Question

Harry and Belinda have a substantial annual joint income—more than $125,000, in fact. Nevertheless, they expect to experience some cash-flow deficits during the months of November and December of the upcoming year. To resolve this difficulty, the couple is considering opening a credit card account and using it exclusively for those expenditures that will cause the deficits they face. They could also open a line of credit that would allow them to borrow money by simply going online and having money placed in their checking account.

(a) What are the advantages and disadvantages of the Johnsons opening these accounts?

(b) What financial calculations should Harry and Belinda undertake to see whether they could afford to borrow more money at this time?

(c) What might Harry and Belinda do before applying for credit to ensure that they will pay the lowest interest rate possible?

(d) Should they use credit to resolve their budget imbalances? Why or why not?

Answer 1

Answer to part a)

Advantage of opening credit card account and opening a line of credit is that Harry and Belinda can get cash inflow anytime during the year as and when cash flow deficit occurs. As they were expecting a cash-flow deficit, funds might be available for them through the two alternatives of line of credit and credit card account.

Disadvantage of opening the two accounts i.e., credit card account and line of credit is that interest has to be paid by Harry & Belinda as they will be availing the credit facility through the above mentioned sources.

Answer to part b)

The financial calculations that Harry & Belinda should see at the time of borrowing money is that whether they will be having sufficient cash inflows in the future to repay the loan as well as the interest thereof. So, Harry & Belinda should anticipate and forecast their future cash flows to check if they will be in a position to repay the loan. If they are forecasting that the future cash inflows will be good, then they might think of borrowing more money.

Answer to part c)

Before applying to credit, Harry & Belinda should compare both the options available with them i.e., line of credit and credit card account with respect to following aspects:-

1. The option that will charge them less rate of interest should be opted by the couple- Usually, Line of credit charges less rate of interest so it should be preferred but only after comparing.

2. The option in which total interest repayment is lower should be opted by Harry & Belinda- Sometimes rates of interest of one alternative is lower but the other factors such as compounding and other processing charges are higher, so in that case ultimate cash outflow should be considered.

Answer to part d)

Harry & Belinda may or may not use credit to resolve their budget imbalance.

They should use credit to resolve their budget imbalance in case the imbalance is serious and infusion of cash in an urgent and serious requirement. In addition to it, this must also be ensured that future cash flows should be capable to repay the borrowed amount. If both the conditions are present then they should borrow the amount to resolve the imbalance.

They should not use credit to resolve their budget imbalance in case there is no serious need of cash at that time and functions can be operated without borrowing money also. Secondly, if the interest rates are very high and they might not be able to afford it, in that case also they should avoid taking credits. Lastly, if the future cash flows do not assure the repayment of the loan, in that case also they should avoid credit.