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.
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,"
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/