Credit

What is Credit?
• When you borrow money to purchase
something and promise to pay the money
back later, you are using credit.
 Terms you need to know:
• Principal: the amount of money borrowed
• Finance charge: the interest charges on
the amount you owe (principal + interest
accrued)
• Interest Rate: interest charged over time
for using credit, written as a percent of the
principal over one year.
 So, how much am I paying?
• That depends on a lot of things:
– Amount of money borrowed (Principal)
– Length of time to pay back the principal
– The annual rate of interest (% extra charged
per year)
– Repayment schedule (how often payments
are made)
– Method used to calculate interest
 Example:
• $1000 installment loan at 9% interest

• Term of Loan: 24 months 36 months

• Monthly Payment $45.69 $31.80
• Total interest paid $96.56 $114.80
• Total Payment $1,096.56 $1,114.80

• Who is better off?

 Example (cont.)
• Even though the principal and the interest
rate were the same, the amount paid was
different.
• Why?
• Time! A shorter loan term (24 months) had
higher monthly payments, but paid less
overall (less time to accrue interest). The
longer loan (36 months) had lower
payments, but ended up paying more!
 Simple Interest
• The interest is only paid on the original
amount borrowed for the length of tie the
borrower has use of the credit.

• Ex. I borrow $1000 at 5% and repaid the

loan in one payment at the end of the
year. Simple interest, 5% of $1000 for 1
year is $50.
$1000*.05=$50
$1000+$50=$1050
 Compound Interest
• Interest is calculated on the original
principal plus all interest accrued to that
point in time. Since interest is paid on
interest as well as the amount borrowed,
the effective interest rate is greater than
the nominal (stated) interest rate.

• In English: Interest is charged on interest,

making Compound Interest greater than
Simple interest
 Example of Compound Interest
I borrow $1000 at 5% interest for 1 years, paying it
back at the end of the year. Interest is
compounded semiannually (2X a year)
After 6months, $25 interest is charged. (5% of
$1000/2).
At the end of the year, the interest is calculated on
the principal ($1000) plus the Interest already
charged ($25), so the second interest payment
is $25.63 (5% of $1025/2)
The total interest paid is $50.63. ($25+$25.63) vs.
$50 in simple interest.
Compound interest is greater than simple
interest!
 Huh?
• Okay, let’s simplify: Simple interest is
calculated once- Principal times interest
rate.
• Compound interest is calculated again and
again, adding any extra interest.-
Principal + interest times interest rate.
The added difference makes compound
interest greater than simple. It may seem
like a little bit, but given time, it adds up!
Start of Year Principal amount Interest at 5% Principal at end of the year
- $100.00 $5.00 $105.00
1 $105.00 $5.25 $110.25
2 $110.25 $5.51 $115.76
3 $115.76 $5.79 $121.55
4 $121.55 $6.08 $127.63
5 $127.63 $6.38 $134.01
6 $134.01 $6.70 $140.71
7 $140.71 $7.04 $147.75
8 $147.75 $7.39 $155.14
9 $155.14 $7.76 $162.90
10 $162.90 $8.14 $171.04
11 $171.04 $8.55 $179.59
12 $179.59 $8.98 $188.57
13 $188.57 $9.43 $198.00
14 $198.00 $9.90 $207.90
15 $207.90 $10.39 $218.29
What do those numbers mean?
• They mean that over time, compound
interest grows and grows! If that chart was
a savings account, by doing nothing but
leaving $100 in it for a 15 years, your
money DOUBLED! Now imagine if you put
in $1000, or $10,000! Or if it had a higher
interest rate, say 10%! Or if you added
$100 to the account every year! The
money earned would be even higher! By
doing very little, you can earn a lot of
money over time!
 Or…
• Or, if that $100 was on a loan or credit
card, your debt could grow and grow until
the interest you owe was more than the
original principal!
 Credit Score or Rate
• Your credit score is how well you pay off
your credit and other bills.
• Pay on time, don’t carry much debt, your
score is good.
• Pay late, owe a lot, default on loans, your
credit score is poor.
 Good/Bad/No Credit
• Good credit score gets more credit and
lower interest rates
• Bad credit score limits amount of credit
and gets higher interest rates
• No credit: If you have not credit history (no
bills, loans or credit cards) banks and
credit card companies do not know if you
will pay back your loans. It is like bad
credit. It is important to establish good
credit early to build up a good credit score.
 Credit Cards
• How they work:
1. Merchant passes card through machine,
gets approval from the credit company for
the amount
2. When you sign the paper, you agree to pay
the amount
3. Merchant deposits receipt in bank who
credits their account and bills the credit
company.
 How a Credit Card works cont.
4. Credit card company pays the
merchant’s bank account and debits the
issuer’s account
5. Issuer of your card bills you for the
purchase, which you pay.
 Paying Credit Cards
• Credit cards charge interest on money
owed, compounded monthly. Often, credit
cards can charge interest rates around 20-
30%, which can add up over time.

• Add up a lot!
 Extra Costs of Credit Cards
• Annual Fees- once a year charge for using
the card
• Grace Period- time between when you are
billed and when you have to pay
• Over limit fee- usually $25 if you exceed
your credit line.
• Cash Advance Fee- usually 2% for any
cash withdrawals from an ATM
• Late Payment- usually $25 if min. payment
is not on time.
 Are Credit Cards Bad?
• No, they aren’t bad. Credit is useful if you
do not want to carry large amounts of
cash. They also allow you to make a
purchase you may not have the money to
pay for at that time.
• Just make sure you pay off your debt
quickly. Don’t owe so much that you are
paying more than you can afford.
 But…
• If you get carried away, run up your bills
and only pay the minimum, a card with a
high interest rate will take YEARS to pay
off. So you could be paying for something
you bought years ago, and paying more
than it originally cost!
• And, if you max out your credit, you can’t
buy what you may really need.
• Finally, having a lot of debt and missing
payments hurts your credit score, making
it harder to get more credit when you need
it!
Installment Loans
 Installment Loan
• A form of credit where the money is
borrowed all at once
• Payment is made on a regular schedule
for a set amount
• Ex. Auto Loan, Mortgage (home loan),
Student Loan
 Secured vs. Unsecured Loans
• Secured Loans: security or collateral is
used to guarantee the loan. If you fail to
repay loan, the lender keeps the security.
Collateral ex. Home, property, valuables.
• Unsecured Loan: made solely on the
person’s promise to repay the loan. Less
money available without the collateral.
Poor credit score, less likely to get an
unsecured loan.
Auto Loan vs. Auto Lease
 Loan
• Loan: Bank gives you money to buy car.
Over the next 3 to 5 years you pay back
the principal and interest. The car is the
collateral on the loan. When you are done,
you own the car.
 Lease
• Lease: Payments are made for the right to
use the car. At the end of the period, the
bank takes the car. A lease is like renting
the car for a long period of time. Often
there are stipulations about mileage and
condition for the lease.
 Loan
• Making Payments on a $18,000 car

• $2,500 Down Payment

• $1,260 Sales Tax
• $20,126 paid remaining principle + interest
($559/monthx 36 months)

• $23,886 TOTAL PAYMENT

Minus resale value
 Lease
• Making Payments on a $18,000 car

• $400 Lease Fee

• $317 Prepayment Fee
• $11,412 Monthly Payments ($317x36)

• $12,129 TOTAL PAYMENT

But no CAR!
Which is better, Loan or Lease?
Loan (Advantages) • Lease (Advantages)
You keep the car! Drive – Pay less initially
it for years to come – Pay less monthly
without making a – Pay less overall
payment!

But…(Disadvantages)
But… (Disadvantages)

No car once the lease

– Pay more initially
runs out. You have to
– Pay more monthly lease or buy another
– Pay more overall car. May cost more in
the long run.
 The cost of taking longer to repay
The term of your loan determines final cost
3 different auto loans for $13,500 at 12.5%
# of 36 48 60
payments (3 years) (4 years) (5 years)
Amount per $451.62 $358.82 $303.72
payment
Total Paid $16,258.32 $17,223.36 $18,223.20

Interest $2,758.32 $3,723.36 $4,723.20

Paid
Buying a House
 Mortgage
• Def.: a long term loan to buy a house or
other property.
• The house and land it sits on are collateral
for the loan. If the borrower doesn’t make
payments, the lender can take the home
through foreclosure.
• Most mortgages require a cash down
payment of 5%,10%,or 20%
 Escrow
• Def.: monthly payment on property which
includes the mortgage and other costs.
– Principal: amount borrowed
– Interest: interest owed on the principal
– Real Estate Taxes: taxes assessed on
property by county, city/town and school
district.
– Property Insurance: insurance coverage
against theft, fire and natural disasters.
 Closing Costs
• When the final purchase of a home
occurs, called a closing, the costs can
reach thousands of dollars for taxes, fees,
insurance and lawyer fees.
 How much for a house?
• On a 30 year, $150,000 mortgage with a
fixed interest rate of 7.5%, a homeowner
who keeps the loan full term (30 years) will
pay $377,000!
$150,000 for the home
$227,575.83 in interest on the loan!
 So why buy a home?
• Equity: The value of your home to be used
as collateral for other loans. As you pay for
your home, you build equity. This can be
used to get a home equity loan or home
equity line of credit to make more
purchases: cars, vacation homes, pay for
college, etc.
 Benefits of a good interest rate:
Home Down Mortgage 6% rate 8% rate 10% rate
Price Payment

$80,000 $8,000 $72,000 $432/ $528/ $632/

month month month

$140,000 $15,000 $125,000 $749/ $917/ $1,097/

month month month

$240,000 $40,000 $200,000 $1,199/ $1,468/ $1,755/

month month month
 Length of Mortgage
• Most mortgages are offered as 15 or 30
year mortgages. The length of time
determines how much is paid per month
and how much is paid overall for the
house.
Adv/Disadv of 30 year mortgage
• Adv.
– Lower monthly payments than 15 year
– Stretches money; buyer can afford a larger
house because of the lower payment
• Dis.
– Builds equity at a slow rate
– Overall interest paid is much higher than 15
yr.
– Tend to have higher interest rates than 15 yr.
 Adv/Disadv of 15yr. mortgage
• Adv.
– Build equity much faster
– Overall interest is less than 30yr. mortgages
– Interest rates tend to be lower
• Dis
– Monthly payments are higher than 30yr.
Mortgages
– Buyers restricted to a smaller home because
of high monthly payments
 Effect of term on a $100,000
mortgage
• Monthly payment at 15 year $956
8% interest mortgage
30 year $734
mortgage

15 year $172,080
mortgage
• Total payment at 8%
interest 30 year $264,240
mortgage
 Student Loans
• Loans to pay for higher education
• Backed by government
• Low interest rates make them easy to get
and easy to pay for.