|Indiana Department of Financial Institutions
LOW-INCOME CONSUMER CREDIT: TOOL OR TRAP?
A mini-lesson for:
high school teachers
adult and community educators
students and consumers
This mini-lesson includes learning objectives, background information, discussion questions, an activity, bankruptcy worksheets and sources of additional information.
identify common credit problems confronted by low-income consumers.
analyze ways low-income consumers can avoid credit problems.
Who are the Low-Income?
Most Americans will experience low income at some point in their lives. Many people are less affluent, at least temporarily, because of circumstances beyond their control. They may have lost jobs due to illness or downsizing. They are often children, older people, single parents, or college students. They may be widowed or divorced. They are often undereducated and trapped in urban ghettos or rural pockets of poverty. This mini-lesson addresses the significant challenges of managing consumer credit while dealing with low income.
Why Use Credit?
Across all income levels, people want to improve their lives. They often want better jobs, more education and training, better housing and more of the comforts we have come to expect in the United States. Credit can be useful when other funds are not currently available. Making credit purchases can be more convenient than using cash. When a product is defective, the consumer has greater leverage with the seller if it is a credit purchase.
On the other hand, credit commits future income, making tight budgets in low-income households even less flexible. Credit makes it easy to charge impulse purchases that the buyer may later regret. Credit purchases are almost always more expensive than paying cash because of finance charges. And when credit payments are not made on schedule, late fees must be paid, items may be repossessed, wages garnished, and credit records blemished.
Should Low-income Households Use Credit?
Should everyone be able to obtain a credit card, a car loan, a house mortgage or a student loan for a college education? The right to borrow money is often taken for granted in America today, yet in some cases it may not be smart to borrow money.
The fact that lenders lend money to low-income consumers simply says that the lender expects to get the money back and to make a profit. Very few lenders even pretend to be credit advisors. The lender assumes that the consumer has already made the decision to borrow money when she or he applies for a loan. It may not be easy for the consumer to pay back the loan, and going deeper into debt may not help the low-income household reach its important financial goals.
High-Cost Credit Services. Credit services in low-income neighborhoods are sometimes offered at extremely high cost with little or no consumer protections. They include pawn shops, tax refund anticipation loans, rent-to-own stores and other rental-purchase agreements. The creditors feel that higher prices are justified because of the higher risk that the loan will not be repaid.
It can be argued that low-income people should avoid use consumer credit. Credit is a promise to repay, with interest, money borrowed from another. Since it costs money to borrow money, low-income people would be prudent, the argument goes, to spend limited resources carefully and rarely use credit. On the other hand, credit can be a useful financial tool for low-income people as well as for the more affluent. Some low-income households manage their money skillfully. They often use a common sense approach.
A Common Sense Approach. The most important questions low-income consumers have to ask about consumer credit are common sense questions related to their personal financial situation. "Is buying on credit now worth the extra cost and of paying back the loan with interest at a later date. Where will I get the money to pay back the loan? Is this purchase something we really need, or is it impulse buying?" These common-sense questions about credit use are faced by middle and upper income households as well, but the decision becomes more critical for people with limited incomes.
Do the Poor Pay More?
In a classic low-income study of the 1960s, David Caplovitz revealed in a book titled The Poor Pay More that low-income consumers often buy more on credit than do other groups. Their low income and higher risk of default are often cited as reasons low-income consumers are charged a higher rate of interest to borrow money than are other income groups. Caplovitz pointed out that many low-income consumers achieve only a limited level of education and often lack mobility for shopping purposes. Without the skills or opportunity to comparison shop, the poor pay more through high prices and limited choices.
Credit Problems of Low-Income Consumers
The largest growth in consumer credit in recent years has been among the poorest Americans. Some analysts explain that rising consumer credit default rates are caused by credit issuers who offer credit to individuals who are less able to repay than are higher income households. The Consumer Federation of America identifies this practice of targeting less affluent consumers as "bottom feeding".
Rising Expectations. People who study consumer behavior patterns observe that most of us spend a shrinking share of our income on the necessities -- food, clothing, housing and transportation -- while we spend an increasing share of income for goods and services that reflect our hopes and wants. To counter this trend, many households in the late 1990's practice the lifestyle they call "voluntary simplicity", cutting back on spending while enjoying life's simple pleasures with family and friends. Low-income households are often experts in making this lifestyle work effectively.
Deceptive advertising. Low-income consumers are often prime targets for deceptive advertising. They are persuaded to buy products and services using the "easy credit" plan. When they have money problems, they often deal with pawn shops, rent-to-own stores and credit repair clinics, paying excessively high prices for disappointing goods and services.
See our Web Sites:
Bandit in Your Mailbox at http://www.in.gov/dfi/education/bandit_in_your_mailbox.htm,
Telemarketing Fraud at http://www.in.gov/dfi/education/telemarketing_fraud.htm, and
Advance-Fee Loan Scams at http://www.in.gov/dfi/education/advancefee_loan_scams.htm.
Rent-to-Own Traps. Rent-to-own stores often target poor and minority consumers who do not have credit cards. Critics of rent-to-own businesses point out that these stores charge the equivalent of 100 to 125% average annual interest rates. Rent to own businesses offer televisions, washers and dryers, refrigerators, automobiles and furniture using short term rental-purchase agreements. No down payment or credit checks are required. The renter usually makes payments that add up to much more than the cost of the item. Rent-to-own deals should be avoided where other alternatives are available.
Credit insurance. Credit insurance is sold to low-income consumers on the idea that if the consumer should die, become disabled or lose a job, the insurance company will pay off the loan. This type of insurance is usually a rip-off because it is often overpriced and consumers
rarely get value for money. It is said that over 70 percent of credit insurance premiums are commissions for sales people.
Minimum Monthly Payment. Low-income consumers sometimes fall into the trap of paying only the minimum monthly payment on credit cards. If you have a credit card balance of $2,000 at 18.5 annual interest rate, make no new purchases, and pay only the minimum payment each month, how long will it take to pay off the balance? It will take 11 years and you will pay an additional $1,934 in interest charges. If you continue to make new purchases on the card, the revolving debt and high-interest costs will follow you forever. A better choice would be to pay as much as possible each month on the credit card balance and to save money at the bank or credit union for future major purchases. Then ask before you buy, "Do I really need this product or service? Have I shopped for the best price and quality combination? Do I need it now, or can I save and pay cash later?"
High Interest Rates. Can creditors change the interest rates on credit cards without informing consumers? Yes, the current Truth in Lending Law does not require lenders to inform consumers when they change interest rates on variable-rate credit cards. Many consumers are surprised to learn that the "low-introductory rate" has jumped to a high rate before they know it. What is a consumer to do? Check the interest rate when the statement arrives, restrict new purchases, pay off the balance as soon as possible, and comparison shop for a better interest rate.
Affordable Housing. Credit problems of low-income consumers, particularly African Americans and Hispanics, extends to affordable housing. The affordable housing problem is serious for low-income home buyers who struggle to save money for even a low down payment, then to meet the monthly mortgage payments.
A number of housing loan programs exist for low-income consumers and first-time home buyers. Key among them is the Federal National Mortgage Program (Fannie Mae). This program allows borrowers to make a down payment of as little as $1,000. All states have funds reserved to subsidize interest rates for low-income home buyers. To find out about income requirements and other details, contact local housing officials, usually listed in local phone books.
How Much Credit Can You Afford?
The first rule of using consumer credit, especially important for low-income consumers, is to review your income and expenses and make sure you can safely make credit payments out of future income. Develop a plan to track expenditures using the fact sheet, Your Income and Expense Statement.
Households of all income levels who have difficulty making ends meet, should probably not take on additional debt until they have repaid current debt or their income increases. Use the fact sheet How Much Credit Can You Afford to determine your credit limits.
See our Web Site Guidelines for Setting Credit Limits at http://www.in.gov/dfi/education/MiniLessons/guidelines_for_setting_credit_li.htm.
Your Credit Rights
The U.S. Congress has passed several credit laws to protect the rights of all consumers, including low-income households. Among them are the Equal Credit Opportunity Act and the Fair Credit Reporting Act.
The Equal Credit Opportunity Act prohibits discrimination against a credit applicant on the basis of sex, marital status, race, color, religion, national origin, age or income from public assistance. The Act does not give anyone an automatic right to credit. It does require that creditors apply the same standards of creditworthiness equally to all applicants.
The Fair Credit Reporting Act, revised in 1997, gives the following specific rights:
You must be told if information in your file has been used against you, such as denying an application for credit, insurance or employment.
You can find out what is in your file. You are entitled to one free report each year if you are unemployed and plan to seek employment within 60 days, if you receive public assistance, or if your report is inaccurate due to fraud. Otherwise, the credit reporting agency may charge up to $8.
You can dispute inaccurate information in your file. Inaccurate information must be corrected or deleted.
Access to your file is limited. The credit reporting agency may provide information about you only to people with a need, usually to consider your application with a creditor, insurer, employer, landlord, or other business.
Your consent is required for reports that are provided to employers, or reports that contain medical information.
Outdated information may not be reported. In most cases, a credit reporting agency may not report negative information that is more than seven years old, ten years for bankruptcy.
Check your credit report. The three national credit bureaus that collect information about a consumer's credit history are Equifax at 1-800-685-1111, Experian at 1-800-682-7654, and TransUnion at 1-216-779-7200 or 610-690-4909. There is an $8 charge for a copy of a credit report, $16 for a couple's joint report. You are entitled to a free copy if action has been taken against you because of information found in your credit report.
See our Web Sites:
Building A Better Credit Record at http://www.in.gov/dfi/education/building_a_better_credit_record.htm
Credit Repair Scams at http://www.in.gov/dfi/education/crscam.htm
Check your creditworthiness. The four main factors creditors evaluate to determine creditworthiness are often the "Four Cs of Credit":
Capacity -- your amount and source of income
Character -- your ability and willingness to repay, based on your credit history
Collateral -- something of value that you offer as security
Conditions -- your future income potential, your general financial health
Negative information on a credit report that affects whether or not credit is granted include late payments, delinquent payments, bankruptcy, current debt as compared to income, and too many credit inquiries from businesses. Too many inquiries can be viewed as a possible indication that the borrower is desperate, therefore a bad credit risk.
While consumer credit protection laws protect people from discrimination on factors such as age, sex and marital status, the creditor can refuse to grant credit for economic reasons. Low-income consumers may be refused credit if the creditor decides that the person is a bad credit risk.
Many people, both borrowers and creditors, feel that the use of credit is not a basic right, that the creditor may do the consumer a favor by refusing credit if it is likely that the consumer will be unable to pay back the loan.
1. Define consumer credit.
2. Describe reasons people may have low incomes at various times throughout life.
3. Debate whether or not low income people should use credit.
4. Discuss potential credit problems of low-income consumers, such as rent-to-own traps,
minimum monthly payments, high interest rates.
5. List the "Four Cs of Credit", factors that creditors consider when determining
6. What protections are provided under the Equal Credit Opportunity Act?
7. What protections are provided under the Fair Credit Reporting Act?
8. List three national credit reporting agencies and discuss reasons why consumer might want
to check their credit reports.
1. A Case Study. Mary Jane and Bill Brown were turned down for a bank credit card. They are concerned that the denial is related to unpaid medical bills that the health insurance company has been late in paying.
What should Mary Jane and Bill do first?
What steps would you recommend to solve this problem?
How can Mary Jane and Bill protect their credit history.
2. Using the fact sheet Your Income and Expense Statement, evaluate your spending, saving and borrowing habits. Decide how much credit is appropriate for your income using the NICE fact sheet How Much Credit Can You Afford. Enjoy the satisfaction that comes from knowing that through careful money management, you can avoid financial problems.
Give students a copy of our Brochures.
SOURCES OF ADDITIONAL INFORMATION