Managing your credit
Borrow smart. Live well.
Credit is one of your most powerful financial tools. Managing it properly can help you achieve major personal goals like home ownership, a major renovation, or acquiring that coveted vacation property. If not carefully handled, however, it can result in financial hardship. Here are a few things to think about when it comes to ensuring your debts are all to your credit.
Statistics Canada reports current low interest rates are prompting Canadians to save less and borrow more than ever before. Recent studies identify BC household debt as one of the highest in the country, with a debt-to-income ratio of 160% (the national average is 127%). Of course, much of this is real estate debt.
Inevitably, interest rates will rise again and this could mean trouble for some households with large floating rate loans like mortgages. For example, a $500,000 25-year mortgage at 3.6% costs $2,500 a month. A 1% interest hike will add $300; 3% will add $800 a month.
Credit counsellors suggest that total debt payments – including your mortgage – should consume less than half your after-tax income. Realistically, that figure will be a bit higher in the Lower Mainland where real estate is expensive. Managed well, your debt and subsequent credit rating can help you move towards building financial security. That said, it's important to distinguish between "good" debt and "bad" debt.
Good debt is an investment.
Good debt consists of loans aimed at building long-term financial security, ideally at reduced cost thanks to tax breaks. Here are some examples:
- Student loans. A recent economic study found that, on average, university graduates earn 20% more than those without degrees. Many people already in the workforce boost their earnings potential by returning to school to upgrade their skills. Especially popular are graduate degrees, such as an MBA. Note that there's a tax credit for interest paid on loans granted under government programs. In addition, as a student you may be able to claim tuition, textbooks and education tax credits.
- Home mortgage. A well-chosen residential property will likely increase in value, particularly in the greater Vancouver market. Even better, the gain is tax-free if the property is your principal residence. Meanwhile, you get the enjoyment of living in it. Plus, home mortgages are normally the cheapest loans around if you put down at least 30% of the home's value.
- Business loans. Prudent borrowing makes it possible for entrepreneurs to start and build their own businesses. If the business is a qualified small business corporation, the shares may be eligible for a lifetime capital gains exemption of up to $800,000.
- RRSP loans. Short-term RRSP loans can help build retirement savings while potentially resulting in a tax refund which can be used to reduce the debt. Longer-term RRSP catch-up loans can help by imposing discipline, such as an automatic monthly repayment plan.
- Borrowing to invest. An investment loan can be good debt if you invest wisely. Under current regulations, the interest may be tax-deductible if the investment has the potential to generate taxable income.
Bad debt costs you in the long run.
The most obvious example of bad debt is a high-interest credit card where you carry a balance, month after month. The best strategy for minimizing your exposure to this kind of debt is to use credit cards for convenience, and then pay them off in full each month, or transfer your balance to a lower-interest line of credit.
Other examples of what might be considered bad debt are any other loans that aren't contributing to your long-term goals or have high interest rates. If you have funds sitting in low-interest savings accounts or cashable term deposits (outside of your emergency fund), use them to pay down these debts. This will deliver an instant return on your money that's hard to beat.
Home Equity Line of Credit
If you don't have extra cash available to pay down or consolidate expensive debt, consider drawing some from a Home Equity Line of Credit. This way you'll be exchanging an expensive form of debt for a cheaper one.
Remember if you don't pay your credit card balances in full, everything you charge could eventually cost much you more than the price you saw in the store. Before buying an item, ask yourself how it will enhance your life over the long term. That's the crux of distinguishing between good debt and bad debt.
Using credit strategically today helps determine what you can borrow tomorrow.
Credit ratings are key to whether you can get a loan, rent an apartment or open a utility account without posting a deposit. A high score can translate into lower borrowing costs when you apply for a loan. Two services – Equifax and TransUnion – compile your credit history and score your reliability in paying it back.
How do these credit reporting companies get this information? From you. The fine print on each loan or account application you sign authorizes that company to provide data to a credit reporting agency. The agency maintains a file that other vendors can check whenever you apply for credit.
For a small fee, you can take a look at your own credit history and find out your score. Even if you have a clean credit history, it's important to know your credit score and know which organizations have checked your record. Review your report for errors. Uncorrected mistakes can affect your credit profile, lowering your credit worthiness.
How to improve your credit rating.
If you find that your score is less than ideal, you can improve it by limiting the number of loan and credit accounts you have and avoid getting too close to your borrowing limit. Looking for credit too often and pushing against your loan limits can raise alarm bells about your ability to repay your debts.
Smart use of your credit card helps maintains a good credit rating.
It is important to have a credit history. If you don't have one, you can begin by using a credit card – as long as you use it wisely.
- Pay the full balance amount on time each month and you'll build a solid payment history that will benefit your credit rating. If you aren't able to do this, pay at least the required minimum amount shown on your monthly statement.
- Make sure your monthly statement is correct. Report any unauthorized transactions on your account. Contact your credit issuer if your bill includes items you didn't buy. Keep up to date on any fee increases or changes in your card's terms and conditions.
- Deal with companies you know and whose security measures you trust.
- Get a copy of your credit report from one of the two credit-reporting agencies at least once a year and make sure they're accurate.
- Contact your creditors if you're having trouble making payments.
- Don't go over the credit limit on your credit card.