Chapter 6 Using Credit Cards: The Role of Open Credit
Learning Objectives • Know how credit cards work. • Understand the costs of credit. • Describe the different types of credit cards. • Know what determines your credit card worthiness and how to secure a credit card. • Manage your credit cards and open credit.
Introduction • Credit cards are convenient, but if you’re not careful, credit cards will cost you. • Some charge 20%-30% interest on unpaid balances. • Most people don’t consider interest charges on purchases they have to have. • Manage credit wisely to avoid high interest.
A First Look at Credit Cardsand Open Credit • Credit involves receiving cash, goods, or services with an obligation to pay later. • Open credit (revolving credit) is a line of credit extended before the purchase. • You can use it and pay back at your own pace • Unpaid balance plus interest carries over to next month. • The higher the balances on credit lines, the higher the costs.
Interest Rates • Annual Percentage Rate (APR)—the true simple interest rate paid over the life of the loan. • The Truth in Lending Act requires that all APRs be disclosed • Including credit cards and consumer loans
Interest Rates • Fixed APR (doesn’t change) vs. variable APR • Most credit cards are variable-usually it is the prime rate plus a percentage • Teaser Rates • A lower interest rate for the first months to entice customers to sign up for the card • After the introductory period, interest rates go up • Credit card interest rates are compounded • You pay interest on interest
Calculating the Balance Owed • There are several method of calculating interest and balances on credit cards • Average daily balance method • Sum of the balances for every day divided by the number of days in the period multiplied by the interest rate • Previous balance method • Uses the balance at the end of the previous billing period multiplied by the interest rate
Calculating the Balance Owed • Adjusted balance method • Interest is charged on the previous month’s balance, after any payments have been subtracted • Results in a lower interest rate • Variations • Average daily balance may include new purchases • May exclude new purchases
Buying Money: The Cash Advance • Cash advances using your credit card at ATMs are just like taking out a loan • Disadvantages: • Higher interest rate charged immediately on cash advances • Up-front fee of 2-4% of the amount advanced. • Many cards require you to pay down the balances for regular purchases before paying down the higher interest rate cash balance.
Grace Period • Grace period —the length of time given to make a payment before interest is charged against the outstanding balance on a credit card. • Usually it is 20-25 days from date of bill. • There is no grace period with cash advances—interest accrues immediately • On most cards, the grace period is canceled if there is unpaid balance from previous month.
Annual Fee • A fixed annual charge imposed by a credit card company just for having the card • Over 70% of the biggest credit card issuers do not charge an annual fee. • Many don’t charge the fee if the card is used at least once a year. • Merchant’s discount fee —the percentage of the sale that the merchant pays to the credit card issuer • The merchant pays the bank 1.5% - 5% of the amount charged
Additional Fees • Cash Advance Fee • Late Fee • Over-the-Limit Fee • Penalty Rate
Pros and Cons of Credit Cards Advantages: • Convenience • Used as identification • Phone and internet purchases • Temporary funds • Use product before paying for it • Bill consolidation • Pay less today and earn interest elsewhere • Extended warranties, travel insurance, and rewards • May need for reservations
Pros and Cons of Credit Cards Disadvantages: • Too easy to spend money • Too easy to lose track of spending • High interest rate • Obligating future income • Heavy budgetary problems with uncontrolled spending
What the CARD Act Means for You • Your credit card company has to tell you when they plan to increase your rate or other fees. • Your credit card company has to tell you how long it will take to pay off your balance. • No interest rate increases for the first year. • Increased rates apply to new charges.
What the CARD Act Means for You • Restrictions on over-the-limit transactions. • Caps on high-fee cards. • Protections for underage consumers. • Standard payment dates and times. • Payments directed to highest interest balances first. • Your credit card company cannot charge you a fee of more than $25 in most cases.
Choosing a Source of Open Credit • BankCredit Cards—a credit card issued by a bank or large corporation, generally a Visa or Mastercard. • Bank Card Variations—different classes (credit levels) of bank credit cards. • Premium or Prestige card (high credit limits) • Affinity card (associated with a charity or other organization) • Secured credit card (back by collateral, usually cash)
Choosing a Source of Open Credit • Travel and entertainment cards (T&E)—do not offer revolving credit and require full payment of balance each month. • Usually have a high credit limit—up to $100,000 • Interest-free grace period. • Issuers receive annual fee (up to $2,500 a year) and merchant’s discount fee. • American Express, Diners Club, and Carte Blanche are the primary issuers.
Choosing a Source of Open Credit • Single-Purpose Cards—can be used only at a specific company • JC Penney, Kohl’s, Macy’s, Target, etc. • Companies issue their own cards to avoid merchant’s discount fees. • Terms vary, some offer revolving credit. • Typically, no annual fee.
Choosing a Source of Open Credit • Traditional charge account—can be used to make purchases or get services only at the issuing company such as utility companies and doctors who provide services and bill later. • Convenient for both issuer and payee. • Pay monthly bill in full or pay interest/fee.
The Choice: What’s Best for You • Credit user —carries an unpaid balance from month to month • APR is the most important factor • Convenience user —pays off the credit card balance each month (avoids interest) • Low annual fee, interest free grace period, and rewards are the most important factors • Convenience and credit user—generally pays off all the balance • Look for a card that offers the best features
Figure 6.3 What Features Different Types of Credit Card Users Find Important
Getting a Credit Card • You can get a card if you are over 21 • You can get a card if you are under 21 with a co-signer (usually a parent) • The average college senior has about four credit cards • Excellent idea for students if used appropriately • Emergency funds • Build solid credit history if used prudently
Credit Evaluation: TheFive C’s of Credit • Character • Capacity • Capital • Collateral • Conditions
The Key to Getting Credit: Your Credit Score • A credit bureau —gathers information on consumers’ financial history, including payment history • This information is sold to customers • Credit bureaus compile credit reports and assign a credit score • Credit report —information on a person’s financial situation and dealings. • Credit information impacts whether you get a loan; it also affects your interest rate.
Determining Creditworthiness • Credit scoring —numerical evaluation of “scoring” of applicants based on their credit history. • Reduces the lender’s uncertainty and risk • Lender is able to make credit available to good risk customers at lower interest rates.
Your Credit Score Affects You In Many Ways • Affects interest rates you pay on credit cards • Affects size of credit line • Affects insurance rates (car, home, etc.) • Affects mortgage interest rate • High credit score = lower interest rate
How Your Credit Score is Computed • Based on models developed by Fair Isaac Corporation—called a FICO score • Credit Reporting Agencies are Experian, TransUnion, and Equifax • Your score will vary slightly among agencies • Scores range from 300-850 • Visit www.myfico.com/ficocreditscoreestimator to get an estimate of your score.
How Your Credit Score is Computed • What is a good score? • A good credit score doesn’t just mean that you’ll get a loan, it also means you’ll pay less for it through lower rates. • Creditworthiness is also based on employment history, job history, and amount of debt you currently have.
Table 6.1 Representative Rates and Monthly Payments for Different FICO Scores
What’s in Your Credit Report? • Identifying Information • Trade Lines or Credit Accounts • Inquiries • Public Record and Collection Items
Factors That Determine Your Score • Your Payment History (35%) • Amount You Owe and Your Available Credit (30%) • Length of Credit History (15%) • Types of Credit Used (10%) • New Credit (10%)
Monitoring Your Credit Score • Check for errors in credit report. • Get free copy of your credit report each year from the three major credit bureaus at www.annualcreditreport.com • Check that all information is correct and that all accounts on the report are yours.
TABLE 6.2 The Fair and Accurate Credit Transactions Act (FACT Act) 2003
Consumer Credit Rights • Take credit complaints directly to the creditor. • Federal laws protect consumers with complains about credit
The Credit Bureau andYour Rights • FACTA —you can request one free copy for your credit report from national bureaus and contact them for inaccuracies • Up to 25% of reports have errors • Credit Bureau must investigate and correct if inaccurate • FCRA —negative information remains on report for 7 to 10 years, but no longer
If Your Credit Card Applicationis Rejected • Apply for a card with another financial institution. • Find out why you have been rejected. • Set up an appointment with credit card manager. • Address the problem.
Identity Theft • Identity theft is use of your name, address, Social Security number, bank or credit card account number, or other identifying information by someone other than you without your knowledge to commit fraud and other crimes
How Do You Know if You’re a Victim of Identity Theft? • Receive a credit card you didn’t apply for. • Denied credit or offered less favorable terms. • Calls or letters from debt collectors. • Fail to receive bills or other mail.
What To Do If Your Identity Has Been Stolen • Put fraud alert on credit file. • Close accounts that have been tampered with or you didn’t open. • File police report. • File a report with the FTC (Federal Trade Commission)
Controlling and Managing Your Credit Cards and Open Credit • Reducing your balance • Protecting against fraud • Trouble signs in credit card spending • If you can’t pay your credit card bills