Chapter 7: Credit Score and Borrowing
The opportunity to borrow money today and return it some day in the future is a tempting offer. As we’ll see shortly, borrowing money can be very helpful when used correctly. Too often, though, borrowing leads to poor spending habits and a debt you may not have the experience to handle. This chapter will cover the importance and steps of managing your borrowing. You’ll learn how to establish credit, which is your reliability in the eyes of a lender, how your credit score—a number that represents your financial consistency—is determined and how to get out and stay out of high-interest debt. This will help you better understand the value and risks associated with the use of personal credit.
Your credit represents how capable you are of borrowing money today and consistently paying it back on time. Establishing a history of positive relationships with lenders demonstrates that you’re financially responsible. This leads to several benefits. Financial institutions may offer you rewards and cash back on purchases and lower interest rates on loans. Landlords may be more likely to rent to you, and employers may be more likely to hire you.
Developing any relationship takes time for trust to build. Consider your credit score an overall value of your relationships with your current and previous lenders. As more of your borrowing encounters go well, your score will increase, and other lenders will be more likely to do business with you.
How to Build Credit
The act of building credit is a lengthy process involving several factors that demonstrate your ability to repay a loan. These factors are combined to determine a number, referred to as a credit score. Your credit score falls somewhere between 300 and 900. A higher value implies a better credit score and higher trustworthiness. If each interaction you’ve had with a lender was a test, your credit score would be your current grade in the class. Just as with most tests, the teacher—or credit bureau in this case—has a consistent rubric they use to assign a grade.
The aspects considered when calculating your credit score include your payment history, your current credit, your credit history, recent credit applications and the types of credit you have. All these factors contribute in some way to how you’re viewed as a borrower and can therefore impact your financial situation.
Payment History
Your payment history is the most important portion of your credit score. It shows how promptly and consistently you pay back the money you’ve borrowed. If payments are made late to a cell phone company or credit card bill, it reflects poorly on your ability to properly borrow and pay back money. By ensuring you monitor bills coming in and pay them on time, this aspect of your credit score will gradually improve.
Current Credit
The second important factor is your current credit. This includes both how much you owe and how much you could borrow across all your lending accounts. The amount you owe is important since lenders want to know what other obligations are competing for your money. The amount you could borrow across your accounts is important because it may be more than you could reasonably pay back.
These numbers are also combined and are called your credit utilization. This is the amount you’re currently borrowing relative to the total you could borrow across all your accounts. If you use all the available credit you have and then lose your job, you could have difficulty repaying your loans for a while. As a result, high utilization rates reflect poorly on your ability to repay a loan and will lower your credit score. To demonstrate, if you had a credit card with a $5,000 limit and you owed $4,500, you’d have a credit utilization of 90%. To help build a good credit score, a standard approach is to maintain a ratio that is below 30%. To achieve this, if you spend $1,200 a month on your credit card, you should aim to have a limit of at least $4,000.
Credit History
The length of your credit history is important because it’s the sample size a borrower can reference when making their decision. It’s harder to predict your likelihood to pay off a loan if you’ve only been borrowing for eight months. Therefore, start demonstrating your reliability as early as you can once you’re comfortable with the responsibility. For instance, getting a student credit card is typically a good way to start the clock on your credit history.
Credit Applications
A less significant consideration is the number of recent credit applications you’ve made. For instance, when you apply for a new credit card or car loan, there’s an entry added to your credit history. These entries are assessed in your credit score and too many can lower your score. It may suggest you’re running into financial difficulty or your payment behaviour is about to change, both presenting uncertainty to lenders. While this factor often only carries temporary changes to your credit score, it’s wise to limit the number of new credit cards, limit increases and loans taken out over short periods.
Forms of Credit
One final grading consideration is the different forms of credit that you have. Making payments that vary in frequency and amount demonstrates your reliability as a borrower. While this is a consideration for lenders, it’s unlikely to be worth taking out additional loans to meet this category. Instead, this aspect will likely improve naturally overtime as your borrowing relationships mature.
Managing Your Credit Score
Equifax and TransUnion are the two official providers of credit scores in Canada. You can obtain your score directly from these providers or from a growing number of free online services. In addition, lenders will often look at your history to determine their own ranking of your trustworthiness. While the calculations differ across the official providers and various lenders, it’s generally best to:
only borrow what you know you can pay back
make payments on time
avoid maxing out your borrowing accounts
check your credit history occasionally to ensure there are no errors
Exhibit 18 – There’s no single formula used to calculate your credit score. However, the following chart provides a common breakdown of the important areas discussed above.
Benefits of Good Credit
Now that you’ve seen how to manage your credit score, let’s review why having good credit is valuable. The first example we’ll consider is the use of various credit cards. Credit card issuers, which are often banks, earn money by receiving a fraction of the purchases made on their cards. When a credit card is used to pay for a purchase of $100, roughly $98 goes to the seller and $2 goes to the card issuer. This means credit card issuers want you to use their cards because every time you do, they make money. As a result, many credit card issuers offer rewards for using their cards. These rewards typically come in the form of cash back, travel points or deals through major companies. However, credit card issuers are only willing to offer these cards to you if you’ve proven yourself to be a trustworthy borrower.
The simplest of these cards to assign a dollar value to is a credit card that offers cash back on purchases. Every time a purchase is made on your cash back credit card, there are three parties being paid. The first and most obvious is the company charging you, the second, as we saw above, is the credit card issuer and the third is you. A typical cash back card offers 1% of the purchase price. This time, when that $100 sale is rung through the till, $98 goes to the seller, $1 goes to the card issuer and $1 is paid back to you. By using this credit card for day-to-day spending, those small amounts add up over time. In a year, if you charge $20,000 to a credit card offering 1% cash back, you’d earn $200.
A good credit score can also provide sizeable savings by reducing the interest rate you’re charged on loans. Whether you’re buying a used car or a new home, taking out a loan is a common way to obtain the money you need today. Your lender will charge you interest to be paid in addition to the original loan amount. The total interest you pay is determined by the rate of interest on the loan and how long you borrow the money for. As we’ve mentioned, the higher your credit score, the more trustworthy you are to lenders. As we saw in Chapter 4, the lower the risk of an investment, the lower the rate of return. Therefore, as your credit score increases, the rate of interest that you’re charged typically decreases. This lower interest rate means you pay less for your loan, allowing you to put your money toward other goals.
To illustrate the impact a lower interest rate can have, let’s consider two mortgages with different rates. In each case, the mortgage will be for $300,000 and will be paid back over twenty-five years. The first mortgage will be provided to an individual with a good credit score of 690, at an annual rate of 3.75%. The second mortgage is offered to an individual with an excellent credit score of 800, at an annual rate of 3.5%.
Exhibit 19 – A small difference in interest rates provided by a better credit score can lead to savings of $12,200.
If the monthly savings were invested and earned an average annual rate of 6%, they’d grow to $27,000.
As you can see from both the credit card rewards and favourable mortgage rates, there are direct cash benefits from maintaining your credit score. Following the rubric we went over earlier in this chapter will help your credit score gradually increase, providing opportunities to benefit.
Risks of Using Credit
It’s important to remember that, as with any form of trust, your relationship with borrowers can be broken in a moment. As a result, ensure you can pay off a loan within the given timeframe before borrowing the money. We’ll cover two common approaches to paying off debt shortly. However, if you encounter a situation where you owe money that you can’t pay back, do everything in your power to address the situation. Contact your lender directly to work out a repayment plan that works for everyone or contact an alternate company to see about refinancing the debt. Regardless of how you handle the situation, remember that your credit history will impact you for better or for worse.
We mentioned in Chapter 1 that high-interest loans are very dangerous to your financial success. Paying these loans back can feel like rolling a snowball up a hill, as the interest you’re charged weighs on you like gravity. Credit cards often charge interest rates as high as 20% and are one of the most common sources of high-interest debt. To avoid these interest fees, you’ll need to pay off your credit card in full each month. To achieve this, make sure your credit card balance is never higher than the amount you have available in a chequing or savings account.
Most financial institutions are happy to lend you money because it means they’ll earn interest from you over time. So far, we’ve discussed interest as a very valuable aspect of savings because it allows your money to grow. However, when you borrow, the interest you’re paying is damaging to your financial situation. One way of considering interest you pay on a loan is that you’re contributing to someone else’s savings account. This is, of course, much less desirable than contributing to your own savings account. Because of this, it’s important to avoid loans when possible, especially if they carry high interest rates or have a long payback period.
How to Get Out of Debt
It’s easier said than done to avoid debt. The reality is that household borrowing in Canada continues to hit all-time highs. Student loans, mortgages and personal loans are all being used to help pay for purchases. Sometimes this is out of necessity, due to higher education costs and housing prices. And sometimes it’s out of convenience, due to historically low interest rates. Whatever the source of any debt you may have, if you’re looking to pay it off, there are two common approaches.
Regardless of which approach you take below, the first step for paying off debt is to see if you can refinance it. This involves finding a loan that charges a lower interest rate than what you’re currently paying. If you have credit card debt charging 20% interest, it’s worth seeing if you can find another loan. You may be able to get a personal loan from a bank or digital lender at a lower rate. If you borrow and pay off your credit card, you’ll have an easier time paying back the new loan. It’s important to ensure the rate of the new loan is lower and not a temporary offer that could increase later. Once you’ve refinanced any debt where it makes sense, the next step is to choose one of the following two approaches.
The first approach is to focus on your high-interest loans:
List your debts in order of the interest rate charged, from highest to lowest.
Make the minimum payment required to all loans and pay any extra you have to the highest interest loan.
Continue this process until you’ve paid off your loans.
This is helpful if your goal is to pay the least amount of interest and get out of debt the fastest.
The second approach is to focus on your small balance loans:
List your debts in order of the balance owed, from smallest to largest.
Make the minimum payment required to all loans and pay any extra you have to the smallest balance loan.
Continue this process until you’ve paid off your loans.
This is helpful if you want to see progress and simplify your debt situation by paying off individual loans faster.
Exhibit 20 – To compare these two options, let’s consider Sarah who has three loans.
We’ll assume Sarah has $500 a month to pay toward debt. In both cases, she would make the minimum payment required to each loan, avoiding damage to her credit score. After paying the $300 minimum required, Sarah would have $200 remaining to apply where she sees fit.
With the first approach, the excess $200 would be paid to credit card 1 since it has the highest interest rate. Sarah would do this for a year until credit card 1 is fully paid off. From there, she’d continue paying the minimum amount for the student loan and start putting everything else toward credit card 2. Through this approach, Sarah would pay the least amount of interest and be out of debt sooner.
If Sarah chose the second approach, she’d pay extra toward credit card 2 since it has the smallest balance. Either way, the key is to pay at least the minimum required to all your loans and make extra payments as often as you can.
Common Types of Loans
From credit cards to mortgages, we’ve discussed quite a few types of loans thus far. To help organize them, we’ll now cover the two main categories of loans. The first type is a secured loan. These require that you provide an asset, for example a house or car, to guarantee the loan. Common examples of secured loans include home mortgages and car loans. In these cases, if you can’t repay your loan, the lender can recover its money by taking and selling the home or car.
The second type is an unsecured loan. These don’t offer an asset for the lender to collect if you fail to repay the debt. Common examples of unsecured loans include student loans, most credit cards and bank overdrafts. Instead of securing these loans with an asset, you use your credit score to obtain them. If either loan type isn’t paid back, it can have damaging effects to your credit score and future borrowing options.
When Loans Are Helpful
Some purchases require a loan since saving up enough money ahead of time often isn’t reasonable. The purchase price of a home is so large, it would take quite some time to save up enough to buy one with cash. Instead, you can get a mortgage to buy and begin to live in the home today. This allows you to spread the burden of paying for the home over a more manageable period. Although a mortgage may be unavoidable, you can take steps to limit the amount of interest paid over the years.
By purchasing a home within your budget, more of your payments will go toward repaying the loan, rather than just covering interest expenses. Let’s consider what would happen if you paid $1,200 a month toward two different mortgages. One is for $200,000 and another for $300,000, both charging 4% interest.
Exhibit 21 – The $200,000 mortgage is paid off in half the time, with less than a third of the interest charged.
This shows that just because you can afford to make payments on a mortgage doesn’t mean the amount you’re borrowing is wise. You could choose to borrow slightly less while making the same payments. By limiting the amount you borrow, you’ll pay significantly less in interest and have more money to put toward earning a return of its own.
Other common uses for loans include the purchase of a car and getting a post-secondary education. In both cases, it’s important to consider interest costs when deciding how much you can afford to borrow. A car with a sticker price of $10,000 ends up costing $11,400 if paid off over five years at an interest rate of 5%. Similarly, a $25,000 education financed fully through student loans would cost $33,100 if paid off over ten years at 6%.
Final Thoughts
Loans allow you to make valuable purchases well before you could otherwise. While loans are helpful, the interest costs can add up quickly. If you’re not careful, the interest will begin to consume your income over time. Before taking out a loan, be sure to calculate and account for the total interest you’ll pay. As we mentioned previously, paying interest is equivalent to making contributions to someone else’s savings account. Avoid this when possible and instead put that money to work for yourself.
Key Takeaways
Spend the time and effort required to build up and maintain your credit score.
Avoid borrowing when possible, especially at high interest rates.
Pay off debt starting with the highest interest or smallest balance, depending on your goal.
This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.