Overview – Understanding the Complex World of Credit
Chances are you have heard the word “credit” in a financial context at least once in your life. Credit cards, lines of credit, credit history, credit score, creditworthiness: the list goes on.
This word is thrown around so nonchalantly yet some people have no idea what exactly credit is in the first place. This deficiency of knowledge can lead to a person abusing credit, and as a result, hurt their financial future for many years to come.
To help prevent that, this article will provide a quick overview of what credit is, some different forms of credit, and what determines how much of it you can access.
What Is Credit, Anyways?
Imagine a transaction: two parties who wish to exchange goods of equivalent value. One party is the seller; they may be selling a product, a service, or assets. The other party, the buyer, has two ways to make a purchase, with money or with credit.
Credit represents a promise – otherwise known as an IOU (I owe you) in financial jargon. The promise is that in exchange for receiving an item of value from the seller, the buyer must eventually repay the monetary amount of this good.
If you decide to buy a pair of pants for $50 and you tell the buyer you’ll pay them back later, you’ve just created credit – in exchange for pants, the seller is left with a promise that they’ll hopefully get $50.
Money supply is tightly regulated and controlled; however, credit can essentially be made from thin air. Herein lies the power of credit: you can create as much of it as you want (theoretically speaking, of course).
While it sounds great, this notion of creating something out of thin air to purchase goods is a double-edged sword.
On one hand, credit enables people to purchase things they normally couldn’t afford right now. Without it, the only way a person can make purchases is by using the money they currently have available, or in other words, their disposable income.
For example, if you earn $50,000 a year in income after taxes, then this is the amount you can use to make purchases. Once you’ve exhausted this $50,000, you can no longer buy anything.
The only way you can afford to buy more goods would be to increase your income, and to increase your income, you need to be more productive (e.g., work longer hours, earn more business revenue, etc).
If you wanted to buy a new iPhone, your only option to get your hands on one would be to have the money on hand needed to pay for it in full. If you don’t have the money right now to buy one, you better start saving up.
Without credit, your ability to make purchases depends entirely on how productive you are. With the use of credit, however, you can make larger purchases without having to be more productive.
With credit, you can now purchase that iPhone without needing to save up. You can buy the phone now and repay the amount owed at a later date as funds become available.
Although credit can be used to make purchases that otherwise would be impossible, or at least very difficult, to make, it’s very easy to abuse this power.
At the end of the day, your outstanding credit balances still need to be repaid. Use too much of it and you may soon find yourself drowning in debt.
According to StatsCan, in January 2021 Canadians owed $74 billion of credit card debt. With a population of roughly 38 million people, the per capita credit card of Canadians in January 2021 was approximately $1,947.
Some people have the means to handle their use of credit, but others can easily become addicted to it and can end up severely damaging their personal finances. All this damage, simply because we have the ability to use money that doesn’t even exist.
Therefore, the responsible use of credit cannot be stressed enough.
The Importance of Using Credit Judiciously
The risks of using credit and its potential pitfalls make it seem like it is something that should be avoided, but that isn’t necessarily the case.
Credit can help people make financially responsible large purchases and can help them take out favourable loans in the future if needed (more on this later).
In some instances, the use of credit is the only option. Purchasing plane tickets or reserving a hotel room requires the buyer to input their credit card information. Many hotels also charge a holding fee, a fee that’s charged against your credit card.
However, there are some benefits to be had.
If your credit card information is stolen and a purchase is made using it, you can have those charges removed from your account without losing any money in the process. In contrast, if your debit card is used for unauthorized purchases, that money is directly withdrawn from your bank account.
Using credit also helps build your credit score. Credit score will be discussed in a later section, but essentially it is a measure of how well an individual uses and manages their credit.
Having a high credit score has the potential to open a lot of doors for you, and it starts with making sure you use credit wisely.
Judicious use of credit is a very clear sign that you know how to use borrowed money responsibly, and that you can be trusted to repay whatever outstanding balances you may have. Responsible use of credit is one of the fastest ways to convince landlords, creditors, banks, and countless other people that you are financially responsible.
Generally speaking, if you want to have a relatively hassle-free financial future, the first place you’d probably want to start is by establishing healthy borrowing habits.
Credit Cards and Lines of Credit
Now that we know what credit is, let’s look at some of the tools you can use to access it, as well as the details surrounding them. The two most common credit tools you’ll most likely use are going to be a credit card and a line of credit.
Credit Cards
A credit card is a financial tool that enables the cardholder to purchase goods or services on the promise that the cardholder will repay the amount owed.
Credit cards all have the following two features: a credit limit and an annual interest rate.
*Aside: There exists a special type of credit card known as a charge card, which doesn’t have a credit limit or an annual interest rate, but the balance must be paid in full every month or else the cardholder will face late fees and restrictions on the use of the card.*
Credit limits (how much credit can be used in a certain period, typically per month) are usually set by the cardholder, but the institution issuing the card may cap the credit limit (for example, it is very unlikely for a high school student to be given a credit limit of $100,000).
Annual interest rates vary by card, but all interest rates share the same feature: they are incredibly high. To understand why that’s the case, it’s important to understand how loans are structured.
Collateralized vs. Uncollateralized Loans
Credit card interest rates are so high because every time you use your credit card the institution offering the card is essentially lending you an uncollateralized loan.
To understand what a collateralized loan is, let’s first look at its opposite, a collateralized loan: a loan that has some sort of asset to back it up in case the borrower can’t repay the loan.
A common example of a collateralized loan is a mortgage: if a homeowner can no longer pay their mortgage (known as mortgage default), the financial institution who lent them the mortgage will proceed to seize and sell the house to compensate for any money they lost on the defaulted mortgage.
Since debt accrued using a credit card is uncollateralized, that is, there are no assets available to seize if the cardholder can’t pay, the financial institution must find a way to recoup their lost money, or at least discourage people from delaying their repayments.
They accomplish this by charging annual interest rates that are upwards of 20%. To make matters worse, the interest being charged is compound interest.
Simple vs. Compound Interest
There are two types of interest: simple and compound. For both types of interest, any time an interest rate is given, it is almost always an annual rate, unless otherwise stated.
For example, if a credit card has a 20% interest rate and interest is charged monthly, every month the interest rate is 1.67% (20% divided by 12).
As the name implies, simple interest is…simple. The equation for simple interest is shown below:
A quick example: suppose you borrow $200 (P = 200), the annual interest rate is 20% (i = 0.2), and the loan will be repaid in 10 years (t = 10). Therefore, your interest payment would be $400.
Despite its simplicity, no creditor (or at least very, very few) uses this method to assess interest fees.
Instead, the most widely used method to calculate interest is compound interest. The equation for it is shown below:
Compound interest introduces the additional variable “n”, which represents the number of compounding periods per year. With simple interest, the interest is applied only once for the duration of the loan. When it comes to compound interest, however, interest can be applied more than once per year.
This nuance in compound interest leads to a slight increase in the annual interest rate and produces a more accurate interest rate known as “effective interest” (this will be explained shortly).
Using the same values as the previous example, assuming interest is applied annually (n = 1), the interest owed would be:
When compound interest is used, the interest owed is almost 2.5 times the amount of the simple interest. Assuming that the above example is compounded monthly (like a credit card), then the interest owed becomes:
Now, you may be asking yourself: “how can the interest owed be higher if the interest rate is unchanged?”
This is the effect of having multiple compounding periods, which slightly modifies the annual interest rate. The “true” interest rate is known as the effective rate.
Nominal vs. Effective Interest Rates
Interest rates take one of two forms: nominal and effective. Nominal interest is the rate applied yearly, but it does not take the number of compounding periods into consideration. Effective interest, on the other hand, does account for the number of compounding periods and is thus a more accurate measure of interest. The effective interest rate can be calculated as follows:
Using the 20% nominal rate from earlier, the effective rate is:
The 1.9% increase makes a big difference, as seen in the previous example. Whenever interest is reported to consumers looking for loans or credit cards, almost always the nominal interest rate is the one being disclosed, so be aware of this.
Line of Credit
A line of credit (LOC) shares many features with a credit card, such as:
- Offered by a financial institution (usually a bank)
- Has an annual interest rate
- Credit available for use is limited
LOCs do have some key differences, some of which are discussed below:
- LOCs can be secured or unsecured.
- Remember that credit cards are always unsecured, hence the very high interest rate. Secured LOCs are a bit easier to obtain since creditors have some assurance that if an individual defaults, they can seize the individual’s assets to recoup losses.
- Unsecured LOCs usually demand an individual to have a higher credit score, usually have higher interest rates, and generally offer less favourable terms.
- LOCs can be repaid gradually.
- To avoid paying interest on credit card debt and taking a hit to your credit score, outstanding balances must be paid in full at the end of every billing cycle. LOCs allow borrowers to repay an outstanding balance gradually, usually monthly.
- Though interest will apply, the repayment is usually much more manageable. As long as a borrower sticks to their repayment schedule, their credit score will not be adversely affected.
- LOCs offer higher credit limits.
- LOCs typically offer higher credit limits than a credit card. If an individual ever finds themselves needing more funds but can only repay gradually, then a LOC is a suitable option.
Like credit cards, it would be best to use a LOC judiciously. Reckless use may end up severely damaging your credit score, which could prevent you from being granted another LOC in the future.
Now that we’ve looked at some of the tools you can use to access credit, let’s look at what determines how much of it you can access: your credit score.
Understanding the Credit Score
Throughout this article, the term “credit score” has been mentioned a few times and has probably left you wondering what exactly it is. We will go over what a credit score is, the factors that affect it, and its importance in the sections below.
Credit Score
A credit score is a three-digit number (in Canada, it usually ranges from 300 to 900) that determines the creditworthiness of an individual: that is, how well the individual in question manages their use of credit and how much of a risk they are to creditors.
In the 300 the 900 range, there generally exist five categories of creditworthiness. They are:
- Poor [300 – 559]
- Fair [560 – 659]
- Good [660 – 724]
- Very Good [725 – 759]
- Excellent [760 – 900]
As you can see from these categories, it is in your best interest to have as high a credit score as possible. Canada has two credit bureaus that collect information and issue scores: Equifax and TransUnion.
Note that these bureaus only gather information about your financial activities in Canada and may issue you a different number (but may fall in the same category). You may have a separate credit history outside of Canada if you have lived and spent money in another country for a significant period.
Factors That Affect Your Score
Credit bureaus and lenders do not disclose the formulas they use to calculate credit scores. There are a plethora of factors and it is impossible to say which of those factors are used and their relative weighting. Some of the factors that affect your credit score include, but are not limited to:
- How long you have had credit
- How much credit you have (several credit cards, line of credit, car loan, etc.)
- Any outstanding, unpaid, credit balances
- How frequently you repay credit on time
- Being close to, at, or above your credit limit
- Any record of insolvency or bankruptcy
For young people, the easiest (and arguably safest) way to build your credit score would be to use a small amount of credit in a given period, and to pay off the balance in full before it comes due. This will help build a strong credit history without running the risk of being overwhelmed by large outstanding balances.
Why Your Credit Score Matters
Having a high credit score isn’t just for show, your credit score can affect you in the following ways:
- Applying for loans from a financial institution.
- Whether it’s applying for a mortgage or a short-term cash loan, a low credit score can prevent you from securing these loans.
- Even if a loan is granted to you, chances are you will not be lent as much as you originally hoped for and with high interest to match.
- With respect to LOCs, having a poor credit score may force you to go with a collateralized LOC, even if you do not want to put any of your assets on the line.
- Renting an apartment/house.
- Many landlords ask for a pay stub or your credit score to determine whether you will be a good tenant (i.e. how likely you are to pay your rent on time for the duration of your term).
- A poor credit score may force you to look for less desirable homes run by less desirable landlords.
- Leasing a vehicle or securing an auto loan.
- Like the previous two examples, securing a car lease or car loan may be difficult if the lender finds out you have a poor history of managing credit. If you do secure a loan despite a low score, prepare to take on higher than average interest rates.
Wrapping Up
Credit is a very powerful tool that allows people to make purchases they normally wouldn’t be able to if they were to rely solely on the money they currently have.
If used wisely, can help people acquire the products or services they want or need without paying the entire amount right away, as well as establish a history of how responsibly you use credit.
However, uncontrolled use of it can easily land an individual in hot water very quickly. Interest charges can easily overwhelm anyone, and the subsequent decrease in credit score can make it very difficult to secure loans in the future.
Therefore, despite the power the credit offers, it would be best to use this power wisely, lest you want to destroy your financial health.
