Consumer finance is a subcategory of finance that deals with assets, liabilities, lending, and creditworthiness (incl. credit building). It does not address investing, which falls under a close but separate field called personal finance. Consumers who understand these basics can avoid mistakes made due to misinterpretation, so it's worth reading.
We can think of consumer finance in two parts. The first is foundational concepts, which includes assets & liabilities, lending, creditworthiness, as well as their sub-parts. The second is simple math, including addition, subtraction, multiplication, & division — each applied in a handful of ways.
Concepts
Fundamental consumer finance concepts include assets & liabilities (owing and being owed money or goods), lending, & creditworthiness (if and for how much a consumer can borrow money). Each of these has a number of key terms. For the sake of readability, we'll define and give examples of each without going into theory.
#1 Assets & Liabilities
Assets are money or physical things you own, as well as anything that someone owes to you. Liabilities are cash or anything you owe to someone else.
Asset
Many consumers believe assets only include physical goods like houses, vehicles, or jewelry, but cash and "rights to ownership" are also a form of asset.
Money in a savings account is an asset, and if you are owed money (i.e you have a right to it), this is also an asset. For example, insurance premiums paid at the beginning of the month represent a right to coverage during the month.
Transaction Account (Checking)
A checking account, also known as a transaction account, that has deposits is an example of an asset.
Savings Account
Likewise, a savings account with any money in it is an example of an asset.
Liability (Debt)
A liability occurs when you owe someone money, a service, or a physical good. The most common type of liability is a loan from the bank. You borrow the money and must pay it back. Other example include delivering your used car after being paid for it.
#2 Lending
Lending is the second major category of consumer finance. It is the borrowing of money in exchange for interest paid back on top of principal.
Lender
The lender is the party that provides the principal and ultimately earns interest over time. In most cases, lenders are banks.
Borrower
The borrower is the party that receives the loan principal and pays it back to the lender with interest. In most cases, borrowers are consumers.
Collateral
Collateral is a physical asset a borrower promises to deliver to a lender in the event of default. In standard "collateralized" loans, the asset being financed doubles as collateral. For example, the house itself is collateral in a mortgage loan. The same applies in auto loans with the vehicle.
Savings-based collateral
There is one exception to physical collateral: cash collateral. As the name suggests, cash collateral is money pledged to the lender in the event of default. In a normal loan structure, cash collateral is not value-additive because the borrower could simple use his/her cash rather than take out a loan and pay interest on it.
A common example of this value-destructive offer is savings-secured loans (SSL). SSLs allow borrowers to take out a loan against savings they have already built up, usually at their credit union. This is rarely a good call and the math only works out when early withdraw fees outweigh interest.
However, savings-based collateral has a major use-case in credit building. Collateral lowers risk for lenders, so they're more likely to accept borrowers with damaged or in-existent credit history. For some, this is an ideal way to rebuild credit.
Revolving Debt (Credit Card)
Revolving debt is one of the two types of debt structures. By structure, we mean the frequency of repayment and how interest is calculated. The most common form of revolving debt is a credit card.
Revolving debt works by providing a credit limit from which the borrower can draw funds. The borrower enjoys a grace period in which no interest is charges, after which the open balance accrues interest.
The type of accrual is usually a daily rate compounding at midnight, then an average of each day's interest, compounded one more time by the daily rate and added together (this is called the "average daily balance" on cards).
Most balances are due on a monthly basis, with a "minimum payment" possibility in a dangerously-low proportion to the open balance — often only 1% of the total.
Installment Debt (Loan)
Installment loans, or installment debt, are the traditional lending structure in which the borrower receives a principal amount and pays it back in fixed payments (aka installments) by a specific end date. Because the end date is a known variable, installment debt is often called closed-end credit.
Lump Sum Payment
A lump sum payment is one made in a single transaction rather than 2 or more. For example, most people make a lump sum payment when they pay the full balance on their credit card each month. Those who use 2 or more transactions do not make a lump sum payment.
Interest Rate
Interest is the cost of borrowing. Interest rate is a percent of the principal amount, calculated in most cases in a way that maintains a consistent total payment (principal + interest) each month for installment debt, and using the average daily balance method on most credit cards and other revolving debt.
APR
APR stands for annual percentage rate and it is not the same as interest rate. Where interest rate is the figure used to calculate payments, APR is the total amount of interest & other admin charges as a percent of principal, divided by the number of days or years of the loan to annualize it.
Default
Default is a debt status that occurs when a borrower misses a payment for longer than a period defined in the debt contract, usually 90 days (3 months).
#3 Creditworthiness
Creditworthiness is the likelihood an individual will default on new debt based on previous borrowing activity.
Credit Profile
A credit profile consists of a credit report and a credit score.
Credit Report
A credit report is a document containing up to ten years of revolving and installment account history, as well as any unpaid bills that are picked up by a debt collector. It shows the account balances, payment history, missed payments, and several other figures such as maximum ever owed on the account.
Credit Score
A credit score is a numerical representation of a credit report. There are hundreds of models, but the most common one is the FICO 8 score. It is a 3-digit number ranking from 300 to 850 with an average of just over 700. Scores over 700 are generally where more desirable offers can be found.
The 5 Cs of Credit
Credit profile is only one tool lenders use to determine if a borrower is accepted. It is often referred to as "character" and is joined by capacity, capital, collateral, and conditions. Together, these are the 5 Cs of credit approval decisions.
Capacity is the amount of income you have available to repay the loan, usually calculated as a debt-to-income ratio. Capital is the amount of the purchase the borrower pays (usually as a down payment). Collateral is an asset pledged to the lender in the event of default.
Conditions are use of funds and external factors such as federal interest rates.
Alternative Creditworthiness Metrics
Lenders can also look at alternative creditworthiness metrics such as stable employment, bill payments, and even social media behavior, to discover insights about a borrower's default risk based on factors in his/her present circumstances rather than relying solely on past borrowing behavior.
Math of Consumer Finance
Consumer finance may sound like a mathematically complex discipline, but the arithmetic is straightforward.
In fact, we can categorize a small number of transactions from the concepts above under each operator: adding, subtracting, multiplying, & dividing.
Addition
Adding any principal amount of loans and adding asset values together are the most common uses of addition.
Subtraction
Inversely, subtracting loan and asset values are the most common uses of subtraction.
Multiplication
Interest rates multiplied by principal amounts, as well as computing APR, are the most common uses of multiplication.
Division
Calculating APR requires dividing by principal amount and debt duration. In addition, calculating debt-to-income ratio requires it. Few other concepts need division.
