This limit is illustrated in Exhibit 7.4. You determine the maximum amount of credit you will use each month only after accounting for all spending to be paid by check or cash, as well as a specified amount of saving. 7.6 Financial Planning Online: Establishing and Protecting Credit Go to: http://www.chicagofed.com /consumer_information/ budgeting_and_saving.cfm Click on: conserve spend sensibly; pay wisely. This Web site provides: information about establishing, using, and protecting your credit.
TIPS ON USING CREDIT CARDS 201 Exhibit 7.4 Self-Imposed Credit Limit Based on Monthly Cash Inflows and a Monthly Savings Goal Expected cash inflows this month Maximum credit to use this month Monthly savings goal Expected spending to be paid by cash or check PAY CREDIT CARD BILLS BEFORE INVESTING MONEY When you finance credit card balances, your cost of financing will normally be much higher than the return you are receiving on any money market investments that you hold. You should always pay off any balance on credit cards before you invest funds anywhere else. EXAMPLE Stephanie Spratt just received a credit card bill for $700. The sponsoring financial institution charges a 20 percent annual interest rate on the outstanding balance. Stephanie has sufficient funds in her checking account to pay the credit card bill, but she is considering financing her payment. If she pays $100 toward the credit card bill and finances the remaining $600 for one year, she will incur interest expenses of: Interest Loan Amount Interest Rate $600.20 $120. She could use the $600 to invest in savings rather than pay off her credit card bill. After one year, the $600 in a savings account will accumulate to $618 based on a 3 percent annual interest rate, as shown here: Interest Earned on Deposit Initial Deposit Interest Rate $600.03 18. Her interest owed on the credit card loan ($120) exceeds the interest earned on the deposit ($18) in one year by $102. Stephanie decides that she would be better off using her cash to pay off the credit card bill immediately. By using her money to cover the credit card bill, she gives up the opportunity to earn 3 percent on that money, but she also avoids the 20 percent rate charged on the credit card loan. Thus,
202 M A N A G I N G Y O U R C R E D I T her wealth is $102 higher as a result of using funds to pay off the credit card bill rather than investing in a bank deposit. Although she could have used the funds to invest in a high-risk investment that might achieve a greater return, paying off the credit card guarantees that she can avoid a 20 percent financing rate. In general, avoid carrying a balance on your credit cards when you have the money to pay the balance. The likely return that you might earn from investing your money is usually less than the financing rate that you will be charged when you delay paying your credit card bills in full. Debit cards are a good alternative to credit cards because they offer the same convenience of not holding cash. Some individuals use their money to invest in risky investments (such as stocks) rather than pay off their credit card bills. They apparently believe that their return from the investments will be higher than the cost of financing. Although some investments have generated large returns in specific years, it is difficult to earn returns that consistently exceed the high costs of financing with credit cards. If the thrill of a good return on your investment makes you think about delaying your credit card payment, consider the following logic. When you use money to pay your credit card bill immediately, you are preventing a charge of about 20 percent interest. Therefore, you have effectively increased your savings by 20 percent by using these funds to pay off the credit card debt. 7.7 Financial Planning Online: Estimating the Time Necessary to Pay Off Your Balance Go to: http://www.free-financialadvice.net/time-to-pay-debt.html Click on: Budget, then What will it take to pay off my balance? This Web site provides: estimates of the time it wil take to pay off your credit cards utilizing different monthly payments.
TIPS ON USING CREDIT CARDS 203 USE SAVINGS IF NECESSARY TO PAY THE CREDIT CARD BILL ON TIME If your cash inflows are not sufficient to cover the credit card bill, you should pull funds from savings (if there is no penalty for withdrawal) to cover the payment. IF YOU CANNOT AVOID CREDIT CARD DEBT, PAY IT OFF BEFORE OTHER DEBT If you cannot pay off your credit card balance in full each month with income or with savings, at least pay off this balance as soon as possible and cut back your discretionary spending. If you have other debt outstanding, you should pay off credit card debt first (assuming that the credit card debt has a higher interest rate). Even if you cannot pay your bill in full, you should still attempt to pay as much as possible so that you can minimize finance charges. If possible, you may even consider taking out a home equity loan (discussed in the next chapter) to pay any credit card bills so that you can avoid the high interest expenses. This strategy makes sense only if your credit card debt is substantial (such as several thousand dollars), and the interest rate on the home equity loan is less than that on your credit card. AVOID CREDIT REPAIR SERVICES Companies that offer credit repair services claim to be able to solve your credit problems. For example, they may help you fix a mistake on your credit report. However, you could have done this yourself, without paying for the service. If you have made late credit payments or have defaulted on a loan, a credit repair service does not have the power to remove such credit information from your report. AVOID CREDIT CARD FRAUD There are several commonsense steps you can take to reduce your risk of credit card fraud. Always sign a new credit card as soon as you receive it. Save your receipts from credit card purchases and compare them to the charge amounts on each month s billing statement. Never give out your credit card number on a public phone and do not give out your account number over a private phone unless you re making the call to a reputable company. Be sure to destroy any preapproved credit offers you receive in the mail, so that a thief will not be able to pick the application from your trash and apply for the card in your name. What if your card is stolen and a thief runs up charges? Under federal law, consumers are not responsible for more than $50 if they are the victim of credit card fraud and report the theft promptly. Keep a record of your account number and the phone number for the credit card company so that you can contact the credit card company immediately in the event that your card is lost or stolen. DETER IDENTITY THEFT Thieves may steal not only your credit card, but also your identity. That is, they first obtain personal information that you may have disclosed on a job application, credit card application, or hotel registration. Using your name, address,
204 M A N A G I N G Y O U R C R E D I T 7.8 Financial Planning Online: Identity Theft Go to: http://www.consumer.gov/idtheft/ This Web site provides: information on how thieves can steal your identity and how you can prevent identity theft. and social security number, they open a credit card or bank account in your name. Any purchases that are charged to the account appear under your name. When they use a credit card and don t pay the bills, the delinquent account is reported on your credit report. Meanwhile, you are not even aware that this account exists. You can discourage such criminal activity by conducting periodic checks of your account statements and credit report and carefully guarding your social security number. Before you reveal any personal identifying information, find out how it will be used and whether it will be shared with others. Follow up with creditors if your bills don t arrive on time: a missing credit card bill could mean an identity thief has changed your billing address to cover his tracks. Put passwords on your credit card, bank, and phone accounts. Avoid using easily available information like your mother s maiden name, your birth date, and the last four digits of your social security number or your phone number. DEALING WITH CREDIT DEBT If you find yourself with an excessive credit balance, there are several steps you can take. First, spend as little as possible. Then, consider how you can obtain funds to meet your monthly payment or to pay off your balance. Get a job if you don t have one, or work more hours at your current job. However, for students, additional work could disrupt your school schedule. An alternative solution is to borrow funds from a family member. You will now have a monthly
HOW CREDIT MANAGEMENT FITS WITHIN YOUR FINANCIAL PLAN 205 personal bankruptcy a plan to the court in which you repay at least a portion of your debt and pay attorney and filing fees. loan payment to a family member rather than credit card balances, but the payments may be lower. Another possibility is a debt consolidation loan from a financial institution. The structured schedule for paying off the loan in a set time period will instill more discipline in you than meeting a low minimum monthly payment on a credit card. If you do not choose to get a loan, you should still discipline yourself to make more than the minimum payment on your credit card. You might even consider selling some assets to obtain cash, such as trading in a relatively new car for an old car. Also consider ways of reducing your everyday expenses. For example, if you have large monthly payments due to your cell phone, you could discontinue the use of a cell phone. If you have your own apartment, you may consider getting a roommate. If all else fails, you may need to file for personal bankruptcy. In this case, you propose a plan to the court for repaying at least a portion of your debt and pay attorney and court filing fees. Chapter 7 and Chapter 13 are the two types of personal bankruptcy. Chapter 7 allows the discharge of almost all debts, but you may also have to surrender assets to help satisfy the debt. Under Chapter 13, you keep your property but surrender control of your finances to the bankruptcy court. The court approves a three-to-five-year repayment plan based on your financial resources. You incur no interest charges on the indebtedness during the repayment period. Bankruptcy should only be considered if there is no other option. HOW CREDIT MANAGEMENT FITS WITHIN YOUR FINANCIAL PLAN The following are the key credit management decisions that should be included within your financial plan: 1. What limit should you impose on your credit card? 2. When should you use credit? By making proper decisions, you can avoid using credit and can maximize the return on your liquid assets. As an example, Exhibit 7.5 shows how credit decisions apply to Stephanie Spratt s financial plan. Exhibit 7.5 How Credit Management Fits within Stephanie Spratt s Financial Plan Goals for Managing Credit 1. Set my own limit on credit card purchases to ensure that I will always be able to pay off the credit balance in the same month. 2. Set a policy to avoid incurring high interest expenses on credit cards.
206 M A N A G I N G Y O U R C R E D I T Analysis Monthly Cash Inflows $2,500 Typical Monthly Expenses (paid by checks) 1,400 Amount of Funds Available 1,100 Liquid Assets Balance Annualized Interest Rate (%) Cash $100 0 Checking account balance 800 0 Money market fund 400 3.0 One-month CD 1,200 4.3 Credit card balance 600 20.0 Decisions Decision on Credit Limit: Given that I have $1,100 each month left from my salary after paying typical expenses (by check), I have $1,100 remaining that can be used for credit card purchases if necessary. I will impose a maximum limit of $1,100 on my credit card spending. As my income rises over time, I may consider increasing my credit limit, but only up to some level that I can afford to pay off immediately when I receive the bill. Decision on Paying Off Credit Balances: Given the interest rates that I can earn on deposit accounts versus the interest rate I would pay on a credit card balance, I will always pay off my credit card balance, even if I must withdraw funds from my savings account to do so. DISCUSSION QUESTIONS 1. How would Stephanie s credit management decisions be different if she were a single mother of two children? 2. How would Stephanie s credit management decisions be affected if she were 35 years old? If she were 50 years old? SUMMARY An advantage of using credit is that it enables you to obtain products and services that you cannot afford otherwise. A disadvantage of credit is that it is easier to obtain it than to pay it back. Some individuals use too much credit and are unable to make their credit payments, which may prevent them from obtaining credit in the future. When individuals apply for credit, they provide information about their cash inflows (income), cash outflows (spending habits), and collateral. Creditors also evaluate your credit report, which contains information on your credit history collected by a credit bureau. Credit cards are distinguished by whether the sponsor is Visa, MasterCard, American Express, a proprietary merchant (such as J.C. Penney), or some other
INTEGRATING THE KEY CONCEPTS 207 sponsor. They are also distinguished by the credit limit, the annual fee, the interest rate charged on credit not paid by the due date, and whether they provide cash advances. Credit cards should be used with discipline. You should impose your own credit limits rather than spend up to the limit granted by the card. You should attempt to avoid financing costs, either by using income to cover the amount due or by withdrawing money from savings if necessary. INTEGRATING THE KEY CONCEPTS Your credit decisions affect not only your liquidity level, but also other parts of your financial plan. If you have borrowed a large amount of funds through credit cards, you will be more restricted on additional financing (Part 3) because lenders are less willing to lend you funds if you already have substantial debt. Lenders may also be less willing to lend funds if you have a large amount of credit open in your name, even if you have not used the credit. Your credit decisions may affect your insurance planning (Part 4), because you might need more life insurance to cover your debt. Your credit decisions will also affect your investment decisions (Part 5) because you would probably be better off avoiding investments until you pay off any credit card balances. Alternatively, you may need to sell some of your investments to obtain sufficient cash to pay off any credit card balances. 6. Retirement and Estate Planning (Retirement Planning, Estate Planning) 1. Financial Planning Tools (Budgeting, Time Value, Tax Planning) Credit Decisions 2. Liquidity Management (Banking, Money Management, Credit Management) 5. Investing (Stocks, Bonds, Mutual Funds) 4. Protecting Your Assets and Income (Insurance) 3. Financing (Personal Loans, Mortgages)
A P P E N D I X 7A Finance Payment Methods This appendix explains the methods that financial institutions use to calculate finance charges on outstanding credit card balances. The following three methods are commonly used: Previous Balance Method. Under the previous balance method, interest is charged on the balance at the beginning of the new billing period. This method is the least favorable of the three to the cardholder because finance charges are applied even if part of the outstanding balance is paid off during the billing period. Average Daily Balance Method. The most frequently used method is the average daily balance method. For each day in the billing period, the credit card company takes your beginning balance at the start of the day and then subtracts any payments made by you on that day in order to determine the balance at the end of the day. Then, it determines the average daily balance at the end of the day for every day in the billing period. This method takes into account the time when you pay off any part of the outstanding balance. Thus, if you pay off part of the outstanding balance during the billing period, your finance charges will be lower under this method than under the previous balance method. Adjusted Balance Method. Under the adjusted balance method, interest is charged based on the balance at the end of the new billing period. This method is most favorable for you because it applies finance charges only to the outstanding balance that was not paid off during the billing period. The following example illustrates the three methods for determining finance charges. EXAMPLE Assume that as of June 10, you have an outstanding credit card balance of $700 from purchases made over the last month. The new billing period begins on June 11. Assume that your outstanding balance for the first 15 days of this new billing period (from June 11 to June 25) is $700. Then, on June 25, the financial institution receives a payment of $200 from you, reducing the balance to $500. This is the balance for the remaining 15 days of the billing period. 208
FINANCE PAYMENT METHODS 209 Previous Balance Method. Under this method, you will be subject to a finance charge that is calculated by applying the monthly interest rate to the $700 outstanding at the beginning of the new billing period. Using a monthly interest rate of 1.5 percent, your finance charge is: $700.015 $10.50. Average Daily Balance Method. Under this method, the monthly interest rate is applied to the average daily balance. Since your daily balance was $700 over the first 15 days and $500 over the last 15 days, your average daily balance was $600 over the 30-day billing period. Using a monthly interest rate of 1.5 percent, your finance charge is: $600.015 $9.00. Adjusted Balance Method. Under this method, you will be subject to a finance charge that is calculated by applying the monthly interest rate to the $500 outstanding at the end of the new billing period. Using a monthly interest rate of 1.5 percent, your finance charge is: $500.015 $7.50. Notice from this example that the finance charge is lower if the credit card company uses the adjusted balance method. Individuals who frequently have financing charges can save a substantial amount of money over time by relying on a credit card that uses this method. The best way to reduce financing charges, however, is still to pay the entire credit card bill before the due date every month.