1

Chapter 15: CreditThe Wonderful World of Credit

What is Credit?Credit is the privilege of using someone else’s money to purchase an item or service now and then pay for it later. Using credit means a transaction has occurred between a creditor and debtor. The creditor is the person or business that sells on credit or grants a loan. The debtor is the person or business that buys on credit or obtains a loan.

2

Chapter 15: CreditThe Wonderful World of Credit

Consumer Credit A consumer uses credit for expensive items, such as a home or car, and for inexpensive things like theatre tickets or DVDs. Vacations, investments, and paying off other debts can also be arranged on credit. Advantages of Consumer Credit

Disadvantages of Consumer Credit• credit costs• impulse buying

• overbuying• financial difficulties

•instant enjoyment•convenience•emergency needs

•saving money•credit rating•monthly statement

3

Chapter 15: CreditThe Wonderful World of Credit

Government Credit•All three levels of government borrow money to provide goods and services to citizens.

•Funding capital projects such as a new theatre arts building, a skate park, new community centre

•Funding new programs such as health and fitness awareness

•Canada Savings Bonds and Government of Canada Treasury Bills are two examples of the government using credit.

4

Chapter 15: CreditThe Wonderful World of CreditBusiness CreditBusinesses use long-term credit to purchase land, buildings, and equipment, and short-term credit to buy goods, raw materials, and supplies. Entrepreneurs start new businesses by using loans and credit. Advantages of Business Credit

Disadvantages of Business Credit

Why Business Grant CreditFinancial institutions and retail businesses grant credit to consumers.Retailers offer credit to increase sales, attract customers, and to potentially collect interest charges.

•increased costs •defaulting on a loan

• finance major purchases• consolidate payments

• use of corporate credit cards• overcome cash-flow shortages

5

Chapter 15: CreditTypes and Sources of Credit

The type of credit that people use depends on their needs, wants, goals, and purposes. The four common types of credit are credit cards, installment sales credit, loans, and mortgages.

Credit CardsThe average Canadian has at least three different credit cards. The three basic types of cards issued to consumers come from banks (the most popular), retailers, and travel and entertainment businesses.

Bank-issued Credit CardsWith a good credit rating, consumers can acquire bank-issued credit cards, such as a Visa and/or MasterCard. The credit limit on the card depends on the consumer’s credit rating. Businesses that allow consumers to pay with credit cards incur the cost of equipment, transaction fees, monthly statement charges, charge-back fees and customer disputes.

6

Chapter 15: CreditTypes and Sources of Credit

Travel and Entertainment Credit Cards

Travel and entertainment cards are used to pay for luxury services and products, such as hotels, airline tickets, and so on.

Retailer Credit CardsRetailers establish their own credit cards, or single-purpose cards, to avoid the charges and fees associated with universal card companies.Businesses that have their “own” card effectively lower costs and make money on the interest payments received.For example: Sears, Zellers, Home Depot

7

Chapter 15: CreditTypes and Sources of Credit

Installment Sales CreditInstallment sales credit is a credit plan that requires a down payment and fixed regular payments with finance charges added to the purchase price. This form of credit involves a contract that includes the terms of the purchase and payment, including finance charges.•For example: Leon’s, the Brick, Best Buy

Installment credit is slightly more complicated than handing over a credit card to pay for something. The consumer must fill out an application, be approved for credit risk, and then sign a detailed sales contract for the purchase. The buyer takes possession of the product or service, but the ownership stays with the seller until the buyer makes full payment according to the contract.

8

Chapter 15: CreditTypes and Sources of Credit

LoansLoans can be used to make a wide variety of purchases except real estate. Loans, with a variety of repayment options, can be obtained from most Canadian financial institutions.

Term LoansA term loan is a form of borrowing in which the borrower agrees to make fixed payments over a set period of time or term.

A lease is an agreement to rent something for a set time and at an agreed price. It is an alternative to a term loan.

9

Chapter 15: CreditTypes and Sources of Credit

Demand LoansA demand loan is usually short-term with flexible terms of repayment. Repayment of the entire sum owing can be demanded by the lender at any time.Collateral—something of value that the lender can take and sell if the loan is not repaid—serves as security for the loan.

Student LoansGuaranteed by the federal and provincial governments, student loans are available through most financial institutions. Student loans are usually interest-free until six months after graduation.

10

Chapter 15: CreditTypes and Sources of Credit

Mortgage Loans

A mortgage loan is a 10 to 25 year credit plan to purchase property. The property is pledged as collateral for the loan. A bank and buyer renegotiate the terms of the loan and the interest rates many times during the mortgage’s time frame due to varying interest rates.

11

Chapter 15: CreditThe Cost of Credit

Factors that affect the cost of credit include• principal borrowed• the term for repaying the loan• current interest rates• inflation and economic conditions• security or collateral• risk and credit rating

Principal – amount borrowedTerm – period of timeMortgage Calculator.

12

Chapter 15: CreditThe Cost of Credit

How to Calculate Simple InterestThe formula for calculating simple interest is as follows:

I (interest) = P (principal) x R (interest rate) x T (time)However, financial institutions do not calculate using this simple formula. Instead, they take into account amounts repaid during the loan, and charge interest only on the amount outstanding. From a financial institution’s perspective, the total cost of a loan is as follows:

P (principal) + I (interest)

Security or CollateralOften collateral is necessary to secure a loan. It reduces the risk to the lender as the asset can be sold if the borrower fails to repay the loan.

13

Chapter 15: CreditCredit Worthiness

Prior to granting credit, a lender looks at the potential borrower’s credit worthiness, a person’s ability to take on and repay debt. The three Cs of credit are character, capacity, and capital: qualities that a potential borrower must possess for a lender to consider when making a decision.

Character

Character refers to the borrower’s willingness, reliability, and trustworthiness to make a loan repayment. A lender needs to assess the character of the borrower to determine if the individual or business will repay the debt.

14

Chapter 15: CreditCredit Worthiness

CapacityCapacity refers to the borrower’s ability to make payments on time and to pay the debt when it is due. Assessment of capacity by the lender determines if the individual or business can repay the debt.

CapitalCapital is the value of the borrower’s assets that could be used to repay debts. The lender makes an assessment of capital to know what the borrower has of value that could be sold if the individual or the business does not repay the debt.

15

Chapter 15: CreditCredit Worthiness

Credit Bureaus

A credit bureau is a business that gathers credit information on borrowers and then sells it to credit grantors and lenders. Information is collected on both individuals and businesses for a period of seven years. After that, it is removed from their files.

The three major credit bureaus in Canada are Equifax Canada, TransUnion of Canada, and Northern Credit Bureaus.

Credit Rating

A credit rating is an indication of the level of risk that a consumer, business, or government will pose if credit is granted.

16

Chapter 15: CreditCredit Worthiness

Getting a Credit HistoryStudents usually do not have any credit history, which makes it difficult for them to receive a loan for education, for transportation, or to start a business. Ways for students to achieve worthiness in lender’s eyes include

• obtaining good marks and attending school• getting and keeping a job• buying something on credit and paying it off before interest is

charged• taking out a small loan• having someone, such as a family member or close friend with a

good credit rating, co-sign a loan

Checking Your Credit FileOnce a credit rating is established, it is a good idea to check it periodically by contacting one of the credit bureau(s).

17

Chapter 15: CreditCredit WorthinessCredit CrisisIt is important to re-examine spending habits and get out of debt when in crisis. Signs of credit crisis include

• consistently unable to pay off your credit cards• using cash advances for everyday living expenses• not knowing how much debt you have• seeming to always be in debt

Getting out of DebtThe steps towards getting out of debt include

• contact and explain difficulties to creditors• be honest and realistic when working with creditors on a plan• pay a portion of overdue payments• put away credit cards• seek help from credit counselling services