Updated in June 2015 by the Manitoba Association of Home Economists
Why use credit cards?
Most people use credit cards for convenience. It’s handier to use a credit card than to carry large amounts of cash. You can pay one bill using one cheque or debit your account. The item purchased is interest free as long as the bill is paid on time. A good deal for the consumer!
However if only a portion of the bill is paid off, we need to be aware of the consequences. Paying a portion of the bill encourages us to impulse buy without considering the selling price, the operation or maintenance of the purchased services or goods. Money managers say it is often the nice handbag or other items we would like to have that tip the scale and run up the bill. We think only of how we can manage the monthly payment and forget we will pay interest on the unpaid balance. Buy now, pay later commits future income as well as interest charges and as a result we lose financial flexibility. We need to think about how we are going to make the payment if we have a family emergency, lose our job or become ill.
Some people argue buying now, paying later enforces saving and without it they would never be able to buy large ticket items because they cannot save regularly. Others use a credit card to bridge the gap until the arrival of the next pay cheque. Others say in times of inflation there is an advantage for the borrower to buy before the price goes up and to pay back in the future when the inflated dollar will buy less. As consumers we need to weigh the pros and cons of using credit against our personal needs and values and to recognize that credit can be a powerful tool but it must be managed carefully. Operating with a large credit card balance can keep people in continual debt and load the borrower with stress.
Do you know how much debt you are carrying?
Every family needs to know how much money is coming in each month and how much money is going out. We need to analyze where the money is being spent and if that is the way we want to spend it. In weighing the pros and cons of using credit, consider your capacity to make payments.
The payments on any credit should not exceed 40% of your gross income (before taxes and other deductions). The total amount of credit payments covers all borrowing including the mortgage on your home, car, loans and monthly credit card payments. Using more than 40% of your gross income (including your mortgage) for credit can leave you without enough money for necessary living expenses.
Can you cover unexpected costs without using credit?
Money managers tell us families should have an emergency fund of three months salary particularly for unexpected expenses such as sickness, car repairs, unexpected travel and other emergencies during the year. In order to establish an emergency fund, estimate the amount spent each year for dental and eye appointments, kids activities, house and car repairs, gifts, etc. Total the amount and divide that amount by 12. Then try to save that amount of money each month to help pay for unexpected expenses. Place it in a separate account so it is hard to access. Call it your slush or emergency fund.
Do you shop for credit? Credit cards are not the only source of credit. Consumer loans may be obtained from banks, trust companies, credit unions, sales finance companies and life insurance companies. Shop around for the best interest rates and conditions.
The interest rate is not fixed but it is tied to the prime lending rate (the best or lowest rate charged by banks to corporate customers). Repayment of a demand loan may be required at any time but in most cases repayment is made over a period of time in equal payments – including principal and interest as per the loan agreement. Depending upon the security required for the loan, the interest is usually lower than for other loans. Sometimes a co-signer will be needed for the loan.
Life Insurance Loans
Money is borrowed from an insurance company against the cash surrender value of the policy. The face value of the policy is reduced by the amount of the loan until the loan is repaid.
Personal Line of Credit
You apply for a line of credit the same way you apply for a loan. You receive a fixed limit according to your ability to repay. It has a variable rate of interest and a minimum payment is required each month. Total or partial payments can be made. Interest is charged on the amount of credit being used for the number of days it is used. Interest rates are lower than those charged on an overdraft.
Overdraft protection allows deposit accounts to become overdrawn to a set amount. The overdraft becomes a loan, which has interest rates as high as, or higher than those charged on credit card loans.
Do credit cards have traps?
There is no interest rate regulation on credit cards. Demand establishes the rate. As long as consumers are willing to pay the price, credit card companies will continue to charge as much as the market will bear.
You can be trapped with credit cards. There are often penalties for going over the credit limit, paying late, paying less than the minimum amount, for balance transfers and cash advances. Interest rates can go up too, if a consumer does nothing more than sign up for a new card, inquire about a car loan or make a single late payment to any creditor.
According to Consumer Reports (Nov 05) if you are a consumer who pays off the balance in full each month, there may be hidden penalties. You may have to pay fees to receive a year-end summary; you may receive a reduction in reward programs, or be switched to penalty interest rates unless you use the cards frequently.
Read the fine print in contracts. Fixed rates may only mean the credit card company has to give a certain number of days written notice before the rate changes. Take a look at when you receive your statement. Some card issuers mail statements close to the due date, making it harder for consumers to pay on time. When payment arrives late a penalty fee can be applied. If you are paying electronically some issuers may take two to three days to post payment to your account so play it safe, pay the bill electronically two to three business days in advance of the required deadline.
What is the role of the Credit Bureau?
Provincial laws govern credit bureaus so rules and regulations vary.
Credit bureaus offer credit history to financial institutions, credit card issuers, retailers and oil companies. Records show the consumer’s credit applications, the number of previous loans and conditions of payment. Your record also holds general information regarding age, citizenship, social insurance number plus present and past employment. It also shows information about your paying habits.
According to Consumer Reports (Aug/05) credit scores are used by the lender to determine how much interest you pay on loans, by insurers to calculate premiums, by employers who are hiring, by mortgage lenders, by landlords and by utility companies to have power or gas connected. Because this information is used in so many different ways, it is important that it be correct and up-to-date. If the information isn’t accurate, you should challenge it.
How do you obtain a copy of your credit file?
There are three main credit bureaus in Canada – TransUnion, Equifax and Northern Credit Bureaus. Find out where your credit file is located by checking with your bank or the phone book for the nearest credit bureau. Call or write for an appointment to review your file.
An accurate file can save you money on loans, mortgages, insurance, credit card payments, and lost employment opportunities. The system used to calculate credit scores is based on data gleaned from financial institutions and credit card companies. The information includes payment and debt histories. Information is also taken from public records such as bankruptcies, secured loans backed by an asset such as your property, back taxes and liens. The formula used involves several pieces of data, which reveal a final figure forecasting your payment behaviour based on mathematical models. It tells lenders which borrowers will likely pay bills on time. The higher your score, the better credit risk you are.
By Betty Burwell, Home Economist