Reading: Lesson 4 - Credit Principles and Practices

9.3.A - Credit Principles and Practices

1. DETERMINING BUSINESS CREDIT NEEDS

1. Most businesses today offer credit to their customers. Many credit choices are available. Credit decisions can have a big impact on business operations and profit. To make the best credit decisions, businesses need to understand the types of credit plans and providers of the plans, the kinds of financial transaction cards, and the guidelines for establishing credit policies. They must also be familiar with sources of credit information, credit laws, and basic practices for managing customers who do not pay on time. Businesses offer credit if they believe it will increase sales and profits while satisfying customer needs. Consumers approach credit from the point of view of convenience and affordability, and they buy from businesses that satisfy those needs.
   
2. Businesspeople have several choices of credit systems. They can (1) choose to work with a major credit card company, (2) offer their own business credit to customers, or (3) use credit plans managed by a bank or finance company.
   
3. Starting an operation to accept credit cards begins with the establishment of a relationship with a major credit card company such as Visa, MasterCard, Discover, or American Express. However, those companies work directly only with very large businesses. Most businesses need to establish a merchant account in order to be able to accept major credit cards. A merchant account is a special form of bank account established by a business in order to process credit card payments from its customers. Merchant accounts are managed only by a limited number of banks known as acquiring banks. Acquiring banks are approved by the credit card company and handle the funds connected to each credit card transaction from the point it is approved until the funds are transferred into the business’s regular bank account and payment is collected from the customer. A merchant account can be obtained from an authorized local bank or through an independent merchant account provider. A merchant account provider is a private company that acts as an intermediary between businesses and one or more credit card companies to establish and maintain credit services. Using a bank or merchant account provider makes it easier and faster to begin accepting credit cards. It also allows the business to accept several major credit cards while dealing with only one intermediary rather than developing agreements with each of the credit card companies. Merchant account providers can explain the types of services available and their costs, help the business establish a merchant account, recommend and sell the equipment the business will need to process credit sales, and then work with the business to make sure the credit card operations run smoothly.
   
4. To be approved to accept credit cards, a business is evaluated to make sure it is financially strong enough to offer credit and has effective operating procedures in place to process and approve credit purchases. The bank, merchant account provider, or credit card company will request information on the business’s operations and history. It will need credit reports and financial statements to determine if the business is a good credit risk. Risky or start-up firms often face very strict maximums on the credit card payments that may be received. Companies that provide credit card services to businesses must be cautious because too many businesses fail to handle credit operations well. Having a relationship already established with a bank and a good financial record will speed the process of being approved to accept credit cards. Before beginning to accept credit cards, a business needs credit card processing equipment. Most businesses use electronic processing and approval systems that are built into point-of-sale terminals or cash registers. Small electronic card readers are now available that can be attached to cell phones, tablets, and other portable devices so a credit card can be accepted and processed electronically at almost any location.
   
5. Computerized credit card systems are now the accepted way to process credit transactions because they are efficient and accurate. The customer’s credit card is swiped through an electronic device that reads the bar code and micro-processor on the card, records the sale, and in some cases, prints a sales slip for the customer’s signature. Some systems record the signature on an electronic pad at the sales terminal. The bank and credit card company receive the credit sales information electronically at the same time. The electronic system also checks to make certain the credit card has not been reported as lost or stolen and the sale is within the customer’s credit limit. A quick authorization decision is received on the computer terminal. Credit card sales can also be made over the telephone and via the Internet. Procedures for those sales are developed by each credit card company and must be followed strictly to make sure the information is correct and the purchase is authorized by the customer. Internet credit card sales are made on secure websites to protect the customer’s personal information, including the credit card account number, while that information is encoded and uploaded. Most credit card companies require businesses to establish a separate Internet merchant account because the procedures are different from transactions where the credit card is swiped. In addition, there are other risks associated with processing credit sales on the Internet. Once a credit card transaction has been processed and approved by the acquiring bank and the credit card company, the business’s bank is notified. The bank then credits the payment to the business’s account. The entire process can often occur in a day or less. The credit card company collects the payment from the customer through a bill issued each month. If the customer returns the merchandise, the reverse of this process occurs, where the bank deducts the amount of the return from the business account and returns it to the credit card company.
   
6. When considering a credit card operation for a business, it pays to shop around. Credit card company and bank agreements are not all the same. Business owners should compare the requirements, services offered, start-up costs, and support provided by each company and bank. The business must be able to meet all of the requirements of the credit card provider and plan chosen. Employees will need to be trained to process credit card transactions according to those procedures and requirements. Equally important are the fees business owners must pay for credit sales. The bank and the credit card company both provide a service for which they receive a fee on each transaction, generally between 1.9 and 4 percent of credit sales. The rate usually depends on the total monthly credit card sales and the average size of each sale. The greater the volume of credit card sales, the lower the rate will be. A number of fees are paid on credit card services and individual transactions as the transaction moves from the business through the banks and credit card companies. To ensure a profit for the credit card companies and banks, fees may be set higher. As a percentage, fees are higher for very small transaction amounts, for a small number of transactions processed, or for errors made by the business completing the transaction. Businesses also must pay application fees and equipment costs to the credit card company and the merchant account provider when the credit system is first established.
   
7. Some large regional and national businesses, especially retail and service businesses, develop their own private credit card systems using the name of the business. Kohl’s, Lowe’s, and Target are a few notable examples. A few businesses will accept only their private card. However, most customers expect businesses to accept major credit cards as well. Operating its own credit system requires that a business establish a credit department to perform the tasks that a bank and credit card company would ordinarily complete. A credit manager, credit analysts, and clerks will be needed to solicit credit card applications, check applicants’ creditworthiness, and issue cards. Then they must manage the credit accounts, including recording credit sales, sending out monthly statements, and collecting unpaid accounts. Businesses have another alternative to offer a private credit card without the cost and risk of managing a credit department. They work with a bank or other financial services company that operates the credit card service under the name of the business. The credit card carries the name of the business, but all transactions are processed through the credit services company. Target and Nordstrom are examples of companies that manage their own credit services while Walmart, Lowe’s, and Macy’s rely on other companies to manage their private label credit.
   
8. The major advantage of a store credit card is the opportunity to advertise and offer special promotions available only to the company’s cardholders. Customers who possess a private card are usually loyal to that business. A major disadvantage is the cost and inconvenience of operating a private credit system. Only a very large and efficient system would be less expensive than the fees charged by major credit card companies. Many customers do not want to carry a separate credit card for each business. Some customers sign up for a private credit card to receive a one-time discount or as part of a promotion and then seldom use it after that initial purchase.
   
9. In addition to or instead of accepting credit cards, businesses may offer customers other types of credit plans. For expensive purchases, businesses often offer installment credit, a plan where a customer agrees to make a specified number of payments over a fixed period of time at a specified interest rate. Consumers buy cars, furniture, and major home electronics and appliances using installment credit. For example, if you bought a car on an installment plan, you would pay a fixed monthly amount for three to seven years until you have paid off the loan and gain full ownership of the car. Installment credit plans often have a high interest rate, and interest charges are included in each payment made by the customer. For promotional purposes, businesses may offer customers interest-free or low interest payment plans if payments are made on time and all payments are made by a specified date, such as six months or one year. Some businesses operate their own installment credit system. However, unless they are very large and have the financial resources to make multiyear loans to consumers, they offer the credit through a finance company. The business takes the customer application and sends it to the finance company for approval. If the credit is approved, the finance company pays the selling company the selling price of the merchandise less a discount for the cost of the credit service. Then the finance company collects the installment payments from the customer.
   
10. A popular type of installment credit is revolving credit, which combines the features of a store credit card and installment credit. With revolving credit customers can make credit purchases at any time as long as the credit balance does not exceed a specified pre-determined dollar amount (credit limit). Under most revolving credit plans, customers may pay off the full amount by the statement due date without a finance charge. Customers who do not choose to pay in full have the option of making partial payments each month. The minimum amount of a partial payment depends on the amount of the unpaid balance in the account. A finance charge, stated as an interest rate, is added each month to the unpaid amount. Revolving credit plans often carry a high interest rate on unpaid balances. Credit card systems are a type of revolving credit since most credit customers are given a credit limit and are required to make a minimum payment each month if there is an unpaid balance.
    

2. TYPES OF FINANCIAL TRANSACTION CARDS

1. Consumers often view credit cards as if they are actual money. Over the years, credit purchases have grown steadily. The average consumer has three or four credit cards. The top 15 U.S. credit card companies reported total credit purchases of nearly $2 trillion in 2015. The total unpaid credit card debt by consumers was nearly $900 billion. The major credit card firms compete intensely in countries around the world. Newer types of credit plans have been developed for financial transactions, and more and more brands of credit cards are offering an increasing number of features to attract customers.
   
2. Banks and nonbanks provide credit cards. For consumers, bank cards do not differ much from nonbank cards. Visa and MasterCard are bank cards in that their ownership is made up of banks. You can obtain a bank credit card under the MasterCard or Visa brand from various local banks. Examples of nonbank cards include most American Express and Discover cards. American Express is a large financial services company that provides credit through a variety of cards that use the American Express name. American Express—through products like Serve—has made intentional efforts to provide credit cards to individuals without bank accounts. Discover was originated by Sears in 1985 and later acquired by Morgan Stanley, a large financial services company. In 2007, Discover Financial Services was formed as an independent company to manage the Discover credit card, Discover Bank, and Pulse interbank electronic funds transfer system.
   
3. Consumers obtain nonbank credit cards from a company by filling out and mailing an application, applying online through the company’s website, or completing an application at partner businesses. Most bank and nonbank credit card companies have different cards for different types of customers. For example, American Express offers cards with a range of services. The prepaid, blue, green, gold, platinum, black, and optima cards each meet the needs of different consumers. Special cards are offered to business customers with services designed to meet the needs of various types of businesses and occupations. So-called “prestige cards” often charge higher fees for added services but can be free of annual fees for customers with excellent credit who use the card frequently. Credit cards are often co-branded. A co-branded credit card is cosponsored by two companies and has benefits and rewards designed specifically for the companies’ joint customers. For example, the American Express Delta SkyMiles Card is a co-branded credit card for people who travel frequently on Delta Air Lines that offers cardholders travel-related benefits. Another type of credit card that builds on consumer loyalty is an affinity card. An affinity credit card is issued by a financial institution and cosponsored by an organization that receives a small percentage of the sales or profits generated by the card. Affinity cards are offered to people associated with the cosponsoring organizations. The cards often carry the logo of the affiliated charity, club, or school. Many charitable organizations offer affinity credit cards to their donors. People who use affinity credit cards generally do so to help support an organization or cause they care about.
   
4. Debit cards resemble credit cards in appearance but are very different. Using a credit card is like obtaining a short-term loan, while using a debit card is equivalent to paying with cash. A debit card immediately transfers funds electronically from the cardholder’s checking account to the business’s account when a purchase is made. With a debit card, customers can also withdraw cash from their checking or savings accounts through ATMs and pay bills by phone or computer. The same scanner hardware may be used to process debit cards as credit cards. However, with debit cards, customers may have to enter a personal identification number (PIN) before the transaction can be processed.
   
5. A debit card transaction assures the business accepting the card that the customer has funds to pay for the purchase. The bank or company that manages the card doesn’t have to bill and collect from customers. It does, however, send monthly summaries of transactions to retailers and customers. Fees are charged to both consumers and businesses for debit card services. Those fees and the time needed to process transactions are less than with credit cards due to recent legal changes. The use of debit and credit cards reduces the amount of cash and the number of checks handled in the economy. Customers benefit from debit cards by not having to carry large amounts of cash or a checkbook. People who are not approved for credit cards may be able to obtain a debit card because it reflects money on deposit in a bank. A debit card is riskier than a credit card, however, because the money transfer is immediate. There are fewer legal protections for consumers using debit cards than for those using credit cards. With credit cards, customers who pay their bill at the end of the month are actually receiving a “free” loan of that money for a short time. Debit card charges are withdrawn immediately from the account, so no money is loaned.
   
6. American Express, MasterCard, Visa, and other companies sell prepaid debit cards that can be used as a ready source of funds wherever major credit cards are accepted. Parents may buy a card with a prepaid amount for their children to use at summer camp, on school trips, or at the mall. Colleges and universities frequently offer prepaid cards that can be used at campus venues including bookstores, cafeterias, restaurants, and vending machines. The cards can also be used in laundry machines, photocopiers, and parking meters operated by the schools. Students and their families can add funds to the card at regular intervals or as needed. Some high schools, recreation centers, and swim clubs offer similar cards. Gift cards issued by many businesses are also examples of prepaid cards. The cards can be purchased for a specified amount that can be redeemed for merchandise from the retailer. Customers can use gift cards as if they are cash, but they have no protection against lost or stolen cards and the value of some prepaid cards expires after a certain date. According to many industry resources, up to 10 percent of the over $100 billion of gift cards sold in the United States each year are never redeemed.
   
7. A smart card is a plastic card with an embedded microprocessor that can store and process a large amount of information. The microprocessor has a reader “pad” on the surface instead of the magnetic strip used on credit and debit cards. Smart cards are used extensively in Europe but just became required in the United States due to increasing security concerns. In Germany, every citizen has a smart card containing his or her health records. Swedish citizens use smart cards to vote. Currently smart cards are used by businesses for computer security, in cable and satellite television receivers, and in cell phones. The information on smart cards can be tailored to specific purposes, and it can be changed and updated. For example, financial institutions can offer a smart card that serves as a credit, debit, and ATM card. Health care providers can record and update medical information on each patient’s smart card. Commuters can use smart cards to pay fares on city buses, subways, and trains, or even to pay tolls on toll roads. University students can use them for student identification, food service, library book checkout, parking meters, copy machines, and campus computer labs. Smart cards hold several hundred times more data than cards with magnetic strips, and their storage capacity is increasing rapidly. They have the potential to replace debit, credit, and ATM cards for several reasons. First, because a smart card provides up-to-the-minute account balances after every transaction, it can reduce defaults on debts. Second, because lost or stolen cards cannot be used without personalized verification, the cards can reduce fraud. Uses for smart cards are expected to expand greatly in the future, including online security protection for purchases made on the Internet. New technologies are emerging as a way for consumers to make payments for purchases. With a chip in the customer’s smartphone, payments can be made by passing the phone over a business’s scanner or code reader. This technology also allows customers to access product information, special promotions, maps, and other services from businesses using their cell phones.