The Ultimate Guide to Credit: Simplifying Credit And its Rules.
The ability to effectively understand and manage your finances is a crucial skill every Canadian must develop. Financial literacy helps you to stay out of debt, obtain loans, and generally breathe easier knowing you have good credit. But what is Credit itself?
What is Credit?
Credit is an arrangement (agreement) between a lender and a consumer who is allowed to access goods and services that are paid for at a later date. This type of contract stipulates that the consumer repays the full value of the loan as well as any accumulated interests or fees.
The contract will contain the agreed-upon interest rate, the value of payments to be made, when payments should be made, and the length of the repayment period. All the relevant conditions must be clearly outlined and fully understood by the consumer before any purchases can be made with the loan.
Types of Credit
Credit accounts fall into two main categories, namely installment credit and revolving credit. Both credit types operate differently based on how payment is processed and how they are reported.
An installment credit account is easily identifiable by a few defining features. It’s a close-ended loan with clearly specified payment terms; it has a clearly outlined repayment schedule with definitive repayment period.
In installment credit accounts, the term “utilization ratio” refers to the ratio of the amount owed to the amount that’s already been paid. Your utilization ratio tends to be higher in the beginning – before the loan has been paid off – and reduces as the loan gets serviced. Some examples of installment credit include mortgages, car loans, student loans, personal loans, and traditional business loans.
A revolving credit account operates on easily identifiable conditions: a set credit limit is established with the required minimum monthly payment; interest is charged to the borrower if balance is carried from one month to another.
A revolving credit account offers the borrower a level of flexibility since you are allowed to make purchases while waiting for cash supply. However, this comes at the price of high-interest rates and a bit more risk.
The Different Types of Borrowers
There exist two classifications of borrowers concerning revolving credit contracts. They are classified based on a system that identifies their unique behaviors. The types of borrowers are:
Transactors, are individuals who have a set limit on their line of credit – e.g., credit card. They only spend a portion of the imposed limit and go ahead to pay for the balance monthly fully. Transactors enjoy the benefit of not having to pay additional interests on their loans. Transactors generally have favorable credit reports.
A revolver is an individual who spends more out of their limit than they repay. Assuming you have a C$5000 monthly limit on your credit, you spend C$4000 from it but only pay back $1000. This means that you will carry the remaining balance of C$3000 into the next month and the accompanying interest charges. This can quickly add up and put you in danger of being a delinquent payer.
Thoroughly understanding the differences between both groups and their accompanying penalties will help you in securing a positive credit report.
What is a Credit Report?
A credit report is a representation of your financial history as controlled by credit bureaus. Credit bureaus are agencies that gather an individual’s credit data and summarize it on behalf of lenders. Canada has two national credit bureaus – TransUnion Canada and Equifax Canada – that collect your information and calculate your credit score using a formula called the FICO algorithm.
Your credit score greatly influences your ability to open credit cards or apply for loans based on your financial management history. Your credit score also affects loans taken out for your business. Factors like your credit history, credit utilization, payment history, and any applications for new credit are put into consideration for your credit score. Lenders rely on credit scores to determine the probability of an individual paying back on a business loan according to schedule.
Who Has Access to Your Credit Report
Insurance companies, banks, utility companies, lenders, employers, and landlords all require permission to access your credit report. The report helps to give a clear insight into your financial history.
There are specific scenarios in which express permission is not required to view your credit report. These are referred to as “soft inquiries or soft pulls” and do not impact your overall credit score. Still, a legitimate need must be established before such an inquiry can be made.
The other scenario is a hard inquiry that can reflect on your report for up to two years and can be seen by anyone who requests for your credit report. Hard inquiries are made when you apply for things such as credit cards, student loans, utilities, mortgages, phones, and others.
Other instances that do not require permission to view your credit report include the following:
- When responding to a court order or a grand jury subpoena
- When you apply for a license or any other government-provided benefit that requires a financial check by law
- For risk assessments that are carried out by an investigator
- Specific circumstances for the determination of child support
Rating your Credit score
An individual’s credit score is rated on a scale from 300 to 900. The higher the number, the greater your credit score. Typically, a score between 760 – 900 translates to ‘excellent credit’ and will allow you to acquire future credit if you should need it.
A credit score between 725 – 759 is considered to be ‘good credit,’ and you will be able to access credit from banks at their advertised rates.
A score that falls between the range of 660 – 724 is considered as ‘fair credit.’ You might be able to secure new credit but at slightly higher interest rates.
Scores between 560 – 659 are considered as ‘poor credit’ and severely limits your borrowing options to high-risk lenders. Any score below the 559 mark will not be allowed to access new credit and is tied to significantly higher interest rates.
How to Fix Your Credit
Performing credit-positive actions such as paying your bills on time, fixes your bad credit score. Also, limiting the amount of new credit and reducing debt over some time will help with repairing bad credit scores.
Properly managing your credit score will make life easier and give you ready access to goods and services that are beneficial to your life goals. You have a responsibility to thoroughly understand and stay on top of your credit management since errors can occur on it.
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