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?