LESSON 4

CONSUMER CREDIT

TOPICS
1. Consumer Credit
2. Types and Sources of Consumer Credit
3. Kinds of Loans

LEARNING OUTCOMES
At the end of the lesson, you should be able to:
1. Explain the significance of consumer credit;
2. Differentiate instalment credit with revolving credit; and
3. Identify kinds of loans available

TOPIC 1. CONSUMER CREDIT

Consumer credit is more than a powerful force in the economy. In the past few decades,
it has become a way of life for most of the people. When handled effectively, consumer
credit can help achieve many of the most important goals. When misused, it can create
serious financial problems for individuals and families
alike. The decision to use consumer credit depends on
needs, resources, and available alternative choices. To
shop for credit intelligently, students need to
understand the various credit sources, the plans they
offer, the services they provide, the requirements of
each plan, and the laws that govern credit transactions
Consumer credit is personal debt taken on to purchase
goods and services. A credit card is one form of
consumer credit. Although any type of personal loan could be labeled consumer credit,
the term is usually used to describe unsecured debt that is taken on to buy everyday
goods and services. It is not usually used to describe the purchase of a house, for
example, which is considered a long-term investment and is usually purchased with a
secured mortgage loan. Consumer credit is also known as consumer debt. Consumer
credit in industrialized countries has grown rapidly as more and more people earn
regular income in the form of fixed wages and salaries and as mass markets for
durable consumer goods have become established.

Consumer loans fall into two broad categories: installment loans, repaid in two or more
payments; and non-installment loans, repaid in a lump sum. Installment loans include:
(1) automobile loans, (2) loans for other consumer goods, (3) home repair and
modernization loans, (4) personal loans, and (5) credit card purchases. The most
common non-installment loans are single-payment loans by financial institutions, retail-
store charge accounts, and service credit extended by doctors, hospitals, and utility
companies. Finance charges on consumer loans generally run higher than the interest
costs of business loans, although the way costs are quoted may disguise the actual
charges.
Consumer Credit Example
If a person has a credit card, this is considered consumer credit because he uses it to
purchase services and material goods instead of investment products such as real estate
or stocks. He has to predetermine the amount allowed to spend and he can use it for
everything from dining out to home furnishings, electronics or other material goods. If
he has a line of credit with a specific store, this is also considered consumer credit
because it works in much the same way.

Understanding Consumer Credit

Consumer credit is extended by banks, retailers, and others to enable consumers to
purchase goods immediately and pay off the cost over time with interest. It is broadly
divided into two classifications: installment credit and revolving credit.

Special Considerations. Consumer credit use reflects the portion of a family or

individual's spending that goes to goods and services that depreciate quickly. It includes
necessities such as food and discretionary purchases such as cosmetics or dry cleaning
services. Consumer credit use from month to month is closely measured by economists
because it is considered an indicator of economic growth or contraction. If consumers
overall are willing to borrow and confident they can repay their debts on time, the
economy gets a boost. If consumers cut back on their spending, they are indicating
concerns about their own financial stability in the near future.

Advantages of Consumer Credit. Consumer credit allows consumers to get an advance

on income to buy products and services. In an emergency, such as a car breakdown, that
can be a lifesaver because credit cards are relatively safe to carry. Revolving consumer
credit is a highly lucrative industry. Banks and financial institutions, department stores,
and many other businesses offer consumer credit.

Disadvantages of Consumer Credit. The main disadvantage of using

revolving consumer credit is the cost to consumers who fail to pay off their entire
balances every month and continue to accrue additional interest charges from month to
month. The average annual percentage rate on new offers of credit cards was 19.24% as
of April 2019. Department store credit cards averaged 25.74%. A single late payment
can boost the cardholder's interest rate even higher.

TOPIC 2. TYPES AND SOURCES OF CONSUMER CREDIT

Understanding the Types and Sources of Consumer Credit

Consumer credit can be a small business owner's best friend. Or it can wreak havoc on
the personal finances. Learn how to use, and when to avoid, consumer credit options.
Credit is an arrangement to receive cash, goods or services now and pay for them in the
future. Consumer credit refers to the use of credit for personal needs by individuals and
families as contrasted to credit used for business or agricultural purposes. Although this
discussion mainly focuses on credit as it affects the personal finances, as a business
owner the personal and business financial situations are closely intertwined. As a result,
the personal and business credit standing and management are also closely related.

If the business gets into trouble by incurring too much debt, this will likely affect the
business's profitability, which will in turn likely affect your ability to qualify for personal
credit. The flip side of this can also be true: If an individual is over-burdened with
personal debt, the business creditors (who can be expected to ask for the personal
guarantee on loans made to the small business) may be less willing to extent credit to
the business if they think the personal guarantee to be of little or no value.

Although Polonius cautioned, "Neither a borrower nor a lender be," using and providing
credit have become a way of life for many individuals in today's economy. Consumer
credit is based on trust in the consumer's ability and willingness to pay bills when due. It
works because people, by and large, are honest and responsible. In fact, personal credit,
if used wisely, has its advantages.

The Basics of Closed-End Credit

This form of credit is used to finance a specific purpose, for a specific amount, and for a
specific period of time. It is also called installment loan because consumers are required
to follow a regular payment schedule (usually monthly) that includes interest charges,
until the principal is paid off. Payments are usually of equal amounts. An agreement, or
contract, lists the repayment terms, such as the number of payments, the payment
amount, and how much the credit will cost. The interest rate for installment loans varies
by lender and is tied closely to the consumer’s credit score. Generally, with closed-end
credit, the seller retains some form of control over the ownership (title) to the goods
until all payments have been completed. For example, a car company will have a "lien"
on the car until the car loan is paid in full. Examples of closed-end credit include:
 Mortgages
 Car loans
 Appliance loans
 Payday loans

The Basics of Open-End Credit

With open-end, or revolving credit, loans are made on a
continuous basis as the purchase items, and are billed
periodically to make at least partial payment. Using a credit
card issued by a store, a bank card such as VISA or
MasterCard, or overdraft protection are examples of open-
end credit. There is a maximum amount of credit that can
be used, called the line of credit. Unless a person pay off the
debt in full each month, then often he has to pay a high-
rate of interest or other kinds of finance charges for the use
of credit.

Open-end credit, better known as revolving credit, can be used repeatedly for purchases
that will be paid back monthly, though paying the full amount due every month is not
required. The most common form of revolving credit are credit cards, but home equity
loans and home equity lines of credit also fall in this category. Credit cards are used for
daily expenses, such as food, clothing, transportation and small home repairs. Interest
charges are applied when the monthly balance is not paid in full. The interest rates on
credit cards average 15 percent, but can be as low as zero percent (temporary,
introductory offers) and as high as 30 percent or more, depending on the consumer’s
payment history and credit score. Loans for bad credit may be hard to find, but lower
interest rates are available within nonprofit debt management programs, even for credit
scores below 500.

 Revolving check credit. This is a type of open-end credit extended by banks

typically with credit card. The consumer has a specified amount of credit he can use
of not use at his leisure. It is a prearranged loan for a specific amount that can use by
writing a special check. Repayment is made in instalments over a set period and the
 finance charges are based on the amount of credit used during the month and on the
outstanding balance. The credit does not close unless the company offering the
credit closes the account. Since it usually does not close, this makes the credit
revolving.

 Charge cards. Charge cards are usually issued by department stores and oil
companies and, ordinarily, can be used only to buy products from the company that
issued that card. They have been largely replaced with credit cards, although many
are still in use. You pay your balance at your own pace, with interest.

 Credit cards. Credit cards, also called bank cards, are issued by financial
institutions. Credit cards provide prompt and convenient access to short-term loans.
You borrow up to a set amount (your credit limit) and pay back the loan at your own
pace—provided you pay the minimum due. You will also pay interest on what you
owe, and may incur other charges, such as late payment charges. Whatever amount
you repay becomes immediately available to reuse. VISA, MasterCard, American
Express and Discover are the most widely recognized credit cards.

 Travel and Entertainment (T&E) cards. This cards require that you pay in full
each month, but they do not charge interest. American Express (not the credit card
version), Diners Club and Carte Blanche are the most common T&E cards.

 Debit cards. These are issued by many banks and work like a check. When you
buy something, the cost is electronically deducted (debited) from your bank account
and deposited into the seller's account. Strictly speaking, they are not "credit"
because you pay immediately (or as quickly as funds can be transferred
electronically).

Secured versus Unsecured Consumer Loans

Secured consumer loans are loans that are backed by collateral (assets that are used to
cover the loan in the event that the borrower defaults). Secured loans generally grant
the borrower greater amounts of financing, a longer repayment period, and a lower
charged interest rate. As the loan is backed by assets, the risk faced by the lender is
reduced. For example, in the event that the borrower defaults, the lender would be
able to take possession of collateralized assets and liquidate them to repay the
outstanding amount.

Unsecured consumer loans are loans that are not backed by collateral. Unsecured
loans generally grant the borrower a limited amount of financing, a shorter repayment
period, and a higher charged interest rate. As the loan is not backed by assets, the
lender faces increased risk. For example, in the case of borrower default, the lender
may not be able to recover the outstanding loan amount.

So what do consumer credit and equity cash-outs have to do with the housing bubble?
Simply put, they reduced homeowners’ ability to make monthly payments on their
home loans and increased the likelihood of default and foreclosure.

Consumer credit is a way for people who spend money on products to get an advance
on the money required to pay for the object. The most common example of consumer
credit is a person using a credit card. He uses the credit card to pay for goods and
services, then he repays the credit card company at a future date.
Non-installment credit is either secured or unsecured, depending on the company
offering the credit. This credit does not have monthly payments of a set figure, but
instead is due all at once in a lump sum payment of the full amount owed. Non-
installment credit tends to be due in a short period of time, such as in a month.

Installment closed-end credit allows the consumer to receive a certain amount of credit
to purchase one item or a few goods. One type of installment closed-end credit is a car
loan. The car company offers the consumer credit to buy the car. The credit does not
extend beyond the sales price of the car. In addition, the person pays the credit in
installments over a period of time instead of paying it back in one lump sum.

Co-signing a Loan Is Risky Business

Creditors are required to give a notice to help explain the obligations as a cosigner. The
cosigner's notice says: "You are being asked to guarantee this debt. Think carefully
before signing it. If the borrower does not pay the debt, the cosigner will have to. Be
sure that the cosigner can afford to pay if he has to, and that he wants to accept this
responsibility. Cosigner may have to pay up to the full amount of the debt if the
borrower does not pay. He may also have to pay late fees or collection costs, which
increase this amount. The creditor can collect this debt from cosigner without first
trying to collect from the borrower. The creditor can use the same collection methods
against the cosigner that can be used against the borrower, such as suing the cosigner,
garnishing his wages, etc. If this debt is ever in default, that fact may become a part of
his credit record."

Several points are worth highlighting:

 The lender does not have to chase the borrower before coming to the co-signer
for repayment—the co-signee is on the hook every bit as much as the borrower.
 It is the loan, even if the co-signer will not have any use or enjoyment from the
property. If there is a default, he will have to pay the obligation, in full, plus any
"expenses" of collection.
 The lender does not feel confident that the buyer will be able to repay, or it
would not be requesting a co-signor. That means the lender already has co-signer in
its sights the minute he pick up that pen to co-sign.

If a person does co-sign:

 Make sure the co-signer can afford to pay the loan—the odds are good that co-
signer will have to. If co-signer is asked to pay and cannot, he could be sued, or
her credit rating could be damaged.
 Consider that even if co-signer is not asked to repay the debt, the liability for this
loan will appear on the credit record. Having this "debt" may keep him from
getting other credit that need or want.
 Before co-signer pledge property, make sure he understand the consequences. If
the borrower defaults, he could lose these possessions.
 There is good reason why one law school professor defined "co-signer" as "an idiot
with a fountain pen." The same reasoning applies, to a lesser extent, with a joint
credit account.

Tax Disadvantages of Consumer Credit

Interest paid on the personal auto, credit cards, education and other consumer loans is
no longer deductible on the tax return. Interest allocated to business use of property
may be deductible. In addition, there is only a certain amount of qualified residence
(mortgage) interest that is deductible. Qualified residence interest is the interest paid or
accrued on acquisition loans or home equity loans with respect to your principal
residence and one other residence.

The Sources of Consumer Credit

Commercial Banks . These make loans to borrowers who have the capacity to repay them. Loans are the sale of the use of money by those who
have it (banks) to those who want it (borrowers) and are willing to pay a price (interest) for it. Banks make several types of loans, including
consumer loans, housing loans and credit card loans.

Savings and Loan Association. They specialize in long-term mortgage loans on houses and other real estate. S&Ls offer personal installment loans,
home improvement loans, second mortgages, education loans and loans secured by savings accounts. S&Ls lend to creditworthy people and
collateral may be required. The loan rates on S&Ls vary depending on the amount borrowed, the payment period and collateral. The interest
charges of S&Ls are generally lower than those of some other types of lenders because S&Ls lend depositors' money, which is a relatively
inexpensive source of funds.

Credit Unions. They are non-profit cooperatives organized to serve people who have some type of common bond. The nonprofit status and lower
costs of credit unions allow them to provide better terms on loans and savings. The costs of the credit union may be lower because sponsoring
firms provide staff and office space and some firms agree to deduct loan payments and savings installments from members' paychecks and apply
them to credit union accounts. Credit unions often offer good value in personal loans and savings accounts. CUs usually require less stringent
qualifications and provide faster service on loans.

Consumer Finance Companies. They specialize in personal instalment loans and second mortgages. Consumers without an established credit history can often borrow
from CFCs without collateral. CFCs are often willing to lend money to consumers who are having difficulty in obtaining credit somewhere else, but because the risk is
higher, so is the interest rate. The interest rate varies according to the size of the loan balance and the repayment schedule. CFCs process loan applications quickly, usually
on the same day that the application is made and design repayment schedules to fit the borrower's income.

Sales Finance Companies (SFCs), when buying a car, one could have probably encountered the opportunity to finance the purchase via the manufacturer's financing
company. These SFCs let the buyer pay for big-ticket items, such as an automobile, major appliances, furniture, computers and stereo equipment, over a longer period of
time. The buyer does not deal directly with the SFC, but he is generally informed by the dealer that the instalment note has been sold to a sales finance company. Then
make the monthly payments to the SFC rather than to the dealer where the buyer bought the merchandise.

Life Insurance Companies. Insurance companies will usually allow to borrow up to 80 percent of the accumulated cash value of a whole life (or straight life) insurance
policy. Loans against some policies do not have to be repaid, but the loan balance remaining upon the death is subtracted from the amount the beneficiaries receive.
Repayment of at least the interest portion is important, as compounding interest works against the borrower. Life insurance companies charge lower interest rates than
some other lenders because they take no risks and pay no collections costs. The loans are secured by the cash value of the policy.

Pawnbrokers. They are common, sources of secured loans. They the property and lend a portion of its value. If the borrower repay the loan and the interest on time, he
get the property back. If the borrower does not, the pawnbroker sells it, although an extension can be arranged. Pawnbrokers charge higher interest rates than other
lenders, but the borrower does not need to apply or wait for approval.

Loan Sharks. These usurious lenders have no license to engage in the lending business. They charge excessive rates for refinancing, repossession or late payments, and
they allow only a very short time for repayment. They are infamous for using collection methods that involve violence or other criminal conduct. Steer clear of them.

Family and Friends. The relatives can sometimes be the best source of credit. All such transactions should be treated in a businesslike manner; otherwise,
misunderstandings may develop that can ruin family ties and friendships. 

Types of Consumer Credit & Loans

Loan contracts come in all kinds of forms and
with varied terms, ranging from simple
promissory notes between friends and family
members to more complex loans like
mortgage, auto, payday and student loans.
Banks, credit unions and other people lend
money for significant, but necessary items like
a car, student loan or home. Other loans, like
small business loans. Regardless of type, every
loan – and its conditions for repayment – is governed by state guidelines to protect
consumers from unsavory practices like excessive interest rates. In addition, loan length
and default terms should be clearly detailed to avoid confusion or potential legal action.

In case of default, terms of collection of the outstanding debt should clearly specify the
costs involved in collecting upon the debt. This also applies to parties of promissory
notes as well. If the is a need of money for an essential item or to help make life more
manageable, it is a good thing to familiarize with the kinds of credit and loans that might
be available and the sorts of terms that can be expected.

Types of Loans
Loan types vary because each loan has a specific intended use. They can vary by length
of time, by how interest rates are calculated, by when payments are due and by a
number of other variables.

• A consolidation loan is meant to simplify your finances. Simply put, a

consolidation loan pays off all or several of your outstanding debts, particularly credit
card debt. It means fewer monthly payments and lower interest rates. Consolidation
loans are typically in the form of second mortgages or personal loans.

• Student loans are offered to college students and their families to help cover the
cost of higher education. There are two main types: federal student loans and private
student loans. Federally funded loans are better, as they typically come with lower
interest rates and more borrower-friendly repayment terms.

• Mortgages are loans distributed by banks to allow consumers to buy homes they
can’t pay for upfront. A mortgage is tied to your home, meaning you risk foreclosure if
you fall behind on payments. Mortgages have among the lowest interest rates of all
loans.

• Like mortgages, auto loans are tied to the property. They can help afford a
vehicle, but the risk of losing the car if there is a miss payments. This type of loan may
be distributed by a bank or by the car dealership directly but should understand that
while loans from the dealership may be more convenient, they often carry higher
interest rates and ultimately cost more overall.

• Personal loans can be used for any personal expenses and don’t have a
designated purpose. This makes them an attractive option for people with outstanding
debts, such as credit card debt, who want to reduce their interest rates by transferring
balances. Like other loans, personal loan terms depend on the credit history.

• Loans for Veterans. The Department of Veterans Affairs (VA) has lending
programs available to veterans and their families. With a VA-backed home loan, money
does not come directly from the administration. Instead, the VA acts as a co-signer and
effectively vouches for you, helping you earn higher loan amounts with lower interest
rates.

• Small business loans are granted to entrepreneurs and aspiring entrepreneurs to

help them start or expand a business. The best source of small business loans is the U.S.
Small Business Administration (SBA), which offers a variety of options depending on
each business’s needs.

• Payday loans are short-term, high-interest loans designed to bridge the gap from
one paycheck to the next, used predominantly by repeat borrowers living paycheck to
paycheck. The government strongly discourages consumers from taking out payday
loans because of their high costs and interest rates.

• Borrowing from Retirement & Life Insurance. Those with retirement funds or
life insurance plans may be eligible to borrow from their accounts. This option has the
benefit that you are borrowing from yourself, making repayment much easier and less
stressful. However, in some cases, failing to repay such a loan can result in severe tax
consequences.

• Borrowing from Friends and Family is an informal type of loan. This isn’t always
a good option, as it may strain a relationship. To protect both parties, it’s a good idea to
sign a basic promissory note.

• A cash advance is a short-term loan against the credit card. Instead of using the
credit card to make a purchase or pay for a service, you bring it to a bank or ATM and
receive cash to be used for whatever purpose you need. Cash advances also are
available by writing a check to payday lenders.

• Home equity loans and home equity lines of credit (HELOCs) use the borrower’s
home as a source of collateral so interest rates are considerably lower than credit cards.
The major difference between the two is that a home equity loan has a fixed interest
rate and regular monthly payments are expected, while a HELOC has variable rates and
offers a flexible payment schedule. Home equity loans and HELOCs are used for things
like home renovations, credit card debt consolidation, major medical bills, education
expenses and retirement income supplements. They must be repaid in full if the home is
sold.