Module 2 - Debt and Borrowing

McGill Personal Finance Essentials

Transcript
Module 2: Debt and Borrowing, Part 1

Hi! I'm Amanda Abrams. I'm a chartered professional accountant and a professor at Desautels
Faculty of Management at McGill University.

In this module, we'll be covering the topic of debt and borrowing.

When it comes to financial debt, they are two extreme mentalities that tend to exist. The first
being: "Debt is bad! I should avoid it at all costs." The second one is: "Why wait? Free money!
Buy now, pay later” mindset.

The truth is neither of these philosophies are correct. And yet, there are some elements of each
that are valid. Today, it's simply unrealistic to preach that we should aim to live completely debt
free.

So that being said, how should we be using debt? Throughout this module, we are going to
address just that by discussing the following debt and borrowing topics. First, I'll provide an
overview of some of the more common sources of debt identifying their basic features and some
key considerations that you should be taking into account when determining which sources of
debt are most appropriate for you.

We'll then learn about credit scores and how they work. And how you can manage and improve
your credit score. We'll finish off with some key takeaways or cardinal rules for borrowing.

Chapter 1: Common Sources of Debt

Why do people borrow money? One of the most obvious benefits to borrowing money is that
you're able to buy things or have experiences now that you wouldn't otherwise be able to do like
going on a trip, buying furniture, buying a car or a home.

However, there is a cost to debt and bearing in mind that you must repay it along with all of the
other interest and fees that are associated with it. It's very important to make an informed and
educated decision about what forms of credit you can use. And which are most appropriate for
you.

Generally, when comparing the different sources of credit, you'll need to consider the credit limit
available to you, meaning; how much money are you able to borrow using this source? How
easily can this debt be obtained? What is the cost of borrowing? And this is not always
something that's made transparent. So, it's necessary to really understand the terms that are
associated with the debt.
When does it need to be repaid? How often do your payments need to be made? Are there any
other benefits to using this form of credit over another? Let's start off with credit cards.

Credit Cards
Credit cards are issued by financial institutions and certain retailers. These cards allow you to
pay for goods or services contingent on your promise to repay the issuer based on an agreed-
upon term.

When you make a purchase using a credit card, either physically in store or using the credit card
information online, the issuer is providing the funds directly. And they will then collect the
payment from you.

Credit cards are generally easier to obtain compared to other forms of debt. Credit cards are
widely accepted as valid forms of payment and often required for virtual purchases. They're
linked to smartphone applications and most credit cards can often be used internationally, which
is convenient for someone who travels often.

    
Another common advantage of using credit cards are rewards and benefits offered by many
credit card issuers. For example, depending on the credit card that you obtain, you can earn
loyalty points for purchases made using the card that can then be redeemed for other goods and
services such as hotels, flights, etc.
    
Using your credit card responsibly has benefits as well. It helps to establish your credit history
and by making regular payments, preferably paying the entire balance in whole each month, you
are building up good credit. And that will be incorporated into your credit score. We'll cover this
later.
    
Before applying for a credit card, you should compare all of the different types of cards available
to you. Different credit cards may vary significantly.

Some of the important features that you'll want to compare are the annual interest rates, annual
fees, other fees charged for various types of transactions like cash advances, foreign currency
transactions, balance transfers, and many others.
    
Annual interest rates for credit cards are generally between 15% and 20%. However, there are
cards that charge lower interest rates, but they may have annual fees or other cards that may have
higher rates and have other benefits.

It's also important to understand how the mechanics of regular transactions accrue interest and
what it means to pay the minimum monthly balance versus the entire outstanding debt.
Normally, when you make a purchase, there's a minimum period, usually 21 days, where interest
does not accrue.
    
Let's do a small exercise where we examine a credit card statement. If you refer to the column on
the right, you'll see that the minimum balance is indicated. This represents the balance that's due
now. However, you'll notice that your full balance is indicated below. If you were to pay only the
minimum balance, interest would begin to accrue on transactions starting back from the date of
purchase. Meaning not repaying your balance in full can be quite costly.

The Government of Canada has great resources available to you online, on their website, related
to debt and borrowing. Here you can compare all of the credit cards available in terms of the
costs, benefits and features, which can help you choose the card that best fits your needs.

Lines of Credit
A line of credit is essentially a loan usually from a bank that allows you to borrow a
predetermined amount of money. It behaves similarly to a debit card in that you can use the
funds to withdraw cash, pay for purchases or services in store and transfer balances to other
accounts or pay bills.
    
You can often write personal cheques from a line of credit and, if you have other chequing or
saving accounts with the same bank, you can often set up your overdrafts to transfer directly to
your line of credit in order to avoid paying certain fees. Unlike credit cards, the money that's
drawn on a line of credit, meaning the money that you borrow from your line of credit, starts
accruing interest immediately. And it accrues interest until it's paid off in full.
    
If you have not used your line of credit, the balance will be 0. And it will not accrue interest and
will generally not have any significant fees to pay. There are different types of lines of credit:
personal, home equity, student, secured, unsecured. And you should speak with a financial
specialist and do additional research in order to determine which type is most appropriate for
you.

The differences will usually relate to the credit limits, interest rates and limitations of the loans.
The major benefit of a line of credit compared to a credit card, is that the interest in fees that are
charged are generally lower than those charged on credit cards.

This allows you to manage your borrowing in a way that minimizes the interest that you will pay.
For example, if you had a credit card balance, say $1,000 that's accruing 20% interest and you're
unable to pay it off within the interest-free grace period. If you had borrowing room available to
you on a line of credit that charges 9%, you would then be able to transfer your outstanding
credit card balance to your line of credit and you'd be able to benefit from lower overall interest
payments.
    
One of the more notable risks with a line of credit relates more to people's behaviours and habits
when it comes to using them. Because these loans are offered at a lower interest rate, people
sometimes tend to accumulate a larger balance. It then may become difficult to pay it off.
    
A solid financial plan for any major purchases made on credit, either credit cards or lines of
credit is essential. 

Long-Term Financing
While lines of credit and credit cards can be used almost interchangeably with cash, there are
often specific, more tailored financing options available to you for larger, more significant asset
purchases. The risk to the lenders in these circumstances is lower because in the event that
someone is unable to make the required payments, the lender has collateral on their loan.
    
The underlying asset that you’re paying for can be repossessed by the lender and this provides
them with additional security for their loan.

It's the same concept for a couch that you purchased and are paying off in 48 equal installments.
You're using the couch, but you don't own that couch until the last payment is made.

Mortgages
The one purchase that will almost undoubtedly require all of us to borrow money will be buying
a home. Let's walk through some of the mechanics of mortgages, how they work and some of the
key considerations you will need to have when applying for a mortgage.

    
A mortgage is a debt instrument or a loan that's specific to real estate properties. The property
you buy serves as collateral and secures the loan. In order to obtain a mortgage, a minimum
down payment is required.
    
Depending on the purchase price, the minimum down payment percentage ranges from 5% to
20%.  Ideally, these funds will come from money that's been saved and there are programs that
allow you to use your savings from your RRSPs towards this down payment.
   
If your down payment saved is less than 20%, along with other factors such as being self-
employed or having poor credit history, you will need to purchase mortgage loan insurance. This
provides the financial institution additional protection in the case of defaulted payments.

Once your total mortgage amount is determined by taking the purchase price of the property,
subtracting the down payment amount and adding any additional insurance fees or other costs,
you'll need to determine what type of mortgage is most appropriate for you.
    
When you obtain a mortgage, you need to select various terms. And these terms will be set or
locked in for the term of your mortgage. A common mortgage term is for five years. However,
depending on your specific needs, the term can be shorter or longer and can be open, meaning it
can be changed with applicable fees and charges.
    
The mortgage contract is generally fixed for the term and any changes that need to be made
before the term expires usually come at a cost of penalties of additional fees. Once the mortgage
term expires, you'll need to either renew the balance of the loan, refinance the loan or pay it off
in full.
    
When drawing up a mortgage contract, some of the important features that you'll need to select
involve the following: the amortization period, this represents the length of time it will take you
to repay the entire mortgage including both the principal and interest. Every payment that you
make towards your mortgage includes both an interest and principal component. So, what does
that mean?

If you have a mortgage of $300,000 and every month you pay $1,500, by the end of the year, you
will have paid $18,000. However, your mortgage balance will not have gone down to $282,000,
unfortunately. The payments made in the earlier years will go mostly towards interest and as you
approach the end of the amortization period, more and more of your payments will contribute to
paying down the principal component of your loan.
    
The total amount of interest that you will pay on a mortgage, by the end of the amortization
period, is significant. Another important feature to consider is the type of interest rate you want
to select. You'll need to decide whether a fixed or variable interest rate is most appropriate for
you. The primary benefit to a fixed interest rate is that your mortgage payments will remain the
same for the term of your contract regardless of any changes in the market interest rates.

Variable interest rates are subject to change depending on the market interest rates. Usually,
variable rates are lower than fixed rates offered. However, if the market rates increase, your
mortgage payments would also increase. If the rates were to decrease, you would also benefit
from lower mortgage payments.
    
Certain mortgages will allow you to initially select a variable interest rate and then later lock in a
fixed interest rate. However, you'll be required to pay fees for this change and the new fixed
interest rate will likely be higher than the rate initially offered to you at the time you originally
signed for your mortgage.
    
Another feature you will need to determine is the frequency of the mortgage payments, meaning
how often you will make the payments. This can be done monthly, semi-monthly, biweekly,
weekly. Depending on how often you make payments, you may be able to shave some time and
interest off the entire mortgage balance. Have a look at RBC's online mortgage calculator to see
how different payment variables affect your overall mortgage payment, the total interest you will
pay on your mortgage, and the time it will take you to repay the loan in full.

I cannot stress enough how important it is that you speak with a trusted financially literate
advisor before making any major decisions involving debt.

Chapter 2: Credit Scores

Now, let's talk about the concept of credit worthiness and how our credit history impacts our
ability to borrow money and how much it costs us to do so. So how do creditors assess our credit
behaviours? Where do they get this information? Among other sources, creditors will review
your credit history using your credit report.
    
Your credit report is like a life-long report card. Creditors, lenders, landlords, employers and
other parties like insurance companies, utilities and mobile phone companies are able to access
your credit report in order to view your credit history and credit score. From this report, they're
able to see the type of credit that you're using and how responsibly you're using it.
Your report contains information about the credit you use including credit cards, retail or store
cards, lines of credit and loans. Anytime you've had non-sufficient funds payments or written
bad cheques, any chequing and savings accounts that have been closed for cause due to money
owing or fraud committed. It will indicate any bankruptcies or court decisions against you that
relate to credit.
    
If you've ever had debt sent to a collection agency, it will appear on your report and several other
items. Information generally stays on your credit report for a period of six years. However, some
information may stay longer or shorter. For instance, a declaration of bankruptcy may remain on
a credit report for longer.
    
If you've consistently demonstrated good credit behaviour, this will appear on your credit report
as well and positive information, such as making regular payments on time, can remain on your
report for a longer time period.
    
Now, let's talk about your credit score. A mathematical formula calculates your credit score
using the information from your credit report. The score is a three-digit number that falls
between the range of 300 to 900. The higher the score, the more credit worthy you are. This
score helps creditors assess your credit behaviours and how risky it will be for them to lend you
money.
    
The Government of Canada lists the following factors that impact your score. How long you've
had credit for, if you have an outstanding balance on your credit cards, this includes any joint
credit cards, if you regularly miss payments, the amount of your outstanding debts, being close to
your credit limit, the number of times you tried to get more credit, the types of credit you are
using, if your debts have been sent to a collection agency, any record of insolvency or
bankruptcy.
    
So, how does your credit score ultimately affect you? A good credit score will help to ensure that
when you apply for credit and you actually need it, you're more likely to be loaned the money.
Additionally, having good credit worthiness will often allow you to have more preferential
interest rates.
    
In general, it's important to be aware of your own financial health and how creditors will view
you. You can actually obtain a copy of your credit report and you should. This will allow you to
review your credit information. It will also allow you to detect any errors or anomalies like
identity theft.

Chapter 3: Rules for Borrowing

So, what are my rules of borrowing? The first would be: try to live within your means as much as
possible. Before you buy something on credit, try to question whether you really need it and
whether the benefits outweigh the cost of borrowing. Always ensure you are using debt wisely.
For example: don't let balances sit on a credit card that's accruing higher interest if you have
borrowing room on a lower interest bearing debt.
And finally, you need a solid plan. What is my plan to repay this debt? Before engaging in high
amounts of debt, make sure that you will be able to abide by the restrictions imposed on those
debts.

That you'll be able to make all of your necessary payments and that you have a plan to ultimately
repay the debts that you owe. Every one of these guidelines is equally important.

I hope that this module helped shed light on some of the major debt and borrowing topics. Please
refer to the additional resources provided. And remember to discuss with a trusted advisor prior
to making any significant decisions involving debt.

Thanks again for joining and best of luck as you continue on your path towards financial literacy.