The Beginner’s Guide To Credit
In a recent conversation with my dentist friend, I discovered that I should not stereotype a person’s financial knowledge based on their profession.
We can usually safely assume my dentist friend’s above average IQ, but does not mean it overlaps into other categories; his job is to make sure your teeth is sparkling clean after all.
Like the lot of you, I expected Josh to be a “smart guy” as well, but turns out he did not have a fundamental grasp on the basics of personal finance!
I am not degrading him, however, it just further cements my belief in how the Canadian public is so oblivious to personal finance regardless of their level of intellect.
Therefore, I was inspired to start this blog to promote about personal financial health. Today, our topic will be all about credit.
WHAT IS CREDIT?
Credit is the act of using someone else’s money and promising to pay it back.
This is a very important definition to understand. I will break it down into two parts:
- Using SOMEONE ELSE’S money; it is the money that you do not have at the moment, therefore you need to borrow it from “someone else” (e.g. bank, credit union)
- PROMISING to pay it back; read that again, yes, you will HAVE to pay it back or else there will be consequences such as increasing interest rates, product termination or in the case of loan sharks you may lose a finger or two
So who came up with this crazy idea?
Believe it or not, this ingenious concept first originated in Edward Bellamy’s novel written in 1887, Looking Backward, in which a rations card was issued to citizens for spending their dividends from the government. Eventually, some really smart people took this idea and found a way to weave it within the Western society ever since.
Now, please let my business school professor give you a real life example of credit.
When you go to Costco you will have two options to pay for your groceries. You can use either your hard earned cash or credit card. When you use cash you will experience the pain of each bill leaving your hand one by one, thus leading you to reconsider your choices on those delicious fat inducing chips.
When you use your credit card, you do not experience any emotional stress, ding, money swiftly transfers into the cashier’s register from the plastic card.
Now, before you start to fight the system and decide to go off the grid. The truth of the matter is, credit is so deeply entrenched into today’s financial system, there is no way to get rid of it!
This intangible thing is what lenders use to judge you when you need to borrow money. Whether it is applying for a credit card, buying a car or house, you need to understand a key statement:
HAVING NO CREDIT IS JUST AS BAD AS HAVING BAD CREDIT
For example, an 18 year old would walk out of a dealership disappointed after getting denied to purchase a new ride.
Why was he not able to get a new car?
Because he does not have credit. He did not get declined due to bad credit, but merely his credit does not even exist. In Canada, a Western country, it is easy to understand this need for credit, but for the newcomers from other countries that use cash for most purchases, this concept baffles them.
Particularly, Asian countries do not understand the need to establish credit right away upon arrival.
HOW DO YOU GET CREDIT THEN?
Majority of the banks in Canada adjudicate you based on a general guideline that incorporates both qualitative and quantitative measures called the Five C’s of Credit.
Five C’s of Credit:
Character:
No, this doesn’t refer to your zodiac sign, it is about your track record on repaying debts. In the 18 year old’s case, he has zero credibility therefore he will have to ask a co-signor with established credit to buy the car with him.
Capacity:
This one refers to your current income versus your recurring debts. If you must pay $60/month in cellphone bills and you only make $60/month in income…
Why would anybody lend you money?
Capital:
In caveman terms, it is the money that you already have in your account. If you have $10,000 in cold hard cash and you wanted to borrow $5,000, the lender knows you at least have enough money to pay them back. This will make the lender more reassured in lending to you than the other guy with $100 in their wallet.
Collateral:
This means the stuff you have of value in case you decide to not pay back the lender. In the case of getting the car, the lender will take back your car if you decided to stop paying them back.
Conditions:
This is about what the borrower intends to do with the money. It is easier for the lender to give you money if your purpose is clear cut such as buying a car. For example, if you go to a lender asking for money to open a marijuana dispensary but do not have a clear business plan, then most likely the lender will not approve of the credit.
Now that you understand how credit is approved, that is only half of the battle.
Majority of Canadians fall into debt because they fail to recognize the importance of credit after they get approved. You can view credit as a grown-up report card, which is heavily scrutinized whenever you wish to ask for lending.
WHY IS CREDIT SO IMPORTANT?
In Canada, there are two credit bureaus TransUnion and Equifax. I recommend calling them yearly to get your free credit report card to see where you stand.
You start at the top with 900 points and for each boo-boo you make, you get points reduced. The two bureaus also offer plans that cost $19.95/mth to continually check your credit score. You will need to stay on top of your credit assessment; whether you are recovering from debt, monitoring your credit health or just plain paranoid, it doesn’t hurt to keep track of your rating.
Keep in mind, you get one freebie each year and any additional credit check will cost you in fees and credit score reduction; think about it logically, if you have great credit why do you have to keep on checking it?
HOW ARE WE JUDGED?
The main indicator to the credit bureau is credit utilization. This means you will have to use your credit product and then pay it off on time in order to maintain a history of usage.
In other words, if you have a credit card and you never use it, it doesn’t actually help much in building your credit.
For example, having a credit limit of $10,000 on a line of credit is great but you will have to use it and repay it in order to establish a track record. And this track record is what the bureaus use to “judge” your credit score.
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By now, I hope you have had a firm grasp on credit and its attributes and implications. I know it’s fairly basic stuff, but let’s not kid ourselves here… currently there is $1.79 in credit market debt for every dollar of disposable income in Canadian households.
Falling into debt sucks, but the root of evil is the neglected education of financial relationships we have with our money. Studying and understanding credit is the first thing we can do to arm ourselves in prevention of debt. So do yourselves a favor and keep on rocking with me, as I will continue to update with more posts in regards to personal financial health.
In the meanwhile – stay thrifty
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