Chapter 4

Consumer Credit

Answers to Think It Over (p.100)

1 2 Any reasonable answer It wants its cardholders to develop a spending habit by using the credit card regularly in the first three months so that they will keep using the card in the future. An interest rate of 2% per month is equivalent to an interest rate of 26.8% per year. This rate is very high for a personal loan. 4 Advantages: Convenient and safe; Worldwide acceptance; Payment flexibility Disadvantages: High interest rate; Credit card abuse; Rejected by particular shops

Check Your Progress

Q1 A credit card is a form of revolving consumer credit because within the pre-set limit, consumers can withdraw and repay the money anytime. No fixed deadlines or number of payments to repay the loan in full are involved. Consumers can repay the loan by irregular or lump-sum payments and the repayment period can be flexible and lengthy. Q2 Affinity cards are credit cards that are jointly offered by a financial institution (e.g., a bank) and a non-financial group (e.g., a university, a retailer or airline). Affinity cardholders can enjoy discounts and other benefits on purchases with their credit cards. Credit cards are convenient and safe for consumers as they do not have to carry large sums of cash around. When they need to buy something but do not have enough cash, they can simply pay with a credit card. People can avoid the trouble of looking for an ATM or delaying their purchase. Q4 From a consumers point of view, an overdraft facility can prevent a cheque from being dishonoured due to careless mistakes by the account holder (e.g., writing a cheque without depositing the money in the current account). In addition, an overdraft arrangement can provide short-term liquidity to consumers who are temporarily short of cash. (a) The loans offered are non-revolving loans because the borrower is required to repay the loan by regular payments within the stated periods.
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Q3

Q5

(b)

(i) AAA credit card. This is because the MP3 player costs $2,500, which is less than the minimum loan amount of $3,000 for the BBB credit card. (ii) BBB credit card. As the remote-controlled car costs $3,000, I can obtain an interestfree loan with the AAA credit card or the BBB credit card. The maximum repayment period on the BBB credit card is 24 months, longer than that of the AAA credit card (18 months). This means that the monthly payment on the BBB credit card is lower. Thus, the BBB credit card is preferable.

Q6

The major advantage of non-revolving credit is that it forces the borrower to plan for the repayment, for example, how much he can afford to pay in each instalment.

Q7

(a)

PVA = $5,000, PVIFA8%, 4 = 3.312 (see Appendix 5 on p.189) $5,000 = Pmt 3.312 Pmt = $1,509.66 Annual payment amount is $1,509.66.

(b) Year Loan balance ($) Interest ($) Principal repayment ($) 1 5,000.00 400 (1) 1,109.66 2 3,890.34 (2) 311.23 1,198.43 (3) 3 2,691.91 215.35 (4) 1,294.31 4 1,397.6 (5) 111.81 1,397.85 (1) Interest = $5,000 8% = $400 (2) Loan balance = $5,000 $1,109.66 $3,890.34 (3) Principal repayment = $1,509.66 $311.23 = $1,198.43 (4) (5) Q8 Interest = $2,691.91 8% = $215.35 Loan balance = $2,691.91$1,294.31 = $1,397.6

The total interest = $5,000 8% 4 = $1,600 The annual payment amount = ($5,000 + $1,600) 4 = $1,650

Q9

The simple interest method is the most favourable to consumers because the total interest payment is the lowest. The discount method is the least favourable to borrowers. With the same loan amount, the money actually received by the borrower is the lowest under the discount method. Besides, the total interest paid is higher than that under the simple interest method.

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Q10

Non-revolving credit forces an individual to estimate in advance how much can be repaid each month and how long it will take to pay back the loan. Therefore, a person will not carry the debt for too long and will eventually pay it off within a reasonable period. Some credit cards (or loans) may charge different interest rates on different amounts of outstanding balances. Consumers need to estimate their average balance to know the appropriate interest rates applicable to them. As lenders often state their interest rates in different ways (monthly or annual), consumers should work out the total interest payments under different plans for comparison. A credit record is a detailed report of the credit history of an individual and whether he has filed for bankruptcy. It helps lenders evaluate the financial strength of credit applicants. This helps them make appropriate decisions on loan approvals and reduce their risk of bad debts. It is easier for borrowers to borrow money from lenders and possibly at lower interest rates if they have good credit records.

Q11

Q12

Q13

Q14 Q15

Repayment history, credit history, outstanding debt, past delinquency Positive data include total credit exposure, total available credit and the credit limit of unsecured and secured facilities, while negative data contain default details. A budget helps an individual review his spending habits and distinguish between regular and irregular consumption needs. When he checks the budget against his actual spending, he can see if there are any consumption problems.

Q16

Answers to Discussion Questions (p. 120)

1 At the end of Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Loan balance $ 10,000 9,847.5 9,697.32 9,549.44 9,403.81 9,260.4 9,119.18 8,980.11 8,843.17 8,708.31 8,575.51 Monthly payment $ 250 246.19 242.43 238.74 235.10 231.51 227.98 224.50 221.08 217.71 214.39
27

Monthly interest $ 97.5 96.01 94.55 93.11 91.69 90.29 88.91 87.56 86.22 84.91 83.61

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Dec

8,444.73

211.12

82.34 Total: 1076.70

The total interest payment is $1,076.70. 2 3 4 5 The instalment loan charges the lowest amount of interest. The instalment loan requires the highest monthly payment amount. I would choose the instalment loan because the total interest payment is the lowest. As I cannot afford the monthly instalment loan payment, I would choose either a credit card or a revolving loan. Among these two choices, a revolving loan is preferable because the total interest payment is lower.

Assessment
MCQ
1 2 3 4 5 6 7 8 9 10 11 12 13 C C D B B C D A A A D B C Interest charge = $8,000 7% 4 = $2,240 Annual payment = ($8,000 + $2,240) 4 = $2,560 The interest charge will be: $9,000 0.06 3 = $1,620 Amount that the consumer receives would be: $9,000 $1,620 = $7,380 Total interest is still $1,620, and the annual instalment is: $9,000 3 = $3,000 PV = Pmt PVIFA In this case, PV = $6,000, PVIFA8%, 2 = 1.783 (See Appendix 5) $6,000 = Pmt 1.783 Pmt = $3,365.11

14

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15

B A Loan balance ($) 6,000.00 3,114.89 B Interest (= A 0.08) ($) 480.00 249.19 729.19 C Yearly payment ($) 3,365.11 3,365.11 D Principal repayment (= C B) ($) 2,885.11 3,115.91 E Loan balance (after annual payment for the year) (= A D) ($) 3,114.89

Year 1 2

Short Questions
16 Revolving consumer credit does not involve a fixed number of payments for repaying the loan in full. Examples include credit cards and overdraft facilities. Non-revolving consumer credit refers to personal loans which involve a fixed number of payments for repaying both the loan principal and interest. Examples include car loans and tax loans. Under the simple interest method, interest is calculated on the outstanding loan balance. As the number of payments made increases, the outstanding loan balance declines. The amount of interes paid also becomes lower and lower. Thus, total interest payments under the simple interest method are lower than those under the add-on interest method and the discount method (interest charged on the amount borrowed). 18 It is convenient for consumers to use revolving credit for small purchases. They can avoid high interest costs by repaying the loan within the one-month interest free period. For expensive items, non-revolving credit is more appropriate as it forces an individual to estimate in advance how much can be repaid each month and how long it will take to pay back the loan. Therefore a person will not carry the debt for too long and will eventually pay it off within a reasonable period. Plan for consumption: Individuals should understand how much they can afford to consume. They should draw up some guidelines on consumption (e.g., when to use credit and when to use cash). Prepare a budget and check it against actual spending: Individuals should review their spending habits and distinguish between regular and irregular consumption needs. They should prepare a budget and check it against their actual spending every month. If there is a big difference, they should find out the reasons. Use consumer credit with discipline: Individuals may use consumer credit for convenience, but not for buying things that they cannot afford.
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19

Avoid a sudden increase in credit card applications: A sudden increase in credit card applications may cause CRAs to suspect that the individual is in financial trouble. Consider the repayment ability: Individuals should think about their ability to pay back debts before applying for credit cards or loans. They should not apply for credit cards or loans just for the gifts. Pay all bills on time: CRAs do not care why people do not pay their bills. These people might have been too busy or simply lost their bills, but CRAs will just think that they were unable to pay. Any past due accounts will most likely result in a downgrade of a persons credit score. If an individual has a good personal credit record, it is easier to borrow money from lenders, possibly at lower interest rates. 20 Consumer credit should not be used as a long-term or permanent source of personal financing. With revolving consumer credit, high interest is charged on the outstanding balance. If the borrower does not repay the loan in full, debt will slowly accumulate. On the other hand, nonrevolving consumer credit lacks flexibility in repayment schedules. If a borrower faces an unexpected financial problem such as losing a job, instalment payments under a nonrevolving credit arrangement can push him into financial trouble or even bankruptcy.

Application Problems
21 (a) Total interest = $7,000 6% 2 = $840 Chris should repay: ($7,000 + $840) 2 = $3,920 per year Chris actually gets: $7,000 $840 = $6,160 Assume the loan amount is X, X (1 6% 2) = $7,000 X = $7,955 (d) Chris should pay: PVA = Pmt PVIFA6%, 2 $7,000 = Pmt 1.833 (See Appendix 5) Pmt = $3,819

(b) (c)

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(e)

Interest cost of add-on method = $840 Interest cost of discount method (the usable amount is $7,000) = $7,955 $7,000 = $955 Interest cost of simple interest method = $3,819 2 $7,000 = $638 Since the simple interest method has the lowest total interest cost, Chris can benefit most from this method.

22

(a)

Gloria should repay: PVA = Pmt PVIFA8%, 3 $30,000 = Pmt 2.577 Pmt = $11,641 per year

(b) Year 1 2 3 (c) Loan balance $30,000 $20,759 $10,779 Interest $2,400 $1,661 $862 Annual payment $11,641 $11,641 $11,641 Principal repayment $9,241 $9,9810 $10,779 Loan balance after annual payment $20,759 $10,779 0

Gloria should repay: PVA = Pmt PVIFA5%, 5 $30,000 = Pmt 4.329 Pmt = $6,930

(d)

The interest cost of the original schedule: $11,641 3 $30,000 = $4,923 The interest cost of the new schedule: $6,930 5 $30,000 = $4,650 Since the interest cost of the new schedule is less than the original schedule, the new schedule is more favourable for Gloria.

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