Personal Finance Chapter 5 & 6

CHAPTER 5 & 6 – INTRO TO CREDIT, CHOOSING A CREDIT                Common Types of Credit Revolving Credit o Convenience and Flexibility o Upper borrowing limit established o Interest charged on outstanding balance each month o Ex: Credit Cards Line of Credit A standing charge account Consumer Loans o Usually arranged for a specific purpose o Available through banks, credit unions, trust companies o May or may not be secured o Fixed or variable interest rates o May have prepayment penalties o Ex: Car loan Boat loan Trailer or Motor Home loan Hot tub loan Furniture or appliance loan Credit Cards o Offer a grace period of 15 to 21 o Days after the statement date o If full balance not paid: Bank cards typically charge interest from date of purchase Retail cards tend to charge interest on remaining balance after partial payment is made. o Bank cards tend to charge straight interest; retail cards usually compound interest monthly o Ex: Visa and MasterCard Retail Store cards such as: Future shop, Home Depot, Leon’s   The Cost of Credit The Annual Percentage Rate (APR) is the percentage cost of credit on a yearly basis; it is the nominal or stated interest rate The Effective Annual Rate (EAR) provides the true rate of interest for comparison with other sources of credit. This rate lets you compare like with like when shopping for rates. It accounts for compounding  Effective Annual Percentage Rate Is calculated using the following formula   Where m equals number of times per year interest is compounded and APR is the stated or nominal interest rate E A R = (1 + APR/m)m - 1          Calculating Your Loan Payments Fixed Rate Installment Loan Pay off over a pre-determined period of time Payment represents blend of interest and principal Floating Rate Personal Line of Credit Variable interest rate tied to lender’s prime rate Compounded daily Payments not fixed At risk if interest rates rise Takes longer to repay if only paying minimum required       Cost of Carrying Credit Card Balances Adjusted balance method The assessment of finance charges after payments made during the billing period have been subtracted. Previous balance method Method of computing finance charges that gives no credit for payments made during the billing period. Average daily balance method Uses a weighted average of the account balance throughout the current billing period. If you carried over a balance new purchases may be included in your average daily balance calculation.      Obtaining Credit Character – What is my repayment history; am I responsible enough to stick to a repayment schedule? Credit History / Credit Rating Capacity – Borrower’s financial ability to meet credit obligations; TDSR and GDSR Capital – Borrower’s assets or net worth Collateral – Valuable asset that is pledged to ensure loan payments Conditions– the general economic conditions that can affect borrower’s ability to repay a loan  General Rules of Credit Capacity Debt payments-to-income ratio o Monthly payments*/net monthly income o Should not exceed 20% o *Not including housing  Credit Score Purpose   o measure of your creditworthiness so lenders know how risky it is to lend you money and how likely you are to pay them back Factors o Debt payment history – all R1’s and evidence of loans being paid o Need at least two forms of revolving credit (credit cards, lines of credit) o Generally use less than 50% of the credit available o Long-term use of credit (have had a credit card for many years) Number of credit checks can affect your score Range o Perfect score 900 o Average 700 o Anything less than 620 is a problem         Build and Maintain Your Credit Rating Your credit experiences, or lack of, is a major consideration for the creditor A good credit rating is a valuable asset Revolving credit/ Lines of Credit Have 2 sources (credit cards) Never use more than 50% of credit limit Installment Loans Always make payments on time Limit use to extent possible        Credit Scoring The following categories are weighted Payment history Length of credit history Amounts owed Types of credit used Number of recent applications for credit Improve your score by managing your debt responsibly Debt Free Plan 1. Tell yourself the truth about your spending habits and debt situation 2. STOP accumulating bad debt 3. List all debt you have; include balance, minimum payment, # of months remaining. Order the debts based on # of month remaining. Shortest to longest 4. Pay Yourself 1st add an amount ($100) to the debt on the top of your list and pay minimum amount on other debts 5. Once 1st debt is paid off add the amount you have been paying on the 1st debt to the minimum amount on the 2nd debt on the list. 6. Continue Step 6 until all debts are paid off!!! Debt Elimination Strategy – Why?     Quick success – 1st debt is paid off quickly Provide hope and confidence that debts can be paid off By adding payments made to the top debt on the list to the payments on the next debt on this list you rapidly increase the pace of debt repayment. You will reduce your interest expense dramatically.