Personal Financial Planning: An "How-To" Guide (part 27)

THE BASIC CONCEPTS OF CREDIT

by

Charles Lamson

Just say "Charge it." With those two little words and a piece of plastic, you can buy gas for your car, have a gourmet meal at an expensive restaurant, or furnish an apartment. It happens several hundred million times a day across the United States. Credit, in fact, has become an entrenched part of our everyday lives, and we as consumers use it in one form or another to purchase just about every type of good or service imaginable. Indeed, because of the ready availability and widespread use of credit, our economy is often called a "credit economy."

Consumer credit is important in the personal financial planning process because of the impact it can have on (1) the attainment of financial goals, and (2) cash budgets. For one thing, various forms of consumer credit can help you reach your financial objectives by enabling you to acquire some of the more expensive items in a systematic fashion, without throwing your whole budget into disarray. But there is another side to consumer credit: It has to be paid back! Unless credit is used intelligently, the "buy-now-pay-later" attitude can quickly turn an otherwise orderly budget into a budgetary nightmare and lead to some serious problems---even bankruptcy! So, really, the issue is one of moderation and affordability.

In today's economy, consumers, businesses and governments alike use credit to make transactions. Credit helps businesses supply the goods and services needed to satisfy consumer demand. In addition, business credit provides higher levels of employment and helps raise our overall standard of living. Local, state, and federal governments borrow for various projects and programs that also increase our standard of living and create additional employment opportunities. Clearly, borrowing helps fuel our economy and enhance the overall quality of our lives. Consequently, customers in a credit economy need to know how to establish credit and how to avoid the danger of using it improperly.

Why Borrow?

People typically use credit as a way to pay for goods and services that cost more than they can afford to take from their current income. 

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 a portion of the purchase price and then repay the loan on some scheduled basis. Spending payments over time makes big-ticket items more affordable and consumers get the use of an expensive asset right away. Most people consider the cost of such borrowing a small price to pay for the immediate satisfaction they get from owning the house, car, or whatever it happens to be. In their minds, at least the benefits of current consumption outweigh the interest costs on the loan. Unfortunately, while the initial euphoria of the purchase may wear off over time, the loan payments remain---and perhaps for many more years to come.
• 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. However, use of savings (not credit) is a more preferred way to provide for financial emergencies.
• For convenience: Merchants as well as banks offer a variety of charge accounts and credit cards that allow customers to charge just about anything---from gas and oil or clothes and stereos to doctor and dental bills and even college tuition. Further, in many places---restaurants, for instance---using a credit card is far easier than writing a check. Although such transactions usually incur no interest (at least initially), these credit card purchases are still a form of borrowing, because payment is not made at the time of the transaction.
• For investment purposes: It is relatively easy for an investor to partially finance the purchase of many different kinds of investment vehicles with borrowed funds.

Improper Uses of Credit

Many people use consumer credit to live beyond their means. Overspending is the biggest danger in borrowing, especially because it is so easy to do. Once, hooked on "plastic," people may use their credit cards and can still afford to pay the minimum amounts each month.

Unfortunately, such spending eventually leads to mounting bills. And by making only the minimum payment, borrowers pay a huge price in the long run. Look at Exhibit 1, which shows the amount of time and interest charges required to repay credit card balances if you make only a minimum payment of 3 percent of the outstanding balance. For example, if you carry a $3,000 balance on a card that charges 15.0 percent annually, it would take you 14 years to retire the debt, and your interest charges would total some $2,000---or more than 66 percent of the original balance! Incredibly, some cards offer even lower minimum payments of just 2 to 2.5 percent of the outstanding balance. While such small payments may seem like a good deal, clearly they do not work to your advantage and only increase the time and amount of interest required to repay the debt!

To avoid the possibility of future repayment shock, you should keep in mind the following types of transactions for which you should not (routinely, at least) use credit: (1) to meet basic living expenses; (2) to make impulse purchases, especially expensive ones; and (3) to purchase nondurable (short-lived) goods and services. Except in situations where credit cards are used occasionally for the sake of convenience (such as for gasoline and entertainment) or payments on recurring credit purchases are built into the monthly budget, a good rule to remember when considering the use of credit is that the product purchased on credit should outlive the payments.

Unfortunately, people who overspend eventually arrive at the point where they must choose to either become delinquent in their payments or sacrifice necessities, such as food and clothing. If payment obligations are not met, the consequences are likely to be a damaged credit rating, lawsuits, or even personal bankruptcy. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 

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