What is Credit?
Credit is a deferred payment arrangement between a borrower and a lender that facilitates access to funds for repayment at a later date. Common types of credit include installment loans for large purchases such as a home or a car, as well as revolving credit arrangements including credit cards and lines of credit.
Types of credit fall under two main categories: Secured, where the borrower pledges a specific asset (such as investments or a home) as collateral; and Unsecured, where funds are borrowed without collateral. Given the reduced risk to the lender, secured forms of credit usually offer lower interest rates and higher credit limits.
The cost of credit
To cover the risk and costs associated with extending credit, a lender will charge the borrower interest or service charges depending on the agreement. These extra charges — the cost of credit — consist of any amount that exceeds the amount borrowed (the principal).
The amount of interest you are charged by a lender is determined by several factors. These include the prime rate, the type of lending product you want, the amount you wish to borrow, and the term over which you plan to pay the funds back. Of primary concern to a lender however, is your “creditworthiness” or ability to repay the loan. Before extending any kind of credit, a lender will carefully consider your income, the amount of debt you already have and your repayment history.
Why use credit?
Access to credit lessens the burden of paying cash outright for high-cost items, allowing you to spread the expense out over time. Credit is what makes purchasing major items like homes and cars possible for most Canadians, even those with substantial savings. Credit is also convenient, safe and easy to manage provided you stay on top of your monthly obligations.
Maintaining good credit
Establishing and maintaining good credit is essential in using lending products for major purchases. Keep your credit in good standing by honouring the terms of your agreements. Missing payments, making late payments or consistently exceeding your authorized credit card limit will negatively impact your credit privileges in the future. Every form of credit you carry, regardless of the amount, is an important part of your credit history and can affect your credit rating.
What is a credit rating?
In Canada, there are two large credit-rating agencies (Equifax Canada and TransUnion Canada) that track one’s credit rating.
Your credit rating is used to create a credit-rating number, or “credit score.” A high score tells potential lenders that you pay your bills (such as telephone, cable, and hydro) and repay loans on time.
Lenders check your credit rating to determine whether to give you credit, and how much. You have the right to know what information is in your credit file, and can get a free copy of it by contacting one of the two credit rating agencies listed above.
How to establish a credit rating
As a newcomer, you have no Canadian credit rating. One of the easiest and most effective ways to build a credit history is to get a Canadian credit card.
Credit cards can be “secured” or “unsecured.” As you use your credit card, you establish your credit history.
In addition to being a convenient way to make purchases, a credit card is:
- Useful as identification
- Interest-free, if the balance is paid in full every month on, or before, the due date
- Safer than cash
- A means of paying for items online
- The preferred means of payment for hotel bookings, car rentals, and airline tickets