DREAMLAND COLLEGE

ACCOUNTING AND FINANCE LEVEL II

Learning guide #06

Unit of Competence: Develop Understanding of Debt and Consumer Credit
Module Title: Developing Understanding of Debt and Consumer Credit
TTLM Code : LSA ACF2 M06 1221
LO1 Identify and discuss the role of credit in society
LO2: Identify and discuss the range of credit options available
LO3:Identify and discuss costs of using credit
LO4: Analyze and discuss the effective use of consumer credit
LO5: Manage personal credit rating and history

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 Chapter-1
Identify and discuss the role of credit in society

1.1. The concepts and terminology of credit provided by a financial institute and
debt incurred by a borrower are analyzed and discussed

Concept of credit

The word credit originates in the latin "credere" verb, and means believing. The
Latin noun is "credititus". From there than something credited somewhat credible.
For example when we say "his words are worthy of credit" or "the titles that has
give credit their knowledge of the subject", or "its punctuality makes it to earn the
credit of confidence".

Meaning of credit

A loan is a sum of money that is given to a person is a form of a loan, the institution
which gives it u offers in full right to make it. Banks are usually the entities that
grant credits, with the purpose that the person does some investment, engaging
with the institution to cancel it in a stipulated time and under the rules and
conditions that this imposes, in general, consist of a fixed rate of financing which
is established as a Commission. For the Bank, the credit is a product, since in
addition to offering it to the public, this generates dividends which in turn
stimulate the growth and development of the Bank as a company and collaborate
simultaneously with the evolution of society.

Meanwhile credit cards, are also products of banks, which make the times of
continuous credits to the person, i.e., with a credit card Ana can buy the portfolio
that you both like, although it does not have money in their accounts, the credit
card offers you a limit of available money that she can then pay. This type of
instrument offers the customer convenience and economic freedom preferentially.
The difference between credit and loan basically is that the loan is a fixed amount,
paid established fees and interest according to the contract, credit is a term
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account for pay, it complies with the same conditions as a loan
since the final credit is a loan, but this can vary according to the condition of
payment or availability of the account which the creditor puts at your disposal.

In general Credit Is defined as

 A contractual agreement in which a borrower receives something of value now

and agrees to repay the lender at some later date. When

a consumer purchases something using a credit card, they are buying on credit

receiving the item at time, and paying back the credit card to the company

according to the agreement between the creditor and debitor. Any time when

an individual finances something with a loan (such as an automobile or a house),

they are using credit in that situation as well.

 The borrowing capacity of an individual or company.

 A journal entry recording an increase in assets. With cash basis accounting,

credits are recorded when income is received. With accrual basis accounting,

credits are recorded and recognized when income is earned. Let us now review

the synonyms the term in question boasts: financing, down payment, mortgage,

advancement, loan; guarantee, solvency, renown, fame, reputation, prestige;

confidence, acceptance.

What Is Debt?

Debt is simply defined as an amount of cash borrowed by a person from

anotherperson, a financial institution, or the government. For instance, if you go to
a bank and borrow birr 50,000, this will be considered a debt –you will owe the
bank the birr 50,000 plus the interest accrued thereof.

Debt is used by both individuals and corporations as a way of making big purchases
which they cannot afford under ordinary circumstances–purchases they can't
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 finance upfront. A debt agreement, also called debt arrangement, is the
document used to give you the authorization to borrow the cash and the conditions
under which you will repay the money at a future date, and often with interest.

Consumer debt refers to debts that arise from purchase of goods that do not
appreciate in value and/or are consumable. Possessing some level of consumer debt
pays off if the debt was incurred to purchase an asset needed to boost one's
earnings. For example, borrowing to finance a car is a wise decision if you need it to
travel to work at a higher paying job. However, high level of consumer debt is not
good because it puts too much strain on your income. If unchecked, consumer debt
can lead one into the debt spiral and/or bankruptcy.

The Difference between Debt and Credit

In general speaking, debt and credit are used interchangeably, but in

strict financial terms, they have distinct interpretations.

Credit is a financial device that businesses and individuals try to obtain from
financial institutions. So, financial institutions don't offer debt, they offer
credit. For instance, banks, credit unions, and credit card companies offer
different type of credit to their customers. These include: Mortgage loans,
Payday loans, Credit cards and Automobile loans and more.

1.2 The Historical and Current Role of Consumer Credit

What Is Consumer Credit?

Consumer credit is personal debt taken on to purchase goods and services. A credit
card is one form of consumer credit.

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Although any type of personal loan could be labeled consumer credit, the term is usually used
to describe unsecured debt that is taken on to buy everyday goods and services. It is not
usually used to describe the purchase of a house, for example, which is considered a long-
term investment and is usually purchased with a secured mortgage loan.

Understanding Consumer Credit

Consumer credit is extended by banks, retailers, and others to enable consumers to purchase
goods immediately and pay off the cost over time with interest. It is broadly divided into two
classifications: installment credit and revolving credit.

Installment Credit
Installment credit is used for a specific purpose and is issued at a defined amount for a set
period of time. Payments are usually made monthly in equal installments. Installment credit is
used for big-ticket purchases such as major appliances, cars, and furniture. Installment
credit usually offers lower interest rates than revolving credit as an incentive to the
consumer. The item purchased serves as collateral in case the consumer defaults.

Revolving Credit
Revolving credit, which includes credit cards, may be used for any purchase. The credit is
"revolving" in the sense that the line of credit remains open and can be used up to the
maximum limit repeatedly, as long as the borrower keeps paying a minimum monthly payment
on time. Revolving credit is available at a high interest rate because it is not secured by
collateral.

Special Considerations
Consumer credit use reflects the portion of a family or individual's spending that goes to
goods and services that depreciate quickly. It includes necessities such as food and
discretionary purchases such as cosmetics or dry cleaning services.

Consumer credit use from month to month is closely measured by economists because it is
considered an indicator of economic growth or contraction. If consumers overall are willing to
borrow and confident they can repay their debts on time, the economy gets a boost. If
consumers cut back on their spending, they are indicating concerns about their own financial
stability in the near future. The economy will contract.

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Advantages of Consumer Credit
Consumer credit allows consumers to get an advance on income to buy products and
services. In an emergency, such as a car breakdown, that can be a lifesaver.
Because credit cards are relatively safe to carry, America is increasingly becoming
a cashless society in which people routinely rely on credit for purchases large and
small.

Revolving consumer credit is a highly lucrative industry. Banks and financial

institutions, department stores, and many other businesses offer consumer credit.

Disadvantages of Consumer Credit

The main disadvantage of using revolving consumer credit is the cost to consumers
who fail to pay off their entire balances every month and continue to accrue
additional interest charges from month to month.

The History of Consumer Credit

Consumer credit may seem like a fairly new invention –but it’s actually b
for more than 5,000 years!

In fact, many millennia before the credit score became ubiquitous, there is
historical evidence that cultures around the world were borrowing for various
reasons. From the writings in Hammurabi’s Co the Ancient Romans, we know that credit was
used for purposes such as getting
enough silver to buy a property or for agricultural loans made to farmers.

Examples of the Ancient Credit

1. 3,500 BC –Sumer. Sumer was the first urban civilization

2. 1,800 BC –Babylon

3. 50 BC –The Roman Republic

4. 1500 –The Age of Discovery

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The Modern Consumer Credit

The Information Age has enabled a new era in consumer credit and assessing risk –
and today, credit reports are used to inform decisions about housing, employment,
insurance, and the cost of utilities.

The Current Role of Consumer Credit

Consumers, along with businesses, are the driving force of the economy. When
they spend, businesses reap the profit and consumers get a quality product or
service that will in some way enhance their lives. Consumers play an important
role in society from the methods they use to research and review products to
their decisions on which brands to use and where to make purchases.

A) Initiator

Consumers determine the products and services they need, whether they are
shopping for themselves, friends, family members or business clients. The media
help to persuade, inform and remind them about products and services that are
available for consumption. Once a consumer becomes interested in a product or
service, regardless of the brand name associated with it, he begins to gather
information to determine if making the purchase is a reasonable, wise-buying
decision.

B) Influencer

Consumers undoubtedly look to family, friends and colleagues for opinions when
they're making a purchase. A referral for a business or a personal experience with
a product holds more weight with a consumer than a well-orchestra print
advertisement or commercial. In fact, Business Wire reports that women often
look to blogs and social networks to research products before they make a decision
to buy. Companies offer customers an opportunity to review their services and
products online, and consumers use this information to gauge quality, service,
features, benefits and pricing.

C) Decider

Children, for example, may initiate the idea of a purchase by mentioning a new
cereal to a parent. The parent decides whether or not to make the purchase after
researching the cereal to determine its price, its availability and how healthy it is.
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Consumers who assume the role of a decider have the financial authority to decide
whether a good or service can be purchased.

D) Buyer

Consumers purchase products and services with their money, a spouse's money, or
by using a company credit card. Whether they visit a store in person, make a
purchase online or place an order over the phone, the buyer gives a payment and
receives a good or service in exchange.

E) User

Consumers typically use the products they buy, unless they make the purchase for
a family member, friend or colleague. Regardless of who makes the purchase, the
user is the person who ultimately consumes the good or service that's purchased
by the buyer.

The Sources of Consumer Credit

A) Commercial Banks

Commercial banks make loans to borrowers who have the capacity to repay them.
Loans are the sale of the use of money by those who have it (banks) to those who
want it (borrowers) and are willing to pay a price (interest) for it. Banks make
several types of loans, including consumer loans, housing loans and credit card
loans.

B) Savings and Loan Associations (S&Ls)

Savings and loan associations used to specialize in long-term mortgage loans on

houses and other real estate. Today, S&Ls offer personal installment loans, home
improvement loans, second mortgages, education loans and loans secured by savings
accounts. S&Ls lend to creditworthy people, and usually, collateral may be required.
The loan rates on S&Ls vary depending on the amount borrowed the payment
period, and the collateral. The interest charges of S&Ls are generally lower than
those of some other types of lenders because S&Ls lend depositors' money, which
is a relatively inexpensive source of funds.

C) Credit Unions (CUs)

credit Unions are nonprofit cooperatives organized to serve people who have some
type of common bond. The nonprofit status and lower costs of credit unions usually

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allow them to provide better terms on loans and savings than commercial
institutions. The costs of the credit union may be lower because sponsoring firms
provide staff and office space, and because some firms agree to deduct loan
payments and savings installments from members' paychecks and apply them to
credit union accounts.

Credit unions often offer good value in personal loans and savings accounts. CUs
usually require less stringent qualifications and provide faster service on loans than
do banks or S&Ls.

D) Consumer Finance Companies (CFCs)

Consumer finance companies specialize in personal installment loans and second

mortgages. Consumers without an established credit history can often borrow from
CFCs without collateral. CFCs are often willing to lend money to consumers who are
having difficulty in obtaining credit somewhere else, but because the risk is higher,
so is the interest rate. The interest rate varies according to the size of the loan
balance and the repayment schedule. CFCs process loan applications quickly, usually
on the same day that the application is made, and design repayment schedules to
fit the borrower's income.

E) Sales Finance Companies (SFCs)

If you have bought a car, you have probably encountered the opportunity to
finance the purchase via the manufacturer's financing company. These SFCs let
you pay for big-ticket items, such as an automobile, major appliances, furniture,
computers and stereo equipment, over a longer period of time.

You don't deal directly with the SFC, but you are generally informed by the dealer
that your installment note has been sold to a sales finance company. You then make
your monthly payments to the SFC rather than to the dealer where you bought the
merchandise.

F) Life Insurance Companies

Insurance companies will usually allow you to borrow up to 80 percent of the

accumulated cash value of a whole life (or straight life) insurance policy. Loans
against some policies do not have to be repaid, but the loan balance remaining upon
your death is subtracted from the amount your beneficiaries receive.

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Repayment of at least the interest portion is important, as compounding interest
works against you. Life insurance companies charge lower interest rates than some
other lenders because they take no risks and pay no collections costs. The loans
are secured by the cash value of the policy.

G) Pawnbrokers

Recently made famous by reality shows, pawnbrokers are unconventional, but

common, sources of secured loans. They hold your property and lend you a portion
of its value. If you repay the loan and the interest on time, you get your property
back. If you don't, the pawnbroker sells it, although an extension can be arranged.
Pawnbrokers charge higher interest rates than other lenders, but you don't have
to apply or wait for approval. Pawnbrokers' chief appeal? They rarely ask questions.

H) Loan Sharks

These usurious lenders have no state license to engage in the lending business.
They charge excessive rates for refinancing, repossession or late payments, and
they allow only a very short time for repayment. They're infamous for using
collection methods that involve violence or other criminal conduct. Steer clear of
them. They are illegal, after all.

I) Family and Friends

Your relatives can sometimes be your best source of credit. However, all such
transactions should be treated in a businesslike manner; otherwise,
misunderstandings may develop that can ruin family ties and friendships.

1.3 The Impact of Consumer Debt on the National Economy

How Consumer Debt Affects the Economy Most people these days are more than a
little familiar with consumer debt. This is the type of debt that is held by

individuals just like you. Sometimes it seem even possible without taking on debt to make it

happen. Of course, consumer debt doesn’t just accumulate without anyssomeeffect information

on various aspects of consumer debt, and how it can affect aneconomy. The Multiplier Effect

One way that consumer debt affects the economy is by creating a multiplier effect, where the

theory goes that an increase in economic activity can create a chain reaction of activity that

results in more than the original increase.

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Basically when people borrow money and then spend that money, business revenues

increase which can result in more jobs being created which results in even more

spending, and so on. What Are the Interest Rates? The state of interest rates is one

factor that will always influence borrowing and any subsequent effect on the economy.

If the economy is in a slow-moving state and things haven’t been

movinglsometimeswell,lowerinterestgovernmentsratesto make borrowing easier and more

manageable for consumers. Most consumers seemto focus on how much their monthly

payments a just borrowed. Lower interest rates increase the level of borrowing and the

levelof spending, which will ultimately give the economy a boost, while at the same time

increasing consumer debt. What Kind of Debt Is It? Even though increased consumer

debt helps grow the economy, many experts naturally become concerned about how much

it can expand before the system caves in on itself. The type of debt that is incurred by

consumers is also a factor in whether the debt is good or bad. With unsecured debts

like credit cards, the money is used to make purchases and stimulate the economy, but

the individual debt load just continues to increase with nothing really to show for it.

With purchases like a home, the consumer has taken on debt, but has also purchased an

appreciating asset. As these debts are paid down and home values rise, consumer wealth

also rises. With an asset like a home and increases in consumer wealth, the likelihood of

defaulting on loans decreases because there is always that home equity to fall back on if

necessary. Of course, with any type of household debt the effect on the economy is at

least partially dependent on future interest rates, unemployment rates and any

unforeseen shocks to the economy.

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1.4 The Advantage and Disadvantage of Credit

All businesses exist in a competitive environment. Although it would be nice to

make all sales on a cash basis, it's not always possible. If your competitors are
giving their customers credit terms, you will need to offer something similar to get
their business. Selling to customers on credit has advantages and disadvantages. A
business owner must consider the effects on his company before venturing into the
potential minefield of taking credit risks with customers.

Advantage:

A) Meet the Competition

When your competitors are making sales on credit to your customers, you will need
to do the same just to stay competitive. If you want to offer more favorable
terms, you might consider giving discounts for prompt payment. For example,
instead of just providing 30-days terms, offer 2/10/30. This means that the
customers can take a 2-percent discount if he pays within 10 days instead of
waiting for the full 30 days to pay.
B) Increase in Sales

An increase in sales may or may not happen when you start selling on credit. If your
competitors are not offering credit terms, then you will gain sales by offering
credit terms, because your customers will buy from you instead of having to pay
cash from your competitors.

C) Better Customer Loyalty

Offering credit to customers indicates that you respect and trust them to pay
their bills before their due dates. Customers will reward these gestures of
confidence by continuing to buy from you. They will feel a degree of loyalty, and
they like to do business with someone who trusts them.

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Disadvantage:

A) Negative Impact on Cash Flow

When you begin selling to customers on credit, your cash flow will be immediately
affected. For example, if you begin to offer credit terms for 30 days, the cash that
you would normally receive during this time will disappear. You will not have this cash
to pay your bills, employee and suppliers.

B) Need to Fund Accounts Receivable

Since giving credit terms to customers will directly affect your cash flow, you must
calculate how much your accounts receivable will increase and then figure out how you
will finance this increase. You may need to use a line of credit with a bank or ask your
suppliers to extend better credit terms to your company.

C) Taking a Credit Risk with Customers

The creditworthiness of each customer must be investigated. This will require

checking the customers' credit references and obtaining a business credit report,
such as Dun & Bradstreet.

D) Keeping Up With Accounts Receivable

Someone needs to keep up with the status of your accounts receivable. The reality is
that customers don't always pay on time, and somebody needs to make calls or to send
out past due notices. If there isn't already an employee in the office who can do this,
you may need to hire a new employee.

E) Potential for Bad Debts

No matter how well you check a customer's credit rating and references, eventually,
there will be someone who doesn't pay. When that happens, if you turn over the
account to a collection agency, you will incur fees. If collection efforts don't work,
then you will need to write off the receivable as a bad debt.
Offering credit to customers is a necessary evil to remain competitive in the
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 marketplace. If your competitors are offering credit terms, you must do the same.
Otherwise, your customers will abandon you.

OPERATION SHEET 1: Identify concepts and terminology of credit

Directions: Answer all the questions listed below. Use the Answer sheet provided
inthe Next page

Self-Check 1 Written Test

1. Define the following terms:

Consumer____________________________________________________

Credit _____________________________________________________

Debit_____________________________________________________

2. Write Difference between Debt and Credit

__________________________________________________________________________________

Note: Satisfactory rating - 3 and 5 points Unsatisfactory - below 3 and 5 points

You can ask you teacher for the copy of the correct answers.
Answer Sheet Score = ___________

Rating: ____________

Name: _________________________ Date: _______________

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 LO4:Analyze and discuss the effective use of
Instruction Sheet
consumer credit

4.1 Ways to avoid excessive or unmanageable debt are analyzed and discussed
4.2 Strategies to minimize fees on credit are identified and discussed
4.3 The importance of meeting minimum payments on credit cards is
analyzed and discussed
Ways to avoid credit card fraud are identified, analyzed and discussed

Information Sheet Strategies to minimize fees

Strategies to minimize fees on credit may include:

 consolidating savings and credit facilities with the one institution where account
servicing fees can be cancelled out
 knowing how many free transactions come with the card
paying the minimum monthly installment on time.

Ways to avoid credit card fraud include:

 not disclosing Personal Identification Number (PIN) to anyone

 selecting a PIN only the card holder would know
signing the back of the credit card.

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 Self-Check -4 Written Test

Describing the impact of consumer debt on the national economy

Directions: Answer all the questions listed below. Use the Answer sheet provided in the

Next page

1. What are the ways to avoid credit Card fraud ?

_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
___________________________________________________________

2. List the strategies to minimizing cost?

_____________________________________________________________
_____________________________________________________________
_____________________________________________________________

Note: Satisfactory rating - 3 and 5 points Unsatisfactory - below 3 and 5 points

You can ask you teacher for the copy of the correct answers.

Score = ___________

Rating: ____________
Answer Sheet

Name: _________________________ Date: _______________

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Instruction Sheet L05:Manage personal credit rating and history (past
events)

5.1 The role of credit reference agencies is analyzed and discussed

5.2 The purpose and use of credit reference reports in assessing loan applications
is analyzed and discussed
5.3 Implications of establishing a poor credit history are analyzed and
discussedThe right to access and methods of obtaining own credit reference
report are
analyzed and discussed

Information Sheet Strategies to minimize fees

Credit reference reports refers to:

reports established and maintained by credit reference agencies which record all
negative events (i.e. defaults) listed by creditors against debtors.

Implications of  higher interest rate penalties

establishing a poor  inability to obtain finance in the future
credit history may  may disadvantage applications for rental accommodation
include: necessity to obtain guarantor in future loans.
Methods of obtaining own credit reference file may include:

writing, emailing or telephoning the relevant agency requesting a copy of your file,
having provided relevant details to identify self.

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 Self-Check -5 Written Test

: Describing the impact of consumer debt on the national economy

Directions: Answer all the questions listed below. Use the Answer sheet provided in the

Next page

1. What are the roles of credit referents?

_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
____________________________________________________________

2. Implications of establishing a poor credit history may include?

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
_________________________________________________________________

Note: Satisfactory rating - 3 and 5 points Unsatisfactory - below 3 and 5 points

You can ask you teacher for the copy of the correct answers.

Score = ___________
Answer Sheet
Rating: ____________

Name: _________________________ Date: _______________

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