What it means
The economic role of consumer credit is to move spending forward in time. A household buys a washing machine or a car now and pays for it out of future income, which smooths consumption but costs interest.
For businesses, consumer credit is both a sales tool and a risk. Offering finance at the point of sale reliably raises conversion and average order value, but somebody in the chain is carrying the risk that the customer does not pay.
The published cost of consumer credit is the annual percentage rate, which bundles interest and compulsory fees into one comparable number. Rates vary widely, with secured car finance often in the single digits and unsecured revolving credit frequently in the twenties.
Revolving credit is where the real cost hides. Minimum payments are typically set at a small percentage of the balance, which is comfortable each month and can stretch repayment of a modest balance over years.
Aggregate consumer credit is also watched as an economic indicator. Rising balances can signal confidence or distress depending on what sits behind them, and lenders track arrears rates closely as an early warning of trouble in the wider economy.
In practice
Real-world examples
Example 1
A furniture retailer offers interest free credit over twelve months and pays the finance provider a 4% subsidy on each order. Conversion rises noticeably, and the retailer treats the subsidy as a marketing cost rather than a finance cost.
Example 2
A car dealer arranges a $24,000 personal contract purchase for a customer. The monthly payment looks affordable because a large balloon payment sits at the end of the term, and the customer only discovers that when the final year approaches.
Example 3
A lender reviewing an applicant totals $650 of existing monthly consumer credit payments against a gross monthly income of $5,000, a ratio of 13%. The application passes on that measure, though the lender still checks the applicant's payment history separately.
Think of it
Consumer credit is like hiring a moving van for your shopping trip. Instead of trying to carry a heavy sofa home on your own right now, the van transports it immediately, and you pay the rental fee in manageable chunks over the following months.
Formula
Calculation
Monthly interest = outstanding balance x (annual percentage rate / 12)
Principal repaid in a month = payment - monthly interest
Someone carries a $3,000 credit card balance at an annual percentage rate of 24%, which is a monthly rate of 24% / 12 = 2%. In the first month the interest charge is $3,000 x 2% = $60.
If they pay $100 that month, $60 goes to interest and only $100 - $60 = $40 reduces the balance, leaving $2,960. The following month's interest is $2,960 x 2% = $59.20, so $40.80 comes off the principal, and the balance falls slowly at first and faster later.
Repeating that until the balance clears takes 47 months, just under four years, and the total interest paid comes to about $1,627. The card holder repays roughly $4,627 for $3,000 of spending. Raising the payment to $200 a month clears the same balance in 19 months for about $602 of interest, which is why the size of the monthly payment matters far more than most borrowers assume.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Larkfield Cycles, an invented chain of five bike shops, introduced point of sale finance because its average bike sold for $1,800 and customers were hesitating. It offered twenty-four month interest free credit, paying the finance provider a 6% subsidy on every financed sale.
In the first year, financed orders made up 38% of revenue and the average order value on financed sales was $2,350 against $1,410 for cash sales. On $2,850,000 of financed revenue the subsidy cost $171,000, which the fictional company compared against the extra gross profit generated by the higher average order value and concluded was clearly worthwhile.
The complication came in year two, when the finance provider tightened its acceptance criteria and the approval rate fell from 84% to 61%. Larkfield had built its sales process around the assumption that finance would be approved, and had to retrain staff to present a cash price and a finance option side by side rather than leading with the monthly payment.
Watch out
Common mistakes
- Judging affordability by the monthly payment alone, which hides both the total interest cost and any balloon payment sitting at the end of the term.
- Paying only the minimum on a revolving balance, which is designed to be comfortable rather than to clear the debt in any reasonable time.
- Comparing a monthly interest rate with an annual percentage rate, since the second includes compulsory fees and reflects compounding across the year.
Questions
People also ask
What is the difference between revolving and instalment credit?
Revolving credit lets a balance be drawn and repaid repeatedly up to a limit, while instalment credit is a fixed amount repaid in set payments over an agreed term.
Is buy now pay later consumer credit?
In substance yes, since it defers payment for personal spending, though it has often sat outside the disclosure rules that apply to traditional credit products.
Does using consumer credit damage a credit score?
Not by itself, because a record of borrowing and repaying on time generally helps, whereas high utilisation of available limits and missed payments do the damage.