Credit Counselor

Costs and Benefits of Credit Cards
The C's of Credit
Credit History
Credit Application Evaluation
Useful Formulas

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Costs and Benefits of Credit Cards

Benefits of Credit Cards

Costs of Credit Cards

The word credit originates from the Latin word creditus meaning entrusted. Credit means that someone will lend you money and give you time to pay it back, usually with interest (money paid for the use or borrowing of money). When purchasing goods and services with your credit card, you are getting a loan from the issuer of the credit card. It is not used in place of cash. Consumers use credit cards to buy things they want or need. A credit card is a plastic card identifying the holder as a participant in a credit plan of a lender. Many stores and companies such as oil companies issue credit cards for use only at their place of business. Banks and other financial institutions issue credit cards, such as Visa or MasterCard, that can be used at any establishment that accepts those credit cards.

Credit is a form of trust between lenders and borrowers. Lenders want to choose only trustworthy or (credit-worthy) applicants. Since there are many applicants, lenders usually have lots of alternative options for lending. Lenders are in business to make a profit, which means that they want to take in more money in revenue than they pay out in costs.

Cardholders can purchase services, merchandise, or obtain cash advances (loans). These accounts have a credit limit (the maximum amount you may charge) and a flexible repayment schedule. The cardholder who pays the entire balance due within the grace period (a period of time after the billing date) avoids interest or finance charges. A late charge is a payment for not paying the billed amount before the billing date. If a card offers a grace period, federal law requires a bill be sent to the cardholder at least 14 days before payment is due. A cardholder can repay any amount equal to or greater than the purchase price to eliminate interest charges. A wise consumer will pay off credit card bills promptly. If you don't pay it off, you are taking out a loan and it can be very expensive. Would you take out a loan for dinner tonight? Also, avoid the minimum payment trap. People who pay the minimum think they are handling their finances, but it could take them a long time to pay off the bill. Many cardholders maintain balances and the average customer takes more than 15 months to pay for the charges.

When a credit card is used responsibly, the cardholder can build a good credit history. If not, it can ruin a person's credit record. A bad credit record is hard to fix and takes many years to correct. Sixty (60%) percent of all families make credit card purchases.

Credit cards are issued by local and national businesses as well as banks. With the passage of the Fair Credit and Charge Card Disclosure Act in 1988, credit card issuers must inform consumers before they sign up about: (1) annual percentage rate (APR), (2) how monthly fees are calculated, (3) cost of all fees such as membership, transaction, cash advance and others, and (4) grace period.

Not all plastic cards are credit cards. The use of bank debit cards and smart cards is increasing. The debit card automatically deducts money from checking accounts. The smart card stores valuable information about the consumer on computer chips instead of magnetic strips. This allows businesses access to better information about the consumer so that they can provide personalized service. Some consumers are concerned about privacy issues associated with smart cards and credit cards knowing so much about them.

Credit cards help consumers satisfy their wants and needs, but how does the credit card affect the issuers of cards and businesses that accept purchases made by credit cards? Credit card issuers charge merchants a transaction fee on purchases.This fee is a percentage of the price of any good or service purchased with a credit card. Credit card issuers charge interest on the unpaid balances not paid during the grace period and they may collect an annual fee from cardholders. American Express and other companies issue gold or platinum charge cards. These cards require full payment upon billing, may have higher annual fees, but include extras such as travel insurance and other benefits.

The prime target for credit companies is the "baby boom" generation. Families headed by younger persons use consumer credit more than families headed by older persons. Higher income groups use credit more than lower income groups. Some companies target a younger market and issue cards to college students.

Protecting Credit

Maintaining a good payment history is one way consumers can protect their credit standing.There are ways consumers can protect their credit from fraudulent use.  Once a card is received in the mail, it should be signed immediately so that no one else can use it.  Some card issuers also require that consumers call customer service to activate the card.  Important information, including any documents received with the card and the customer service telephone number, should be kept in a safe place.  Consumers should protect their credit card number, its expiration date and any personal identification numbers (PIN) to avoid fraud.  If a credit card is lost or stolen, it should be reported to the card issuer immediately.

The C's of Credit

The information used when deciding among credit applicants is commonly classified according to the Cs of credit: capacity, character, capital, and collateral. Information related to the Cs of credit is obtained from several sources including a credit application and a credit report. Borrowers who have made wise financial decisions related to the Cs of credit present fewer costs for lenders and are thus more likely to obtain loans.

Card issuers use the C's of credit to evaluate and choose among applicants.

The C's of credit are defined as follows:

  1. Capacity is the income available to make repayment. Having a substantial income, having the same job for a number of years, and not having a lot of other debts suggest a strong financial capacity to repay. Capacity relates to the ability to pay for the loan.
  2. Character involves your honesty and reliability in meeting financial responsibilities. Your previous credit history indicates how highly you value paying bills on time. Are you the kind of person who takes debts seriously and pays all debts on time and in full? Character relates to the willingness to pay for the loan.
  3. Capital is a measure of your financial worth. Questions about assets (home ownership, stocks, savings accounts) and liabilities (balance due on present credit accounts) reveal whether you have the funds to pay all your loans, including the one you are seeking, should your income drop. In other words, will you have more debt than you can handle if you receive the sought after loan and you lose some or all of your income? Capital relates to assets that might be used to cover the loan should income (capacity) be reduced.
  4. Collateral is property offered and pledged to secure repayment of a loan and subject to seizure should the borrower default. It makes good sense for a lender to rely more on an automobile put up as collateral than on the smiling face of a credit applicant. Should the debtor later default, the automobile would be sold and the proceeds applied against the loan. Included under collateral would be a promise from a family member or friend of the borrower to repay the loan if the borrower fails to do so. This is called cosigning.

Credit History

Risk is related to uncertainty. In this case it is the uncertainty of repayment. People with poor credit histories represent more risk to lenders because, if they fail to repay, the lender's profits are reduced. To accept the additional risk, lenders charge higher interest rates to people with poor credit histories if loans seem justified.

People with poor credit histories represent more risk to lenders because if the borrower fails to repay, the lender's profits will be reduced. To accept the additional risk, lenders may charge higher interest rates to people with poor credit histories.

Lenders attempt to minimize risk by carefully evaluating potential borrowers' willingness and ability to repay. Borrowers can lower the risk they represent to lenders by making personal finance decisions that show their willingness and ability to repay.

Your credit history is derived from information you supply on a loan application as well as from your credit report (obtained from a credit reporting agency which compiles information supplied by your credit grantors regarding your account activity).

Benefits of making financial decisions that result in a good credit history:

  1. Obtaining future credit can be quick and easy.
  2. You will have many more lenders to choose from since most will be interested in lending money to you.
  3. Your costs of borrowing will be lower because you can shop among many lenders and can choose those with lower interest rates.
  4. Positive information stays in your credit history forever, continuing to build and enhance your credit worthiness.
  5. What other benefits might result from having a good credit history?

Costs of making financial decisions that result in a poor credit history:

  1. Obtaining future credit can be difficult and time consuming, and credit may not be available at all.
  2. You will have few lenders to choose from since most will not be interested in lending to you.
  3. Your costs of borrowing will be higher because you cannot shop among many lenders and choose those with lower interest rates.
  4. Negative information stays on your record for seven years.
  5. What other costs might result from having a poor credit history?

Benefits of lending to applicants that have a good credit history:

  1. Granting credit is less time consuming and costly.
  2. Profits will be enhanced as revenue (interest) will be paid on time.
  3. Risk of nonpayment will be reduced.
  4. What other benefits might result from lending to people with a good credit history?

Costs of lending to applicants that have a poor credit history:

  1. The application process for borrowers with poor credit histories is more complicated and time consuming and, therefore, more costly for lenders.
  2. The costs of collecting and servicing the loan will increase, reducing profits.
  3. Some loans will not be fully repaid, thereby reducing profits.
  4. What other costs might result from lending to a person with a poor credit history?

Credit Application Evaluation

Because granting credit is a form of trust between lender and borrower, only credit-worthy applicants are granted credit at comparatively low rates of interest. The decision to grant credit comes after a careful analysis of an applicant's credit history. Individuals with good credit histories face reduced borrowing costs as interest rates are lower. They also benefit from having multiple sources from which they may borrow. Conversely, individuals who have poor credit histories have higher borrowing costs reflected in higher interest rates and reduced benefits, including the possibility of being ineligible for loans. From the point of view of the lender, persons with good credit histories present lower costs and less risk, and therefore, increase the profit potential of the lender.

Lenders gather information about applicants' willingness and ability to repay from two principal sources: a credit application and a credit report. The credit application is usually a form filled out by the applicant. Credit reports come from credit bureaus that keep files on credit users and sell the information to lenders.

What information does the applicant's credit application and credit report tell you about their:

Useful Formulas

Calculating simple interest
i=prt

i- amount of interest
p - amount borrowed, or principal
r - rate of interest
t - length of time

Note: If r is given as a rate per year, then t must be in years.

Available credit
Credit limit-balance = available credit

Minimum payment
Balance * minimum percent of balance due = minimum payment.

References:

Focus: Personal Decisionmaking 1997. National Council on Economic Education, New York, NY

Personal Finance Economics, 6-8: Money in the Middle, 1996. National Council on Economic Education, New York, NY