What is credit?

Credit plays an integral role in your daily life, and you've likely already been exposed to it without even realizing. A credit card is the most obvious example, but did you know your cellphone contract is also a form of credit?

Although most people associate credit with loans or credit cards, it actually has a broader definition. Think of credit as any contractual agreement you have where you’re getting something of value now, but it’s understood that you’ll need to make a payment later, likely with interest. That’s why your cellphone contract counts as a form of credit. You get the service right away, and then you pay for it later when your monthly billing cycle ends.

Credit is also relevant to you since everyone has a credit score. This number is a quick glance at your credit history which allows financial institutions to gauge how creditworthy you are. Maintaining a good credit score is vital if you ever need a loan in the future. Even if you don’t need access to funds now, you should always strive to maintain a good credit score.

When asking “What is credit?” you need to think about the context. Many people only associate credit with paying their bills and their credit score, but there’s so much more to it. Here’s everything you need to know about credit.

How does credit work?

In most cases, credit is used to purchase a good or service now, which you’ll pay for later. This is handy for people who don’t carry cash or currently don’t have the funds available to make the purchase. Of course, you need to pay for these purchases later. With credit cards, you get an interest-free grace period, but you’re expected to pay things back when your bill arrives.

Although merchants have to pay an interchange fee to the credit card issuers when customers use credit cards for purchases, it’s still beneficial to them since it gives consumers more options to pay. Plus, it’s been proven that people tend to spend more with credit, so by allowing it to be a payment option, their sales could potentially increase.

It’s also possible to have a negative credit balance on your credit cards. Let’s say you just paid off your credit card bill of $500 in full. A week later, you return an item that costs $200. Your statement would then show a credit of minus $200. You wouldn’t owe anything until you’ve made purchases that exceed your negative balance. In short, you’ve essentially overpaid your bill.

Also, note that credit is an accounting term that may benefit you in one way or another. Let’s say you bought a plane ticket, but your plans have changed. Airlines don’t typically issue refunds, but they may give you credit (minus any fees) that can be used for future travel. You won’t be able to use that credit at any merchant, but at least you’ll be able to use it with the airline at a future date.

Remember, credit is a contractual agreement. When dealing with credit cards and major merchants, they’ll likely have formal rules in place. However, if you’re at an independent store, you’ll want to have something in writing if you’re offered credit instead of a refund.

"Think of credit as any contractual agreement you have where you’re getting something of value now, but it’s understood that you’ll need to make a payment later, likely with interest."

What are the different credit options?

The different credit options available work in various ways and can be advantageous in the right circumstances. That said, if not used properly, credit products can affect you financially. Here are some of the most common credit products and why you would want to consider them.

Credit cards

Easily the most common form of credit, credit cards allow you to make purchases that you don’t need to pay back until the due date. If you pay the full balance on time, no interest is charged. That said, if you make a payment of anything less than the entire amount, you’ll be paying some pretty hefty interest charges (usually 20%).

Student loans

Many students and new grads are familiar with this type of credit. They’re a great way to pay for your education, and interest rates are typically lower than traditional loans. You may not have to start repaying your loan until you finish your schooling, but that just means you’ll be graduating with debt.

Mortgage

Most people don’t have enough cash on hand to buy a home, so they’ll need to get a mortgage. Every mortgage is different since terms, interest rates, and payment schedules can vary. If you miss your payments, you could face penalties. That said, if you’re struggling with payments, refinancing can sometimes help you manage your budget.

Line of credit

A line of credit is a pre-approved loan that you can access at any time. The interest rate is often low, so it’s an excellent tool to use if you want to reduce any outstanding debt. The minimum payment is typically interest only, which can be appealing. However, you could end up never reducing your debt if you’re not focusing on repaying the entire loan.

Payday loan

When people need access to cash fast, a payday loan can be an easy solution. Terms may seem reasonable, but when you do the math, the interest rates are often astronomical. Since your next paycheque is used to repay your loan, you could fall into a debt cycle.

Whenever you use any type of credit, you’ll want to understand the terms and how much interest you’re paying. In some cases, you don’t have a choice but to pay the charges. However, with a product such as credit cards, you should always strive to pay the full balance, so you’re not spending more than you have to.

How does interest work?

When you borrow money with credit, there’s an interest rate involved. You also earn interest when you save. Many people don’t realize that there are two methods used to calculate interest: Annual Percentage Rate (APR) and Annual Percentage Yield (APY). APR is typically advertised whenever you borrow money, while APY is often used for savings rates. The two calculations are very different and could significantly affect how much you’re paying or earning.

APR is easy to understand since it’s known as simple interest. It’s how much interest you’ll pay over a given time. Let’s say you’re buying something on credit that costs $1,000 and has an interest rate of 12% APR. You’d pay $120 interest over the year, or $12 a month. While APR is a great quick calculation, it doesn’t factor in compounding, which is the actual borrowing cost.

APY takes into account compounding, which is interest on interest. With loans/credit, there’s always a compounding period (annually, semi-annually, etc.), which increases your borrowing costs. For example, let’s say you plan on getting a mortgage and the advertised interest rate is 5% APR. You may not realize that mortgages in Canada are compounded semi-annually, so your true cost to borrow is 5.063% which is the APY.

The above example may not seem like a big difference but think about other forms of credit that could get you into trouble. A payday lender might advertise a loan of $300 for two weeks at a fee of $60. That looks like a reasonable amount since you’re paying $22 for every $100 you’re borrowing, or 22% interest for 14 days.

However, when you do the math and factor in the compounding period, there’s a significant difference. The loan is for 14 days, but there are 365 days in a year. That means your compounding period is actually 26.0714 (365/14). When you multiply the interest rate of 22% with the compounding period of 26.0714, your real interest rate is 573.57%!

Whenever you use any form of credit, you need to understand what it’s costing you. Some credit products have reasonable interest rates and can be used to help you reduce your debt. However, other options could put you in a debt trap that’s hard to escape.

What is a credit score?

How you use different types of credit can affect your credit score. When used responsibly, your credit will improve your credit score over time. That said, one or two mistakes such as not paying your bills or maxing out your cards could quickly tank things. Having a good credit score is crucial if you ever want a loan in the future. Since your credit score is a quick glance at your trustworthiness with debt, lenders use it when deciding if they’re going to give you a loan or extend you credit.

Your actual credit score is a number between 300 and 900. The higher your credit score, the more creditworthy you are. Although there are two credit bureaus: Equifax and Transunion, they both use a similar rating system. You can see how you’re doing just by looking at what your credit score currently is.

• Below 560 — You’re in poor standing.

• 560 - 660 — This is a fair score, but you’ll likely still run into issues when applying for credit.

• 660-724 — This is considered good, but you may not get the best terms.

• 725 - 759 — When you’re in this range (very good), you’ll get approved for most loans.

• 760+ — Any credit score in this threshold is considered excellent. Lenders will likely be happy to extend you any credit that you’re looking for.

It’s important to note that your credit score is just one thing lenders look at when they’re considering your application for additional credit or a loan. Even if your credit score is excellent, the lender may have other concerns. Since every lender has different criteria when extending credit, it can sometimes be worth it to shop around.

"Since your credit score is a quick glance at your trustworthiness with debt, lenders use it when deciding if they’re going to give you a loan or extend you credit."

How do I build my credit score?

Improving your credit score is quite easy, it just requires a little bit of work and smart spending. First off, you’ll want to find out what your credit score is. Borrowell, a Canadian fintech company, allows you to check your credit score for free. Alternatively, you could check directly with Equifax or Transunion. Once you know your number, you can implement the following steps to maintain or improve your credit score.

1. Pay your bills on time and in full

Whenever you get your bills, you need to make the minimum payment at the least. Failing to do so will tank your credit score pretty quickly. That said, you should always strive to pay off the full balance as it’ll reduce how much you owe and your utilization ratio.

2. Keep your utilization ratio under 30%

How much credit you’re using relative to what you have available to use, is known as your credit utilization ratio. Let’s say you have a credit card with a total limit of $10,000. You regularly have a balance of around $4,000. That would mean your utilization ratio is 40%. Even if you pay that balance off every month, your average charges still apply. Ideally, you want to keep your utilization ratio under 30%. You can do this by reducing the amount you charge to your card or you could request a credit limit increase. Mind you, if you increase your credit limit, you could just end up spending more.

3. Start building your credit now

If you’ve been relying on a joint credit card or cell phone plan with your parents, it’s time to break free. You’ll want things in your own name, so your credit history starts building. This is also important since the length of your credit history helps determine what your credit score is.

4. Avoid how often you apply for new credit

Every time you apply for a new credit product, a hard inquiry will usually be performed. When this happens, your credit score drops by around 10 points. It’s not a big deal if you’re applying for a new credit card once a year since your score will go back up eventually. That said, lenders will question things if you’re applying for, say 3-4 cards in a short period.

Can someone with a low credit score get access to credit?

New grads who don’t have a credit history and people who have made credit mistakes in the past will usually have a low or nonexistent credit score. The good news is that you still have options if you’re looking to access credit.

KOHO, for example, is a prepaid Mastercard that allows you to load funds. You can use your card in-store or online wherever Mastercard is accepted. Although prepaid credit cards don’t typically improve your credit score, KOHO has a Credit Building feature that can help. For $10/month, this 6-month long program, which is renewable, will report your payment history to a major credit bureau.

Another option is to get a secured credit card. With these types of credit cards, you deposit a fixed amount of money onto your card as a security deposit. This is required because the credit card provider wants to see that you’re serious about improving your credit. That deposit is usually tied to your spending limit. For example, if you put down $300 as a security deposit, your limit would be $300. You can’t use that money to pay your bills, but you would get it back if you ever cancel your card.

If you use a secured credit card and KOHO’s Credit Building tool, you could potentially build your credit history quicker since you’d have two different forms of credit reporting to the credit bureaus.

Although you can choose to limit how often you use credit, there’s no denying it plays a part in your everyday life. You can use it to make purchases, access services like electricity and your mobile network, and much more. And, sometimes it’s mandatory to have a credit card, such as when making hotel reservations. By understanding how credit works, the cost of the credit you receive, and how it affects your credit score, you can make smarter financial decisions for your bottom line.