Finance 102 - Personal Finance

Financial and Self-Reliant Principles

FIN102 PERSONAL FINANCE

FIN 102-Personal Finance Chapter 5
 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |2

Chapter 5
Understanding Credit
Save Now – Buy Later

“The rich rule over the poor, and the borrower is servant to the
lender” Proverbs 22:7

“Pay the debt thou hast contracted… Release thyself from

bondage” D&C 22:7

Objectives
1. Compare the various types of credit.

2. Discuss the advantages and disadvantages of using credit.

3. Compute the value of owning appreciating assets and the cost of owning
depreciating assets.

4. Compute the benefit of saving versus borrowing.

5. Calculate your credit capacity.

6. Compare interest calculation methods.

7. Realize the consequences of minimum payments.

8. Manage your credit rating.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |3

INTRODUCTION
Borrowing money to pay for consumer purchases has become a way of life
in the materialistic world we live in. But sometimes it is impossible to get what
we need (versus want) without borrowing money. Who can pay cash for a
home, or a car, or education? Most people cannot. These assets have
been endorsed by Church Leaders as asset for which it is ok to borrow
money AS LONG AS a modest home, a functional (not exotic) car, and an
education that leads to reliable earnings is the goal.

But too often, money is borrowed to purchase things that aren’t really
needed but are wanted. As one author put it: “People use money they
don’t have to buy things they don’t need.”

Using Credit
There is almost $2.5 trillion of outstanding consumer credit1 in the United States,
which is over

$8,000 for every person in the country. This amount is continuously growing.
You undoubtedly receive offers in the mail on a regular basis to open a
charge account. Credit is readily available to anyone with a reasonable
credit record or even with no credit record. This is especially true of recent
high school graduates and college students.

Paying cash for your consumer purchases is always the best financial
strategy. Rather than buying now and paying later with the interest charges
that go with borrowing money, you will always be better off financially to
save and earn interest and then pay cash for your purchases.

Types of Credit
So where does one borrow money to make purchases when cash is not
available? There are basically two credit sources; open-ended credit lines
and closed-ended credit lines.

1Consumer Credit – we’ll discuss this more in detail later in this chapter, but a quick
definition is that consumer credit it the amount of money borrowed to buy things EXCEPT a
home. In other words, mortgage loans are NOT considered part of Consumer Credit.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |4

Open-end credit
Open-end credit is a line of credit (credit account) that you can add to for various
purposes. Examples are credit cards, charge accounts and home equity lines of
credit (HELOC). You make payments in varying amounts. There is a credit limit you
cannot exceed and minimum payments are required.

Do not confuse a debit card with a credit card. When you use a debit card, the
purchase amount is electronically deducted from your checking account. You
can think of using a debit card as making an immediate payment using an
“electronic check.” This can be a convenient way to make purchases.

Closed-end credit
Closed-end credit lines involve a contract to borrow and repay a specific amount
over a specified time period in equal installments. Examples include a mortgage
loan, automobile loan, installment loan to buy furniture, and so forth.

Advantages of Credit
Credit allows you to enjoy goods and services now and pay for them in the future.
It is a convenience when shopping and allows you to pay for many purchases
with a single payment. You can make reservations, shop by phone and mail, rent
a car, and buy groceries. Your credit card company will send you a consolidated
statement of your expenses.

You can get as much as a 50-day “float” with a credit card, which is the time
between your purchase and the actual payment. There is also a grace period of
several days between the time you are billed and when the payment is due. No
finance charges are made on current purchases during the grace period. This is
beneficial when you pay the full amount of your monthly credit orcharge account
balance. Some credit cards and charge accounts provide a rebate, cash bonus,
or discount for future purchases. They also inform you of special sales and
promotions in your monthly billing.

If you buy an asset on credit that appreciates in value, you benefit financially as
long as the asset increases in value by more than you pay in interest or finance
charges. This is called “leverage” and it allows you to use debt to magnify your
wealth. However, if you pay more for the debt than you realize in increased value,
or if the value of the asset decreases in value, this reduces your wealth. Most cars
and other consumer assets decrease in value while most homes and investment
assets increase in value.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |5

To illustrate the concept of “leverage”, assume you buy a home costing $200,000,
make a down payment of 10% or $20,000, and borrow the remaining $180,000 at
6% interest for 30 years. By the time you make your final payment to the bank,
you will end up having paid $408,509 for the

$200,000 home. The calculation is as follows:

Excel Formula: =PMT(.06/12,30*12,180000,0)*360-20000 Result: ($408,509)

Your monthly payment is $1,079 and you make 360 payments to which you must
add the down payment. Notice that you end up paying more in interest than the
original cost of the home. However, if you buy the home in the right location
where it will increase in value, you will come out ahead assuming that the value
of the home appreciates.

Assume your home increases in value by 3.5% per year, which is a reasonable
assumption. Your home will be worth $561,359 in thirty years. To determine the
future value of the home, use the Excel FV formula as follows:

Excel Formula: =FV(.035,30,0,-200000) Result: $561,359

To calculate the increase in your personal wealth over the 30 years you own the
home, find the difference between the FV of the home ($561,359) and the original
cost, ($408,509) as follows:

($561,359 (FV) - $408,509 (Cost) = $152,850.

The increased value of your home is the leverage that makes your wealth
increase by using credit to purchase the home. Borrow money (i.e. using credit)
can work to your advantage when you use it to purchase appreciating assets.

Disadvantages of Credit
The major disadvantages of credit cards, charge accounts, and installment
contracts are overspending and the high cost of credit. Spending what you do
not have and cannot pay for will result in loss of goods, income, reputation, peace
of mind, and even your health. It can result in court actions and bankruptcy.
Family relations suffer and financial net worth diminishes.

The use of credit must be accompanied with a high degree of personal discipline.
Discipline is required to make credit work for you. Partial or missed payments will
cause credit to work against you. If you do not have the necessary discipline, the

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |6

best practice is to cut up your charge cards, do not apply for new ones, and stop
buying on credit.

If you buy an asset that depreciates or decreases in value, your wealth will shrink.
Buying a car, for example, that costs $21,000 including taxes and fees, making a
down payment of $1,000, and borrowing $20,000 at 7% interest for four years will
cost you $23,988 as follows:

Excel Formula: =PMT(.07/12,48,20000)*48-1000 Result: ($23,988)

Your monthly payment will be $478.92 and you will make 48 payments. Plus you must
add on the

$1,000 down payment.

To determine the worth of the car in four years you must subtract the depreciation.
Cars depreciate at an average of about 18% per year, but it depreciates more
during the first years and less in the later years. To determine the future
depreciated value of the car, use the FV formula. Calculate the depreciation on
an annual basis so you do not change the interest rate or the periods to monthly.
You can estimate the value of the car in four years as follows:

Excel Formula: =FV(-.18,4,0,-21000) Result: $9,495

Note: The 18% is negative in the formula, which means a decrease in future value
by 18% per year rather than the increase we have been calculating in former
formulas. Also, this is an annual decrease so there is no conversion to monthly.

So you have paid $23,988 for the car that is now worth $9,495. Your wealth has
decreased by

$14,494 ($9,495 - $23,988 = -$14,494).

Owning a car is expensive! We will learn how to minimize this expense in Chapter
5 - Transportation.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |7

Consumer Credit
So far we have talked about credit in general. But in the financial community the
term consumer credit is often used and has a specific meaning. What is it?

As a consumer you buy what you need and what you want. You buy what you
can afford and sometimes what you cannot afford. When you do not have the
money to buy something you want or need, you can charge it to a credit card
account or put it on an installment loan contract. In either case you borrow money
to make the purchase now with a promise to pay back later what you borrowed
PLUS interest.

Such borrowing is called consumer credit; sometimes referred to as consumer

debt. Consumer credit is the portion of total user debt used to buy non-investment
services consumed or goods that depreciate quickly. So using a credit card to
purchase food or clothes would add to consumer debt. Also included would be
debts incurred for automobiles, education, recreational vehicles (RVs), boats and
trailer loans, etc. NOT included in consumer credit are debts obtained to
purchase margin on investment accounts or real estate. Therefore, a mortgage
loan is NOT considered consumer credit. However, the 65-inch high-definition
television charged on a credit card is consumer credit2.

The most common form of consumer credit is a credit card. Retailers, department
stores, banks and other financial institutions offer consumer credit.

Consumer Credit Capacity

How much consumer credit can you afford? You do not want to afford any
except on appreciating assets and often you must ask yourself some tough
questions. What will you give up to pay the monthly payments? Will you give up
some of your planned savings? Will you have to cut back on gifts, clothing, eating
out, entertainment, or some other discretionary expenditure in your budget, or are
you willing to forgo necessities? Are you willing to make the necessary sacrifices
for the item you want to purchase on credit? These are the responsible questions
you must honestly answer.

While we have been counseled to eliminate consumer debt (and therefore the
bondage that results), financial experts say you can afford to spend 15 to 20
percent of your take home pay (net or after-tax monthly income) on consumer
debt. Remember this excludes mortgage payments. This percentage estimate is
illustrated in Exhibit 8.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |8

This estimate is based on an average family with average income with adequate
savings for emergencies. You should not consider yourself safe with 20 percent
credit payments if you are just beginning to use credit. The amount of your net
worth will also determine how much debt you can afford as measured by your
debt-to-equity ratio. Your debt-to-equity ratio is your total debt outstanding
divided by your total net worth. The higher the ratio the more risk you have. This
ratio should never exceed 1, which means that your debt and net worth are
equal.

If you exceed the maximum guideline of 20% of your take home pay going to
consumer debt payments, you will risk becoming bankrupt. This means you can
no longer meet your financial obligations and you must go to the bankruptcy
court to get a new start. As a result, you lose your credit standing and your ability
to borrow at any kind of reasonable interest rate.

While you can manage a certain level of consumer debt, you will always give up
potential savings and the income those savings will produce.

Take-home Pay
In Chapter 1 we introduced the concept of a Cash Flow Statement (Personal
Budget). Many of the guidelines and counsel that you will receive pertaining to
credit are based on “take-home pay” instead of “gross pay”. Therefore, it is
important to know how to calculate take-home pay.

The guidelines quoted in the previous paragraphs were based on “net pay (take-
home pay)”. Almost everyone can tell you their gross pay. It is the answer we all
give when someone asks us “How much money do you make?” I make $20 per
hour and I work 30 hours per week. We know that our paycheck should be $600.00
($20 * 30 = $600). While we state that we make $600 for that week, we do not
have $600 to deposit into the bank. But there are many things that can be
deducted from a paycheck to arrive at the net amount or take-home pay. Various
taxes (Federal, State, etc.) are the most common items deducted.

2
http://www.investopedia.com/terms/c/consumercredit.asp#ixzz4ITXJUCfl

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT PAGE |9

It is important to note that some items qualify to be deducted BEFORE taxes are
calculated. This has the effect of lowering the tax rate. The most common items
deducted “pre-tax” is a 401(k) (money set aside for retirement) contribution. If you
also have an IRS qualified employer medical plan, the premiums that you pay as
the employee share are also “pre-tax” deductions.

Exhibit 8 shows an example of a gross income of $3,000. 10% is set aside for
retirement in a qualified 401k plan. Therefore, it is deducted from the gross pay
BEFORE taxes are calculated. In the example of Exhibit 8, the 12% Federal Income
Tax is calculated on the $2,700 taxable income amount, NOT the $3,000 gross
amount. That is a tax savings of $36. All of the taxes are calculated and subtracted
from the $2,700 taxable income amount. The actual take-home pay is $2,036.

The Dangers and Consequences of Using Credit

The bondage caused by too much debt is real and tragic. You can tell when you
have too much debt by monitoring the danger signals, including the following (as
shown in Advice for Consumers Who Use Credit (Silver Springs, MD: Consumer
Credit Counseling Service of Maryland, Inc.) and How to Be Credit Smart
(Washington, DC: Consumer Credit Education Foundation). If your household is
experiencing more than two of these warning signals you need to examine your
budget for ways to reduce expenses.

• Paying only the minimum balance on credit card bills each month

• Increasing the total balance due on credit accounts each month

• Missing payments, paying late, or paying some bills this month and others next
month

• Intentionally using the overdraft or automatic loan features on checking

accounts or taking frequent cash advances on credit cards

• Using savings to pay routine bills such as groceries or utilities

• Receiving second or third late payment notices from creditors

• Not talking to your spouse about money or talking only about money

• Depending on overtime, moonlighting, or bonuses to meet everyday

expenses

• Borrowing money to pay old debt

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 10

• Not knowing how much you owe until the bill arrives

• Going over your credit limit on credit cards

• Having little or nothing in savings to handle unexpected expenses

• Being denied credit because of a negative credit bureau report

• Getting a credit card revoked by the issuer

• Putting off medical or dental visits because you can’t afford them right now

Calculating the Cost of Credit

The truth in lending law of 1969 requires that lenders provide borrowers with the
exact cost of credit. This allows you to compare alternative sources of credit
because you will know in advance how much you must pay in finance charges
and in the Annual Percentage Rate (APR), and Annual Percentage Yield (APY

). APR is the stated annual percentage rate of the loan. APY is the effective
annual interest rate that you actually pay including all of the finance charges and
other fees. Finance charges are the total dollar amount you will pay for the money
you borrow. This amount includes interest plus other charges such as service
charges, credit insurance, and any other fees. The APY formula and an example
of APY calculations using various methods of determining finance charges are
provided in Exhibit 9.

Use the following 5 steps to determine the Cost of Credit:

1. Determine the original loan (the amount you originally wanted to borrow)

2. Calculate the final loan amount (the original loan + fees, loan processing
costs, etc.)

3. Calculate the payment amount (PMT function on the final loan amount)

4. Calculate the total amount paid back (PMT * NPER)

5. Subtract #1 from #4 (the total amount paid back – original loan amount)

For example, you want to purchase a car. #1 – The total cost of the car (including
taxes, license and dealer prep fees) is $16,500.00. #2 – You are going to finance
the car through your bank at 5% APR for 4 years. The bank charges you $100 to
open the account, set up the loan and process the paperwork. Therefore, your

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 11

total loan from the bank is $16,600 ($16,500 + $100). #3 – The payment on this
loan will be $382.29. #4 – The total amount paid back to the bank will be

$18,349.74 ($382.29 * 48). #5 – The total cost of credit is $1,849.74 ($18,349.74 -

$16,500).

As another example, the following will show how the additional bank fees and
other charges have an impact on the APY. If you borrow $1,000 and the bank
charges you a 1% loan fee ($10) and you also borrow the fee, your loan amount
is now $1,010. If your loan is for 1 year and you make 12 payments at 9% APR
compounded monthly, your payments would be calculated as follows:

PMT Formula: =PMT (0.09/12,1*12,1010) Result: ($88.33)

Since you are borrowing the loan fee and only have use of the $1,000, your APY
will be more than your original interest rate of 9% (APR). Before you calculate the
APY, you must first determine the total dollar cost of credit as follows:

$88.33 (monthly payment) * 12 (number of payments) = $1,059.91 (total

repaid)

Subtract $1,000 (loan amount not including the fees) from $1,059.91 to get the
total dollar cost of credit: $59.91 You can now apply the above figures to the
following APY formula:

APY = 2 * n * I / P * (N+1)

Where:

n = Number of payments in a year

I = Total dollar cost of credit (finance

charges or interest)

P = Principal or net amount of the loan

N = Total number of payments to repay the loan

Calculation: APY = 2 * 12 * 59.91 = 1,437.84 = 11.1%

1,000 * (12+1) 13,000

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 12

In this example with an APR of 9%, the APY is 11.1% because you are borrowing
the fees and only have the use of the net amount of the loan.

The terms or provisions of any loan can be very different from another loan, and
therefore makes a comparison very difficult. However, the APY calculation is
always the same so you can make a direct comparison and know just how much
the interest rate is on any loan.

Open-End Credit Cost

The cost of finance charges for credit card and charge account credit and other
forms of open-end credit are not determined using APY formula, but by using
various methods to determine the balance on which the stated APR is applied.
The lender must inform you of the APY and method used to determine the
balance on which you will be charged. Following are three basic ways finance
charges are calculated:

1. Adjusted balance method. Adds finance charges after subtracting payments

during the billing period. This is the least expensive method. This method is not
commonly used but is the easiest to calculate. For that reason, we
occasionally use this method in class.

2. Previous balance method. Does not give credit for payments during the billing
period. This is the most expensive method and is used in most home equity and
car loans.

3. Average daily balance method. Uses the balance each day and divides by
the number of days in the period. The average daily balance is the fairest
method for credit cards because the earlier in the month you make your
payments, the less interest you pay. This is the most common method used by
credit card companies.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 13

The following chart outlines examples of these methods:

Adjusted Previous Average daily balance

balance balance

Monthly 1.5% 1.5% 1.5%

interest rate at
18% APR

Previous $500 $500 $500

balance

Payments $300 $300 $300

(assume on the 15th day)

Interest charge $500 - $300 = ($500 * 1.5%) $500 - $300 = $200

$200

($200 * 1.5%) =$7.50 ($200 + $300 * 15/30) =

$350

=$3.00 ($350 * 1.5%)

=$5.25

Note: The average daily balance of $350 is arrived at by first subtracting the payment ($300) from
the previous balance ($500). Next add to the $200 the payment amount times the percent of the
month when the payment was made. In this example it is 15/30 or 50% which assumes 30 days in
the month and a payment received on the 15th day of the billing cycle). Last add the $150 to $200
to get $350, which is the amount to which the interest rate is applied.

As illustrated in these examples, regardless of the method used, the finance

charges are different even though there are no new purchases, and the
payments and APR (18 % [1.5% * 12]) are the same.

The lender must tell you how much grace period you have before finance
charges are added. In most cases there is no grace period if there is an
outstanding balance on your account from the prior month. You must pay the
total balance each month to qualify for the interest-free grace period. Additional

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 14

fees are added to the finance charges if no payment is made during the period.
These additional fees can be a substantial penalty. You should understand how
finance charges are applied on your account so you can minimize your cost of
credit.

Consider the extra cost before you make a credit purchase. If you regularly miss
payments or make partial payments you will (a) incur penalties, (b) incur greater
interest rates, and (c) receive a poor credit rating, which may limit your ability to
secure a loan and could also adversely affect your personal reputation, future
job opportunities, and the ability to rent or buy a home. A $50 dinner could cost
$75 to $100; a $100 dress or coat could cost $150 to $200; a $200 sound system
could cost $300 to $400.

Bottom line… credit is expensive! The interest and finance charges will
substantially increase the cost of consumer goods and services. Credit card
accounts allow you to pay a minimum amount on the outstanding balance. If you
pay only the minimum, you will end up paying considerably more for everything
you buy.

The Cost of Making Minimum Monthly Payments

A major problem with open-ended credit is that you are generally allowed to
make a minimum monthly payment. This may be 2% of the outstanding balance
or $20 whichever is greater.

For example, if you purchase a $2,000 sound system using a credit card with 18.5%
interest rate and pay only a 2% minimum payment (or $20, whichever is greater),
it will take 19 ½ years to repay. You will pay a total of $5,949.50 ($3,949.50 in
interest), nearly triple the original cost of the stereo. Not to mention that the super-
expensive stereo system is now 20 years old!! This is calculated for the first year as
follows using the adjusted balance method:

The above calculations are made in Excel as follows:

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 15

2% Minimum in C2 =B2*.02 Result = $40.00

Interest in D2 =(B2-C2)*.185/12 Result = $30.22

Ending Balance in E2 =B2-C2+D2 Result =

$1,990.22

2nd Month Beginning Balance in =E2 Result =

B3 $1,990.22

After one year you have paid $467.29 and been charged $353.00 in interest so
you have reduced the balance in your charge account by the difference of only
$114.29.

This is why it will take almost 20 years to pay for the sound system and you will have
paid a totalof $5,950 for a $2,000 sound system! You can see why so many people
are taking out bankruptcy because they use multiple credit cards and pay the
minimum balance due each month and keep adding to their consumer debt until
they can no longer even make the minimum payments.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 16

Paying the minimum due on a credit card is a devastating financial management

approach. If you cannot resist the temptation to do so, cut up your credit cards
and pay for everything with cash or check so you are only spending money you
have.

Use Credit Wisely

Credit can be a benefit if used properly. Following are some expenses where the
use of credit may be justified. However, even in these expenses it is important to
use wisdom and not create an obligation that will place a hardship on your future.

Suggested expenses Justification for using

credit

Emergencies No cash - use short term

credit

Education Investment in future

income

Transportation To facilitate employment

Diamond wedding ring Appreciates in value and

brings many happy
returns

Home Appreciates in value and

builds equity

Most often expenditures and especially consumer purchases should be paid for
out of current income or accumulated savings. The basic rules for properly using
credit are:

1. Set a goal to eliminate debt. Remember, your goal is to collect interest, not pay it.

2. Pay the total balance on charge or credit accounts each month or don’t use them.

3. Make all loan payments on time.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 17

Use Student Loans Wisely

It is unfortunate than some students consider student loans to be “free money”.
They borrow the maximum that is allowed under the student loan policies without
consideration for the significant challenges they will face in the future.

The title of an article in USA Today newspaper highlighted this growing problem:
Student Loan Debt: A Ticking Time Bomb? (USA Today, Feb 8, 2012). The article
begins:

“Student debt is looming as a national problem that could have

repercussions reminiscent of the mortgage crisis, says a new report by the
National Association of Consumer Bankruptcy Attorneys.

Total debt from student loans is about $1 trillion, about 14 times more than
15 years ago, and well above the estimated total credit card debt of $798
billion.

The study, released Tuesday and based on a nationwide survey of 860

bankruptcy lawyers,said bankruptcy attorneys nationwide are seeing "what
feels too much like what they saw before the foreclosure crisis crashed onto
the national scene."

As an example of this concern, assume that you are a student at Ensign College.
You borrow $2,500 per semester for six semesters. Your student loan interest rate is
6.5%. After you graduate you decide you can repay $150 per month. How long
does it take you to pay off your student loans?

Excel Formula: =Nper (.065/12,-150,(2500*6)) Result: 144.4 months

You used student loans for six semesters and then it takes you over twelve years
to pay them off. Would it have been better to work a part-time job and not use
student loans (or significantly less amount) even if it meant taking fewer hours per
semester?

This example reminds us that any debt should be a concern to us, even if it is for
worthwhile reasons. Use the tools and skills learned in this course to clearly
evaluate the alternatives before entering into any debt and fully understand the
consequences.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 18

Credit Alternatives
Going Without
The very first option that should come to mind in considering whether to buy
something on credit is being honest about whether you really NEED it. Too many
young couples succumb to peer pressure and end up with new cars, fully
furnished and landscaped homes, and the latest fashion in clothes. They often
ignore the good example of their parents who waited a year to have enough
money to buy their first dining room table; content with using a camp table until
they had saved enough.

So be honest with yourself. Do you really NEED the item that you are about to go
into debt for? Why not save until you can pay cash for an item?

Saving Versus Borrowing

Remember the $21,000 car that was purchase before? What if you had saved the
money to buy the car instead of borrowing the money? If you saved $478.92 per
month at 5% interest for 48 months, you would have much more than the $21,000
to pay cash for the car. To determine how many months it would take you to save
the $21,000, use the Nper formula as follows:

Excel Formula: =Nper (.05/12,-479,0,21000) Result: 40.4 months

You put $19,348.37 ($478.92 * 40.4) into your saving account and have earned
$1,651.63

in interest ($21,000 - $19,348.37). You saved $478.92 per month rather than paying
that much per month. When you borrowed the money in the above calculation,
you borrowed $20,000 and you paid back $22,988.39 ($478.92 * 48) which means
you paid $2,988.39 ($22,988.39 - $20,000) in interest. If you add the interest paid
versus the interest earned, you determine that $4,640.02 is the difference between
buying the car and saving to buy it for cash.

You are always better off financially to save and collect interest than to borrow
and pay interest. This is the most fundamental strategy to financial well-being in
life.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 19

Credit Rating
Because there are times when it is impossible to have enough cash to purchase
what you need (e.g. a home) you must do all you can to keep finance charges
as low as possible. That is why your credit rating is so important.

What is a credit rating? It is an estimate of the ability of a person or organization

to fulfill their financial commitments, based on previous dealings. How is it
measured? By a credit score that we will discuss momentarily.

To maintain a positive credit rating, pay your debts on time. Your payment history
will be reported to credit bureaus who will tell anyone who needs to know how
you manage your credit. You can get a copy of your credit report from the 3
major credit bureaus, or many other commercial sites as follows:

Credit company Web site

Equifax www.equifax.com

Trans Union www.transunion.c

om

Experian www.experian.co
m

You have the right to know if you were refused credit and why you were denied
credit. You can also correct any errors in your credit report.

If you suspect you are the victim of identity theft, which means someone is using
your identity to charge purchases or borrow money, you should immediately
contact all three credit bureaus and get copies of your credit report. If identity
theft is indicated, ask the credit bureaus to contact you if new accounts or
changes to current accounts are requested.

Close all unauthorized accounts or accounts that have been tampered with. The
FTC provides an identity theft affidavit on its website at
www.consumer.gov/idtheft. This site can also provide valuable information on
how to protect your personal financial information from fraud.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 20

FICO (Fair Isaac Corporation) Score

You can get your credit or FICO Score and report from the financial institution
when you applyfor credit or by going to www.myfico.com. The FICO score ranges
from 300 to 850. This score is used to determine your credit status and the interest
rate you will pay. The higher your FICO score is, the stronger your financial situation.
You can also receive reduced interest rates provided your FICO score is in the mid
to high 700’s or into the 800’s.

he following chart is provided by the Fair Isaac Corporation to show how the FICO
score is calculated:

What’s in your FICO® score

FICO Scores are calculated from a lot of different credit data in your credit report. This data
can be grouped into five categories as outlined below. The percentages in the chart reflect how
important each of the categories is in determining your FICO score.

Increasing your FICO Score

There are several things you can do to increase and repair a low FICO score. They
are the same principles that you use to maintain a high FICO score. The following
is a list of some of the more important things you can do. Others can be found on
the internet, including the website for the Fair Isaac Corporation
(http://www.myfico.com/CreditEducation/).

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 21

1. Regularly (annually) check for errors on your credit report and correct them
immediately.

2. Since 35% of the score is your payment history, pay all of your balances on time.
A payment that is only a few days late will have a major negative impact on
your credit score. Never skip a payment for your bills. Missing payments and
paying late has the largest single impact on your credit score. Paying all of your
balances, and paying them on time increases your credit score.

3. The second most important category is how much you owe to others. Reducing
your debt as a percentage of your credit limit will improve your credit score.

4. The longer you have an open account with a retailer, the more trust you have
with them. Since length of credit history is the third largest factor, open credit
accounts with companies that you intend to continue to use over time. You
might want to establish credit with 1 or 2 credit card companies and then keep
those accounts open and current over time.

5. Slow and steady is of value in proving your trustworthiness. Try not to open
several new accounts in a short period of time.

6. A broad range of credit account is of value. It provides a history of paying back

loans in a variety of different settings, and demonstrates a factor in your
character.

Impact of your FICO Score

The following is an example shown on the FICO website of the importance of a
high score and how it impacts your interest rates and the total cost to borrow.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 22

If you don’t think that your FICO® scores are important, think again. The rate
you can expect to pay for a loan is dependent on these scores. The difference
between a FICO® score of 620 and 760 can often be tens of thousands of
dollars over the life of your loan. A low score can cost you money each month
or even stop you from refinancing at a rate you know other peopleare getting.

Basically, the higher your FICO® scores the less you can expect to pay for your
loan. For example, on a $216,000 30-year, fixed-rate mortgage:

If your FICO® score is… Your interest rate And your monthly payment will be…
is…

National interest rates, updated daily

760 - 850 4.37% $1,077

700 - 759 4.59% $1,106

680 - 699 4.77% $1,129

660 - 679 4.98% $1,157

640 - 659 5.41% $1,214

620 - 639 5.96% $1,289

As you can see in this example using today’s national rates, a person with a FICO®
score of 760 or better will pay $212 less per month for a $216,000 30-year, fixed-
rate mortgage than a person with a FICO® score of 620 – that’s a savings of $2,544
per year. You can see how essential it is to get your scores in the higher ranges if
they are low, and also how important it is to keep them high if they are good.
(http://www.myfico.com/LoanCenter/Refinance/Step1/GetTheScores.aspx)

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 23

Qualifying for Credit

Following are the five “C’s” of credit used by most lenders to evaluate credit
applications, especially when you apply for a home loan.

1. Character Will you repay the loan? This is determined by your past history of
payments and the stability of your lifestyle. Time at present
address, home ownership, time of present employment, and
living within your means are important factors.

2. Capacity Can you repay the loan? What is your income and will it
likely continue? How much debt do you already have?

3. Capital What are your assets and net worth? What do you own, what
do you owe, and how much wealth is available to repay the
loan if income is not sufficient?

4. Collateral What if you don’t repay the loan? What assets can you pledge
as security that the lender can sell to pay the debt?

5. Conditions What economic conditions may affect your repayment of

the loan? The security of your job and the company you work
for are considerations.

Summary
Paying cash for your consumer purchases is always the best financial strategy.
Rather than buying now and paying later with the interest charges that go with
borrowing money, you will always be better off financially to save and earn
interest and then pay cash for your purchases.

Your goal should be to spend less than you earn and let your savings and
investments work for you. Unwise use of credit or borrowing allows you to spend
more than you earn and increases the cost of each purchase. The key to making
credit work for you is to pay the total balance within the grace period every
month. This will provide many advantages and eliminate the disadvantages of
consumer credit.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 24

Key questions for discussion

1. What does the word afford mean? How do you know you can or cannot afford
to buy something?

2. Describe how credit cards and debit cards work. How are they different?

3. Is there a wise use of credit?

4. If you pay within the grace period, how does the credit card company (the
bank) make any money?

5. How do you decide if an item (vacation, tuition, etc.) is worth borrowing money to
purchase?

6. How do you know your FICO score?

7. What are the ways you can improve your credit score?

8. Why is your credit score important?

9. What is the purpose of the truth in lending laws?

10. How do each of the five “C’s” of credit affect your ability to borrow money.

FIN102 PERSONAL FINANCE

 CHAPTER 5 - UNDERSTANDING CREDIT P A G E | 25

Possible Assignments
NOTE: Your instructor may assign any or all of the following. Check your Learning
Management System to find out what has been assigned.

1. Talk with your parents or older adults and ask what they have learned about using
credit.

2. If you know someone who is making minimum payments as a consumer

practice, find a tactful way to help them understand what you are learning
about the cost and dangers of such a practice.

3. Work through the following Sample Problems to prove that you understand
the material presented in this chapter. If you cannot answer any of the
Sample Problems, bring your questions to class. The next unit will walk through
the answers so that you can understand what you are doing wrong.

FIN102 PERSONAL FINANCE

 Sample Problems
The following Sample Problems are provided to help you understand the
material presented in this chapter:

Understanding Credit – Affordable Debt

If your salary is $3,000 per month and 12% is deducted for federal
1 income taxes, 7% for social security, 1.5% for Medicare, and 6% for
State income taxes, what is your take-home pay? What is the
acceptable and the maximum monthly consumer credit payments
you can afford? No debt is preferred but this is a guideline.

Data Extraction: Solution:

Salary per month = $3,000 Take-home pay: $2,205

Federal income taxes = -$360 Acceptable Payments:

SOLUTION

15% of take-home pay =

Social Security = -$210 $330.75

Medicare = -$45 Maximum Payments:

20% of take-home pay =
State income taxes = -$180 $441.00

FIN102 PERSONAL FINANCE

CHAPTER 5- UNDERSTANDING CREDIT P A G E | 26

Understanding Credit – Affordable Debt

Using the information above (Problem #1), you are considering
2 the purchase of a new 70” plasma TV. You plan to finance the
TV through your credit union at 5% APR for 2 years. The TV and
all of the “extras” will cost $2,000. You already have monthly
payments of $350. Should you make this purchase?

Data Extraction: Solution:

Current monthly payments = $350 =PMT(rate,nper,pv)

New TV cost = $2,000 =PMT(5%/12,2*12,-2000)

Interest rate = 5% =($87.74)

SOLUTION

Financed for 2 years Proposed new monthly

payments = $437.74

Maximum Payments:
20% of take-home pay =
$441.00

You can make this

purchase, but almost at
the maximum amount.

FIN102 PERSONAL FINANCE

CHAPTER 5- UNDERSTANDING CREDIT P A G E | 27

Understanding Credit – Affordable Debt

Use the information in Problem #1. You do not have any debt
3 payments at this time. However, you do need to purchase an
additional car for your family. If you can finance the car at 6.0%
for 3 years, what is the dollar amount you can finance at the
acceptable level and at the maximum level?

Data Extraction: Solution:

Salary per month = $3,000 PV#1:

Federal income taxes = -$360 =PV(rate,nper,pmt)

Social Security = -$210 =PV(6%/12,3*12,-330.75)

SOLUTION

Medicare = -$45 PV#1 = $10,872.09 (min)

State income taxes = -$18 PV#2:

Take-home pay: $2,205 =PV(rate,nper,pmt)

Acceptable Payments: 15% of take- =PV(6%/12,3*12,-441)

home pay = $330.75
PV#2 = $14,496.12 (max)
Maximum Payments: 20% of take-home
pay = $441.000

FIN102 PERSONAL FINANCE

CHAPTER 5- UNDERSTANDING CREDIT P A G E | 28

Understanding Credit – APY Calculations

4
You borrow $3,000 at 7% interest for one year and are charged
interest plus a 1% loan fee, what is the effective APY on this loan?

Data Extraction: Solution:

Amount borrowed = $3,000 Dollar cost of credit:

Interest rate = 7% =PMT(rate,nper,pv)

Fee = 1% pv = 3000 + 30 loan fee

=PMT(7%/12,1*12,-3030)

PMT = ($262.18)
SOLUTION

$262.18*12 = $3,146.16

Cost of Credit =
$3,146.16 - $3,000 =
$146.16

APY = 2*n*I / P*(N+1)

APY = 2*12*146.16 /
3000*(12+1)

APY = 0.0899 = 8.99%

FIN102 PERSONAL FINANCE

CHAPTER 5- UNDERSTANDING CREDIT P A G E | 29

Understanding Credit – Interest Charge

If your credit card balance is $1,500 at the beginning of the month
5a
and you make a payment of $1,000 on the 15th of the month, what is
the interest charge you will pay if 18% interest is charged on the
credit card?

Data Extraction: Solution:

Credit Card balance = $1,500 $1,500 - $1,000 = $500

SOLUTION

Interest rate = 18.0% $500 +$1,500 * 15/30 =

$1,000
Monthly interest rate = 1.5%
$1,000 * 1.5% = $15.00
Payment on the 15th = $1,000
Interest charge = $15.00

FIN102 PERSONAL FINANCE

CHAPTER 5- UNDERSTANDING CREDIT P A G E | 30

Understanding Credit – Interest Charge

5b If you have a credit card balance of $6,522 with an interest rate of

19.9% and you make a 2.0% payment each month, how much
interest did you pay the credit card company for that month?

Data Extraction: Solution:

Credit Card balance = $6,522 Total monthly payment:

Interest rate = 19.9% $6,522 * 2.0% = $130.44

Monthly interest rate = 1.658333% $6,522 - $130.44 =

$6,391.56
SOLUTION

Monthly payment on card = 2.0%

Balance * monthly
interest rate:

$6,391.56 * .01658333 =
$105.99

Interest paid that month

out of total payment of
$130.44 = $105.99

FIN102 PERSONAL FINANCE