Chapter 3 Consumer Credit - Cengage

[Pages:62]Chapter 3

Consumer Credit

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3-1 3-2 3-3 3-4

Introduction to Consumer Credit Loans Student Loans Loan Calculations and Regression

CHAPTER OVERVIEW

Discuss with students that credit is based on honesty, responsibility, and the ability to pay back the debt. Ask students if any of them have used their parents' credit cards.

3-5 Credit Cards

3-6 Credit Card Statement

3-7 Average Daily Balance

Live within your income, even if you have to borrow money to do so.

--Josh Billings, American humorist

What do you think?

Traditionally, living within your income meant that if you needed to borrow money to buy something, you couldn't afford it. Living within your income does not mean not ever borrowing money. Nowadays, it means you should borrow what you can afford to repay. People who borrow are not automatically living beyond their means.

What do you think humorist Josh Billings meant in his quote?

Credit is a promise to pay in the future for goods and services you purchase today. When you think of consumer credit, you might think of loans and credit cards. Most people use credit. Using credit has advantages and disadvantages. Credit lets you enjoy purchases while you are paying for them. However, if you use credit irresponsibly, you may find yourself with debt that you cannot afford to pay. Being in debt is not a problem as long as you can make punctual payments to eliminate the debt.

Can you imagine your life without credit? If you had to save several years to buy a car, what would you use for transportation during the years you were saving? If you had to save for many years to purchase a home, where would you live while you were saving? Credit provides you with a way to increase your standard of living, as long as your purchases are made with careful financial planning.

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Not For Sale

Not For Sale REALLY? REALLY!

Really?

Have students read the bullet points aloud. In the second bullet, the number one trillion is written out with all of its place-holding zeroes. This may be the first time students

have ever seen it written this way. This is an opportune time to review million, billion,

quadrillion, and so on. You can even suggest that students do Internet research to find

T the quantity googol, which is the number 1 followed by100 zeroes.

he use of credit cards is incredibly

? All credit cards have length

prevalent in today's society. Those little

85.60 mm and width 53.98 mm.

plastic cards are everywhere!

? There are more than 500,000 credit

? There are more than 1.5 billion credit cards in use in the United States.

? The bank-issued credit card was created in the 1950s, and its creator, Frank McNamara, thought it would

card transactions around the world-- every minute! ? In 1983, MasterCard became the first credit card to use a hologram on its plastic cards, to help prevent counterfeiting.

just be a fad!

Clearly the small plastic card plays

? It is illegal for a company to send

a major role in how you conduct your

you a credit card you did not request.

financial life. A discussion about the

However, the typical American

credit card industry requires frequent

household receives about six credit

use of numbers in the billions and

card offers per month!

trillions!

? Valeri Potapova/

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Really!

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3-1 Introduction to Consumer Credit

He that goes a borrowing goes a sorrowing.

--Benjamin Franklin, American statesman

Objectives

? Define basic credit terms. ? Identify types of lending

institutions. ? Compute finance charges for

installment purchases.

Key Terms

credit debtor creditor asset earning power credit rating credit reporting agency FICO score installment plan

down payment deferred payment plan layaway plan default

Warm-Up

If Sal saves $55 per month, express his total savings for x years as an expression in terms of x. 660x

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EXAMINE THE QUESTION

Credit is not extended to young children because it requires a degree of financial and legal responsibility. Ask students what they think creditworthiness should be based on.

CLASS DISCUSSION

Why does credit encourage overspending?

Has anyone ever encountered advertisements about obtaining your credit score on television, radio, or in print? For now, explain to students that their credit score is like a credit "report card."

What Do You Need to Know Before

Using Credit?

Goods and services can be purchased in one of two ways: "buy now, pay now" or "buy now, pay later." If you purchase something that you do not pay for immediately, you are using credit. A person who uses credit is called a debtor. Every time you use electricity, you are using credit because you use the electricity and do not pay for it until the monthly bill arrives. A person who uses credit cards or takes out loans is also using credit. An organization or person that extends credit to a consumer is called a creditor.

There are advantages to using credit. You can shop without carrying large amounts of cash. You do not have to wait until you can pay in full to purchase something. Credit allows you to get use out of something while still paying for it. There are also disadvantages to using credit. Creditors charge interest on all purchases. Some people also feel that there is a tendency to overspend when using credit.

Any type of credit is based on honesty. Creditors need to be sure that they will be paid back before they extend credit. They will have you fill out an application for credit and will check your financial history. This history includes three basic items:

? Assets Everything you own--your home, car, bank accounts, and other personal possessions.

? Earning power Your ability to earn money now and in the future. Creditors want to make sure you have enough income to repay the debt.

? Credit rating Your credit "report card." Every time you use credit, the creditor reports how well you met your financial obligations to a credit reporting agency.

A credit reporting agency compiles records on all users of credit. These records are used by creditors before they issue credit to a consumer. The best way

Not For Sale 148 Chapter 3 Consumer Credit

Not For Sale to start a good credit history is to open a savings and checking accounts, get a debit TEACH

card, pay all your bills on time, and handle all your credit transactions successfully. Students may already be familiar

Consumers are given credit scores based on these three criteria. The most popular score is the FICO score, named for its creator, Fair, Isaac and Company. The scores, which range from 300 to about 850, summarize the probability that debtors will repay their debts. A higher score indicates a better credit rating. A person with a score near 800 is less of a risk to a creditor than a person with

with the terms "down payment" and "interest." When they think of interest, they think of receiving interest from a bank. The term "finance charge" indicates that the consumer

a score near 500. The FICO score is widely accepted by creditors as a reliable way is being charged interest, not

to judge creditworthiness. Gender, race, religion, nationality, and marital status

receiving any interest.

do not affect credit scores.

Any transaction involving credit is a legal contract obligating you to make

timely payments. To use credit responsibly, you need to know the language of

credit, and the laws that protect creditors and debtors.

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Skills and Strategies

Some stores offer creditworthy customers the convenience of paying for merchandise or services over a period of time. This is an installment plan. The customer pays part of the selling price at the time of purchase. This is the down payment. The scheduled payments, or installments, are usually made on a monthly basis. Installment buyers are charged a fee. This fee is the interest and is added to the cost.

Whenever you purchase something on an installment plan, you are immediately paying interest on the purchase amount. When you buy on the installment plan, you immediately take possession of the item, agreeing to make payments of the purchase price plus interest over a period of time. Installment plans differ from deferred payment plans. A deferred payment plan also requires you to make periodic payments but there is no interest charged if these payments are made on time. With a deferred payment plan, you are paying the same price for the item as if you paid it in full at the time of purchase. With deferred payment plans, you take possession of the item immediately. Installment and deferred payment plans differ slightly from layaway plans. With a layaway plan, the customer does not receive the merchandise until it is paid for. It is held in the store for a fee. When all of the payments are made, you can take possession of the item. You learn about these plans in the next examples.

EXAMPLE 1

Heather wants to purchase an electric guitar. The price of the guitar with tax is $2,240. If she can save $90 per month, how long will it take her to save up for the guitar?

SOLUTION If Heather saves for the guitar, she is not using credit. But she will also not have use of the guitar while she is saving for it.

Divide 2,240 by 90. Round to the nearest tenth. 2,240 4 90 < 24.9

It will take Heather 25 months to save for the guitar. You can view Heather's savings plan as an arithmetic sequence in which the first term is 90 and the common difference is 90. The 25th term is the earliest term greater than 2,240.

EXAMPLE 1

For problems involving how much to save, "normal" rounding rules are adjusted. If the answer is not an integer, always round up so that the amount saved is greater than the amount needed. Have students model this payment plan by identifying the first term and common difference of the related arithmetic sequence.

CHECK YOUR UNDERSTANDING Answer x

y The answer must be rounded up if it is not an integer.

If Heather's guitar costs x dollars and she can save y dollars per month, express algebraically the number of months it would take Heather to save for the guitar.

Check Your Understanding

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EXAMPLE 2

The finance charge is also called the interest. In Chapter 2 the consumer earned interest, and now the consumer is paying interest.

CHECK YOUR UNDERSTANDING Answer (0.2p + 12w) ? p, or

12w ? 0.8p Students should get comfortable with the simplest form of the expression, but they should recognize that the expression that is not in simplest form is also valuable because it models the sequence of events more clearly.

EXAMPLE 2

Heather (from Example 1) speaks to the salesperson at the music store, who suggests that she buy the guitar on an installment plan. It requires a 15% down payment. The remainder, plus a finance charge (interest), is paid back on a monthly basis for the next 2 years. The monthly payment is $88.75. What is the finance charge? SOLUTION Find the down payment by taking 15% of $2,240. Multiply $2,240 by 0.15. 0.15(2,240) 5 336

Heather pays the store $336 at the time of purchase.

She now has to make 2 years (24 months) of monthly payments of $88.75. The sum of the monthly payments is found by multiplying the number of payments by the monthly payment amount. Multiply $88.75 by 24. 24(88.75) 5 2,130

The sum of the monthly payments is $2,130. Add down payment plus sum of payments. 336 1 2,130 5 2,466

The total cost is $2,466.

The finance charge is the extra money Heather paid for the use of credit.

To find the finance charge, subtract the price of the guitar from the total cost. Total cost ? purchase price 2,466 2 2,240 5 226

Heather paid a finance charge of $226. That is the "fee" she paid for not having to wait two years to start using the guitar.

Check Your Understanding

Assume the original price of the guitar was p dollars, and Heather made a 20% down payment for a 1-year installment purchase. The monthly payment was w dollars. Express the finance charge algebraically.

EXAMPLE 3

Tell students that the finance charge, imposed if the entire balance is not paid in full, usually has a relatively high interest rate. The finance charge applies retroactively to the day the loan was initiated.

EXAMPLE 3

Carpet King is trying to increase sales, and it has instituted a new promotion. All purchases can be paid on the installment plan with no interest, as long as the total is paid in full within 6 months. There is a $20 minimum monthly payment required. If the Schuster family buys carpeting for $2,134 and makes only the minimum payment for 5 months, how much will they have to pay in the 6th month?

SOLUTION This is a common business practice today. It is almost like a discount, except instead of saving money off the purchase price, the customer saves the finance charge.

If the Schusters pay $20 for 5 months, they will have paid a total of $100.

Subtract to find what they owe in the 6th month.

Purchase price ? amount paid 2,134 2 100 5 2,034

They will have to pay $2,034 in the 6th month. If this is not paid in full, there will be a finance charge imposed.

Not For Sale 150 Chapter 3 Consumer Credit

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Not For Sale The Whittendale family purchases a new refrigerator on a no-interest-for-one-year

plan. The cost is $1,385. There is no down payment. If they make a monthly payment

Check Your Understanding

of x dollars until the last month, express their last month's payment algebraically.

CHECK YOUR

UNDERSTANDING

Answer $1,385 ? 11x

EXAMPLE 4

Cecilia purchased $4,322 worth of home appliances on Appliance Depot's deferred payment plan. The plan allows the customer to make no down payment, and there is no payment at all for 3 months. If the entire $4,322 is paid in full before the 3 months is up, there is no interest. (This is a store's way to persuade customers to make purchases.) If it is not paid in full within the 3 months, there is a finance charge with an APR of 21.6% applied each month going back to the first month. If Cecilia makes the full payment a week after the 3 months expired, what is the finance charge?

SOLUTION

Divide to find the monthly interest rate. 21.6% 4 12 5 1.8% , or 0.018

Find the interest after the first month by multiplying. 4,322 3 0.018 5 77.80, rounded to the nearest cent.

Point out that x could be a minimum monthly payment, and x would not necessarily be equal to 1,385.

12

EXAMPLE 4

Point out to students that there could also be a late fee, as well as interest charged on the extra week it took Cecilia to pay. They could compute this by prorating the 7-day week based on what would have been the fourth month's interest. Students should clearly see that not complying with the interest fee conditions can be very expensive.

Find the balance after the first month by adding the interest to the balance. 4,322 1 77.80 5 4,399.80

The balance for the second month is $4,399.80 before computing the second month's interest.

Find the second month's interest by multiplying.

4,399.80 3 0.018 5 79.20, rounded to the nearest cent.

Add to find the second month's balance including interest. 4,399.80 1 79.20 5 4,479

The third month's balance is $4,479 before interest is computed.

Multiply and add to get the third month's balance including the interest. 4,479 3 0.018 5 80.62, rounded to the nearest cent. 4,479 1 80.62 5 4,559.62.

The amount due the week after the 3-month offer expired is $4,559.62. Subtract to find how much interest Cecilia incurred by being a week late.

4,559.62 2 4,322 5 237.62

Cecilia cost herself $237.62 by being only a week late, which is a great deal of money. Imagine if this was a 1-year deferred payment plan, and it was paid late!

CHECK YOUR UNDERSTANDING Answer More; the monthly

compounded interest on $4,322 at 21.6% for 2 years is greater than $2,000.

If Cecilia's plan was a 2-year deferred payment plan and she paid it a week late after the 2 years, would her total interest be more or less than $1,800? Explain.

Check Your Understanding

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EXAMPLE 5

Point out to students that a person who buys on a layaway plan does not take possession of the merchandise until it is paid in full. In that respect, it is not "really" using credit.

CHECK YOUR UNDERSTANDING Answer $60

EXAMPLE 5

Circuit Town is having a huge sale on large screen TVs. Anita purchased a 60-inch curved-screen TV for $2,045.15 including sales tax. This purchase was made on a 6-month layaway plan. She had to pay a monthly payment of $361. What is the sum of the monthly payments? What was the fee charged for the layaway plan?

SOLUTION Determine the total of Anita's monthly payments. $361 3 6 5 $2,166

Anita's total cost for the TV is $2,166 on the layaway plan. Since the TV sold for $2,045.15, subtract that amount from the total of her monthly payments.

2,166 2 2,045.15 5 120.85

The layaway fee for this purchase is $120.85. Keep in mind, Anita was able to lock in the sale price by using the layaway plan even though she didn't have the full amount at the time of purchase, but she does not have use of the item immediately.

Check Your Understanding

Marty is making a layaway purchase of a $1,500 couch at Frank's Furniture Store. He will be paying $156 every 2 weeks for 20 weeks on a layaway plan. What is the layaway fee for this purchase?

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? Dusan Petkovic/

Not For Sale 152 Chapter 3 Consumer Credit

? Casper1774 Studio/

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Not For Sale Credit Scores

Your credit score affects the interest rate a creditor charges you, and borrowers with lower scores pay higher interest rates. This is because they are a greater credit risk to the lender. Lenders are always concerned about a borrower who may default on a loan. A debtor defaults when they fail to make payments according to the schedule set up when the loan originated. Credit scores change as new data about a person's credit becomes available. FICO scores higher than 700 signify a good credit rating and those above 770 are considered excellent.

Generally, any person with a credit score below 600 is considered a significant risk to the creditor. Individuals with scores at 700 or greater qualify for the best interest rates available.

EXAMPLE 6

Mike has a credit rating of 720. Tyler has a credit rating of 560. Mike and Tyler apply for identical loans from Park Bank. Mike is approved for a loan at 3.2% interest, and Tyler is approved for a loan that charged 3 percentage points higher because of his inferior credit rating. What interest rate is Tyler charged?

SOLUTION Add 3% to 3.2%.

3% 1 3.2% 5 6.2%

Tyler will pay 6.2% interest for the same loan.

While the arithmetic in this problem may have been simple, the message is important: Credit scores will affect the interest you pay on loans. If you are a good credit risk, you will save money when you borrow money.

Tyler's loan will have cost him more than Mike's loan for the same amount over the same period of time. The extra dollar amount of what Tyler pays could be hundreds of dollars or even more, depending on the original loan amount.

EXAMPLE 6

Make students aware that their credit rating not only affects whether or not they get a loan, it affects the interest rate they pay.

CHECK YOUR UNDERSTANDING Answer 660 ? x

Janet had a credit score of 660. She then missed three monthly payments on her credit cards, and her score was lowered x points. Express her new credit score algebraically.

Check Your Understanding

3-1 Introduction to Consumer Credit 153

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