| CREDIT: WHAT IS IT AND WHAT DOES IT COST?
Q. What exactly is credit?
A. Credit allows you to buy and use goods and services now, and
pay for them later. For
example, credit lets you use a car or a washing machine before (and, usually,
long after) you
have fully paid for its services. You pay for the services as you use
them. 0f course, you could
save now to buy the car in the future, but you may want or need the car
now, not three years
from now. Similarly, you may buy a pair of shoes or a dinner on your credit
card now and pay
for them later.
Q. What are the basic forms of consumer credit?
A. There are three basic forms of consumer credit: noninstallment
credit (sometimes called
thirty-day or charge-account credit), installment credit or closed-end
credit, which is legally
defined as credit that is scheduled to be repaid on four or more installments
(usually monthly)
and revolving or open-end credit. In addition, some lease arrangements
operate like consumer
credit and may be subject to similar laws, so these are discussed briefly
in this chapter. However, credit secured by real property--your home,
for example--is discussed in the sections on "Home Ownership"
and "Buying and Selling a Home."
How Credit Operates
TYPE OF CREDIT BASIC OPERATION
Charge-account or 30-day credit
Balances owed on such accounts usually require payment in full within
thirty days. Such arrangements are not considered to be installment credit,
since the debt is not scheduled to be
repaid in two or more installments. Travel and entertainment cards, such
as American Express and Diners Club, operate this way, as do most charge
accounts with local businesses,
especially service providers: doctors, plumbers, and so on.
Installment or Closed-end credit
A consumer agrees to repay the amount owed in two or more equal installments
over a definite period of time.
Automobile loans and personal loans are examples of this type of consumer
credit.
Revolving or openend credit
In this more flexible method, the consumer has options of drawing on a
pre-approved open-end credit line from time to time and then paying off
the entire outstanding balance, only
a specified minimum, or something in between. With this type of credit,
the consumer may use the credit, make a payment, and use the credit again.
Bank credit cards, such as Discover, Master Card, and VISA, and those
issued by major retail establishments are examples of revolving credit.
Q. Why does credit cost money?
A. To buy now and pay later, you usually must pay a finance charge.
This is because the supplier who waits for payment, or the lender who
lent you the money to pay a supplier, could have invested the money instead
and earned interest. Thus the finance charge you pay compensates them
for that lost interest, as well as covering some of the costs and risk
involved in extending you credit. The supplier may be the car dealer,
appliance dealer, shoe store, or restaurant. The lender may be a bank,
credit union, or finance company. Only you can decide whether it is worth
the cost of the finance charge to have a car or other goods and services
now, rather than later.
Many states regulate by law how much finance charge you can agree to pay
and provide
penalties if the supplier or lender charges too much. However, some states
allow your agreement and competition among credit extenders to determine
what you pay. You should shop for credit much as you shop for the best
deal on a car or television set. The Truth in Lending Act and similar
state laws allow you to do that.
Q. I keep seeing references to the Truth in Lending Act. What
is it?
A. The Truth in Lending Act (TILA) is a federal law that requires
that all creditors provide
information that will help you decide whether to buy on credit or borrow,
and if so, which credit
offer is the best for you. Creditors include banks, department stores,
credit card issuers, finance
companies, and so on.
Under the law, before you sign an installment contract, creditors must
show you, among
other information, the amount being financed, the monthly payment, the
number of monthly
payments and--very important--the annual percentage rate (APR). The APR
is an annual rate that relates the total finance charge to (l) the amount
of credit that you receive and (2) the length of time you have to repay
it. Think of the APR as a price per pound, like 20 cents per pound for
potatoes. You may buy five pounds for one dollar or ten pounds for two
dollars. In either case the rate is 20 cents per pound. However, the total
cost in dollars depends on the amount of potatoes you buy. When you buy
credit instead of potatoes, you buy a certain amount of credit for a given
number of months. The total dollar amount of your finance charge will
depend upon how many dollars worth of credit you obtain initially and
how many months you use those
dollars.
The TILA also regulates credit advertising, which makes it easy to credit
shop. For
example, if an automobile ad emphasizes the low monthly payment (giving
a dollar figure), it
also must tell you other pertinent information, like the APR.
Of course, the APR can help you in shopping for a credit card and other
forms of open-end
credit.
Carefully Evaluate Your Options
The example on these pages illustrates the importance of checking
all financing options before
making a decision. Fortunately, the law allows you to obtain the information
that you need to
comparison shop. You should use this information, and, factoring it
in with your own situation
and needs, determine which loan or credit arrangement is best for
you. |
Q. How do I select the best way to finance the purchase of, for
example, a car?
A. Let's see how you can use the information required by the
TILA to get the best deal for you in financing a used car having a cash
price of $5,000. You have $1,000 in savings to make a down payment on
the car and need to borrow the remaining $4,000. Suppose that by shopping
around you find the four possible credit arrangements shown below:
________________________________________________________________________
APR Length of Loan Monthly Payment Total Finance Charge
Creditor A 11% 3 years $131 $714
Creditor B 11% 4 years $103 $962
Creditor C 12% 4 years $105 $1,056
Creditor D 12% 2 years $188 $519
________________________________________________________________________
[Please note that the figures for total finance charge are correct, even
though not precisely equal
to the sum of the payments less the amount financed ($4,000). Creditors
often round off monthly payments to the nearest dollar, and adjust the
final payment to make up the difference.]
Let's begin with an easy decision. Notice that the four-year loan of Creditor
B is a better
deal than the four-year loan of Creditor C. Since their lengths are equal,
we know that an 11-
percent loan is cheaper than a 12-percent loan for the same amount of
money. Forget about
Creditor C.
However, look what happens when the lengths of the loans vary: Even though
Creditors
A and B charge an APR of 11 percent, the total dollar finance charge is
a good deal greater on
the 4-year loan from Creditor B than on the 3-year loan from Creditor
A. Of course, the
difference makes sense, since with Creditor B you would have another year
to use the lender's
money. You have to decide whether you would like to have the lower monthly
payment that is
available on the longer loan. Note that it doesn't help to look just at
the total finance charge,
which is lowest on the loan from Creditor D. But that creditor charges
12 percent rather than the 11 percent available from Creditors A and B.
The only reason the total finance charge is the
lowest of the four is that you would have the use of the creditor's money
for only two years.
Forget Creditor D.
Thus, your choice narrows to Creditor A vs. Creditor B, and which you
choose depends
on how easy it will be to meet the monthly payments. And, a big decision
is whether having a car today, rather than later, is worth the monthly
payments at the 11 percent financing rate.
Q. Does this mean that I should look only at the APRs when shopping
for credit?
A. No, when buying on credit, you will not be shopping wisely
if you merely compare APRs.
For example, your car dealer may be pushing "incentive financing"
by offering an APR that is
way below the rate being offered by, say, your credit union. Alternatively,
the auto dealer may
also be advertising a cash rebate if you buy the car for cash. To see
which is the best deal, you
need to find out which arrangement would yield the lowest monthly payment.
You can do this if
you do not change the down payment and the length of the loan from the
dealer or credit union.
In essence, you make all the terms of the two credit arrangements the
same, except the monthly
payment. Then take the deal that gives you the lowest monthly payment
to buy the car.
For example, a major car maker once offered a choice of a $l,500 cash
rebate or 5.8-
percent financing for four years on certain models. Assume that the car
you would like to buy
costs $16,000. If you have $2,000 for a down payment, you have the following
choices:
1. Finance through the dealer's finance company. A $2,000 down payment
would leave
$14,000 to be financed over four years at 5.8 percent. Monthly payments
disclosed under the
TILA would be $327.51.
2. Finance directly from a bank, credit union, or another credit grantor.
With the $l,500
cash rebate from the dealer and your $2,000, you have $3,500 to apply
to the purchase price of
$16,000. This leaves $12,500 to borrow ($16,000-$3,500 = $12,500). If
you borrow $12,500 for
four years at 11.17 percent, you will find from the TILA disclosures that
your monthly payments
would be $324.10. Take it.
Q. Are there any other points to consider when using installment
credit?
A. Yes, consider whether the interest that you pay for the credit
is deductible when calculating
your federal income taxes. Almost all homeowners may still deduct their
entire mortgage interest
for tax purposes. However, the interest that you pay on credit-card debt,
student loans, auto
loans, and other debts is no longer deductible.
If you itemize deductions in preparing your taxes, you might consider
financing major
credit purchases through a home equity loan. This type of loan is discussed
in the chapter
on owning a home. However, remember that if you use a home equity loan,
you are placing
your home at risk. And if the items that you are permitted to deduct for
tax purposes are
less than your standard deduction, you will find that the interest on
home equity credit will not
help you cut your tax bill.
There is another factor to consider. What if you pay the loan off early?
You need to check
how the rebate of unearned finance charges will be calculated.
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