Understanding Credit: Types, Sources, and Costs

Choosing a Source of Credit

• Credit always has a cost
• Weigh the benefits of credit versus waiting

Important Questions to Ask

• Is the loan necessary?
• Can the loan be afforded?
• Are you able to qualify for a loan?

When to Avoid Credit

• When the financed product is not needed or desired
• When the purchase can be made in cash

Types of Credit

• Installment loans
• Revolving credit

Sources of Loans

• Inexpensive loans can be sourced through parents or family.
• Medium-priced loans can be sourced through chartered banks, trust companies, and credit unions.
• Expensive loans can be sourced through finance companies, retailers, and bank credit cards.

Student Loans

• Inexpensive loans are available from the Government of Canada for post-high school education.
• Interest rates on student loans are lower than commercial rates due to federal subsidies.
• Repayment of student loans typically begins after completing education.

Effective Cost of Borrowing Factors

• Quoted APR
• Compounding frequency
• Upfront interest
• Other fees

Annual Percentage Rate (APR)

• It is the yearly cost of credit
• It can be compounded more frequently
• Effective Annual Interest Rate (EAR) may exceed APR

Effective Annual Interest Rate (EAR)

• EAR provides a true interest rate for comparison
• This allows for comparison when shopping for rates

Effective Annual Percentage Rate Formula

• EAR = (1 + APR/m)^m - 1
• m = number of times interest is compounded per year

Example of EAR Calculation

• Borrow $100 with a 6% annual interest rate, compounded semi-annually
• EAR = (1 + 0.06/2)^2 - 1 = 0.0609, therefore EAR = 6.09%

APR and Compounding Frequency

• The EAR increases as the compounding frequency increases

Managing Loan Trade-Offs

• Longer loan terms yield lower monthly payments but increase total interest paid.
• Reducing lender risk can be achieved by accepting a variable interest rate, providing collateral, making a large down payment, or opting for a shorter loan term.

Types of Loan Payments

• Fixed Rate Installment Loan allows payoff over a time period with payments of interest and principal.
• Floating Rate Personal Line of Credit has rates tied to the lender's prime rate, compounded daily and without fixed payments.

Fixed-Rate Installment Loan Example

• Peter MacLellan buys a used car with a $10,000 list price, 13% sales tax, totaling $11,300
• Peter pays $6,300 down and takes a $5,000 loan repaid in monthly installments over a year
• The bank quotes 6% fixed rate compounded monthly, so Peter's monthly interest rate = 0.5% (6%/12)

Cost of Credit and Expected Inflation

• Borrowers and lenders are concerned about purchasing power
• Inflation decreases the purchasing power of money

Minimum Monthly Payment

• It is the smallest amount you can pay to remain a cardholder in good standing and it is not the total amount due
• Paying only the minimum results in accrual of more interest

Types of Credit Insurance

• Credit Life Insurance
• Credit Accident and Health Insurance
• Credit Property Insurance

Managing Debts Effectively

• Bills may become impossible to pay due to sudden illness or job loss
• You can contact creditors to negotiate an adjusted payment plan
• Vehicles can be repossessed for default on payments
• Investigate debt counseling services before using them

Warning Signs of Debt Problem

• Emotional problems
• Using money as punishment
• Expectation of instant gratification
• Keeping up with the Joneses
• Overindulgence of children
• Lack of communication among family
• High finance charges

More Warning Signs of Debt Problems

• Continually exceeding credit limit
• Relying on credit card for necessities
• Borrowing to cover expenses until the next paycheck
• Garnished wages
• Paying only interest or service charges monthly
• Pressured or threatened by creditors
• Utility disconnections for unpaid bills

Consequences of Debt

• Job loss due to wage garnishment
• Neglecting family health and education
• Alcohol or drug abuse
• Marital issues
• Child neglect

Consumer Credit Counseling Services

• Contact creditors or non-profit financial counseling for bill payment assistance
• Credit counseling activities include aiding families with money management and preventing future debt

Federal Government and Finances

• Information can be found online

Declaring Personal Bankruptcy

• Increasing numbers of well-educated, middle-class individuals are filing due to credit card debt
• In 2021, Canadian consumer bankruptcies and proposals occurred at a rate of 2.9 per 1,000
• This percentage is expected to rise with increasing interest rates

Fending off Bankruptcy

• Advantages of debt consolidation loans are single interest rate and extended terms for smaller payments
• Disadvantages include higher interest rates and total costs

Consumer Proposals

• It is a maximum 5-year plan for paying creditors all or a portion of a debt owed
• Requires insolvency and less than $250,000 in debt (excluding home mortgage)
• Must be approved by the court and creditors
• It could prevent bankruptcy

Bankruptcy and Insolvency Act

• It is a federal law in force as of July 7, 2008
• It applies to income tax debt, consumer proposals and student loans
• Registered Retirement Savings Plans are exempt (one-year clawback)
• Individuals owing more than $200,000 with over 75% unsecured liabilities must go to court
• The threshold was raised to $250,000 per person or $500,00 per couple

Effects on Future Credit

• It makes obtaining future credit more difficult
• Consumer proposals are easier
• A bankruptcy remains on your credit file for 7-14 years
• There are significant costs for filing proposals and bankruptcy

Key Formulas

• Effective Annual Interest Rate: (1 + APR/m)^m - 1
• Installment Loan Payment: complex formula
• Monthly Interest in a Line of Credit: Interest = B × APR × (n/365)