FL101: Credit Basics – Finance Charges

photo : andres rueda

Credit Basics Explained
This post is a part of the Financial Literacy 101 series.  You can find an index and introduction to the series here.

Matt and Eric are two young men.  Each has a good credit history. They work at the same company and make approximately the same salary. Matt has borrowed $6,000 to take a foreign vacation. Eric has borrowed $6,000 to buy a car. Who is likely to pay the lowest finance charge?
a) Matt will pay less because people who travel overseas are better risks.
b) They will both pay the same because they have the same financial backgrounds.
c) Eric will pay less because the car is collateral for the loan.
d) They will both pay the same because the rate is set by law.

Credit Card Nation
Our nation was seemingly built on, and has apparently crashed on, consumer spending and consumer credit.  With that said, understanding how credit works and the costs associated with credit is more important than ever.  Lenders charge interest, or a finance rate, for the privilege of borrowing their money.  So what is a finance charge?  Where does it come from and what is it based on?

The Prime Rate
The traditional “peg” for finance charges is the prime rate.  The prime rate is reported by the Wall Street Journal’s bank survey, and is the interest rate charged to their most creditworthy clients.  This might not necessarily be you and me, even with our 850 FICO scores.  Think mega-big mega-stable businesses.

The prime rate is most typically in the area of the Fed Funds Rate plus about 3%.  Most typically used for credit cards and home equity lines of credit (HELOCs), the typical consumer interest rate is the prime rate plus a set interest rate.  This “plus interest” portion is usually known as the spread or margin.

Consumer Credit
The banks are in the business of making money on loans.  Every loan they make carries a particular amount of risk.  So on top of the money they charge for the actual act of lending you money, they require an additional premium for the risk that they are bearing on the loan.

That premium is mainly based on a few things.  The most common risk measure banks use for consumers is the credit score.  The credit score, as reported by the big 3 credit bureaus, is a metric calculated on a combination of how much you owe, how long you’ve owed it, how good you’ve been about paying it, and a few other factors.  If you owe $2,000,000 and you have reported on your credit application that you only make $50,000, this might raise some flags with the banks.  Unless of course you were Citibank a year ago and 40x leverage was completely acceptable.

Collateral
Another key factor in determining a finance charge is the amount a bank should expect to recover in the case you should default, or fail to make good on your loan.  Finance charges in order from lowest to highest typically are in the order of home mortgages, home equity loans or home equity lines of credit, auto loans, and then credit cards.  Part of the reason behind this hierarchy are the items which are posted as collateral for their respective loans.

The typical 30-year home mortgage has a down payment of 15% to 20% and also posts the home as collateral on the loan.  The banks, in theory, stand to recover the most should you fail to make payments.  A home equity based loan does not have a down payment, but still puts up your home as collateral on the loan.  A car loan puts your fancy ride, which might have depreciated by as much as 30% as soon as it left the lot, up on the auction block.  The finance charges are understandably higher due to the valuation of the car.

In the case of credit cards, the banks still haven’t managed to invent a time machine, although they all really wish they could. They can’t repossess your tropical vacation or the last Saturday night you spent at the Roxbury.  If you default and go in to bankruptcy they’re looking at a long line of debtors in front of them when you go in to collection.  If you’re looking for a “gimme” question, you may have found it.  The answer is c.

Saturday, April 04, 2009, 13:12 | posted in explained | 3 comments »