Credit costs money; therefore, always weigh the benefits of buying an
item on credit now versus waiting until you have saved enough money to pay
cash.
Financial and other institutions, the sources of credit, come in all shapes
and sizes. They play an important role in our economy, and they offer a
broad range of financial services. By evaluating your credit options, you
can reduce your finance charges. You can reconsider your decision to borrow
money, discover a less expensive type of loan, or find a lender that charges
a lower interest rate.
Before deciding whether to borrow money, ask yourself these three questions: Do
I need a loan? Can I afford a loan? Can I qualify for a loan?
You should avoid credit in two situations.
The first situation is one in which you do not need or really want a
product that will require financing. Easy access to installment loans
or possession of credit cards sometimes encourages consumers to make expensive
purchases they later regret. The solution to this problem is simple: After
you have selected a product, resist any sales pressure to buy immediately
and take a day to think it over.
The second situation is one in which you can afford to pay cash. Consider
the trade-offs and opportunity costs involved. Paying cash is almost always
cheaper than using credit. In fact, some stores even offer a discount
for payment in cash.
What Kind of Loan Should You Seek?
Because installment loans may carry a lower interest rate, they are
the less expensive credit option for loans that are repaid over a period
of many months or years. However, because credit cards usually provide
a float period-a certain number of days during which no interest is charged-they
represent the cheaper way to make credit purchases that are paid off in
a month or two.
In seeking an installment loan, you may think first of borrowing from
a bank or a credit union. However, less expensive credit sources are available.
Inexpensive Loans
Parents or family members are often the source of the least expensive
loans. They may charge you only the interest they would have earned had
they not made the loan-as little as the 3 percent they would have earned
on a passbook account.
Such loans, however, can complicate family relationships. All loans
to or from family members should be in writing and state the interest
rate, if any, repayment schedule, and the final payment date.
Also relatively inexpensive is money borrowed on financial assets held
by a lending institution, for example, a bank certificate of deposit or
the cash value of a whole life insurance policy. The interest rate on
such loans typically ranges from 7 to 10 percent. But the trade-off is
that your assets are tied up until you have repaid the loan.
Medium-Priced Loans
Often you can obtain medium-priced loans from commercial banks, federal
savings banks (Savings and Loan Associations), and credit unions. New-car
loans, for example, may cost 8 to 12 percent; used-car loans and home
improvement loans may cost slightly more.
Borrowing from credit unions has several advantages. These institutions
provide free credit life insurance, are generally sympathetic to borrowers
with legitimate payment problems, and provide personalized service.
Expensive Loans
Though convenient to obtain, the most expensive loans available are
from finance companies, retailers, and banks through credit cards. Finance
companies often lend to people who cannot obtain credit from banks or
credit unions. Typically, the interest ranges from 12 to 25 percent.
Borrowing from car dealers, appliance stores, department stores, and
other retailers is also relatively expensive. The interest rates retailers
charge are usually similar to those charged by finance companies, frequently
20 percent or more.
The Truth in Lending law of 1969 was a landmark piece of legislation.
For the first time, creditors were required to state the cost of borrowing
as a dollar amount so that consumers would know exactly what the credit
charges were and thus could compare credit costs and shop for credit.
If you are thinking of borrowing money or opening a credit account, your
first step should be to figure out how much it will cost you and whether
you can afford it. Then you should shop for the best terms. Two key concepts
that you should remember are the finance charge and the annual percentage
rate.
Finance Charge and Annual Percentage Rate (APR)-credit costs vary. If
you know the finance charge and the annual percentage rate
(APR), you can compare credit prices from different sources. Under the
Truth in Lending law, the creditor must inform you, in writing and before
you sign any agreement, of the finance charge and the APR.
The finance charge is the total dollar amount you pay to use credit.
It includes interest costs and sometimes other costs such as service charges,
credit-related insurance premiums, or appraisal fees.
Tackling the Trade-Offs-when you choose your financing, there are trade-offs
between the features you prefer (term, size of payments, fixed or variable
interest, or payment plan) and the cost of your loan. Here are some of the
major trade-offs you should consider.
Term versus Interest Costs. Many people choose longer-term
financing because they want smaller monthly payments. But the longer the
term for a loan at a given interest rate, the greater the amount you must
pay in interest charges.
Lender Risk versus Interest Rate. You may prefer financing
that requires low fixed payments with a large final payment or only a
minimum of up-front cash. But both of these requirements can increase
your cost of borrowing because they create more risk for your lender.
If you want to minimize your borrowing costs, you may need to accept
conditions that reduce your lender's risk. Here are a few possibilities.
Variable Interest Rate. A variable interest rate is based
on fluctuating rates in the banking system, such as the prime rate.
With this type of loan, you share the interest rate risks with the lender.
Therefore, the lender may offer you a lower initial interest rate than
it would with a fixed-rate loan.
A Secured Loan. If you pledge property or other assets
as collateral, you'll probably receive a lower interest rate on your
loan.
Up-Front Cash. Many lenders believe you have a higher stake
in repaying a loan if you pay cash for a large portion of what you are
financing. Doing so may give you a better chance of getting the other
terms you want. Of course, by making a large down payment, you forgo
interest that you might earn in a savings account.
Calculating the Cost of Credit-the two most common methods of calculating
interest are compound and simple interest formulas. Perhaps the most basic
method is the simple interest calculation. Simple interest on the declining
balance, add-on interest, bank discount, and compound interest are variations
of simple interest.
Simple interest is the interest computed on principal only and
without compounding; it is the dollar cost of borrowing money. This cost
is based on three elements: the amount borrowed, which is called
the principal; the rate of interest; and the amount of time for which
the principal is borrowed.
Simple Interest on the Declining Balance. When more than
one payment is made on a simple interest loan, the method of computing
interest is known as the declining balance method. Since you pay
interest only on the amount of the original principal that you have not
yet repaid, the more frequent the payments, the lower the interest you
will pay. Most credit unions use this method for their loans.
Cost of Open-End Credit. Open-end credit includes credit cards,
department store charge cards, and check overdraft accounts that allow you
to write checks for more than your actual balance. You can use open-end
credit again and again until you reach a prearranged borrowing limit. The
Truth in Lending law requires that open-end creditors let you know how the
finance charge and the APR will affect your costs.
First, creditors must tell you how they calculate the finance charge.
Creditors use various systems to calculate the balance on which they assess
finance charges. Some creditors add finance charges after subtracting
payments made during the billing period; this is called the adjusted
balance method.
Cost of Credit and Expected Inflation. Interest rates dictate when you
must pay future dollars to receive current dollars. Borrowers and lenders,
however, are less concerned about dollars, present or future, than about
the goods and services those dollars can buy-that is, their purchasing power.
Inflation erodes the purchasing power of money. Each percentage point
increase in inflation means a decrease of approximately 1 percent in the
quantity of goods and services you can purchase with a given quantity
of dollars. As a result, lenders, seeking to protect their purchasing
power, add the expected rate of inflation to the interest rate they charge.
You are willing to pay this higher rate because you expect inflation to
enable you to repay the loan with cheaper dollars.
Credit Insurance
Credit insurance ensures the repayment of your loan in the event
of death, disability, or loss of property. The lender is named the beneficiary
and directly receives any payments made on submitted claims.
There are three types of credit insurance: credit life, credit
accident and health, and credit property. The most commonly purchased
type of credit insurance is credit life insurance, which provides for
the repayment of the loan if the borrower dies.
A sudden illness or the loss of your job may make it impossible
for you to pay your bills on time. If you find you cannot make your
payments, contact your creditors at once and try to work out a modified
payment plan with them.
Automobile loans present special problems. Most automobile financing
agreements permit your creditor to repossess your car anytime you
are in default on your payments. No advance notice is required. If
your car is repossessed and sold, you will still owe the difference
between the selling price and the unpaid debt, plus any legal, towing,
and storage charges.
If you are having trouble paying your bills, you may be tempted
to turn to a company that claims to offer assistance in solving debt
problems. Such companies may offer debt consolidation loans, debt
counseling, or debt reorganization plans that are "guaranteed"
to stop creditors' collection efforts. Before signing with such a
company, investigate it. Be sure you understand what services the
company provides and what they will cost you.
Emotional problems, such as the need for instant gratification,
as in the case of a man who can't resist buying a costly suit or
a woman who impulsively purchases an expensive dress in a trendy
department store.
The use of money to punish, such as a husband who buys a new car
without consulting his wife, who in turn buys a diamond watch to
get even.
The expectation of instant comfort among young couples who assume
that by use of the installment plan, they can have immediately the
possessions their parents acquired after years of work.
Keeping up with the Joneses, which is more apparent than ever,
not only among prosperous families but among limited-income families
too.
Overindulgence of children, often because of the parents' own
emotional needs, competition with each other, or inadequate communication
regarding expenditures for the children.
Misunderstanding or lack of communication among family members.
Just as the causes of indebtedness vary, so too does a mixture
of other personal and family problems that frequently result from
overextension of credit.
The Consumer Credit Counseling Service (CCCS) is a local,
nonprofit organization affiliated with the National Foundation
for Consumer Credit (NFCC).
Branches of the CCCS provide debt counseling services for families
and individuals with serious financial problems. It is not a charity,
a lending institution, or a governmental or legal agency. The
Consumer Credit Counseling Service is supported by contributions
from banks, consumer finance companies, credit unions, merchants,
and other community-minded organizations and individuals.
To find an office near you, check the white pages of your local
telephone directory under Consumer Credit Counseling Service,
or call 1-800-388-CCCS. All information is kept strictly confidential.
Credit counselors are aware that most people who are in debt
over their heads are basically honest people who want to clear
up their indebtedness. Too often, the problems of such people
arise from a lack of planning or a miscalculation of what they
earn. Therefore, the CCCS is as concerned with preventing the
problems as with solving them. As a result, its activities are
divided into two parts:
Aiding families with serious debt problems by helping them
manage their money better and setting up a realistic budget
and plan for expenditures.
Helping people prevent debt problems by teaching them the
necessity of family budget planning, providing education to
people of all ages regarding the pitfalls of unwise credit buying,
suggesting techniques for family budgeting, and encouraging
credit institutions to provide full information about the costs
and terms of credit and to withhold credit from those who cannot
afford to repay it.
Nationwide, the overwhelming majority of bankruptcies are
filed under Chapter 7 of the U.S. bankruptcy code. You have
two choices in declaring personal bankruptcy: Chapter 7
(a straight bankruptcy) and Chapter 13 (a wage earner plan)
bankruptcy. Both choices are undesirable, and neither should
be considered an easy way out.
In a Chapter 7 bankruptcy, a debtor is required to
draw up a petition listing his or her assets and liabilities.
The debtor submits the petition to a U.S. district court and
pays a filing fee. A person filing for relief under the bankruptcy
code is called a debtor; the term bankrupt is not used.
Chapter 7 is a straight bankruptcy in which many, but not
all, debts are forgiven. Most of the debtor's assets are sold
to pay off creditors. However, certain assets of the debtor
are protected to some extent. For example, Social Security payments,
unemployment compensation, and limited values of your equity
in a home, car, or truck, household goods and appliances, trade
tools, books, and so forth are protected.
The discharge of debts in Chapter 7 does not affect alimony,
child support, certain taxes, fines, certain debts arising from
educational loans, or debts that you fail to properly disclose
to the bankruptcy court. At the request of a creditor, the bankruptcy
judge may also exclude from the discharge debts resulting from
loans you received by giving the lender a false financial statement.
Furthermore, debts arising from fraud, embezzlement, driving
while intoxicated, larceny, or certain other willful or malicious
acts may also be excluded.
In a Chapter 13 bankruptcy, a debtor with a regular
income proposes to a bankruptcy court a plan for extinguishing
his or her debts from future earnings or other property over
a period of time. In such a bankruptcy, the debtor normally
keeps all or most of the property.
During the period the plan is in effect, which can be as long
as five years, the debtor makes regular payments to a Chapter
13 trustee. The trustee, in turn, distributes the money to the
creditors. Under certain circumstances, the bankruptcy court
may approve a plan permitting the debtor to keep all property
even though the debtor repays less than the full amount of the
debts. Certain debts not dischargeable in Chapter 7, such as
those based on fraud, may be discharged in Chapter 13 if the
debtor successfully completes the plan.
Effect of Bankruptcy on Your Job and Your Future Credit
Different people have different experiences in obtaining credit
after they file bankruptcy. Some find obtaining credit more
difficult.
Others find obtaining credit easier because they have relieved
themselves of their prior debts or because creditors know they
cannot file another bankruptcy case for a period of time.
Should a Lawyer Represent You in a Bankruptcy Case?
You have the right to file your own bankruptcy case and to
represent yourself at all court hearings. In any bankruptcy
case, however, you must complete and file with a bankruptcy
court several detailed forms concerning your property, debts,
and financial condition.
Many people find it easier to complete these forms with the
assistance of experienced bankruptcy counsel. In addition, you
may discover that your case will develop complications, especially
if you own a substantial amount of property or your creditors
object to the discharge of your debts. Then you will require
the advice and assistance of a lawyer.
Choosing a bankruptcy lawyer may be difficult. Some of the
least reputable lawyers make easy money by handling hundreds
of bankruptcy cases without adequately considering individual
needs. Recommendations from those you know and trust and from
employee assistance programs are most useful.
What Are the Costs? The monetary costs to the debtor
under Chapter 13 bankruptcy include the following:
Court costs. The debtor must pay a filing fee to the clerk
of the court at the time of filing his or her petition. The
filing fee may be paid in up to four installments if the court
grants authorization.
Attorneys' fees. These fees are usually the largest single
item of cost. Often the attorney does not require them to be
paid in advance at the time of filing but agrees to be paid
in installments after receipt of a down payment.
Trustees' fees and costs. The trustees' fees are established
by the bankruptcy judge in most districts and by a U.S. trustee
in certain other districts.
Although it is possible to reduce these costs by purchasing
the legal forms in a local stationery store and completing them
yourself, an attorney is strongly recommended.
