The Center For Debt Management
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The Cost of Credit

Shopping Is The First Step

Credit is a convenience. It lets you charge a meal on your credit card, pay for an appliance on the installment plan, get a loan to buy a house, or pay for schooling or vacations. With credit, you can enjoy your purchase while you're paying for it, or you can make a purchase when you're lacking ready cash.

But there are strings attached to credit as well. It usually costs something. And of course what is borrowed must be paid back.

If you are thinking of borrowing 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 around for the best terms.

What Laws Apply?

Two laws help you compare costs:

TRUTH IN LENDING requires creditors to give you certain basic information about the cost of buying on credit or taking out a loan. These "disclosures" can help you shop around for the best deal.

CONSUMER LEASING disclosures can help you compare the cost and terms of one lease with another and with the cost and terms of buying for cash or on credit.

The Finance Charge and
Annual Percentage Rate (APR)

Credit costs vary. By remembering two terms — the fincance charge and the annual percentage rate (APR) — you can compare credit prices from different sources. Under Truth in Lending, the creditor must tell you—in writing and before you sign any agreement — what these terms will be.

The finance charge is the total dollar amount you pay to use credit. It includes interest costs, and other costs, such as service charges and some credit-related insurance premiums.


Suppose you borrow $100 for one year, and the interest is $10. If there is a service charge of $1, the finance charge would be $11.

The annual percentage rate (APR) is the percentage cost (or relative cost) of credit on a yearly basis, which is your key to comparing costs, regardless of the amount of credit or how long you have to repay it:


Suppose you borrow $100 for one year and pay a finance charge of $10. If you can keep the entire $100 for the whole year and then pay back $110 at the year's end, you are paying an APR of 10 percent. But, if you repay the $100 and finance charge (a total of $110) in twelve equal monthly installments, you don't really get to use $100 for the whole year. In fact, you get to use less and less of that $100 each month. In this case, the $10 charge for credit amounts to an APR of 18 percent.

All creditors — banks, stores, car dealers, credit card companies, finance companies — must state the cost of their credit in terms of the finance charge and the APR. Federal law does not set interest rates or other credit charges. But it does require their disclosure so that you can compare credit costs. The law says these two pieces of information must be shown to you before you use a credit card.

A Comparison

Even when you understand the terms a creditor is offering, it's easy to underestimate the difference in dollars that different terms can make. Suppose you're buying a $7,500 car. You put $1,500 down, and need to borrow $6,000. Compare the three credit arrangements below.

  APR Length of Loan Monthly Payment Total Finance Charge Total of Payments
Creditor A 14% 3 years $205.07 $1,382.52 $7,382.52
Creditor B 14% 4 years $163.96 $1,870.08 $7,870.08
Creditor C 15% 4 years $166.98 $2,015.04 $8,015.04

How do these choices stack up? The answer depends partly on what you need.

The lowest cost loan, in terms of total finance charges and total of payments, is available from Creditor A.

If you were looking for lower monthly payments, you could get then by paying the loan off over a longer period. However, you would have to pay more in total costs. A loan from Creditor B—also at a 14 percent APR, but for four years—will add about $488 to your finance charge.

If that four-year loan were available only from Creditor C, the APR of 15 percent would add another $145 or so to your finance charges as compared with Creditor B.

Other factors, such as the size of the down payment, will also make a difference. Be sure to look at all the terms before you make your choice.

Cost Of Open-End Credit

Open-end credit includes bank and department store credit cards, gasoline company cards, home equity lines, and check-overdraft accounts that let you write checks for more than your actual balance with the bank. Open-end credit can be used again and again, generally until you reach a certain prearranged borrowing limit. Truth in Lending requires that open-end creditors tell you the terms of the credit plan so that you can shop and compare the costs.

When you're shopping for an open-end plan, the APR is only the periodic rate that you will be charged, figured on a yearly basis. (For instance, a creditor that charges 12 percent interest each month would quote you an APR of 18 percent.) Annual membership fees, transaction charges, and points, for example, are listed separately; they are not included in the APR. Keep these fees in mind and compare all the costs involved in the plans, not just the APR.

Creditors must tell you when finance charges begin on your account, so you know how much time you have to pay your bill before a finance charge is added. Creditors may give you a 25-day grace period, for example, to pay your balance in full before making you pay a finance charge.

Creditors also must tell you the method they use to figure the balance on which you pay a finance charge; the interest rate they charge is applied to this balance to compute the finance charge. Creditors use a number of different methods to arrive at the balance. Study them carefully; they can significantly affect your finance charge.

Some creditors, for instance, take the amount you owed at the start of the billing cycle, and subtract any payments you made during that cycle. New purchases are not counted. This is called the adjusted balance method.

With the previous balance method, creditors simply use the amount owed at the beginning of the billing cycle to compute the finance charge.

Under one of the most common methods, the average daily balance method, creditors add your balances for each day in the billing cycle and then divide that total by the number of days in the cycle. Payments made during the cycle are subtracted to get the daily amounts, and, depending on the plan, new purchases may or may not be included. Under another method, the two-cycle average daily balance method, creditors use the average daily balances for two billing cycles to compute your finance charge. Again, payments will be subtracted to get the balances, but new purchases may or may not be included.

Be aware that the amount of the finance charge will vary considerably depending on the method used, even for the same pattern of purchases and payments.

If you receive a credit card offer or an application, the creditor must give you information about the APR and other important terms of the plan (for example, annual fees and late payment fees) at that time. Likewise, with a home equity line of credit, information must be given to you with an application.

Truth in Lending does not set the rates or tell the creditor how to calculate finance charges, it only requires that the creditor tell you the method that it uses. You should ask for an explanation of any terms you don't understand.

Leasing Costs and Terms

A lease is a contract between a lessor (the propery owner) and a lessee (the property user) for the use of a vehicle or property subject to stated terms and limitations for a specified period and at a specified payment.

Leasing has become a popular alternative to buying—under certain circumstances. For instance, you might consider leasing furniture for an apartment you'll use only for a year. The Consumer Leasing law requires lessors to give you the facts about the costs and terms in their contracts, to help you decide whether leasing is a good idea.

A consumer lease is a contract between a lessor and lessee for the use of personal property primarily for personal, family, or household purposes for a period of more than four months and with a total contractual obligation of no more than $25,000. A lease meeting all these criteria is covered by the Consumer Leasing Act. It covers, for example, long-term rentals of cars, furniture, and appliances, but not daily car rentals or leases for apartments.

Certain information on cost and terms must be grouped together and separated or segregated from other information in the lease documents and presented in a prescribed format. First, these disclosures provide a snapshot of what you will pay

— at the beginning of the lease - which means the amount you will pay at lease signing or delivery

— during the lease - that is, the onthly or periodic payments

— other charges that you will face

— and the total amount you will pay over the lease term.

For vehicle leases, the disclosures require an itemization of the amount due at lease signing and how that amount will be paid. The disclosures also provide a mathematical progression showing the way the monthly payment was determined. Starting with the agreed-upon value of the vehicle and the gross capitalized cost, this calculation shows the additions, subtractions, and divisions that lead to the monthly payment.

The final section of the segregated disclosures includes inofmration on early termination, excess wear and use, mileage limits and excess mileage charges, and any purchase option at the end of the lease an directs you to other disclosures and lease terms.

Open-End and Closed-End Leases

There are open-end and closed-end leases and your rights and obligations at lease-end are different in each of these. Both types of leases estimate the lease-end value of the item and use this to project depreciation, which is the basis for calculating your base monthly payment. In an open-end lease, at lease-end, you are responsible for the difference between the estimated lease-end value (the residual value) determined at the beginning of the lease and the actual lease-end value (the realized value). In a closed-end lease, you are not responsible for the item's value at lease-end, but you are responsible for the condition of the item you lease (that is, an excess wear and use charge may be imposed). In an open-end lease, you my receive a refund of any gain and are responsible for any deficiency. In a closed-end lease the lessor usually keeps any gain and assumes any loss due to overestimating the residual value.

The Consumer Leasing Act provides consumers with some protections against unreasonable end-of-term charges in open-end leases. Assuming that you have met the wear-and-use standards, the residual value is considered unreasonable if it exceeds the realized value by more than three times the base monthly payment (the "three Payment Rule"). If you believe the amount owed at the end of the lease term is unreasonable and refuse to pay, the lessor may attempt to prove that the residual value was reasonable when it was set at the beginning of the lease. However, if you cannot reach a settlement with the lessor, you cannot be forced to pay the excess amount unless the lessor brings a successful court action and pays your reasonable attorney's fees. For example, assume that the residual value in an open-end vehicle lease is $12,000, the realized value is $11,000, and the base monthly payment is $250. The end-of-term deficiency is $1,000. However, under the Three Payment Rule, the maximum charge should not exceed $750 (assuming that there is no excess wear-and-use charge) rather than the full $1,000 deficiency unless the lessor can prove the residual value was reasonable when set.

You have the right to an independent appraisal of the property's worth at the end of the lease term; however, you must pay the appraiser's fee.

The Federal Reserve pamphlet "Keys to Vehicle Leasing: A Consumer Guide" also contains useful information on leasing and provides a sample of some of the disclosures you should receive when leasing a vehicle.

Costs of Settlement on a House

A house is probably the single largest credit purchase for most consumers, and one of the most complicated. The Real Estate Settlement Procedures Act, like Truth in Lending, is a disclosure law. The act, administered by the Department of Housing and Urban Development, requires the lender to give you, in advance, certain information about the costs you will pay when you close the loan. The act also requires that lenders give you a booklet "Buying Your Home: Settlement Costs and Information" to help you understand the closing process and shop for lower settlement costs. To get the booklet, write to:

Deputy Assistant Secretary for Housing
Attention: RESPA Enforcement
U.S. Department of Housing and Urban Development
451 Seventh Street, S.W. Room 9416
Washington, D.C. 20410

Should you need to, phone: (202) 708-4560

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