Chapter 6

Using Credit Cards: The Role of Open Credit

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Learning Objectives
1. Know how credit cards work.

2. Understand the costs of credit.

3. Describe the different types of credit cards.

4. Know what determines your credit card worthiness and how to secure a credit card.
5. Manage your credit cards and open credit.

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Introduction
Convenient, but if youre not careful, credit cards will cost you. Some charge over 20% interest on unpaid balances.

Most people dont consider interest charges on purchases they have to have.
Manage credit wisely to avoid high interest.

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A First Look at Credit Cards and Open Credit

Credit involves receiving cash, goods, or services with an obligation to pay later. Open credit (revolving credit) is a line of credit extended before the purchase. Unpaid balance plus interest carries over to next month. Higher balances on credit lines, higher costs.

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Interest Rates
Annual Percentage Rate (APR)the true simple interest rate paid over the life of the loan. APR for all consumer loans must be disclosed. Fixed APR vs. variable APR Teaser Rates Compound interest
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Calculating the Balance Owed

The method of determining the balance (balance calculation method) Average daily balance method Previous balance method Adjusted balance method Variationsinclude new purchases or exclude

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Figure 6.1 Calculation of Interest on Outstanding Balances

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Buying Money: The Cash Advance

Cash advances at ATMs are just like taking out a loan. Higher interest rate charged immediately on cash advances Up-front fee of 2-4% of the amount advanced.

Pay down the balances for purchases before paying down the higher interest rate cash balance.
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Grace Period
Grace periodthe length of time given to make a payment before interest is charged against the outstanding balance on a credit card. 20-25 days from date of bill. Some credit cards have no grace period No grace period with cash advances.

On most cards, the grace period is canceled if there is unpaid balance from previous month.
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Annual Fee
A fixed annual charge imposed by a credit card. Over 70% of biggest credit card issuers do not charge an annual fee. Many dont charge the fee if the card is used at least once a year. Merchants discount feethe percentage of the sale that the merchant pays to the credit card issuer.

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Additional Fees
Cash Advance Fee

Late Fee
Over-the-Limit Fee

Penalty Rate

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Pros and Cons of Credit Cards

Advantages: Convenience Used as identification Phone and internet purchases Temporary funds Use product before paying for it Bill consolidation Pay less today and earn interest elsewhere Extended warranties, travel insurance, and rewards.
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Pros and Cons of Credit Cards

Disadvantages: Too easy to spend money Too easy to lose track of spending High interest rate Obligating future income Heavy budgetary problems with uncontrolled spending

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Figure 6.2 Undergraduates and Payment Behavior

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What the CARD Act Means for You

1. Your credit card company has to tell you when they plan to increase your rate or other fees. 2. Your credit card company has to tell you how long it will take to pay off your balance. 3. No interest rate increases for the first year. 4. Increased rates apply to new charges.

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What the CARD Act Means for You

5. 6. 7. 8. 9. Restrictions on over-the-limit transactions. Caps on high-fee cards. Protections for underage consumers. Standard payment dates and times. Payments directed to highest interest balances first. 10.Your credit card company cannot charge you a fee of more than $25 in most cases.

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Choosing a Source of Open Credit

Bank Credit Cardsa credit card issued by a bank or large corporation, generally a Visa or Mastercard. Bank Card Variationsdifferent classes (credit levels) of bank credit cards.
Premium or Prestige card Affinity card Secured credit card

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Choosing a Source of Open Credit

Travel and entertainment cards (T&E) do not offer revolving credit and require full payment of balance each month. Interest-free grace period. Issuers receive annual fee and merchants discount fee.

American Express, Diners Club, and Carte Blanche are the primary issuers.
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Choosing a Source of Open Credit

Single-Purpose Cardscan be used only at a specific company. Companies issue their own cards to avoid merchants discount fees. Terms vary, some offer revolving credit. Typically, no annual fee.

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Choosing a Source of Open Credit

Traditional charge accountcan be used to make purchases or get services only at the issuing company such as utility companies and doctors who provide services and bill later. Convenient for both issuer and payee. Pay monthly bill in full or pay interest/fee.

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The Choice: Whats Best for You

Credit usercarries an unpaid balance from month to month. Convenience userpays off the credit card balance each month (avoids interest). Convenience and credit usergenerally pays off all the balance

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Figure 6.3 What Features Different Types of Credit Card Users Find Important

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Getting a Credit Card

Excellent idea for students. Emergency funds. Build solid credit history if used prudently. First step is to apply.

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Figure 6.4 Undergraduates Carrying Four or More Credit Cards

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Credit Evaluation: The Five Cs of Credit

Character Capacity Capital Collateral Conditions

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The Key to Getting Credit: Your Credit Score

A credit bureaugathers information on consumers financial history, including payment history and sells to customers. Credit bureaus compile credit report and assign a credit score. Credit reportinformation on financial situation and dealings.

Credit information impacts whether you get a loan, it affects your interest rate.
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Determining Creditworthiness
Credit scoringnumerical evaluation of scoring of applicants based on their credit history. Reduces the lenders uncertainty Lender able to make credit available to good risk customers at lower interest rates.

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Your Credit Score

Affects rates you pay on credit cards Affects size of credit line Affects insurance rates Affects mortgage rate Strong credit scorelower interest rate

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How Your Credit Score is Computed

Based on models developed by Fair Isaac Corporation. FICO Score but name and your score varies with bureau.

Scores range from 300-850.

Visit www.myfico.com/ficocreditscoreestimator to get an estimate of your score.

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Figure 6.5 National Distribution of FICO Scores

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How Your Credit Score is Computed

What is a good score?

A good credit score doesnt just mean that youll get a loan, it also means youll pay less for it through lower rates.
Creditworthiness also based on employment history, job history, and amount of debt you currently have.

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Table 6.1 Representative Rates and Monthly Payments for Different FICO Scores

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Whats in Your Credit Report?

Identifying Information Trade Lines or Credit Accounts Inquiries Public Record and Collection Items

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Factors That Determine Your Score

Your Payment History (35%) Amount You Owe and Your Available Credit (30%)

Length of Credit History (15%)

Types of Credit Used (10%)

New Credit (10%)

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Figure 6.6 Factors That Determine Your Credit Score

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Monitoring Your Credit Score

Check for errors in credit report. Get free copy of your credit report each year from the three major credit bureaus at www.annualcreditreport.com Check all information correct, all accounts on report are yours.

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TABLE 6.2 The Fair and Accurate Credit Transactions Act (FACT Act)

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Consumer Credit Rights

Take credit complaints directly to the creditor. Federal laws protect consumers with complains about credit

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The Credit Bureau and Your Rights

FACTAyou can request one free copy for your credit report from national bureaus and contact them for inaccuracies. Bureau must investigate and correct. File a statement to explain negative information that is accurate, not corrected.

FCRAnegative information remains on report for 7 to 10 years.

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Table 6.3 National Credit Bureaus

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If Your Credit Card Application is Rejected

Apply for a card with another financial institution.
Find out why you have been rejected.
Set up an appointment with credit card manager. Address the problem.

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Resolving Billing Errors

FCBAprocedures for correcting billing errors.

Withhold payment for item in question.

Notify card issuer within 60 days of statement date. Use billing inquiry or billing error address on credit card bill. Should receive notification within 30 days.

Card issuer investigates within 90 days account is credited or not with explanation.
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TABLE 6.4 Major Provisions of Consumer Credit Laws

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Identity Theft
Use of your name, address, Social Security number, bank or credit card account number, or other identifying information by someone other than you without your knowledge to commit fraud and other crimes.

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How Do You Know if Youre a Victim of Identity Theft?

Receive a credit card you didnt apply for. Denied credit or offered less favorable terms.

Calls or letters from debt collectors.

Fail to receive bills or other mail.

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What To Do If Your Identity Has Been Stolen

Put fraud alert on credit file. Close accounts that have been tampered with or you didnt open.

File police report.

File report with the FTC.

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Controlling and Managing Your Credit Cards and Open Credit

Reducing your balance

Protecting against fraud

Trouble signs in credit card spending

If you cant pay your credit card bills

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Table 6.5 How Long It Can Take to Eliminate Credit Card Debt

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TABLE 6.6 How to Prevent Identity Theft

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Checklist 6.1

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Summary
Main form of open credit is the credit card which you can use to make charges up to a certain point as long as you pay off the minimum amount of your debt each month. Costs of open credit include interest rate, cost of cash advances, annual fee, penalty fees.

Choices of open credit lines include different types of credit cards and charge accounts.
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Summary
Lenders determine creditworthiness using the five Cs of creditcharacter, capacity, collateral, and condition. Different credit cards charge different APR and calculate finance charges differently. Focus on controlling credit card spending and look for signs of trouble.

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