Understanding the Types and Sources of Consumer Credit

Consumer credit can be a small business owner's best friend. Or it can reek havoc on your personal finances. Learn how to use, and when to avoid, consumer credit options.

Credit, as you already know, is an arrangement to receive cash, goods or services now and pay for them in the future. Consumer credit refers to the use of credit for personal needs by individuals and families as contrasted to credit used for business or agricultural purposes.

Although this discussion mainly focuses on credit as it affects your personal finances, as a business owner your personal and business financial situations are closely intertwined. As a result, your personal and business credit standing and management are also closely related.

If your business gets into trouble by incurring too much debt, this will likely affect the business's profitability, which will in turn likely affect your ability to qualify for personal credit. The flip side of this can also be true: If you are over-burdened with personal debt, your business creditors (who can be expected to ask for your personal guarantee on loans made to your small business) may be less willing to extent credit to your business if they think your personal guarantee to be of little or no value.

Although Polonius cautioned, "Neither a borrower nor a lender be," using and providing credit have become a way of life for many individuals in today's economy. Consumer credit is based on trust in the consumer's ability and willingness to pay bills when due. It works because people, by and large, are honest and responsible. In fact, personal credit, if used wisely, has its advantages.

Of course, personal credit usually can't help you get financing for your business. And if you offer credit, you'll want to read up on credit and collections. Still, knowing the perks and perils of consumer credit is valuable to nearly every small business owner.

Credit Is Either Closed- or Open-End

Consumer credit falls into two broad categories:

• closed-end (installments) 
• open-end (revolving)

The Basics of Closed-End Credit

This form of credit is used for a specific purpose, for a specific amount, and for a specific period of time. Payments are usually of equal amounts. Mortgage loans and automobile loans are examples of closed-end credit. An agreement, or contract, lists the repayment terms, such as the number of payments, the payment amount, and how much the credit will cost. 

Generally, with closed-end credit, the seller retains some form of control over the ownership (title) to the goods until all payments have been completed. For example, a car company will have a "lien" on the car until the car loan is paid in full.

The Basics of Closed-End Credit

With open-end, or revolving credit, loans are made on a continuous basis as you purchase items, and you are billed periodically to make at least partial payment. Using a credit card issued by a store, a bank card such as VISA or MasterCard, or overdraft protection are examples of open-end credit. 

There is a maximum amount of credit that you can use, called your line of credit. Unless you pay off the debt in full each month, you will often have to pay a high-rate of interest or other kinds of finance charges for the use of credit.

• Revolving check credit. This is a type of open-end credit extended by banks. It is a prearranged loan for a specific amount that you can use by writing a special check. Repayment is made in installments over a set period, and the finance charges are based on the amount of credit used during the month and on the outstanding balance.
• Charge cards. Charge cards are usually issued by department stores and oil companies and, ordinarily, can be used only to buy products from the company that issued that card. They have been largely replaced with credit cards, although many are still in use. You pay your balance at your own pace, with interest.
• Credit cards. Credit cards, also called bank cards, are issued by financial institutions. Credit cards provide prompt and convenient access to short-term loans. You borrow up to a set amount (your credit limit) and pay back the loan at your own pace—provided you pay the minimum due. You will also pay interest on what you owe, and may incur other charges, such as late payment charges. Whatever amount you repay becomes immediately available to reuse. VISA, MasterCard, American Express and Discover are the most widely recognized credit cards.
• Travel and Entertainment (T&E) cards. This cards require that you pay in full each month, but they do not charge interest. American Express (not the credit card version), Diners Club and Carte Blanche are the most common T&E cards.
• Debit cards. These are issued by many banks and work like a check. When you buy something, the cost is electronically deducted (debited) from your bank account and deposited into the seller's account. Strictly speaking, they are not "credit" because you pay immediately (or as quickly as funds can be transferred electronically).

The Basics of Consumer Loans

There are two primary types of debt: secured and unsecured. Your loan is secured when you put up security or collateral to guarantee it. The lender can sell the collateral if you fail to repay.

Car loans and home loans are the most common types of secured loans. An unsecured loan, on the other hand, is made solely on your promise to repay. While that might sound like a pipe dream, think about it for a minute: Nearly all purchases on credit cards fall into this category.

If the lender thinks you are a good risk, nothing but your signature is required. However, the lender may require a co-signer, who promises to repay if you don't.

Because unsecured loans pose a bigger risk for lenders, they have higher interest rates and stricter conditions. If you do not repay an unsecured debt, the lender can sue and obtain a legal judgment against you. Depending upon your state's rules, the lender may then be able to force you to sell other assets to pay the judgment or, if you are employed by another, to garnish a portion of your wages.

Cosigning a Loan Is Risky Business

What would you do if a friend or relative asked you to cosign a loan? Before you give your answer, make sure you understand what cosigning involves.

Several points are worth highlighting:

• The lender does not have to chase the borrower before coming to you for repayment—you are on the hook every bit as much as the borrower.
• It is your loan, even if you won't have any use or enjoyment from the property. If there is a default, you will have to pay the obligation, in full, plus any "expenses" of collection.
• The lender does not feel confident that the buyer will be able to repay, or it would not be requesting a co-signor. That means the lender already has you in its sights the minute you pick up that pen to co-sign.

If you do cosign:

1. Make sure you can afford to pay the loan—the odds are good that you will have to. If you are asked to pay and cannot, you could be sued, or your credit rating could be damaged.
2. Consider that even if you are not asked to repay the debt, your liability for this loan will appear on your credit record. Having this "debt" may keep you from getting other credit that need or want.
3. Before you pledge property, make sure you understand the consequences. If the borrower defaults, you could lose these possessions.

There is good reason why one law school professor defined "co-signer" as "an idiot with a fountain pen." The same reasoning applies, to a lesser extent, with a joint credit account.

Consider the Sources of Consumer Credit

We all have short-term or long-term needs for money or credit. You'll want to familiarize yourself with your options when your needs for credit arises.

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.

• Consumer loans are for installment purchases, repaid with interest on a monthly basis. The bulk of consumer loans are for cars, boats, furniture and other expensive durable goods.
• Housing loans may be for either residential mortgages, home construction or home improvements.
• Credit card loans may be available in the form of cash advances within prearranged credit limits.

Savings and Loan Associations (S&Ls)

As depicted in It's a Wonderful Life, 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.

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 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.

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.

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.

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.

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.

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.

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.

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. 

And, if the IRS catches wind of an intrafamily "loan," it can "impute interest" on the loan—which would be income to the lender, but not deductible to the borrower. Being caught up in an IRS audit can also blight family relationships.

Tax Disadvantages of Consumer Credit

Interest paid on your personal auto, credit cards, education and other consumer loans is no longer deductible on your tax return.

Interest allocatable to business use of property may be deductible. Consult our Controlling Your Taxes article for more information.

In addition, there is only a certain amount of qualified residence (mortgage) interest that is deductible. Qualified residence interest is the interest paid or accrued on acquisition loans or home equity loans with respect to your principal residence and one other residence, usually your "vacation home." 

The total amount of acquisition loans is limited to $1 million and the total amount of home equity loans is limited to $100,000. Interest on any debt over these limits is considered to be personal, consumer interest that is not deductible.

Considering Home Equity Loans

Should you convert your consumer loan interest into interest on a home equity loan in order to be able to deduct your interest? Before you join the rush to a home equity loan, you should consider the pluses and minuses.