Using Credit
Chapter 6
How Will This Affect Me?
The ability to borrow funds to buy goods and services is as convenient as it is seductive. It is
important to understand how to get and maintain access to credit and convenient transactions via
credit cards, debit cards, lines of credit, and other means. This chapter reviews the common
sources of consumer credit and provides a framework for choosing among them. It also discusses
the importance of developing a good credit history, achieving and maintaining a good credit
score, and protecting against identity theft and credit fraud. The chapter will help you understand
the need to use credit intentionally, in a way that is consistent with your overall financial
objectives.
The student needs to understand that the ability to obtain credit is not an invitation to spend
money. The use of credit must be intentional and done for the right reasons. Of special
importance to the students is the section on credit cards and credit scoring, specifically the FICO,
the largest provider of credit scores by far. The FICO scores are a product of Fair Isaac & Co.
LG1 Describe the reasons for using consumer credit, and identify its benefits and problems.
This topic is discussed in the section 6–1a Why We Use Credit. The Power Point slides covers
this topic.
LG2 Develop a plan to establish a strong credit history.
The Financial Road Sign, The 5 C’s of Credit, Page 221, discusses things you can
do to build a strong credit history.
LG3 Distinguish among the different forms of open account credit.
Going over Worksheet 6.1 helps the student to understand the impact of another credit card. The
Section 6.2 discusses the various forms of open account credit. Home Equity Loans are an
important source of credit for homeowners. Financial planners need to understand the
advantages of the home equity loans. The answer to Test Yourself question 6-11 can be used for
this discussion.
LG4 Apply for, obtain, and manage open forms of credit.
Use the Power Points. This topic is well covered in the text. The answer to Test Yourself
question 6-14 discusses the common method used to compute finance charges.
LG5 Choose the right credit cards and recognize their advantages and disadvantages.
The YOU CAN DO IT NOW, “Is Your Credit Card a Good Deal?” can give the student a good
look at their credit cards and with class discussion allow them to compare with other cards. That
could be useful. Section 6-3b discusses the FICO score and how you can increase your score.
LG6 Avoid credit problems, protect yourself against credit card fraud, and understand the
personal bankruptcy process.
Exhibit 6.4 gives a useful look at the Credit Card Act of 2009 about which the students should
increase their awareness. Discussing how to handle unauthorized purchases on their cards and
especially identity theft is important.
I suggest the following exercises will make good homework problems.
Financial Planning Exercise 2 requires the use of the debt safety ratio which is a good thing to
know. The problem uses the ratio to compute amount of debt the debtor can handle.
Worksheet 6.1 evaluating Alyssa’s debt status is used in Financial Planning Exercise 4.
Financial Planning Exercise 9 requires the student to compare two credit cards and discuss which
should be used.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre-test questions” to get their attention.
• One of the benefits of using credit is that it allows you to purchase expensive goods and
services while spreading the payment for them overtime.
Fact: One of the major benefits of buying on credit is that expensive
purchases are made more affordable because the consumer is able to pay
for them systematically over time.
• It’s a good idea to contact your creditors immediately if, for some reason, you can’t make
payments as agreed.
Fact: Let the lenders know and they’ll often give you a credit
extension. This is one of the smartest things you can do to build a sound
credit history. However, except for those occasional tight spots, it’s
important to make credit payments on time consistently!
• Excluding mortgage payments, most families will have little or no credit problems so long as
they limit their monthly credit payments to 25 to 30 percent their monthly take-home pay.
Fantasy: Most experts suggest that you keep your monthly debt
repayment burden, excluding mortgage payments, to 20 percent or less of
your take-home pay. Letting it get as high as 25 to 30 percent can lead to
serious credit problems.
• When you apply for credit, most lenders will contact a credit bureau and let them decide
whether or not you should receive the credit.
Fantasy: Credit bureaus collect information and maintain credit files
about individual borrowers. However, they do not make the credit
decision. That’s done by the merchant or financial institution considering
extending the credit.
• Credit card issuers are required by truth-in-lending laws to use the average daily balance in
your account when computing the amount of finance charges you’ll have to pay.
Fantasy: Truth in lending laws require only that lenders fully disclose the effective rate of
interest being charged and the method used to compute finance charges. Lenders can
choose the specific method used to calculate the balances on which they apply finance
charges. The average daily balance method is the most widely used.
• You use a check rather than a credit card to obtain funds from an unsecured personal line of
credit.
Fact: Credit cards are not issued with unsecured personal credit lines.
Instead, if you want to borrow money through such a line, you do it by
simply writing a check directly against it.
Financial facts or Fantasies as True/False Questions
1. True False One of the benefits of using credit is that it allows you to purchase
expensive goods and services while spreading the payment for
them overtime.
2. True False It’s a good idea to contact your creditors immediately if, for some reason,
you can’t make payments as agreed.
3. True False Excluding mortgage payments, most families will have little or no credit
problems so long as they limit their monthly credit payments to 25
to 30 percent their monthly take-home pay.
4. True False When you apply for credit, most lenders will contact a credit bureau and
let them decide whether or not you should receive the credit.
5. True False Credit card issuers are required by truth-in-lending laws to use the average
daily balance in your account when computing the amount of finance
charges you’ll have to pay.
6. True False You use a check rather than a credit card to obtain funds from an
unsecured personal line of credit.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
Is Your Credit Card a Good Deal?
While your credit card might have been a good deal when you first got it,
that may not still be the case. Go to a credit card Internet site like
http://www.creditcards.com, which allows you to evaluate numerous
credit cards by type. For example, you can focus on 0% APR, rewards, cash
back, travel & airline, cards for students, and more types of cards. It’s worth
a look – you can do it now.
YOU CAN DO IT NOW
How Does Your Credit Report Look?
When did you last check your credit report? It’s a good idea look at it at least
once a year to know where you stand and to assure that there are no errors.
The Fair Credit Reporting Act (FCRA) requires each of the national credit
reporting firms – Experian, Equifax, and TransUnion – to provide a free copy
of your credit report once a year. These three companies have set up an
Internet site where you can get your free annual report at
https://www.annualcreditreport.com. Be careful not to use other
Internet sites that offer free credit reports, free credit monitoring, or free
credit scores. Such sites are not authorized to meet the legal requirements of
the FCRA and often have strings attached. Just go to the authorized site –
you can do it now.
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss
the choices being made.
Stan Has Had It and Files for Bankruptcy
Stan Thompson is overwhelmed by his bills. While making $60,000 a year, he
has amassed credit card debt of $24,000, has an $80,000 college loan, holds
a $150,000 mortgage, and pays monthly on his leased Jetta. He’s having
trouble paying the mortgage monthly and can never seem to pay more than
the minimum on his credit card debt. Stan’s wife, Zoe, is currently
unemployed. Stan has heard that declaring bankruptcy can eliminate some
of his debt commitments and give him extra time to deal with others. He’s
had it and just filed for bankruptcy. What can Stan look forward to as a result
of his decision?
Stan can expect some cash ?ow relief in the short-term and filing for
bankruptcy will likely prevent or at least delay foreclosure on his home.
However, the bankruptcy filing will adversely affect his credit report for up to
the next 10 years. Stan will probably have trouble getting a loan or a new
credit card. And if he can borrow money or get a new credit card, he’ll
probably have to pay the highest allowable interest rate. By not having
managing his family’s indebtedness, Stan has exercised the bankruptcy
“nuclear option.” This provides short-term relief at the expense of longer–
term access to credit on reasonable terms.
Applying Personal Finance
How’s Your Credit?
Establishing credit and maintaining your creditworthiness are essential to your financial well-
being. Good credit allows you to obtain loans and acquire assets that you otherwise might not be
able to attain. This project will help you to examine your credit. If you’ve already established
credit, get a copy of your credit report from one of the credit bureaus mentioned in this chapter.
(If you’ve applied for a loan recently, your lender may already have sent you a copy of your
credit report.) Carefully examine your report for any inaccuracies, and take the necessary steps to
correct them. Then look over your report and evaluate your creditworthiness. If you feel you
need to improve your creditworthiness, what steps do you need to take?
If you haven’t yet established credit, find an application for a card such as Visa, MasterCard, or a
department store or gasoline company credit card. Places to look might be at a department store,
banking institution, gas station, or the Internet. Take the application home and fill it out. Then
look it over and try to do a self-evaluation of your creditworthiness. Based on the information
that you’ve provided, do you think you would qualify for the credit card? What do you see as
your major strengths? What are your major weaknesses? Is there anything you can do about
them?
Test Yourself
6-1 Why do people borrow? What are some improper uses of credit?
Whatever their age group, people tend to borrow for several major reasons.
• To avoid paying cash for large outlays: Rather than pay cash for large purchases such as
To meet a financial emergency: For example, people may need to borrow to cover living
expenses during a period of unemployment or to purchase plane tickets to visit a sick relative. As
For convenience: Merchants as well as banks offer a variety of charge accounts and credit cards
For investment purposes: As we’ll see in Chapter 11, it’s relatively easy for an investor to
Many people use consumer credit to live beyond their means. For some people, overspending
becomes a way of life, and it is perhaps the biggest danger in borrowing—especially because it’s
6-2 Describe the effects of the credit crisis of 2008–2009 on borrowers.
As credit became more readily available and easier to obtain, it also became increasingly
clear that many consumers were, in fact, severely overusing it. Whether or not the consumer
6-3 Describe the general guidelines that lenders use to calculate an applicant’s maximum
debt burden.
The willingness of lenders to extend credit depends on their assessment of your creditworthiness
—that is, your ability to promptly repay the debt. Lenders look at various factors in making this
6-4 How can you use the debt safety ratio to determine whether your debt obligations are
within reasonable limits?
The easiest way to avoid repayment problems and ensure that your borrowing won’t place an
undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt!
A useful credit guideline (and one widely used by lenders) is to make sure your monthly
6-5 What steps can you take to establish a good credit rating?
Here are some things you can do to build a strong credit history:
• Use credit only when you can afford it and only when the repayment schedule fits comfortably
into the family budget—in short, don’t overextend yourself.
6-6 What is open account credit? Name several different types of open account credit.
Open account credit is a form of credit extended to a consumer in advance of any transactions.
Typically, a retail outlet or bank agrees to allow the consumer to buy or borrow up to a specified
Open account credit generally is available from two broadly defined sources: (1) financial
institutions and (2) retail stores/merchants. Financial institutions issue general-purpose credit
cards, as well as secured and unsecured revolving lines of credit and overdraft protection lines.
Commercial banks have long been the major providers of consumer credit; and, since
6-7 What is the attraction of reward cards?
One of the fastest-growing segments of the bank card market is the reward (cobranded) credit
card, which combines features of a traditional bank credit card with an incentive: cash,
6-8 How is the interest rate typically set on bank credit cards?
Most of these cards have variable interest rates that are tied to an index that moves with market
rates. The most popular is the prime or base rate: the rate a bank uses as a base for loans to
individuals and small or midsize businesses. These cards adjust their interest rate monthly or
quarterly and usually have minimum and maximum rates. Generally speaking, the interest rates
6-9 Many bank card issuers impose different types of fees; briefly describe three of these
fees.
Many (though not all) bank cards charge annual fees just for the “privilege” of being able to use
the card.
Many issuers also charge a transaction fee for each (non-ATM) cash advance; this fee usually
6-10 What is a debit card? How is it similar to a credit card? How does it differ?
A debit card provides direct access to your checking account and thus works like writing a check.
A big disadvantage of a debit card, of course, is that it doesn’t provide a line of credit. In
addition, it can cause overdraft problems if you fail to make the proper entries to your checking
Another difference between debit and credit cards involves the level of protection for the user
when a card is lost or stolen. When a credit card is lost or stolen, federal banking laws state that
6-11 Describe how revolving credit lines provide open account credit.
Revolving lines of credit normally don’t involve the use of credit cards. Rather, they’re accessed
by writing checks on regular checking accounts or specially designated credit line accounts.
They are a form of open account credit and often represent a far better deal than credit cards, not
6-12 What are the basic features of a home equity credit line?
A home equity credit line is much like unsecured personal credit lines except that they’re
Home equity lines also have a tax feature that you should be aware of: the annual interest charges
on such lines may be fully deductible for those who itemize. This is the only type of consumer
loan that still qualifies for such tax treatment. According to the latest provisions of the tax code, a