Post on 26-Dec-2015
The Cost of Credit
BBI2O Introduction To Business
Unit 3: Finance
3.D Credit
The Cost of Credit
• Credit can be described as the privilege of buying something now and paying for it later
• When Credit is used*, consumers end up paying MORE for their goods
• The EXTRA amount of money paid is called the Cost of Credit
* An exception would be if you used a Credit Card, and paid your balance in full by the due date
The Cost of Credit
• Forms of Credit– Credit Cards– Personal Loans– Car Loans– Mortgages– Store Credit Cards– Installment/Financing/Payment Plans– Loan Sharks/Mobsters
The Cost of Credit
• When we know the details of a financial transaction, we can determine the Cost of Credit
• This means we can determine the amount of extra money paid for the privilege of having it “now” and paying later
• Let’s see an example
The Cost of Credit - Example
• Mr. Borrower just bought a car for $16,450– But he doesn’t have this much money in his
account so he needs to finance
The Cost of Credit - Example
• He made a down payment of $2450
• A down payment means he’s paid some of the amount, and financed the rest
• Therefore, he is financing $14,000– ($16,450 - $2,450 = $14,000)– (total cost – down pymt = principal)
• So, the principal (borrowed amount) in this case is $14,000
• The interest rate is 4%, paid monthly over 5 years
• Using a financial calculator, we can determine the monthly payment
• In this case the monthly pymt is $264.20
The Cost of Credit - Example
The Cost of Credit - Example
• So where are we now??Our consumer pays $264.20 each month for 5 years.
12*5 = 60 months!
So how much money is that?
$264.20*(12*5) = $15,852.00
The Cost of Credit - Example
• So we now know he’ll pay a total of $15,852.00 in car payments
• He’s also spent $2,450 for the down pymt
• Add these together:– $15,852.00 + $2,450 = $18,302.00
The Cost of Credit - Example
• So our consumer has paid $18,302.00 for a car that was only priced at $16,450.00!!
• The difference between these two numbers is the Cost of Credit $18,302.00 - $16,450 = $1852
The Cost of Credit - Example
• So what does it all mean?
– It means he paid a premium to have the car and use it while paying for it. The premium in this case was $1852.00.
The Cost of Credit
• Discussion:– How can the cost of credit be avoided?– How can the cost of credit be reduced?– Why do people pay this extra amount?– Where does the extra money go?