Chapter 5: Entreprenuership
Chapter 25 The Basics of Credit
Section 25.1 Credit Essentials
Credit: The Promise to Pay
Credit is an agreement to obtain money, goods, or services now in exchange for a promise to pay in the future.
Creditor: the one who lends money or provides the credit.
Debtor: the one who borrows money or uses credit.
Interest: the cost of borrowing money or using credit. The amount of interest to be paid depends on three things:
• Annual Percentage Rate (APR)
• The time it takes to pay back the loan or credit
• The amount of the loan or credit which is also known as the Principal
Principal x APR x Length of Loan = Finance Charges
$200,000 x .03 x 30 years = $180,000 vs. $200,000 x .03 x 25 years = $150,000
$200,000 x .04 x 30 years = $240,000 vs. $200,000 x .04 x 25 years = $200,000
$200,000 x .05 x 30 years = $300,000 vs. $200,000 x .05 x 25 years = $250,000
Who Uses Credit?
Consumer Credit: consumers use credit to buy goods and services as well as homes.
Commercial Credit: businesses use credit to buy supplies, equipment, factories, and goods to be resold. Although businesses must also pay interest on their credits they usually pass this cost on to the consumer in the form of higher prices for goods and services.
Government Credit: the federal government uses credit to finance military and the many services provided to its citizens. Local governments use credit to finance highways, public housing, stadiums, water systems and schools.
The Pros and Cons of Using Credit
Advantages
• Convenient: you don’t have to carry around large amounts of cash and you get to use an item right away while you’re paying for it. (i.e. a car or house)
• Emergencies: if you’re car breaks down you can use credit to fix it.
• Establishes a Credit Rating: measures a person’s ability and willingness to pay debts on time.
• Keep Track of Spending: credit bills are a record of your expenditures.
• Contributes to the growth of the economy: allows consumers to buy more goods and services then they would be able to if just using cash which in turns forces businesses to hire more people to keep up with demand
Disadvantages
• Easy to misuse: can buy things you cannot afford or do not need
• Credit costs more than buying for cash: interest rates can be high and if you don’t pay it off in a timely manner it can be very expensive.
• Failure to pay on time can ruin your credit rating: late or missed payments can also cause you to not be able to get additional credit in the future.
Factors to Consider Before Using Credit
• Do you have the cash you need for the down payment?
• Do you want to use your savings instead of credit?
• Can you afford the item?
• Could you use the credit in some better way?
• Could you put off buying the item for a while?
• What are the costs of using credit?
Section 25.2 Types of Credit
Sources of Credit: short-term (less than one year), medium-term (one to five years), and long-term (over five years)
Charge Accounts (short-term): stores allow customers to buy on credit and bill them monthly
Credit Cards (short-term): there are three basic types of credit cards:
• Single-Purpose Cards: used to buy goods or services at the business that issues the card. These may be paid in full at the end of each month or amounts can be carried over from month to month which results in interest charges (i.e. a gasoline credit cards)
• Multipurpose Cards: also called bank credit cards and are accepted by many different establishments all over the world. These also may be paid in full at the end of each month or amounts can be carried over from month to month which results in interest charges (i.e. Visa and Mastercard)
• Travel and Entertainment Cards: accepted around the world but usually requires payment in full every month and usually carry an annual fee which is higher then annual fees charged for single-purpose and multi-purpose cards (i.e. American Express)
Banks and Other Financial Institutions (medium and long-term)
Commercial Banks: mostly geared for business loans but may also offer mortgages and car loans
Savings and Loan Associations: mostly geared towards consumers and offers mainly mortgages.
Credit Unions: usually only deals with its members and is geared toward consumers.
Most Common Types of Loans
Single-Payment Loan: as the name implies this loan is paid back, both principal and interest, in one payment. These types of loans are mostly associated with businesses and especially farmers who need the money to plant their crops and once they are harvested and sold they repay the loan.
Installment Loan: student loans, car loans, and home improvement loans that have regular payments over a period of time (i.e. $550 per month for 60 months). A portion of each payment goes towards the principal and a portion goes towards interest. This type of loan may require collateral.
Mortgage Loan: a form of installment loan used for the purchase of real estate and usually has a longer period of payback such as 15 to 30 years. The real estate is held as collateral until the loan is paid in full.
Seller-Provided Credit: many stores offer credit for their customers. (i.e. Sears credit card)
Consumer Finance Companies: specialize in loans for people that cannot qualify for the other types of credit listed due to a poor credit rating or no credit rating at all. Loans from here cost a lot more than the aforementioned loans due to the high risk of the borrower.
Other Types of Loans: usually for people that have difficulty getting credit
• Payday Advance Services
• Pawn Shops
• Borrow until Payday
The costs of these loans are extremely high and may have a garnishment clause in the agreement, which allows them to take money directly from their paychecks. [pic]
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