Chapter 15: Credit
The 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.
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Chapter 15: Credit
The 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
• instant enjoyment
• convenience
• emergency needs
• saving money
• credit rating
• monthly statement
Disadvantages of Consumer Credit
• credit costs
• overbuying
• impulse buying
• financial difficulties
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Chapter 15: Credit
The 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.
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Chapter 15: Credit
The Wonderful World of Credit
Business Credit
Businesses 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
• finance major purchases
• use of corporate credit cards
• consolidate payments
• overcome cash-flow shortages
Disadvantages of Business Credit
• increased costs
• defaulting on a loan
Why Business Grant Credit
Financial institutions and retail businesses grant credit to consumers.
Retailers offer credit to increase sales, attract customers, and to
potentially collect interest charges.
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Chapter 15: Credit
Types 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 Cards
The 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 Cards
With 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.
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Chapter 15: Credit
Types 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 Cards
Retailers 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
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Chapter 15: Credit
Types and Sources of Credit
Installment Sales Credit
Installment 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.
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Chapter 15: Credit
Types and Sources of Credit
Loans
Loans 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 Loans
A 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.
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Chapter 15: Credit
Types and Sources of Credit
Demand Loans
A 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 Loans
Guaranteed 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.
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Chapter 15: Credit
Types 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.
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Chapter 15: Credit
The 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 borrowed
Term – period of time
Mortgage Calculator.
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Chapter 15: Credit
The Cost of Credit
How to Calculate Simple Interest
The 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 Collateral
Often 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.
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Chapter 15: Credit
Credit 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.
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Chapter 15: Credit
Credit Worthiness
Capacity
Capacity 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.
Capital
Capital 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.
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Chapter 15: Credit
Credit 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.
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Chapter 15: Credit
Credit Worthiness
Getting a Credit History
Students 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 File
Once a credit rating is established, it is a good idea to check it
periodically by contacting one of the credit bureau(s).
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Chapter 15: Credit
Credit Worthiness
Credit Crisis
It 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 Debt
The 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
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