which leaves little room for error or other costs. His debt safety ratio is 67 percent
[$555/($10,000/12)], well over the 20 percent standard maximum ratio. Not good for Justin.
Collateral: Justin has $6,000 in cash and a $10,000 car. Even if the car can be sold for its value,
he has little collateral for the $50,000 loan. Not good for Justin.
Critical Thinking Problems
6.1 The Gonzales Family Seeks Some Credit Card Information
Luis and Elena Gonzales are a newly married couple in their mid-20s. Luis is a senior at a
state university and expects to graduate in the summer of 2021. Elena graduated last spring
Critical Thinking Questions
1. Advise the couple on how to fill out a credit application.
The type of information requested in a typical credit application covers little more than
personal/family matters, housing, employment and income, and existing charge accounts. It is
Capital, and Condition.
2. Explain to them the procedure that the bank will probably follow in processing their
application.
The steps involved are first to complete the application. Then the application will be reviewed,
3. Tell them about credit scoring and how the bank will arrive at a credit decision.
The bank will use some type of credit scoring scheme will be used to make the decision. An
overall credit score is developed for you by assigning values to such factors as your annual
that identify the characteristics to look at and the scores to assign.
4. What kind of advice would you offer the Gonzales family on the best use of their card?
What would you tell them about building a strong credit record?
Of course, the simple advice is to only use the card for planned, budgeted purchases. Do not
succumb to impulse buying. Raising your FICO score takes time, and there’s no quick fix. But
here are some tips that you might want to follow to reach a higher score:
• Pay your bills on time.
6.2 Molly Starts Over After Bankruptcy
A year after declaring bankruptcy and moving with her daughter into a home with her
sister, Molly Graham is about to get a degree in nursing. As she starts out in a new career,
she also wants to begin a new life—one built on a solid financial base. Molly will be starting
out as a full-time nurse at a salary of $66,650 a year, and she plans to continue working at a
second (part-time) nursing job with an annual income of $21,000. She’ll be paying back
$24,000 in bankruptcy debts and wants to be able to move into an apartment within a year
and then buy a condo or house in five years.
Critical Thinking Questions
1. In addition to opening checking and savings accounts, what else might Molly do to begin
establishing credit with a bank?
Obviously, the first thing Molly has to do is pay back the $24,000 in bankruptcy debt— and the
sooner that can be done, the better! She has to show that she now has the discipline to pay off the
2. Although Molly is unlikely to be able to obtain a major bank credit card for at least a
year, how might she begin establishing credit with local merchants?
She might look into the possibility of obtaining a charge card from one or two major department
3. What’s one way she might be able to obtain a bank credit card? Explain.
For at least a year or so, probably the only way she will be able to obtain a bank credit card is to
4. How often should Molly monitor her credit standing with credit reporting services?
5. What general advice would you offer for getting Molly back on track to a new life
financially?
Molly needs to know that it is possible to start over again. In addition, she should take the time to
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
houses and cars, most people borrow part of the purchase price and then repay the loan on some
6-2 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 the 5 C’s of
credit:
The 5 Cs of Credit
Lenders often look to the “5 Cs of Credit” as a way to assess the willingness and
ability of a borrower to repay a loan.
1. Character. A key factor in defining the borrower’s willingness to live up to the
terms of the loan.
2. Capacity. The ability of the borrower to service the loan in a timely fashion.
6-3 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!
6-4 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
6-5 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
amount on open account. Credit is extended so long as the consumer does not exceed the
6-6 What is the attraction of reward cards?
One of the fastest-growing segments of the bank card market is the reward (cobranded) credit
6-7 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
6-8 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
6-9 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
account ledger or inadvertently use it when you think you’re using a credit card. Also, some
6-10 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
6-11 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
secured with a second mortgage on the home. These lines of credit allow you to tap up to 100
percent (or more) of the equity in your home by merely writing a check.
6-12 Describe credit scoring and explain how it’s used (by lenders) in making a credit
decision.
Using the data provided by the credit applicant, along with any information obtained from the
credit bureau, the store or bank must decide whether to grant credit. Very likely, some type of
credit scoring scheme will be used to make the decision. An overall credit score is developed
for you by assigning values to such factors as your annual income, whether you rent or own your
6-13 Describe the basic operations and functions of a credit bureau.
A credit bureau is a type of reporting agency that gathers and sells information about individual
borrowers. If, as is often the case, the lender doesn’t know you personally, it must rely on a cost-
effective way of verifying your employment and credit history. It would be far too expensive
and time-consuming for individual creditors to confirm your credit application on their own, so
6-14 What is the most common method used to compute finance charges?
According to the Truth in Lending Act, lenders disclose the rate of interest that they charge and
their method of computing finance charges. This is the annual percentage rate (APR), the true
or actual rate of interest paid, which must include all fees and costs and be calculated as defined
by law.
6-15 The monthly statement is a key feature of bank and retail credit cards. What does this
statement typically disclose?
6-16 What are some key factors that you should consider when choosing a credit card?
Refer to Financial Planning Tips, “Choosing the Best Credit Card for You.” The major factors
are:
Spending Habits
6-17 Discuss the steps that you would take to avoid and/or resolve credit problems.
The real problems occur when your use of credit cards is no longer temporary, and the debt
continues to increase. If overspending is not curtailed, then the size of the unpaid balance may
seriously strain the budget. The best way to avoid credit problems is to be disciplined when
using credit.
6-18 What’s the biggest source of credit card fraud? List at least five things you can do to
reduce your chances of being a victim of credit card fraud.
Stolen account numbers are the biggest source of credit card frauds. Be especially careful where
you use your credit card on the Internet. To reduce you chances of being defrauded, here are
some suggestions.
Never, ever, give your account number to people or organizations who call you. No matter how
legitimate it sounds, if you didn’t initiate the call then don’t give out the information!
6-19 Distinguish between a Wage Earner Plan and straight bankruptcy.
The Wage Earner Plan (as defined in Chapter 13 of the U.S. Bankruptcy Code) is a workout
procedure involving some type of debt restructuring—usually by establishing a debt repayment
schedule that’s more compatible with the person’s income. A majority of creditors must agree to
the plan, and interest charges, along with late-payment penalties, are waived for the repayment
period.
Key Terms
affinity cards
A standard bank credit card issued in conjunction with some
charitable, political, or other nonprofit organization.
annual percentage
rate (APR)
balance
(ADB) method
to the ADB of the account over the billing period.
base rate
The rate of interest a bank uses as a base for loans to individuals and
small to midsize businesses
The actual or true rate of interest paid over the life of a loan; includes
all fees and costs.
cash advance
A loan that can be obtained by a bank credit cardholder at any
participating bank or financial institution.
credit bureau
An organization that collects and stores credit information about
individual borrowers.
credit counselor
A professional financial advisor who assists overextended consumers
in repairing budgets for both spending and debt repayment.
credit investigation
An investigation that involves contacting credit references or
corresponding with a credit bureau to verify information on a credit
application.
credit limit
A specified amount beyond which a customer may not borrow or
purchase on credit.
credit scoring
A method of evaluating an applicant’s creditworthiness by assigning
values to such factors as income, existing debts, and credit references.
credit statement
A monthly statement summarizing the transactions, interest charges,
fees, and payments in a consumer credit account.
debt safety ratio
The proportion of total monthly consumer credit obligations to
monthly take-home pay.
pay your credit card bill in full and not incur any interest charges.
home equity credit
line
A line of credit issued against the existing equity in a home.
line of credit
The maximum amount of credit a customer is allowed to have
outstanding at any point in time.
minimum monthly
payment
In open account credit, a minimum specified percentage of the new
account balance that must be paid in order to remain current.
open account credit
A form of credit extended to a consumer in advance of any
transaction.
personal
bankruptcy
A form of legal recourse open to insolvent debtors, who may petition
a court for protection from creditors and arrange for the orderly
liquidation and distribution of their assets.
prepaid card
A plastic card with a magnetic strip or microchip that stores the
amount of money the purchaser has to spend and from which is
deducted the value of each purchase.
revolving line of
credit
A type of open account credit offered by banks and other financial
institutions that can be accessed by writing checks against demand
deposit or specially designated credit line accounts.
reward (co-
branded)
credit card
A bank credit card that combines features of a traditional bank credit
card with an additional incentive, such as rebates and airline mileage.
secured
(collateralized)
credit cards
unsecured personal
credit line
A line of credit made available to an individual on an as-needed basis.
Wage Earner Plan
An arrangement for scheduled debt repayment over future years that is
an alternative to straight bankruptcy; used when a person has a steady
source of income and there is a reasonable chance of repayment
within 3 to 5 years.
A type of credit card that’s secured with some form of collateral, such
as a bank CD.
Chapter Outline
Learning Goals
I. The Basic Concepts of Credit
A. Why We Use Credit
B. Improper Uses of Credit
C. Establishing Credit
II. Credit Cards and Other Types of Open Account Credit
A. Bank Credit Cards
1. Line of Credit
B. Special Types of Bank Credit Cards
1. Reward Cards
2. Affinity Cards
III. Obtaining and Managing Open Forms of Credit
A. Opening an Account
1. The Credit Application
2. The Credit Investigation
3. The Credit Bureau
IV. Using Credit Wisely
A. Shop Around for the Best Deal
B. Avoiding Credit Problems
C. Credit Card Fraud
Planning over a Lifetime
Financial Impact of Personal Choices