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A primer on credit

The concept of credit has different connotations for different people. For some, it's a gateway to money they don't have. For others, it's an invitation to debt.

Credit can help you achieve material or financial goals; unless you're a millionaire rock star who can drop half a million in cash, a mortgage is an unavoidable course in realizing your dream of owning a house. Credit can be handy, and it can be costly. It all depends on how responsibly you use it.

Credit is, first and foremost, a convenience. Credit cards like Visa and MasterCard allow you to make purchases without exchanging physical currency, which enables you to buy stereos and vacations by phone or over the Internet.

Plastic also allays the fear of walking around with a big sheaf of cash in your pocket, which will prove costly in the case of a mugging. You can report the theft of a credit card; with physical cash, when it's gone, it's gone.

What exactly is a line of credit?
A line of credit is a fixed amount of money (the actual figure is based on your income and assets) a lender extends to you to fund a large purchase or act as a fail-safe for an unforeseen emergency. The ability to access that sum comes at a cost, however, namely interest. Interest on a credit card generally ranges between 15 and 22 percent; the rate on a personal line of credit is often between 5 and 8 percent.

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Generally, you repay your debts in manageable monthly installments. The amount you pay back beyond the original loan depends on the interest rate and amortization. You can choose to keep your monthly payments low and extend them over a longer term. In the end, however, it will significantly raise the cost of your purchase.

For many people, credit is simply a means of accessing money they can't readily muster. While that's true, strictly speaking, your credit also speaks to your personal integrity. Having a credit card, for example, is a sign of your trustworthiness -- just try renting a car, or even a movie, without one.

Building a credit history
Once you receive your first credit card or get approved for your first loan, you begin to amass a credit history, which is a physical file that is tracked by your lending institution, as well as credit-reporting agencies, also known as credit bureaus, such as Equifax Canada and TransUnion Canada.

Your credit history is a tally of all of the times you've borrowed money or carried a balance on your credit card. Your credit rating is an analysis of that history. The rating system ranges from 1 to 9 -- 1 signifies a history of always paying your bills on time, while 9 indicates bankruptcy or the intervention of a collection agency. (A rating of 2 means debts are 30 days past the due date, 3 means debts are 60 days past due, etc. A rating of 7 indicates that payments have been made through a consolidation order or an arrangement through a third party, and 8 signals repossession.)

Being approved for a loan has become a more expedient process in recent years thanks to credit scoring. By feeding your borrowing history through an algorithmic model, banks and other lending institutions can calculate the likelihood that you'll repay your debt in a timely manner.

How credit scores are determined
While outlets like Equifax and U.S. firm Fair Isaac Corp. have standardized software, most banks and lending institutions also use their own credit-scoring models, which take into account individual data such as a borrower's age, employment history, place of residence and the number of assets held with that institution.

Maintaining a good credit rating is vital because it can help you obtain better loans in the future. When purchasing a home, for example, a good rating demonstrates that historically, you've managed your credit wisely and are a responsible consumer.

If you have a bad credit rating, you'll likely have to resort to secondary lenders like finance and mortgage companies, who are generally less charitable with their lending terms.

"What we typically see, for example, is that the credit cards with the most favourable interest rates are targeted at the least-risky consumers," says Rick Cleary, president of Equifax Canada. "If your credit history is not as good, there are probably still institutions that want to deal with you, but at a higher interest rate."

There is such a thing as "good credit" and "bad credit"
While some people view all debt as negative, there is a distinction between good and bad credit. "If you're carrying a mortgage, that's good credit, because you have an asset [i.e. a home] to back that mortgage up," says Laurie Campbell, program manager at Credit Counselling Service of Toronto.

"Eventually, it's going to be an asset that you hold, and it does go up in value. Bad credit would be paying large interest on a credit card because you can't pay it off and you're only paying the minimum payments, so it's an unsecured debt."

The easiest way to maintain a good credit rating is self-evident: Pay your bills on time. If you are unable to meet a payment, contact your creditor and explain your situation. Don't sign a credit contract until you've read it and understood it completely.

Be aware of the implications of co-signing a loan for a friend or family member; you are responsible if that person doesn't pay on time. (Many kind-hearted people have poor credit ratings as a result.)

Try to pay off debt quickly -- avoid low payments that are drawn out. "If you're only paying the minimum, that doesn't necessarily look that great [on your credit history] either," says Campbell.

Another tip: Limit the amount of debt that you have, and don't strive for more money than you need. Simply applying for a loan shows up as a statistic on your credit history. While there's something to be said for persistence, people who doggedly approach lender after lender with the belief that someone's bound to give them more money are not helping their own cause.

"[People] shouldn't apply for more credit than they need because another piece of information that's in the credit report is inquiries from other credit grantors," says Cleary. "If you were a lender and you were making a decision about somebody and you saw that in the last 30 days, they applied for eight credit cards, you might be concerned that there's fraud, or that this person is a little desperate."

Andre Mayer is a freelance journalist based in Toronto, Ontario/


-- Posted: Sept. 20, 2004
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