What Is Consumer Credit?

Consumer debt is also called as consumer credit. Credit extended to consumers for the acquisition of goods and services. Credit cards are a type of consumer credit.

Although personal loan could be considered consumer credit, the term is most commonly applied to unsecured debt taken out to purchase everyday goods and services. However, consumer debt can also include secured loans such as mortgages and auto loans.

A consumer credit system permits consumers to borrow money or incur debt and defer repayment over time. Credit enables consumers to acquire goods or assets without having to pay for them in full immediately. A good credit history indicates that a person has an established history of paying back all debts on time. In the future, a person with good credit will be able to borrow money more easily and on better terms.

On the other hand, a poor credit score indicates that a person has had trouble in the past payment of the money borrowed or making payments on time. A person with poor credit is less likely to receive additional loans, making it difficult for them to buy a car, a house, or obtain a credit card. Credit access is a valuable benefit that should be protected and prudently managed.

• Installment credit is issued for a predetermined period of time and is used for a specific purpose.

• Revolving credit is an open-ended line of credit that can be used for any purchase.

• The disadvantage of revolving credit is the cost incurred by those who fail to pay off their balances in full each month and continue to accrue interest charges.

• According to Experian, the average American held a credit card balance of $5,315 in 2020.

Understanding Consumer Credit

The provision of consumer credit by banks, retailers, and others enables consumers to purchase goods immediately and repay the cost with interest over time. Installment credit and revolving credit are the two primary categories.

Installment Credit

Installment credit is issued at a predetermined amount for a predetermined period of time for a specific purpose. Monthly payments are typically made in installment credit . Installment credit is utilized for expensive buying such as automobiles, major appliances, and furniture. As an incentive to consumers, installment credit typically offers lower interest rates than revolving credit. The item purchased serves as collateral in the event that the consumer defaults on the loan.

According to Experian, the average American had a credit card balance of $5,315 in 2020.

Revolving Credit

Credit cards and other forms of revolving credit may be used for any buying. The credit is "revolving" in the context that the line of credit remains open and can be used repeatedly up to the maximum limit, so long as the borrower maintains on-time payment of the required minimum monthly payment.

It may never be paid off in full if the consumer pays only the minimum each month and allows the remaining balance to accrue interest. Because revolving credit is not secured by collateral, the interest rate is relatively high.

History of Credit Bureaus and Credit Reporting

Prior to World War II, retailers offered the majority of consumer credit directly to consumers. A retailer's credit relationships with customers were frequently based on personal familiarity. Because consumers were less mobile, there was less need for a national credit rating system, and there were numerous small, regional credit bureaus.

Credit reporting bureaus in the United States originated as associations of retailers who shared their customers' credit information. Initially, credit bureaus shared information about customers who did not pay their bills and were deemed to be poor credit risks. Later, they exchanged information about their current customers for information about potential customers.

As the economy expanded after World War II, the consumer credit market underwent significant transformations. The retail industry grew, while banks and finance companies replaced retailers as the primary source of consumer credit. As consumers became more mobile, banks began issuing credit cards with nationwide acceptance. Increased interest in a national credit reporting system.

The development of computers that could store and process vast amounts of data allowed credit bureaus to efficiently provide consumer lenders with credit information. It is now feasible to report consumer credit information nationwide. Equifax, Experian, and TransUnion emerged as the three dominant consumer credit reporting agencies in the 1980s.

The availability of consumer credit card information fueled the growth of consumer debt from estimated $100 billion in 1970 to more than $1 trillion in 1995, an increase of approximately 400 percent. As the market for consumer credit information grew, however, so did concerns about data accuracy and the harm that inaccurate data could cause to consumers.

How the Consumer Credit Reporting Works

Consumers receive loans from banks and mortgage companies, among others. These creditors maintain a record about consumer payments. This negative information is reflected in a consumer's credit record for the delay payment. The creditors then report the payment history of the consumer to the credit bureau reporting agencies. The credit bureaus collect all of a consumer's payment history information as reported by all of that consumer's creditors.

The credit bureaus then compile a file containing the consumer's payment history. In the long term, when the consumer wants to borrow money from a new creditor (such as to buy a car or a house), the creditor requests the consumer's credit file from the credit bureau. The credit bureaus send the file to the creditor, who then uses it to determine whether or not to grant the consumer a loan. If the creditor determines, based on the information in the consumer's file, that the consumer represents a favorable credit risk, the creditor will likely grant the consumer a loan. If the creditor decides to offer the loan, the creditor will begin to track the consumer's payment history on the new loan and report it to the credit bureaus for future use by other creditors.

Credit Is Either Closed or Open-End

Consumer credit falls broadly into two categories:

1.   Closed-end (installments)

2.   Open-end (revolving)

1. Introduction to Closed-End Credit

This credit is used for a specific purpose, for a specific amount, and during a specific time period. Typically, payments are made in equal amounts. Automobile and mortgage loans are examples of closed-end credit. A contract specifies the repayment terms, including the number of payments, the payment amount, and the cost of the credit.

Typically, with closed-end credit, the seller retains some form of ownership (title) control over the goods until all payments have been made. A car company, for instance, will have a "lien" on the vehicle until the car loan is paid in full.

2. Introduction to Closed-End Credit

With open-ended credit, also known as revolving credit, loans are made continuously as you make purchases, and you are billed periodically to make at least a partial payment. Open-ended credit includes the use of store-issued credit cards, bank cards such as VISA or MasterCard, and overdraft protection.

The maximum amount of credit you can use is referred to as your line of credit. If you do not pay off your debt in full each month, you will often be required to pay a high interest rate or other types of finance charges.

Revolving check credit.

This is a form of revolving credit provided by banks. It is a prearranged loan for a predetermined amount that can be utilized by writing a special check. Finance charges are calculated based on the amount of credit used each month and the outstanding balance.

Credit cards.

Charge cards are typically issued by department stores and oil companies and can only be used to purchase products from the issuing company. Credit cards have largely replaced them, although many are still in use. You make payments at your own pace, accruing interest.

Credit cards.

Credit cards, also known as debit cards, are issued by monetary institutions. Credit cards offer convenient and prompt access to short-term loans. You can borrow up to a predetermined amount (your credit limit) and repay the loan at your own pace, as long as you make the minimum payment each month. In addition to paying interest on your debt, you may incur additional fees, such as late payment fees. Regardless of the amount repaid, it is immediately available for reuse. American Express, VISA, MasterCard, and Discover are the most widely accepted credit cards.

T&E (Travel & Entertainment) cards.

These cards require monthly payment in full, but do not charge interest. The most common T&E cards are American Express (not the credit card version), Diners Club, and Carte Blanche.

Debit cards.

These are issued by a number of banks and function like checks. When you make a purchase, the amount is deducted (charged) from your bank account and deposited into the seller's account. They are not technically "credit" because you pay immediately (or as quickly as funds can be transferred electronically).

The Basics of Consumer Loans

There are two principal categories of debt: secured and unsecured. Your loan is secured when you provide collateral or security to guarantee it. If you fail to repay, the lender may sell the collateral.

Automobile and real estate loans are the most prevalent types of secured loans. In contrast, an unsecured loan is granted solely on the basis of your word to repay. This may sound like a pipe dream, but consider for a moment that almost all credit card purchases fall into this category.

If the lender deems you to be a low-risk borrower, only your signature is required. However, the lender may require a co-signer who guarantees repayment in the event that you do not.

Unsecured loans carry higher interest rates and more stringent terms due to the greater risk they pose for lenders. If you fail to repay an unsecured debt, the lender may file a lawsuit and seek a court judgment against you. Depending on the laws of your state, the lender may then be able to force you to sell other assets or, if you are employed by someone else, to garnish a portion of your wages.

Cosigning a Loan Is Risky Business

If a friend or relative asked you to cosign a loan, what would you do? Make sure you understand what cosigning involves before you respond.

Tip

Creditors are required by an FTC Rule to provide you with a notice that explains your responsibilities as a cosigner. The cosigner's letter indicates:

"You are being asked to guarantee this debt. Think carefully before agreeing to do so. If the borrower fails to pay the debt, you will be responsible for it. Ensure that you can afford to pay if necessary and that you are willing to accept this responsibility.

If the borrower does not pay, you may be required to pay up to the full amount of the debt, as well as late fees and collection costs, which increase this amount.

The creditor can collect this debt from you without first attempting to collect from the borrower. The creditor has the same collection methods against you as against the borrower, including such suing you, garnishing your wages, etc. If this debt becomes delinquent, the fact may be reported to credit bureaus."

We couldn't agree more with the FTC's statements.

Several points are worthy of emphasis:

·       The lender is not required to pursue the borrower before coming to you for repayment; you are equally responsible for the debt as the borrower.

·       The loan is yours, even though you will not use or enjoy the property. If there is a default, you must pay the obligation in full plus any "collection expenses."

·       The lender lacks confidence in the borrower's ability to repay; otherwise, it would not require a co-signer. This implies that the lender has you in its sights the moment you pick up the pen to co-sign.

If you do cosign:

·       Ensure that you can afford to repay the loan, as the likelihood is that you will have to. If you are asked to pay and are unable to do so, you could be sued or have your credit rating damaged.

·       Keep in mind that even if you are not asked to repay the debt, this loan will appear on your credit report. This "debt" may prevent you from obtaining other credit that you need or desire.

·       Before pledging property, ensure you understand the repercussions. If the borrower defaults, you risk losing these items.

The same logic applies, to a lesser extent, to a joint credit account.

Consider the Consumer Credit Sources

Everyone has both short- and long-term needs for money or credit. When you find yourself in need of credit, you should familiarize yourself with your options.

Commercial Banks

Commercial banks extend credit to borrowers with the ability to repay. Loans are the sale of the use of money by those who own it (banks) to those who want it (borrowers) and are willing to pay a price for it (interest). Banks offer a variety of loans, such as consumer loans, mortgage loans, and credit card loans.

·       Consumer loans are for installment purchases and are repaid monthly with interest. The majority of consumer loans are for expensive durable goods such as automobiles, boats, and furniture.

·       Housing loans may be used for residential mortgages, home construction, or home renovations.

·       Credit card loans may be obtained as cash advances within predetermined credit limits.

Savings and Loan Associations (S&Ls)

As depicted in the film It's a Wonderful Life, savings and loan associations previously specialized in long-term mortgage loans on houses and other real estate. Currently, S&Ls offer personal installment loans, loans for home improvement, second mortgages, education loans, and loans secured by savings accounts.

S&Ls lend to creditworthy borrowers, and collateral is often required. The interest rates on loans from S&Ls vary based on the amount borrowed, the payment period, and the collateral. Even though S&Ls lend depositors' money, which is a relatively inexpensive source of funds, their interest rates are generally lower than those of other types of lenders.

Credit Unions (CUs)

Credit unions are not-for-profit cooperatives that serve members who share a common bond. Credit unions are typically able to offer better loan and savings terms than commercial institutions due to their non-profit status and lower expenses. Because sponsoring firms provide staff as well as office space, and because some firms consent to deduct loan payments and savings installments from employees paychecks and apply them to credit union accounts, the credit union's expenses may be lower.

The personal loans and savings accounts offered by credit unions are frequently competitively priced. Credit unions typically require less stringent qualifications and offer faster loan service than banks and S&Ls.

Consumer Financial Services (CFCs)

Personal installment loans and second mortgages are the specialty of consumer finance firms. Consumers without an established credit history can frequently borrow without collateral from CFCs. CFCs are frequently willing to lend money to consumers who are unable to obtain credit elsewhere, but because the risk is greater, the interest rate is also higher.

The interest rate fluctuates based on the loan balance and the repayment schedule. CFCs process loan applications rapidly, typically on the same day they are submitted, and tailor repayment plans to the borrower's income.

Sales Finance Companies (SFCs)

If you've ever purchased a vehicle, you've likely encountered the option to finance the purchase through the manufacturer's financing company. These SFCs allow you to pay for expensive items such as a car, major appliances, furniture, computers, and stereo equipment over a longer time period.

You do not interact directly with the sales finance company, but you are typically informed by the dealer that your installment note has been sold to one. You then make monthly payments to the SFC instead of the dealer from whom you purchased the merchandise.

Life Insurance Companies

Typically, insurance companies will allow you to borrow up to 80% of the cash value accumulated in a whole life (or straight life) insurance policy. Loans against some policies are not required to be repaid, but the outstanding loan balance is deducted from the death benefit payable to your beneficiaries.

It is essential to repay at least the interest portion, as compounding interest works against you. Life insurance companies charge lower interest rates than other lenders due to the fact that they assume no risk and incur no collection expenses. The loans are secured by the policy's cash value.

Pawnbrokers

Recently popularized by reality television, pawnshops are uncommon but common sources of secured loans. They are in possession of your property and lending you a portion of its value. If you timely repay the loan and interest, the property is returned to you. If not, the pawnshop will sell it, although an extension may be possible. Pawnshops charge higher interest rates than other lenders, but there is no application or approval process. What is the appeal of pawnshops? Rarely do they ask questions.

Loan Sharks

No state license is required for these usurious lenders to engage in the lending business. They charge exorbitant interest rates for refinancing, repossession, and late payments, and allow for a very brief repayment period. They are notorious for using violent or otherwise illegal collection techniques. Keep away from them. They are, after all, illegal.

Friends and Family

Sometimes, your relatives can be your best source of credit. However, all such transactions must be conducted in a businesslike manner; otherwise, misunderstandings may arise that can damage familial and platonic relationships.

Moreover, if the IRS becomes aware of an intra family "loan," it can "impute interest" on the loan, which would be taxable income for the lender but nondeductible for the borrower. Involvement in an IRS audit can also negatively impact family relationships.

Tax Disadvantages of Consumer Credit

No longer is the interest paid on your personal auto, credit card, education, and other consumer loans tax deductible.

Interest on property used for business purposes may be deductible.

Additionally, only a limited amount of qualified residence (mortgage) interest is tax-deductible. Interest paid or accrued on acquisition loans or home equity loans for your principal residence and one other residence, typically your "vacation home," is qualified residence interest.

The maximum amount of acquisition loans is $1,000,000, and the maximum amount of home equity loans is $100,000. The interest on any debt exceeding these limits is deemed to be personal, consumer interest and is therefore not tax deductible.

Think About Home Equity Loans

Should you convert the interest on your consumer loan into interest on a home equity loan in order to deduct the interest? Before applying for a home equity loan, you should weigh the advantages and disadvantages.

What is contained in a consumer's credit file?

The credit reporting file of a consumer contains a variety of information about the individual and how well he or she has handled credit in the past. Initially, the file contains the individual's name, date of birth, address, and Social Security number (SSN). The SSN is crucial because it enables credit bureaus to identify consumers on an individual basis. When creditors report new information about consumers to credit bureaus, they typically use the SSN to identify the specific individual to whom the new information pertains.

Next, the file contains information about money the consumer has borrowed or can borrow in the future (as with credit cards) from a particular lender. The file will include the name of the lender, the original loan amount, the type of loan (such as a car loan, mortgage, or credit card), and the amount of money the consumer still owes on the loan. This section also provides information on a consumer's payment history, which helps potential lenders determine the likelihood that the consumer will repay a loan in full and on time. Consumers who routinely pay late or do not repay their debts in full are typically viewed as credit risks, and lenders are less likely to offer them additional credit in the future.

A consumer's credit reporting file will also include any public record information that could affect his/her ability to repay a loan. For instance, if a consumer has recently filed for bankruptcy or if he or she owes money due to a lawsuit or tax obligations, this information will be included in the credit reporting file.

Last but not least, a consumer's credit report will include their credit score. The credit score is a numeric representation of a consumer's creditworthiness. The credit bureaus calculate a consumer's credit score using complex mathematical formulas based on all of the other historical credit information enclosed in the consumer's credit reporting file. Similar to a statistical index, credit bureaus mathematically summarize a consumer's credit history into a credit score. In general, consumers with better credit histories and better credit have higher credit scores. Credit scores are frequently used by lenders and other creditors to rapidly evaluate the creditworthiness of consumers who apply for financing. Creditors view consumers with higher credit scores as presenting a lower credit risk and as being more likely to repay their debts.

Why the Contents of a Consumer's File Could Be Incorrect?

Although credit bureaus strive to provide accurate information about consumers to creditors, the system is not flawless. There are three main ways in which a creditor could obtain inaccurate information about a consumer. First, creditors may provide credit bureaus with inaccurate or incomplete information about a particular consumer. Second, credit bureaus may add information received from creditors about one consumer to the file of another consumer. Thirdly, a credit bureau may send the file of the wrong consumer to a creditor.

When creditors evaluate a consumer's credit risk based on flawed or inaccurate information, undesirable outcomes may occur. A creditor may incur losses by extending credit to consumers with poor credit histories or by denying credit to customers with excellent credit histories. Equally important, credit reporting file errors can prevent a consumer from obtaining a good job, a suitable residence, or other necessities. An efficient consumer credit system must include a mechanism for consumers to correct any errors on their credit report.

Particular Considerations

Consumer credit utilization reflects the proportion of a family's or individual's expenditures on goods and services with a rapid depreciation rate. It includes essentials such as food and luxuries such as cosmetics and dry cleaning services.

Economists closely monitor the month-to-month utilization of consumer credit because it is regarded as an indicator of economic expansion or contraction. If consumers are willing to borrow and confident in their ability to repay debts on time, the economy benefits. If consumers reduce their spending, it indicates that they are concerned about their own financial security in the near future. The economy will decline.

Advantages of Consumer Credit

Consumer credit enables consumers to obtain an income advance to purchase goods and services. In a dire situation, such as a car breakdown, this can be lifesaving. Due to the relative safety of carrying credit cards, the United States is increasingly becoming a cashless society in which people routinely rely on credit for large and small purchases.

The industry of revolving consumer credit is extremely lucrative. Numerous businesses, including banks and financial institutions, department stores, and others, offer consumer credit.

Disadvantages of the Consumer Credit

The primary disadvantage of revolving consumer credit is the cost to consumers who do not pay off their balances in full each month and continue to accrue interest charges from month to month. According to the Federal Reserve, the average annual percentage rate on all credit cards was 14.75 percent at the end of the first quarter of 2021. A single missed payment can increase the cardholder's interest rate.

Consumer Credit Example

If you have a credit card, it is considered consumer credit because you use it to buy services and material goods rather than investment products like real estate or stocks.

You have a predetermined budget that can be used for dining out, home furnishings, electronics, and other material purchases. If you have a credit line with a particular store, this is also considered consumer credit because it functions similarly.

Bottom Line

Consumer loans typically have higher finance charges than business loans, although the manner in which costs are quoted may conceal the actual charges. In the United States, the Truth in Lending Act (part of the Consumer Credit Protection Act of 1968) mandates that lenders disclose finance charges in a manner that enables borrowers to compare the terms offered by different lending companies.

Consumer credit, short- and medium-term loans used to finance the purchase of goods and services for personal consumption or the refinancing of debts incurred for these purposes. The loans may be provided by lenders as cash loans or by sellers as sales credit.

The rapid expansion of consumer credit in industrialized nations is a result of an increase in the number of people earning regular income in the form of fixed wages and salaries and the emergence of mass markets for durable consumer goods.

There are two broad categories of consumer loans: installment loans, which are repaid in two or more payments, and non-installment loans, which are repaid in one lump sum. There are five types of installment loans:

(1) auto loans, (2) home repair and modernization loans, (3) loans for other consumer goods,(4) personal loans, and (5) credit card purchases. Single-payment loans from financial institutions, retail store charge accounts, and service credit extended by doctors, hospitals, and utility companies are the most prevalent types of non-installment loans.