PFIN5 5th Edition Billingsley Solutions

Manual
Visit to download the full and correct content document:
https://testbankdeal.com/download/pfin5-5th-edition-billingsley-solutions-manual/
 Chapter 6

Using Credit

Chapter Outline
Learning Objectives

I. The Basic Concepts of Credit

A. Why We Use Credit
B. Improper Uses of Credit
C. Establishing Credit
1. First Steps in Establishing Credit
2. Build a Strong Credit History
3. How Much Credit Can You Handle?
II. Credit Cards and Other Types of Open Account Credit
A. Bank Credit Cards
1. Line of Credit
2. Cash Advances
3. Interest Charges
4. Other Fees
B. Special Types of Bank Credit Cards
1. Reward Cards
2. Affinity Cards
3. Secured Credit Cards
4. Student Credit Cards
C. Retail Charge Cards
D. Debit Cards
E. Revolving Credit Lines
1. Overdraft Protection
2. Unsecured Personal Lines
3. Home Equity Credit Lines

III. Obtaining and Managing Open Forms of Credit

A. Opening an Account
1. The Credit Application
2. The Credit Investigation
3. The Credit Bureau
B. The Credit Decision
C. Computing Finance Charges
D. Managing Your Credit Cards
1. The Statement
 2. Payments

IV. Using Credit Wisely

A. Shop Around for the Best Deal
B. Avoiding Credit Problems
C. Credit Card Fraud
D. Bankruptcy: Paying the Price for Credit Abuse
1. Wage Earner Plan
2. Straight Bankruptcy

Major Topics
Managing credit is an important part of personal financial planning. Consumer credit can be used
in one form or another to purchase just about every type of good or service imaginable. It is a
convenient way to make transactions, but when consumer credit is misused it can lead to real
problems. It is important for you to understand where consumer credit fits into your financial
plans so that it is used wisely. This chapter covers the following major topics:

1. Consumer credit enables the user to pay for relatively expensive purchases, to deal with
financial emergencies, and to enjoy the convenience of using credit.
2. Disadvantages to using consumer credit generally arise from abuse of credit—people
borrow more than they can handle—and this can eventually lead to bankruptcy.
3. Open account credit is the most popular form of consumer credit. It is provided by banks,
stores, and other merchants and includes bank credit cards, retail charge cards, travel and
entertainment cards, and personal revolving credit lines, which include overdraft
protection and home equity loans.
4. Formal application for open account credit involves a credit investigation; a credit report
will probably be obtained from one of the major credit bureaus.
5. Finance charges are typically based on a variation of the average daily balance method.
6. Using open account credit wisely involves choosing the right card or line of credit,
avoiding credit problems and fraud, and not abusing credit.

Key Concepts
Open account credit is a very important concept in the understanding of your personal financial
plan. Improper use of this type of credit can lead to disaster, but wise use of open account credit
can help you implement your overall plan. To understand the application of open account credit,
you should understand some of the key terminology, including the following terms:
1. Debt safety ratio
2. Credit history
3. Credit limit
4. Bank credit cards
5. Retail charge cards
6. Cash advance
7. Debit cards
8. Revolving line of credit
9. Overdraft protection
10. Home equity credit lines
11. Credit bureau
12. Credit scoring
13. Finance charges
14. Credit card fraud
15. Personal bankruptcy
16. Credit counseling
17. Open account credit
18. Line of credit
19. Base rate
20. Grace period
21. Reward (co-branded) credit card
22. Affinity cards
23. Secured (collateralized) credit cards
24. Student credit card
25. Unsecured personal credit line
26. Credit investigation
27. Annual percentage rate (APR)
28. Average daily balance (ADB) method
29. Minimum monthly payment
30. Wage Earner Plan
31. Straight bankruptcy

Financial Planning Exercises

The following are solutions to some of the problems at the end of the PFIN 5 textbook chapter.

1. Establishing credit history. Cindy is wise to begin establishing a good credit history
early. She should start by opening bank accounts (checking and savings) and applying for
a few credit cards. She should use these cards sparingly and pay bills promptly. Having a
student loan helps establish her credit history, as by making payments on time, she
demonstrates her ability to meet her loan obligations. The size of her student loan may
impact her ability to obtain additional credit. She needs to focus on paying off the
student loan.

2. Evaluating debt burden. If Craig makes payments of $410 and his take-home pay is
$1,685, his debt safety ratio is $410/$1,685 = 0.24 or 24%, which is slightly above the
maximum suggested limit of 20%; as such, he should be cautious about incurring any
more debt before he pays off his current obligations.

If his take-home pay were $850 and his payments were $150 per month, his debt safety
ratio would be $150/$850 = 0.176 or approximately 18%, which is within the
 recommended guidelines. However, 18% is close to the maximum suggested limit of
20%, so Jake would do well to try to reduce his debt load.

3. Evaluating debt safety ration. Use Worksheet 6.1. Ashley’s consumer debt safety ratio is
calculated as follows: Use worksheet 6.1.

Type of Loan Mo. Payment

Auto loan $380

Dept. store charge card 60

Bank credit card 85

Personal line of credit 120

Total Monthly Payments $645

Debt Safety Ratio = Total Monthly Consumer Credit Payments

Monthly Take-Home Pay
= $645
$3,320

= 19.4%

If Natalie wants her debt safety ratio to be only 12.5% of her current take-home pay, she
must reduce her total monthly payments to $415 ($3,320 x .125).

If she wants her current consumer debt load to equal 12.5% of take-home pay, then she
would have to increase her take-home pay to $5,160 ($645 = 0.125 x Take-home pay or
Take-home pay = $645 ÷ 0.125)

4. Comparing credit and debit cards. Credit cards provide a line of credit and can be used
worldwide as well as on the Internet to make purchases or pay for services. Credit cards also
allow the holder to obtain cash advances, either from a financial institution or at an ATM
machine. Other features offered by credit cards may include a buyer protection plan on
merchandise purchased with the card, travel accident insurance, auto rental insurance coverage
or other added attractions, such as a rebates or frequent flyer miles. Even though most credit
cards carry a fairly high interest rate, cardholders who pay their balance in full each month
usually pay no interest or finance charges. So in essence, such card users are the beneficiaries
of a short, free loan each month. The main drawback to credit cards is the tendency of some
cardholders to overspend, go into debt and incur high interest charges.

Debit cards do not provide credit, but rather are like writing a check. Purchases on debit cards
come directly from one’s checking account and therefore incur no finance charges. People who
 have difficulty managing credit many times prefer a debit card because they are not as tempted
to overspend. However, some merchants charge a fee to debit card users, and some issuers
charge transaction fees. Debit cardholders can have overdraft problems when they fail to record
transactions in their checkbooks.

Sergio would be a convenience user of either type card. He is a disciplined spender and
probably would not be tempted to overspend. He likely will not need credit for emergency
purposes, either, as he has an emergency fund of $8,500 built up.

Sergio might want to consider a credit card with a rebate or frequent flyer miles. With his
disciplined approach to spending, he could charge purchases, pay them in full each month, and
rack up points or miles. Also, when a credit card is stolen, the most the cardholder can be out is
$50. When a debit card is stolen, the cardholder can possibly lose a lot more, plus the money
has been removed from his or her account and the burden falls to the cardholder to get the
money restored to his or her account. In the meantime, before the money is restored the debit
cardholder is denied use of his or her funds. On the other hand, if fraudulent charges appear on
one’s charge card statement, the credit cardholder contests the charges and doesn’t pay the bill.

5. Home equity lines. If Max and Claudia have a home appraised at $180,000 and a
mortgage balance of only $90,000, they have equity in the home of $90,000 ($180,000 –
$90,000). If an S&L will lend money on the home at a loan-to-value ratio of 75%, the
S&L would be willing to lend up to $135,000, or .75 x $180,000. Subtracting the first
mortgage of $90,000, the Chadwicks could qualify for a home equity loan of $45,000.

According to the latest provisions of the tax code, all of the interest paid on their home
equity loan would be fully deductible (for federal tax purposes). It makes no difference
what the house originally cost; the only thing that matters is that the amount of
indebtedness on the house not exceed its fair market value (which is virtually impossible
given a loan-to-value ratio of 75%). Other than that, a homeowner is allowed to fully
deduct the interest charges on home equity loans of up to $100,000; since the Chadwick’s
home equity line is within this limit (theirs is a $45,000 line), the interest on it is fully
deductible.

Note: under current tax laws, the total amount of itemized deductions as reported on
Schedule A may be reduced for taxpayers with adjusted gross incomes greater than a
certain level. Also, if taxpayers do not itemize deductions and if they take the standard
deduction instead, the tax deductibility feature of a home equity loan would not make a
difference in the amount of taxes owed.

7. Choosing between credit cards. If Wyatt promptly pays off his balances every period
and carries forward no balance to the next term, Card B would be a better option. The
rate of interest on the card is irrelevant because account balances are not carried over on a
monthly basis. In sharp contrast, if Wyatt does not pay off his account in full, he should
look for cards that charge a low rate of interest on unpaid balances. Hence, Card A would
be a better option. The length of the grace period isn’t all that important, here, but
obviously, other things being equal, Wyatt is better off with low or no annual fees.
8. Calculating credit card interest. Assuming that Anne has a balance of $380 on her retail
charge card, the monthly interest on her account would be: $380 × (21% ÷ 12) = $6.65.

9. Balance transfer credit cards.

Audrey has a fairly large balance of $14,500 on her credit cards. If her current cards
charge her 12% per year, she would be paying $1,740/year or $145/month ($14,500 x
.12/12) in interest on this amount. Therefore, if she feels she would not be able to pay off
this balance fairly rapidly, she might indeed wish to transfer her balance to a 0% interest
rate card for 9 months. If such a card charges a 2% transfer fee, she would pay $290 to
transfer her $14,500 balance. She would have paid that amount in interest in 2 months
anyway by leaving her balance with her old cards. Most cards have a maximum amount
charged to transfer a balance, such as $65 or $75. However, since Lilly has multiple
cards, she might be charged that maximum several times. She should call the customer
service number on the new credit card offer, explain her situation, and ask them to
calculate what her fees would be to transfer the balance. She should also inquire what the
regular rate will be on the new card, because she will have to pay that on her unpaid
balance once the special offer time period is over. She should also be aware that if she
pays late on such an offer, many times the rate will automatically go up to the card’s
regular rate and even higher if she has several late pays.

10. Credit card liability

Jade should immediately notify the credit card issuer of any charges on her statement which are
not hers. The customer service representative of the issuing card can give her more information
concerning the purchases so that she can determine if she indeed made them and forgot or if
they are fraudulent. Her liability would be limited to $50 on any charges she did not make. She
definitely should “make some noise”.
Answers to Test Yourself Questions
The following are solutions to “Test Yourself Questions” found on the student website, PFIN 5
Online, at www.cengagebrain.com.

6-1 Why do people borrow? What are some improper uses of credit?

Whatever their age group, people tend to borrow for several major reasons.
• To avoid paying cash for large outlays: Rather than pay cash for large purchases such as
houses and cars, most people borrow part of the purchase price and then repay the loan on some
scheduled basis.
To meet a financial emergency: For example, people may need to borrow to cover living
expenses during a period of unemployment or to purchase plane tickets to visit a sick relative. As
indicated in Chapter 4, however, using savings is preferable to using credit for financial
emergencies.
For convenience: Merchants as well as banks offer a variety of charge accounts and credit cards
that allow consumers to charge just about anything. Further, in many places—restaurants, for
instance—using a credit card is far easier than writing a check.
For investment purposes: As we’ll see in Chapter 11, it’s relatively easy for an investor to
partially finance the purchase of many different kinds of investments with borrowed funds.

Many people use consumer credit to live beyond their means. For some people, overspending
becomes a way of life, and it is perhaps the biggest danger in borrowing—especially because it’s
so easy to do. Once hooked on “plastic,” people may use their credit cards to make even routine
purchases and all too often don’t realize they have overextended themselves until it’s too late.

6-2 Describe the effects of the credit crisis of 2008–2009 on borrowers.

As credit became more readily available and easier to obtain, it also became increasingly clear that many consumers
were, in fact, severely overusing it. Whether or not the consumer deserved the credit was really not an issue—the
only thing that seemed to matter was that it was there for the taking! All this resulted in a credit meltdown unlike
anything this country had ever seen.

6-3 Describe the general guidelines that lenders use to calculate an applicant’s maximum
debt burden.

The willingness of lenders to extend credit depends on their assessment of your

creditworthiness—that is, your ability to promptly repay the debt. Lenders look at various factors
in making this decision, such as your present earnings and net worth. Equally important, they
look at your current debt position and your credit history.

6-4 How can you use the debt safety ratio to determine whether your debt obligations are
within reasonable limits?

The easiest way to avoid repayment problems and ensure that your borrowing won’t place an
undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt!
A useful credit guideline (and one widely used by lenders) is to make sure your monthly
repayment burden doesn’t exceed 20 percent of your monthly take-home pay. Most experts,
however, regard the 20 percent figure as the maximum debt burden and strongly recommend a
debt safety ratio closer to 15 percent or 10 percent—perhaps even lower if you plan on applying
for a new mortgage in the near future. Note that the monthly repayment burden here does include
payments on your credit cards, but it excludes your monthly mortgage obligation.

6-5 What steps can you take to establish a good credit rating?
Here are some things you can do to build a strong credit history:
• Use credit only when you can afford it and only when the repayment schedule fits comfortably
into the family budget—in short, don’t overextend yourself.
• Fulfill all the terms of the credit.
• Be consistent in making payments promptly.
• Consult creditors immediately if you cannot meet payments as agreed.
• Be truthful when applying for credit. Lies are not likely to go undetected.

6-6 What is open account credit? Name several different types of open account credit.

Open account credit is a form of credit extended to a consumer in advance of any transactions.
Typically, a retail outlet or bank agrees to allow the consumer to buy or borrow up to a specified
amount on open account. Credit is extended so long as the consumer does not exceed the
established credit limit and makes payments in accordance with the specified terms.

Open account credit generally is available from two broadly defined sources: (1) financial
institutions and (2) retail stores/merchants. Financial institutions issue general-purpose credit
cards, as well as secured and unsecured revolving lines of credit and overdraft protection lines.
Commercial banks have long been the major providers of consumer credit; and, since
deregulation, so have S&Ls, credit unions, major stock-brokerage firms, and consumer finance
companies. Retail stores and merchants make up the other major source of open account credit.
They provide this service as a way to promote the sales of their products, and their principal form
of credit is the charge (or credit) card. Let’s now take a look at these two forms of credit, along
with debit cards and revolving lines of credit.

6-7 What is the attraction of reward cards?

One of the fastest-growing segments of the bank card market is the reward (cobranded) credit
card, which combines features of a traditional bank credit card with an incentive: cash,
merchandise rebates, airline tickets, or even investments. About half of credit cards are rebate
cards, and new types are introduced almost every day.

6-8 How is the interest rate typically set on bank credit cards?

Most of these cards have variable interest rates that are tied to an index that moves with market
rates. The most popular is the prime or base rate: the rate a bank uses as a base for loans to
individuals and small or midsize businesses. These cards adjust their interest rate monthly or
quarterly and usually have minimum and maximum rates. Generally speaking, the interest rates
on credit cards are higher than any other form of consumer credit. But more and more banks—
even the bigger ones—are now offering more competitive rates, especially to their better
customers. Indeed, because competition has become so intense, a growing number of banks
today are actually willing to negotiate their fees as a way to retain their customers

6-9 Many bank card issuers impose different types of fees; briefly describe three of these
fees.

Many (though not all) bank cards charge annual fees just for the “privilege” of being able to use
the card.
Many issuers also charge a transaction fee for each (non-ATM) cash advance; this fee usually
amounts to about $5 per cash advance or 3 percent of the amount obtained in the transaction,
whichever is more.
Other fees include late-payment fees, over-the-limit charges, foreign transaction fees, and
balance transfer fees.

6-10 What is a debit card? How is it similar to a credit card? How does it differ?

A debit card provides direct access to your checking account and thus works like writing a check.
A big disadvantage of a debit card, of course, is that it doesn’t provide a line of credit. In
addition, it can cause overdraft problems if you fail to make the proper entries to your checking
account or inadvertently use it when you think you’re using a credit card. Also, some debit card
issuers charge a transaction fee or a flat annual fee; and some merchants may even charge you
just for using your debit card. On the plus side, a debit card enables you to avoid the potential
credit problems and high costs of credit cards.

Another difference between debit and credit cards involves the level of protection for the user
when a card is lost or stolen. When a credit card is lost or stolen, federal banking laws state that
the cardholder is not liable for any fraudulent charges if the loss or theft is reported before that
card is used. If reported after the card is used, the cardholder’s maximum liability is $50.
Unfortunately, this protection does not extend to debit cards.

6-11 Describe how revolving credit lines provide open account credit.
Revolving lines of credit normally don’t involve the use of credit cards. Rather, they’re
accessed by writing checks on regular checking accounts or specially designated credit line
accounts. They are a form of open account credit and often represent a far better deal than credit
cards, not only because they offer more credit but also because they can be a lot less expensive.
The three major forms of open (non–credit card) credit are overdraft protection lines, unsecured
personal lines of credit, and home equity credit lines.

6-12 What are the basic features of a home equity credit line?
A home equity credit line is much like unsecured personal credit lines except that they’re
secured with a second mortgage on the home. These lines of credit allow you to tap up to 100
percent (or more) of the equity in your home by merely writing a check.
Home equity lines also have a tax feature that you should be aware of: the annual interest
charges on such lines may be fully deductible for those who itemize. This is the only type of
consumer loan that still qualifies for such tax treatment. According to the latest provisions of the
tax code, a homeowner is allowed to fully deduct the interest charges on home equity loans up to
$100,000, regardless of the original cost of the house or use of the proceeds. Indeed, the only
restriction is that the amount of total indebtedness on the house cannot exceed its fair market value,

6-13 Describe credit scoring and explain how it’s used (by lenders) in making a credit
decision.

Using the data provided by the credit applicant, along with any information obtained from the
credit bureau, the store or bank must decide whether to grant credit. Very likely, some type of
credit scoring scheme will be used to make the decision. An overall credit score is developed
for you by assigning values to such factors as your annual income, whether you rent or own your
home, number and types of credit cards you hold, level of your existing debts, whether you have
savings accounts, and general credit references.

The biggest provider of credit scores is, by far, Fair Isaac & Co.—the firm that produces the
widely used FICO scores. Unlike some credit score providers, Fair Isaac uses only credit
information in its calculations. There’s nothing in them about your age, marital status, salary,
occupation, employment history, or where you live. Instead, FICO scores are derived from the
following five major components, which are listed along with their respective weights: payment
history (35 percent), amounts owed (30 percent), length of credit history (15 percent), new credit
(10 percent), and types of credit used (10 percent). FICO scores, which are reported by all three
of the major credit bureaus, range from a low of 300 to a max of 850.

6-14 Describe the basic operations and functions of a credit bureau.

A credit bureau is a type of reporting agency that gathers and sells information about individual
borrowers. If, as is often the case, the lender doesn’t know you personally, it must rely on a cost-
effective way of verifying your employment and credit history. It would be far too expensive
and time-consuming for individual creditors to confirm your credit application on their own, so
they turn to credit bureaus that maintain fairly detailed credit files about you. Information in your
file comes from one of three sources: creditors who subscribe to the bureau, other creditors who
supply information at your request, and publicly recorded court documents (such as tax liens or
bankruptcy records).

6-15 What is the most common method used to compute finance charges?

According to the Truth in Lending Act, lenders disclose the rate of interest that they charge and
their method of computing finance charges. This is the annual percentage rate (APR), the true
or actual rate of interest paid, which must include all fees and costs and be calculated as defined
by law.
 The amount of interest you pay for open credit depends partly on the method the lender
uses to calculate the balances on which they apply finance charges. Most bank and
retail charge card issuers use one of two variations of the average daily balance (ADB)
method, which applies the interest rate to the ADB of the account over the billing period.
The most common method (used by an estimated 95 percent of bank card issuers) is the
ADB, including new purchases. Card issuers can also use an ADB method that excludes new
purchases. Balance calculations under each of these methods are as follows:

• ADB, including new purchases: For each day in the billing cycle, take the
outstanding balance, including new purchases, and subtract payments and credits; then
divide by the number of days in the billing cycle.
• ADB, excluding new purchases: Same as the first method, but excluding new
purchases.

6-16 The monthly statement is a key feature of bank and retail credit cards. What
does this statement typically disclose?

If you use a credit card, you’ll receive monthly statements similar to the sample bank
card statement in Exhibit 6.9, showing billing cycle and payment due dates, interest
rate, minimum payment, and all account activity during the current period.
Solutions to Online Bonus Personal Financial Planning Exercises
The following are solutions to “Bonus Personal Financial Planning Exercises” found on the
student website, PFIN 5 Online, at www.cengagebrain.com.

1. Establish a credit history. After graduating from college last fall, Nicole butler took a job
as a consumer credit analyst at a local bank. From her work reviewing credit applications,
she realizes that she should begin establishing her own credit history. Describe for Nicole
several steps that she could take to begin building a strong credit record. Does the fact that
she took out a student loan for her college education help or hurt her credit record?

Here are some things you can do to build a strong credit history:
• Use credit only when you can afford it and only when the repayment schedule fits comfortably
into the family budget—in short, don’t overextend yourself.
• Fulfill all the terms of the credit.
• Be consistent in making payments promptly.
• Consult creditors immediately if you cannot meet payments as agreed.
• Be truthful when applying for credit. Lies are not likely to go undetected.

Having a student loan on which you may consistent and regular payments can help you build a
good credit history. Payments of a student loan will be consider when determining your debt
safety ratio, an indicator of your ability to carry more loans.

2. Evaluating debt burden. Isaac Wright has a monthly take-home pay of $1,685; he makes
payments of $410 a month on his outstanding consumer credit (excluding the mortgage on
his home). How would you characterize Isaac’s debt burden? What if his take-home pay
were $850 a month and he had monthly credit payments of $150?

The debt safety ratio is total monthly consumer credit payments divided by the monthly take-
home pay. In Isaac’s case, with monthly take-home pay of $1,685 and payments of $410, his
debt safety ratio is 410/1,685 = 24.3. This ratio is over the preferred maximum of a ratio of 20.
Therefore, Isaac’s ability to borrow is limited. He needs to pay off some debt or increase his
monthly income to take on additional debt.

In Isaac’s second case, with monthly take-home pay of $850 and payments of $150, his debt
safety ratio is 150/850 = 17.6. This ratio is under the maximum of 20. It is over the preferred
ratio of 15, but Isaac can handle a small additional loan. He should be careful and only borrow if
he needs to do so. One more consumer loan and he will be at or over the maximum debt safety
ratio and heading to debt trouble.

3. Calculating and interpreting personal debt safety ratio. Calculate your own debt safety
ratio. What does it tell you about your current credit situation and your debt capacity?
Does this information indicate a need to make any changes in your credit use patterns? If
so, what steps should you take?

The easiest way to avoid repayment problems and ensure that your borrowing won’t place an
undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt!
To improve your debt safety ratio, reduce the amount of debt or increase income.

4. Evaluating debt safety ratio. Use Worksheet 6.1. Alyssa Clark is evaluating her debt
safety ratio. Her monthly take- home pay is $3,320. Each month, she pays $380 for an auto
loan, $120 on a personal line of credit, $60 on a department store charge card, and $85 on
her bank credit card. Complete Worksheet 6.1 by listing Alyssa’s outstanding debts, and
then calculate her debt safety ratio. Given her current take-home pay, what is the
maximum amount of monthly debt payments that Alyssa can have if she wants her debt
safety ratio to be 12.5 percent? Given her current monthly debt payment load, what would
Alyssa’s take-home pay have to be if she wanted a 12.5 percent debt safety ratio?
 Monthly consumer Loan Payments & Debt Safety Ratio
Name Alyssa Clark Date 5/5/2016

Current Monthly or
Type of Loan Lender Minimum Payment
Auto & Personal Loans: 1 Auto 380
2 Retail 60
Education loans: 1
2
Overdraft Protection line
Personal line of credit Personal line 120
Credit Cards: 1 Bank 85
2
Home Equity line
Total Monthly Payments $ 645
*Note: List only those loans that require regular monthly payments.
Monthly Take-Home Pay 1 3320
2
Total Monthly Take-Home Pay $ 3,320
Debt Safety Ratio:
Total monthly payments * 100 = 19.4
Total monthly take-home payments
Change needed to reach a new debt safety ratio:
1 New Target debt safety ratio: 0.125
2 At current take-home pay of 3320
total monthly payments must equal:
Total monthly take-home pay * Target debt safety ratio
3320 * 0.125 = $ 415.00
New Monthly Payments
OR
3 With current monthly payment of 645
total take-home pay must equal:
Total monthly payments = 645 $ 5,160.00
New (target) debt safety ratio 0.125

**Note: Enter debt safety ratio as a decimal (e.g., 15% = 0.15).

From Worksheet 6.1 above, Alyssa’s current debt safety ratio is 19.4 which is close to the
maximum of 20 and above the desired ratio of 15. In order to reach the desirable ratio 12.5,
Alyssa will have to reduce monthly payments to $415, or increase monthly income to $5,160.

5. Implication of Credit Card Act. What are the main features and implications of the
Credit Card Act of 2009?

See Exhibit 6.4.

6. Using overdraft protection line. Isabella Harris has an overdraft protection line. Assume
that her October 2015 statement showed a latest (new) balance of $862. If the line had a
minimum monthly payment requirement of 5 percent of the latest balance (rounded to the
nearest $5 figure), then what would be the minimum amount that she’d have to pay on her
overdraft protection line?

5% * 862 = 43.1, rounded to nearest $5, = $45.

7. Home equity line interest. Sean and Amy Anderson have a home with an appraised value
of $180,000 and a mortgage balance of only $90,000. Given that an S&L is willing to lend
money at a loan-to-value ratio of 75 percent, how big a home equity credit line can Sean
and Amy obtain? How much, if any, of this line would qualify as tax-deductible interest if
their house originally cost $100,000?

Current appraised value $180,000

First mortgage balance 90,000

Remaining value available for loan $ 90,000

If loan to equity is limited to 75%, most that could be loan is 75% or $180,000 = $135,000
Total available $135,000
First mortgage balance 90,000

Remaining value available for loan $ 45,000

The interest on the entire home equity loan of either $90,000 or $45,000 may be deducted as an
itemized deduction. The deductible interest in limited to the interest on a first mortgage of a
maximum $1,000,000 from the acquisition of up to two homes. The deductible interest on home
equity loan is limited to principal of $100,000. So if the acquisition interest was $100,000, the
interest on both the first mortgage of $90,000 and the home equity loan of either $45,000 or
$90,000 would be deductible.

8. Calculating credit card interest. Ryan Gray, a student at State College, has a balance of
$380 on his retail charge card; if the store levies a finance charge of 21 percent per year,
how much monthly interest will be added to his account?

The monthly interest is the annual interest divided by 12. Thus, an annual interest of 21% is a
monthly interest of .21/12 = .0175 or 1.75%. With a balance of $380, that is $6.65 per month.

If the interest is computed on an Average Daily Balance method, the daily rate is 21%-365 or
.0575% per day or 1.726% per 30 days.
9. Choosing between credit cards. Wyatt Collins recently graduated from college and is
evaluating two credit cards. Card A has an annual fee of $75 and an interest rate of 9
percent. Card B has no annual fee and an interest rate of 16 percent. Assuming that Wyatt
intends to carry no balance and to pay off his charges in full each month, which card
represents the better deal? If Wyatt expected to carry a significant balance from one month
to the next, which card would be better? Explain.

Assuming that Wyatt intends to carry no balance and to pay off his charges in full each month
Card B would not cost Wyatt any fees. Card A would cost him the annual fee of $75.

Assuming Wyatt expected to carry a significant balance from one month to the next, Card A
would cost an annual fee of $75 plus 9% of the monthly balance. Card B has no annual fee, but
a rate of 18%. If Wyatt has a monthly balance of $100, Card A would cost total fees of $75 +
9%*100 = $84 per year. Card B would have total fees of 18% * 100 = $18. The difference in
interest is 9%, thus the breakeven point is the annual fee of $75 divided by 9 %, or a debt balance
of $833.33. With a debt balance of $833.33, card A total fees would be $75 + 9%*833.33 =
$150. Card B annual fees would be 18%* 833.33 = $150.

Thus, if the monthly debt balance is under $833.33, Card B is better. Over $833.33, Card A is
better.

10. Balance transfer credit cards. Martina Lopez has several credit cards, on which she is
carrying a total current balance of $14,500. She is considering transferring this balance to
a new card issued by a local bank. The bank advertises that, for a 2 percent fee, she can
transfer her balance to a card that charges a 0 percent interest rate on transferred balances
for the first nine months. Calculate the fee that Martina would pay to transfer the balance,
and describe the benefits and drawbacks of balance transfer cards.

Martina has a fairly large balance of $14,500 on her credit cards. If her current cards charge her
12% per year, she would be paying $1,740/year or $145/month ($14,500 x .12/12) in interest on
this amount. Therefore, if she feels she would not be able to pay off this balance fairly rapidly,
she might indeed wish to transfer her balance to a 0% interest rate card for 9 months. If such a
card charges a 2% transfer fee, she would pay $290 to transfer her $14,500 balance. She would
have paid that amount in interest in 2 months anyway by leaving her balance with her old cards.
Most cards have a maximum amount charged to transfer a balance, such as $65 or $75. However,
since Martina has multiple cards, she might be charged that maximum several times. Martina
should call the customer service number on the new credit card offer, explain her situation, and
ask them to calculate what her fees would be to transfer the balance. She should also inquire
what the regular rate will be on the new card, because she will have to pay that on her unpaid
balance once the special offer time period is over. She should also be aware that if she pays late
on such an offer, many times the rate will automatically go up to the card’s regular rate and even
higher if she has several late pays.

11. Calculating credit card finance charge. Parker Young recently received his monthly
MasterCard bill for the period June 1–30, 2015, and wants to verify the monthly finance
charge calculation, which is assessed at a rate of 15 percent per year and based on ADBs,
including new purchases. His outstanding balance, purchases, and payments are as follows:

Previous Balance: $386

Purchases:
June 4 $137
June 12 78
June 20 98
June 26 75
Payments:
June 21 $ 35

What is his ADB and the finance charge for the period? (Use a table like the one in Exhibit
6.3 for your calculations.)
The calculation of Joel’s interest is as follows:

Number of Days Balance (1) x (2) =

(1) (2) (3)
Previous balance 4 $386 $ 1,544
Purchases and payments:
June 4–11 balance ($386 + $137) 8 523 4,184
June 12–19 balance ($78 + $523) 8 601 4,808
June 20 balance ($98 + $601) 1 699 699
June 21–25 balance ($699 – $35) 5 664 3,320
June 26–30 balance ($75 + $664) 4 739 2,956
$17,511

Average daily balance = $17,511 = $583.70

30

Finance charge = $583.70 x (0.15 ÷ 12) = $583.70 x .0125 = $7.30

12. Credit v debit card. Henry Stewart is trying to decide whether to apply for a credit card
or a debit card. He has $8,500 in a savings account at the bank and spends his money
frugally. What advice would you have for Henry? Describe the benefits and drawbacks of
each type of card.

Credit cards provide a line of credit and can be used worldwide as well as on the Internet to
make purchases or pay for services. Credit cards also allow the holder to obtain cash advances,
either from a financial institution or at an ATM machine. Other features offered by credit cards
may include a buyer protection plan on merchandise purchased with the card, travel accident
insurance, auto rental insurance coverage or other added attractions, such as a rebates or frequent
flyer miles. Even though most credit cards carry a fairly high interest rate, cardholders who pay
their balance in full each month usually pay no interest or finance charges. So in essence, such
card users are the beneficiaries of a short, free loan each month. The main drawback to credit
cards is the tendency of some cardholders to overspend, go into debt and incur high interest
charges. Also, when a credit card is stolen, the most the cardholder can be out is $50. When a
debit card is stolen, the cardholder can possibly lose a lot more, plus the money has been
removed from his or her account and the burden falls to the cardholder to get the money restored
to his or her account. In the meantime, before the money is restored the debit cardholder is
denied use of his or her funds. On the other hand, if fraudulent charges appear on one’s credit
card statement, the credit cardholder contests the charges and doesn’t pay the bill.

Debit cards do not provide credit but rather are like writing a check. Purchases on debit cards
come directly from one’s checking account and therefore incur no finance charges. People who
have difficulty managing credit many times prefer a debit card because they are not as tempted to
overspend. However, some merchants charge a fee to debit card users, and some issuers charge
transaction fees. Debit cardholders can have overdraft problems when they fail to record
transactions in their checkbooks

Henry would be a convenience user of either type card. He is a disciplined spender and probably
would not be tempted to overspend. He likely will not need credit for emergency purposes,
either, as he has a sizeable emergency fund of $8,500 built up.

Henry might want to consider a credit card with a rebate or frequent flyer miles. With his
disciplined approach to spending, he could charge purchases, pay them in full each month, and
rack up points or miles.

13. Credit card liability. Christine Lin was reviewing her credit card statement and noticed
several charges that didn’t look familiar to her. Christine is unsure whether she should pay
the bill in full and forget about the unfamiliar charges, or “make some noise.” If some of
these charges aren’t hers, is she still liable for the full amount? Is she liable for any part of
these charges, even if they’re fraudulent?

Christine should immediately notify the credit card issuer of any charges on her statement which
are not hers. The customer service representative of the issuing card can give her more
information concerning the purchases so that she can determine if she indeed made them and
forgot or if they are fraudulent. Her liability would be limited to $50 on any charges she did not
make. She definitely should “make some noise”; otherwise she may have to pay the
unauthorized charges.

14. Evaluating loan request. Carter Hall recently graduated from college and wants to
borrow $50,000 to start a business, which he believes will produce a cash flow of at least
$10,000 per year. As a student, Carter was active in clubs, held many leadership positions,
and did a lot of community service. He currently has no other debts. He owns a car worth
about $10,000 and has $6,000 in a savings account. Although the economy is currently in a
recession, economic forecasters expect the recession to end soon. If you were a bank loan
officer, how would you evaluate Carter’s loan request within the context of the “5 C’s of
Credit”? Briefly describe each characteristic and indicate whether it has favorable or
unfavorable implications for Carter’s loan request.

The 5 Cs of credit are character, capacity, collateral, capital, and condition. Refer to the
“Financial Road Sign”.
a. Carter certainly seems to be a person of great character. He was active in clubs and
community service while in college, serving frequently in a leadership role.

b. His capacity to service a loan would depend on his other sources of income. We are not told if
he has another job lined up or not. If he has other income that would greatly increase his
capacity to repay the loan, particularly since he has no other debts to service. However, if
he does not have other income, the $10,000 expected cash flow from his investment is
certainly not enough for him to live off of plus pay on his loan.

c. Carter might consider offering his car as collateral for this loan, since he owns it free and
clear. Backing a loan with collateral would likely allow him to obtain a much lower
interest rate on the loan, since the bank would have an asset to seize in the event he did
not repay his loan as promised. The lower the interest rate, the lesser it would cost Carter
to service his loan, which in turn would also increase his capacity to repay the loan.

d. Carter has a fair amount of capital for a young person who has just completed college. He
owns his car, which is valued at $10,000, plus he has $6,000 in savings. This should be a
positive for him.

e. However, the current condition of the economy will probably work against Harvey. Even
though an economic recovery is predicted soon, it may not be soon enough for Harvey’s
business to generate the cash flow he anticipates. A high percentage of new businesses
fail in the first year, and a slow economy usually increases the likelihood of failure.

Solutions to Critical Thinking Cases

The following are solutions to “Critical Thinking Cases” found on the student website, PFIN 5
Online, at www.cengagebrain.com.

Critical Thinking Problems

6.1 The Ramirez Family Seeks Some Credit Card Information
Felipe and Lucia Ramirez are a newly married couple in their mid-20s. Conrad is a senior
at a state university and expects to graduate in the summer of 2015. Lucia graduated last
spring with a degree in marketing and recently started working as a sales rep for the
Momentum Systems Corporation. She supports both of them on her monthly salary of
$4,250 after taxes. The Ramirez’s currently pay all their expenses by cash or check. They
would, however, like to use a bank credit card for some of their transactions. Because
neither Felipe nor Lucia knows how to apply for a credit card, they approach you for help.

Critical Thinking Questions

1. Advise the couple on how to fill out a credit application.

Exhibit 6.5 provides an example of a bank credit card application. As you can see, the type of
information requested in a typical credit application covers little more than personal/family
matters, housing, employment and income, and existing charge accounts. It is important that the
information on the application be correct and honest. False or misleading information will
almost certainly result in outright rejection of your application. The key items that lenders look at
are how much money you make, how much debt you have outstanding and how well you handle
it, and how stable you are (for example, your age, employment history, whether you own or rent
a home, and so on).

2. Explain to them the procedure that the bank will probably follow in processing their
application.

The steps involved are first to complete the application. Then the application will be reviewed
and the data thereon will be checked with information from other sources such as a credit bureau.
. Further investigation by the bank may involve contacting references listed on the credit
application. Generally, only in the case where a credit report cannot be obtained or when the
credit report is marginal will the bank check credit references.

3. Tell them about credit scoring and how the bank will arrive at a credit decision.

The bank will use some type of credit scoring scheme will be used to make the decision. An
overall credit score is developed for you by assigning values to such factors as your annual
income, whether you rent or own your home, number and types of credit cards you hold, level of
your existing debts, whether you have savings accounts, and general credit references. Fifteen or
20 different factors or characteristics may be considered, and each characteristic receives a score
based on some predetermined standard.

The idea is that the more stable you are perceived to be, the more income you make, the better
your credit record, and so on, the higher the score you should receive. In essence, statistical
studies have shown that certain personal and financial traits can be used to determine your
creditworthiness. Indeed, the whole credit scoring system is based on extensive statistical studies
that identify the characteristics to look at and the scores to assign.

4. What kind of advice would you offer the Ramirez family on the “correct” use of their
card? What would you tell them about building a strong credit record?

Of course the simple advice is to only use the card for planned, budgeted purchases. Do not
succumb to impulse buying. Raising your FICO score takes time, and there’s no quick fix. But
here are some tips that you might want to follow to reach a higher score:
• Pay your bills on time.
• If you’ve missed payments, get current and stay current.
• If you’re having trouble making ends meet, contact your creditors and work out a payment
plan.
• Keep credit card balances low.
• Pay off debt rather than move it around.
• Don’t open new credit cards just to increase your available credit.
• Reestablish your credit history if you’ve had problems in the past.
6.2 June Starts Over After Bankruptcy
A year after declaring bankruptcy and moving with her daughter back into her parents’
home, June Maffeo is about to get a degree in nursing. As she starts out in a new career,
she also wants to begin a new life—one built on a solid financial base. June will be starting
out as a full-time nurse at a salary of $52,000 a year, and she plans to continue working at a
second (part-time) nursing job with an annual income of $10,500. She’ll be paying back
$24,000 in bankruptcy debts and wants to be able to move into an apartment within a year
and then buy a condo or house in five years. June won’t have to pay rent for the time that
she lives with her parents. She also will have child care at no cost, which will continue after
she and her daughter are able to move out on their own. While the living arrangement
with her parents is great financially, the accommodations are “tight,” and June’s work
hours interfere with her parents’ routines. Everyone agrees that one more year of this is
about all the family can take. However, before June is able to make a move—even into a
rented apartment—she’ll have to reestablish credit over and above paying off her
bankruptcy debts. To rent the kind of place she’d like, she needs to have a good credit
record for a year; to buy a home, she must sustain that credit standing for at least three to
five years.

Critical Thinking Questions

1. In addition to opening checking and savings accounts, what else might June do to begin
establishing credit with a bank?

Obviously, the first thing June has to do is pay back the $24,000 in bankruptcy debt— and the
sooner that can be done, the better! She has to show that she now has the discipline to pay off the
debt that she owes. She also has to be careful about taking on any new debt—though that
probably will not be much of a problem, since she is likely to find new debt very hard to come
by. Finally, if she has any monthly bills (like phone bills, etc.), she should make sure she always
pays them on time.