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.
Under an FTC Rule, creditors are required to give you a notice to help explain your obligations as a cosigner. The cosigner's notice says:
"You are being asked to guarantee this debt. Think carefully before you do. If the borrower doesn't pay the debt, you will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility.
You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late fees or collection costs, which increase this amount.
The creditor can collect this debt from you without first trying to collect from the borrower. The creditor can use the same collection methods against you that can be used against the borrower, such as suing you, garnishing your wages, etc. If this debt is ever in default, that fact may become a part of your credit record."
We couldn't agree with the FTC's words more.