Personal Finance: Chapter 6

Credit represents funds provided by a creditor to a borrower that the borrower will repay with interest
or fees in the future. The funds borrowed are sometimes referred to as the principal, and we segment
repayment of credit into principal payments and interest

For installment loans, the interest and principal payments are blended, meaning that each payment
includes both principal and interest. For other types of loans, interest payments are made monthly and
the principal payment is made at the maturity date, when the loan is terminated.

Credit can be classified as installment or revolving open-end.

Installment loan- A loan provided for specific purchases, with interest charged on the amount borrowed.
It is repaid on a regular basis, generally with blended payments.
- The timing and amount of each payment depend on the terms of the loan
- Made according to a specific repayment schedule with a portion of the payment being applied to
the principle and the remainder representing interest paid to the lender

Revolving open-end credit or Demand Loan- Credit provided up to a specified maximum amount based
on income, debt level, and credit history; interest is charged each month on the outstanding balance
such as a credit card or a line of credit
- Allows consumers to borrow up to a specified maximum amount (such as $1000 or $10 000). The
credit limit is determined by the borrower’s income level, debt level, credit history, and other
factors determined by the lender
- Can pay the entire amount borrowed at any time, up to, and including the payment due date, or
pay a portion of the balance and have interested charged on the remainder
- Unlike an installment loan, the borrower can re-borrow the amount that was paid when using
revolving open-end credit
- Typically, a minimum payment is due each month of at least 3%
- Financial institutions can ask for a repayment at any time

Advantages of Using Credit

- Access to credit allows you to achieve some of your goals, such as purchasing a home or car,
sooner than you would have been able to
- Help to establish a good credit history
- Eliminates the need to carry cash
- Make purchases where cash may not be an option
- Additional benefits ie. air miles points
- Record of your transaction in maintained by the credit card company
Disadvantages of Using Credit

- High cost to using credit (ie. if you borrow too much money and fail to make a budget for your
debt payment, you may have difficulty making them)
- Tempt you to make impulse purchases
- If unable to make the minimum required repayment on the credit you use, you can damage your
credit ratings (maybe not be able to obtain credit again or need to pay high interest)
- Your ability to save money will also be reduced if you have large credit payments (ie. if your
spending and credit card payment exceed your net cash flows, you need to withdrawal savings to
cover the deficiency); no ability to save

Credit card gives a feeling of freedom, as if it allows customers to avoid the cost of purchases. There is
more psychological pain associated with using cash to make purchases than with using a credit card.

Credit History:
- Receive credit when you apply for and are approved to use credit instruments such as credit
cards, retail credit cards, lines of credit, and personal loans
- Paying your credit card before or on-time indicates to potential creditors that you may also repay
other credit in a timely manner; establishing your character

The Credit Application Process:

- The process of applying for credit from a financial institution usually involves filling out an
application form, negotiating the interest rate, and negotiating the loan contract. In the case of
revolving open-end credit, such as a credit card, the interest is often non-negotiable and the
loan is pre-determined.

Application Process:
- When applying for credit, you need to provide information from your personal balance sheet
and personal cash flow statement to document your ability to repay the loan. You also may need
to provide proof of income using either a recent pay slip or a T4 (indicates annual earnings)

In your personal balance sheet, assets are relevant because they indicate the level of capital ie. savings
and investments that you currently have. Assets may also serve as collateral. Liabilities showcase already
existing debt.

Cash Flow Statement: Indicates your income and expenses, therefore suggesting how much free cash
flow you have; thereby give you a loan you can afford

Some creditors may charge higher interest rates to individuals who have higher risk of default. Interest
rates charged on a credit card not only are relatively high but are calculated on the daily outstanding
balance.
Credit Report: summaries credit repayment with banks, retailers, credit card issuers etc; shows your
creditworthiness
- Credit problems remain on a credit bureau report for up to 10 years

Credit insurance:
- Ensure that you keep making credit payments (thereby maintaining their credit standing) under
adverse conditions
- Variety of different kinds: credit accident and sickness, credit unemployment)
- Small-terms (ie. 3 months)
- Not a good substitute for insurance coverage

Credit Reports: Reports provided by credit bureaus that document a person’s credit payment history

Provides the following information:

● Your personal information
● A consumer statement showing the details of any explanation that you have submitted to
the credit bureau regarding a particular account
● A summary of your accounts
● Your account history
● Bank information regarding any accounts that were closed for derogatory reasons
● Public information regarding bankruptcies, judgments, and secured loans
● The names of creditors who have made account inquiries
● A list of creditor contacts

Credit Score: A rating that indicates a person's creditworthiness

- Reflects the likelihood that an individual will be abel to make payments for credit in a timely
manner
- It affects lenders decision to extend personal loan or mortgage and interest rate

Credit Bureaus rely on credit scoring models created by the Fair Isaac Corporation (FICO), model is
referred to as your BEACON score.
- Payment history has the highest impact (35%) on your credit score
- Use exhibit 6.3 to point out the other factors

Credit Scores among the Bureaus

- Each bureau may give you a different score; the information each bureau receives about you in
not exactly the same

Interpreting Credit Scores

- Credit scores range from 300 to 900
 - A score of 600 or higher is considered good and may indicate that you are considered worthy of
credit.
- While lenders commonly rely on credit information and a credit score from a credit bureau, they
also consider other information not disclosed by credit bureaus, such as your income level
- Low credit scores is normally due to either missed payments or carrying an excessive amount of
debt
- Poor credit history will appear on your credit report for 3 to 10 years, depending on the
type of information contained
- Filing for bankruptcy will remain on your credit record for 6 to 7 years

You can improve your credit score by catching up on late payment, making at least the minimum
payment on time, and reducing your debt.

You should review your credit report from each of the credit bureaus at least once a year. Since each has
its own process for reporting credit information, you should check the accuracy of the credit report
provided by each one.

Review your credit report for 3 reasons:

1. You can ensure that the report is accurate

2. A review of the report will show you the types of information that lender or credit cards
companies may consider when deciding whether to provide credit
3. Your credit report indicates what kind of information might lower your credit rating, so that you
can attempt to eliminate these deficiencies and improve your credit rating prior to applying for
additional credit

Credit Cards
- Easiest way to establish credit is to apply for a credit card
- No shortage of credit card companies eager to extend credit to you

Credit cards:
- Offer you the same advantages of using credit:
- Establishing a good credit history
- Create credit capacity
- Eliminate the need for carrying cash
- Provide a method for payment when cash is not an option
- Earn additional benefits
- Receive free financing until the due date on your credit card statement
- Keep track of all expenses made using a credit card

Types of Credit CardsL

- Mastercard
 - Visa
- American Express

A credit card company receives a percentage (commonly 2%-4%) of the payments made to merchants
with its credit card. Ie. Petro- Canada would pay Mastercard 3% of your purchase

Specialized Credit Cards

- Available that fulfill a specific purpose or provide a particular benefit
- Ie. Retail Credit Cards: a credit card that is honored only by a specific retail establishment
- have a higher interest rate than on standard or prestige cards and it limits your
purchases to a single merchant
- Rewards are available

Prestige Cards: credit cards, such as gold cards or platinum cards, issued by a financial institution to
individuals who have an exceptional credit standing
- Offer even more benefits
- Available to individuals with high incomes and exceptional credit histories

Balance transfer cards: related to rewards cards in that they help you to save money
- Allows a consumer to transfer the balance owned on an existing credit card to a new one to save
money on interest

Student credit card: help you to establish a credit rating while still in school

Secured credit card: used by individuals who have credit problems in the past and want to rebuild their
credit score ie. bankruptcy or being new to Canada
- How much you deposit will be your limit

Credit limit:
- Credit card companies set a credit limit, which specifies the max. amount of credit allowed
- Varies depending on the person (ie. from 500 to 10,000)

Overdraft Protection
- Allows you to make purchases beyond your stated credit limit
- Prevent your card from being rejected because you are over your credit limit
- Fees are charged whenever overdraft protection is needed

Annual Fee
- Many credit cards charge an annual fee for the privilege of using the card

Grace Period
 - Typically allow a grace period during which you are not charged any interest on your purchases
(ie. 20 days)
- The grace period is usually about 20 days from the time the credit card statement is “closed”
(any purchases after that date are put on the following month’s bill) to the time the bill is due.
The credit card issuer essentially provides you with free credit from the time you made the
purchase until the bill is due, but only if you start the month with a zero balance.

Convenience Cheques: used to make purchases that cannot be made by credit cards

The Interest rate on outstanding credit balances is between 20 to 30% on an annualized basis and does
not vary much over time.
- Although financing through credit is convenient who are short on funds, it is expensive and
should be avoided if possible

Credit cards can offer a variable, fixed, or tiered. A variable rate adjusts in response to a specified market
interest rate ie. prime rate. Tiered interest rates on their credit cards occur when cardholders who make
late payments are charged a higher rate.

Finance Charge- the interest and fees you must pay as a result of using credit
- Normally , the amount you have to pay at the end of each billing cycle is the greater of $10 or 3%
of the outstanding balance
- Purchases after the statement closing date are not normally considered when determining the
finance charge because of the grace period
- Compounded daily, which means that interest is calculated every day

Three methods to calculate finance charges on outstanding credit card balances:

Previous Balance Method:

- Least favorable because finance charges are applied even if part of the outstanding balance is
paid off during the billing period

- Previous Balance Method. With this method, you will be subject to a finance charge that is
calculated by multiplying the $2700 outstanding at the beginning of the new billing period, by
the daily interest rate and the number of days in the billing cycle. The daily interest rate is
calculated as 21%÷365=0.057534247%.Your finance charge is:
$2700×0.057534247%×30 days=$46.60

Average Daily Balance Method

- Most frequent
 - For each day in the billing period, the credit card company adds together the ending balance of
your credit card account
- Finds the average daily balance
- Interest charged to your account is determined by multiplying the average daily balance by the
daily interest rate, and then multiplying this result by the number of days in the billing period

- Average Daily Balance Method. With this method, the daily interest rate is applied to the average
daily balance. Since your daily balance was $2700 for the first 15 days and $1500 for the last 15
days, your average daily balance was $2100 for the 30-day billing period. As a result, your
finance charge is:
$2100×0.057534247%×30 days=$36.25

Adjusted Balance Method

- Interest is charged based on the balance at the end of the new billing period
- Most favorable because it applies finance charges only to the outstanding balance that was not
paid off during the billing period

- Adjusted Balance Method. With this method, you will be subject to a finance charge that is
calculated by applying the monthly interest rate to the $1500 outstanding at the end of the new
billing period. In this case, your finance charge is:
$1500×0.057534247%×30 days=$25.89

A credit card statement includes the following information:

● Previous balance: the amount carried over from the previous credit card statement
● Purchases: the amount of credit used this month to make purchases
● Cash advances: the amount of credit used this month by writing cheques against the credit
card or by making ABM withdrawals
● Payments: the payments you made to the sponsoring financial institution this billing cycle
● Finance charge: the finance charge applied to any credit that exceeds the grace period or to
any cash advances
● New balance: the amount you owe the financial institution as of the statement date
● Minimum payment: the minimum amount you must pay by the due date
To choose the most desirable credit card:
- Acceptance by merchants
- Does not charge an annual fee (if so, what additional benefits do they add)
- Interest rate among financial institutions
- Max. limit

The higher the average monthly balance, the higher your interest expense because you will have to pay
interest on the balance

If you always pay off your balance in the month, you will not have any interest expenses.

Home Equity Line of Credit (HELOC)- a loan in which a home serves as collateral
- Allows homeowners to borrow, up to a specific credit limit, against the equity in their homes
- Home equity refers to the market value of your home less any outstanding mortgage balance/
debts (80% of that)
- You pay monthly interest only on the funds that you borrow and then pay the principal at a
specified maturity date
- The amount of credit available in the HELOC will go up to that credit limit as you pay down the
principal on your mortgage.
- Considered a second mortgage: a secured mortgage loan that is subordinate (or secondary) to
another loan
 - Because the primary lender is the financial institution that provided the first mortgage
and the second is the financial institution (can be the same or different) that provided
the HELOC

HELOC uses a variable interest rate that is tied to a specified interest rate index that changes periodically
ie. prince rate plus 3 percentage point
- Prime rate: the interest rate a bank charges its best customers
- Because the home serves as collateral, the lenders less risk and therefore have a lower interest
rate

Therefore, the borrow should monitor interest rates; if the rates are expected to rise, they should
consider locking in current rates

The variable interest rates may be an issue for borrows because they may never get around to paying the
down principle of the loan or IR rate rise to point where they can no longer afford to the minimum
interest-only payments

Loan contract: a contract that specifies the terms of a loan as agreed to by the borrower and the lender
- Contract identifies the amount of the loan, interest payments, repayment schedule, maturity
date etc.
- Loan repayment schedule: personal loans are usually amortized, which means that the principle
of a loan is repaid through a series of equal payments of both interest and portion of the
principal
- As more of the principal is paid down, the amount of interest is reduced and a larger
portion of the payment is used to repay principal
- Longer maturity of the loan, easier to cover the payments; but pay more interest over
the life of the loan
- Shorter the better if you doing well financially/ sufficient liquidity