Simplifying Credit: The Basics You Should Know
What is Credit?
Financial literacy is an important skill every Canadian should be equipped with. One important aspect of financial literacy is understanding how credit works. It can be a daunting endeavour to embark upon on your own, but with a guiding hand understanding credit and all that it entails can be much easier than you think.
Let’s start with understanding what exactly credit is. In the simplest terms, credit is an arrangement between a consumer and a lender to obtain goods or services that are paid for at a later date. For this type of contract, it is expected for the consumer to repay the loan in full in addition to any interest or other fees that might have accumulated over time. The interest rate, the length of the repayment period, how much these payments will be and when they must be made will be outlined within the contract and should be understood by the consumer before any purchases with the loan are made.
Types of Credit Accounts
There are two main types of credit accounts: installment credit and revolving credit. Each works a little differently in regards to how they are reported and how they process payments.
An installment credit account is recognizable by a few defining characteristics. It is a close-ended loan with specific payment terms; a repayment schedule is clearly outlined and there is a definitive agreed upon end date when the loan must be repaid. You might hear the term “utilization ratio” when discussing installment credits, which simply means the ratio of the amount owed to the amount already paid. Meaning, the utilization ratio will be higher in the beginning before you’ve paid off the majority of the loan. Examples of installment credit include car loans, mortgages, student loans, traditional business loans and personal loans.
The most common example of revolving credit is a credit card. This type of credit account offers a set credit limit with required minimum monthly payments. If any balances are carried from month to month, interest is charged to the borrower. Revolving credit allows flexibility to the borrower as you don’t have to wait until you have a cash supply in order to make purchases. However, the convenience of not having to pay for goods and services right away is exchanged for high-interest rates, making this credit account type a little risky.
Types of Borrowers
In relation to revolving credit lines, borrowers are classified into two groups depending on their behaviours: transactors and revolvers. This classification system isn’t just for credit bureaus who collect your information, but the category you fall into will impact your credit as well.
In an ideal world, everyone would approach their credit contracts with the hopes of becoming a transactor. This first group is made up of individuals who have a certain limit on their credit card or line of credit. They will spend a specific portion of that limit and subsequently pay the balance in full every month. The benefit of falling into this category is that you never have to worry about paying interest on your loans. Since the balance is paid off each month, the amount owed is never carried over, therefore interest charges are never generated. If you manage your credit relationships as a transactor, you’re essentially assured a favourable credit report.
The other group is made up of individuals referred to as revolvers. This type of consumer spends more than they repay. For example, say you have a monthly limit on your credit card of $5,000 and you spend $4,000 of it, but you only pay back $1,000. Meaning, you will carry the remaining $3,000 with you into the following month. As previously discussed, balances carried from month to month gather interest, which can quickly add up. The danger of the revolver behaviour type is that it would only take one unforeseen expense or loss of income to convert you into a delinquent payer.
A thorough understanding of the difference between the two groups will help you secure a positive credit report.
Your Credit Report
A credit report represents your financial history controlled by credit bureaus—agencies that gather individual’s credit data and summarizes it on behalf of lenders. All information collected is used in order to calculate your credit score through a formula called the FICO algorithm. In Canada, there are two national credit bureaus, Equifax Canada and TransUnion Canada, that collect your financial information and transform it into a score.
Your score will determine whether or not you can apply for a loan or open a credit card based on your past financial management. The length of your credit history, your payment history, the mix of your credit accounts, your credit utilization and any applications for new credit are all taken into consideration on your report. Your score will affect your ability to qualify for any future financing. Even loans you take out for your business rely on your personal credit score, as small businesses tend to have high failure rates. Lenders will use personal credit scores to determine whether or not it’s probable an individual will pay back a business loan on schedule.
Who Can Access Your Credit Report
There are strict laws in place that regulate who is able to access your credit report. Banks and other lenders, insurance companies, utility companies, employers and landlords can access your report with permission in order to assess your risk as a consumer and gain insight into your financial history.
However, there are some situations in which permission is not needed in order to access your credit report. These are called “soft pulls” or soft inquiries and do not affect your overall credit score. Of course, there must be a legitimate reason why a soft inquiry is made—no one can simply access your credit report without justification. On the other hand, hard inquiries can stay on your credit report for up to two years and anyone who checks your credit report, unlike soft inquiries that can only be seen by you. Hard inquiries occur when you’re applying for things like credit cards, mortgages, student loans, utilities, phones, etc.
In addition to soft inquiries, there are other instances that do not require permission to view your credit report that include:
- When you apply for a license or any other benefit provided by the government and an examination of financial responsibility is required by law.
- When responding to a court order or federal grand jury subpoena.
- Under specific circumstances regarding child support determination.
- For the assessment of the risk of an existing responsibility by an investigator.
- When there is a credit or insurance transaction not initiated by you, an offer of credit or insurance is extended, or other restrictions are met.
What Is Considered a Good Score?
Credit is typically rated on a scale from 300 to 900; the higher the number, the better your score. Any score between 760 to 900 means that you have excellent credit and will be able to acquire any future credit that you might need. You will also have the lowest interest rates and fees compared to other score categories. A score of 725 to 759 is considered good and there is a good chance banks will extend credit to you, also giving you their advertised standard rates. 660 to 724 is the middle ground. If you fall within this range your credit score is treated as fair and you might be approved for new credit. You are also more inclined at this level to pay slightly higher interest rates. Between 560 and 659 is considered a poor score and your borrowing options will be limited to high-risk, alternative lenders. Any score below 559 won’t result in approval of new credit and you will have to pay extremely high-interest rates and fees.
Your credit report can act as your financial references when applying for future loans. If managed well, it can be a powerful tool and financial resource. If not managed well, your bad credit can keep you from any number of life goals or dreams. However, it’s not just about achieving the perfect score. It’s more important to gain an understanding of how credit is affected by different behaviour so that you can better prepare financially for your future.
How to Fix Your Credit
There is no way to instantly “fix” your credit. Unless you have been a victim of identity theft or there have been major errors made on your credit report, the only approach to rebuilding your credit is by paying your bills, reducing your current debt over a period of time, and limiting the amount of new credit.
It is more common than you might think for mistakes to appear on your credit report. The responsibility is on you to catch any errors, not the credit bureau. If you do notice a discrepancy, make sure you take the steps to fix it as soon as possible. The easiest way you can stop this from happening is by continuously checking your credit report. As a Canadian, you are entitled to a free copy of your credit report every 12 months.
Learning the intricacies of credit management is an important part of your financial literacy education. With a little research, you can expand your knowledge base and gain a deeper understanding of how to improve your credit.