Debt, Credit Cards, and Credit Ratings| E003
Full Transcript:
Jason Pereira: Hello and thank you for joining me for the Wisdom of Wealth, a show where we help educate Canadians about the fundamentals of financial literacy to help you make better and more informed decisions, and to know when and where to reach out for help. I'm Jason Pereira and I have the privilege of being your host. Today on the Wisdom of Wealth, we are going to talk about something that affects the lives of all Canadians, debt.
Jason Pereira: Debt comes in many forms, mortgages, lines of credit, credit cards, student loans, car loans, you name it. And we're going to talk about several of them shortly. When we obtain debt, we borrow money not only from a bank or other person, but we actually borrow money from our future selves. And in doing so, it comes at a cost. That cost of course is the interest rate you pay on the money you borrow. So because you consume more today by taking out debt, the you up tomorrow can afford to consume less, because you are obligated to not only repay that debt, but also the interest on the amount you owe. Interest you pay also increases the cost of what you bought. How much more? That depends on how much you owe, the interest rate and the length of time it takes you to pay it back.
Jason Pereira: For example, let's say you owe $1,000 on your credit card at a rate of 18%. now that may sound high, but in the credit card world, that sort of rate is normal. If you make the minimum scheduled payment, which is the greater of 3% of the balance owing or $10 it would take you 10 years to pay off that $1,000. And you would pay a total of $798 in interest. That's almost 80% more than the money you spent in the first place. Future you is going to be pretty upset with present you. And Canadians have a real debt problem. It's estimated that Canadians over $2.16 trillion. That's $60,000 for every man, woman, and child in Canada, and almost as much as the country's GDP.
Jason Pereira: What's worse is that $80 billion of that is credit card debt. That's more than the GDP of over 100 different countries. That also results in $15 billion in interest alone, which is as much as 7% of Canada's total GDP. Clearly we need to start doing better. But in life, debt is almost unavoidable. Few of us have the luxury of paying upfront for education, cars, homes. All those require debt. So let's talk about how to be smart about it.
Jason Pereira: Let's start with mortgages. We all know what mortgages are. They're a loan that you take out in order to buy real estate, either to live in or to rent. In general, lenders see these as secure, because if you can't pay, they have the right to take your property. Because of this, mortgage interest rates are often the lowest interest rate that anyone can get. Currently, rates are near all time lows of below 3%. this has not always been the case. It wasn't that long ago that rates were up over 20%, so take my advice. Don't plan on having low rates for the rest of your life. There are a few important terms you need to know when it comes to a mortgage.
Jason Pereira: The first is amortization. This is the period of time over which the loan is stretched. 25 years is the most common, but you can always get shorter periods. A shorter period means a higher payment schedule.
Jason Pereira: The second is the term. The term is the period over which the mortgage deal cannot be changed without penalty. The most common term is five years. But you can have shorter or longer terms.
Jason Pereira: The third is the type of rate you have, variable or fixed. Variable rates are lower than fixed rates, but they can change when the Bank of Canada changes their interest rate. If they go down, you save money. If they go up, you pay more. Historically, in most cases, the variable rate tends to be the lowest cost option over the life of a mortgage. But you should only take out one of these if you can absorb the volatility. The fourth is payment frequency. That is to say how often you'll make regularly scheduled payments. The minimum a bank will typically permit is monthly, but you can always make payments more often. And of course there's the interest rate. The rate you will pay on your mortgage. So how can you better handle your mortgage?
Jason Pereira: First off, keep the size of your mortgage reasonable. Just because a bank tells you you can borrow up to a certain amount, it doesn't mean you should do it. Just remember, they want you to be in debt because that's how they make money. Second, pay more often. If you pay weekly or every two weeks, you actually end up paying down more principal than if you're paying monthly, getting out of debt sooner. Third, take advantage of prepayment options. All mortgages allow you to pay off your mortgage faster, up to certain limits. Wherever possible do so. Even at a rate of 3%, every dollar you pay can save you up to another dollar in interest over the life of a mortgage.
Jason Pereira: Fourth, make repayment a priority. Do not let your 25 year mortgage go 25 years. Future you will thank you for it. Now let's move on to the most expensive form of debt. Credit cards.
Jason Pereira: Credit cards can be great. They make paying for things easy and convenient. But the problem is, they make it too easy. As long as you pay them off every month, you have no issue. But if you don't, then you have a problem. Not paying your credit card every month is called carrying a balance, and it can cost you. Credit cards in general have some of the most expensive interest rates on the market, from the high teens to the high twenties. And As you saw earlier, paying only the minimum can double the cost of what you bought. So here are my tips for how to better deal with credit card debt.
Jason Pereira: First, whatever you do, avoid carrying a balance. Second, if you do have to carry a balance, do not miss the minimum payment. Doing so can adversely impact your credit rating. Third, get it paid off as soon as possible. Fourth, if you can, pay it off with another lower interest debt facility like a line of credit and do so right away. You will save the difference between these interest rates over time. Fifth, if you don't have access to another lending facility, look to get a debt consolidation loan. This is a type of loan that can be specifically used to pay off your debt and comes at a lower rate. Sixth, if your situation is such that none of these are an option to you, and the debts are going to be more than you can handle, go talk to a bankruptcy trustee. You might be eligible for something called a consumer proposal. This is not as severe as a bankruptcy, and can reduce your debt load. Lastly, if you can't trust yourself, don't have a credit card.
Jason Pereira: As for other loans, there are a few general rules you should abide by. First, consolidate at the lowest rate possible. This could mean adding debt to your mortgage, because that is typically the lowest rate you can typically get. Some people don't like the idea of increasing their mortgage. But really, the choice is simple. Would you rather pay more interest or pay less? Second, do not miss payments. Missing payments can hurt your credit rating.
Jason Pereira: Third, pay the debt with the highest interest rate first, paying the minimum on everything else, and focus on getting rid of that one. Lastly, use the snowball method. Once you pay off the highest rate debt, don't start spending that money. Start using that to pay off the next highest rate debt, and so on and so on. By doing this, you pay off debt at a faster and faster speed, like a snowball going down a hill. Now let's talk about an important factor that helps determine how much debt you can get access to, and the rate you will pay, your credit rating. And to discuss that and take a closer look at how credit ratings work and how you can improve your own, I've invited CEO of Lending Loop, Cato Pastoll, to the studio.
Jason Pereira: Cato, thank you for coming in today.
Cato Pastoll: Thanks for having me.
Jason Pereira: My pleasure. So Cato Pastoll, tell us what it is you do for a living.
Cato Pastoll: Yeah, so I'm one of the co-founders and the CEO of lending loop. So what lending loop is, is an online lending platform for small businesses. So we help businesses across Canada access financing. One of the really important things that we do as well is actually educate business owners about that credit. So we have a platform that allows them to access both personal and business credit scores for free. And through that, we not only provide their scores to them, we also help educate them on the different types of credit that are available to them, how they impact their credit score, what positively and what negatively impacts that.
Jason Pereira: Excellent. So clearly, credit ratings are really important to you as a lender, right? So let's talk about, first, let's talk about credit scores, right? What's the maximum score you can get? What's a good range? What's a bad range?
Cato Pastoll: Yeah, so credit scores in Canada for consumers range anywhere from 300 to 900. So as an individual, you usually have a score that that range is there. I would say anything that's below a 600 is generally considered to be a weak score. Anything from 600 to 700 is an average score. And then 700 plus is generally considered to be a good or a strong score.
Jason Pereira: Good. So in general though, the better your credit score, the better chance you have of getting a larger and lower cost loan, I think it's safe to say, right?
Cato Pastoll: Yep.
Jason Pereira: So what goes into a credit score? What are the factors that impact it, and let's talk about how we can help people improve theirs.
Cato Pastoll: Absolutely. So there's five main factors that come into a credit score. So the credit scores are calculated by credit bureaus, Equifax and TransUnion are the two credit bureaus here in Canada. And they look at five main things. So the first thing is payment history. So payment history, just to put it simply is, are you making your payments every month on time?
Jason Pereira: Like I was telling people not to miss the minimum payment because it will adversely affect your credit score. This is exactly what we're talking about.
Cato Pastoll: Exactly. And that's actually the most important factor. About 35% of your credit score is made up just off of your payment history.
Jason Pereira: Yeah. And all sometimes see people trying to focus on the bigger debts or the more expensive debt first and letting the other one pile up. Not the way to do things. You're actually making your situation worse.
Cato Pastoll: Correct. Yeah. So the best way to optimize your payment history is to make sure that you're consistently making your payments on time every single month, no matter if it's high cost, low cost, making sure that you're not missing any payments.
Jason Pereira: Yeah. And there's ways to do that. You can automate those payments now. And even if you don't automate them, when you get that bill, a smart thing to do is go in and program that expense to actually go out on the date before it's due. So that way you don't forget it. And I think we've all been guilty of missing a credit payment at some point in our history.
Cato Pastoll: Absolutely.
Jason Pereira: Okay, so that's the first piece. What's the second piece? So the second biggest one is what's called utilization. So utilization is basically how much of your available credit you're using. So let's just use an example here.
Jason Pereira: Let's say that you have a $100,000 home equity line, so a line of credit against your house. If you're borrowing 50,000 against that home equity line, that would mean that your utilization on that facility is 50%. same thing with a credit card. Let's say you have a $10,000 credit card and currently your balance is $5,000. That would mean a 50% balance. So with utilization, the way that works is the higher your utilization, the bigger the negative impact on your score. So if I'm at like 100% on all of them or 90% on all of them, it's going to be a big strike against my credit score. Exactly. And so what we really recommend to our clients that we work with is try to keep that number at 35% or below.
Cato Pastoll: Might be hard for some people, but sure enough, yeah.
Jason Pereira: It is. But at least try to target or push towards that.
Jason Pereira: The lower your utilization, the more likely you're going to have a good score.
Cato Pastoll: So that's interesting because if you have a lot of debts all at 35 versus one at a hundred, you're actually in better shape on a credit score.
Jason Pereira: That's correct. And so, if you're looking at your overall debt portfolio, it's better to borrow a small on a large amount of available credit, as opposed to having a small amount of credit that is very highly leveraged.
Cato Pastoll: Yeah. And this is the unfortunate part of how these things work, that unfortunately, the advice to pay off the highest rate first is great from a monetary standpoint, but maybe not the best thing for your credit rating. So don't leave every other credit facility at 100%. Basically, try to get them all down, but really focus on the most expensive one.
Cato Pastoll: Absolutely. Yeah.
Jason Pereira: So what's the next factor they look at?
Cato Pastoll: So the next thing would be credit history. So what credit history is, how long your credit facilities have been established. And so more preference is given to people who have had a longer time of borrowing history. So if you've had credit cards for 20 years, you've been making your payments on time for 20 years. That's given more of a positive weighting than somebody who just opened their first credit card a year ago.
Jason Pereira: So someone who's never had credit before who basically just got their first credit card, the banks have no idea whether or not this person is actually going to be responsible with it, pay it back on time. So this is actually a piece of advice I give to people whose kids become 18. Let them get a credit card. Don't let them use it.
Jason Pereira: But let them get it, because that establishes a history.
Cato Pastoll: Exactly. And even further to that, what I sometimes recommend people do is get a credit card and actually overpay your balance. So preload it, treat it almost like it's a debit card. Put money on it before you spend it. But that way you're building that credit history. You don't have to borrow money. You can just use it in order to start to build some of that repayment history.
Jason Pereira: Good advice. So what's the next piece they look at?
Cato Pastoll: Yeah. So the next thing is inquiries. So what inquiries are is basically how many people are looking at your credit. And a lot of people don't actually know this, but when you're shopping around, when you go into a store and they have an offer for an in store credit card, and there might be a nice free thing that comes along with that.
Jason Pereira: A free T-shirt.
Cato Pastoll: It's a free T-shirt or something. What happens when you fill out form out is that lender will register what's called an inquiry against your credit file. And that will negatively impact your score. Same thing if you're going shopping for a car and looking for an auto loan. That will also register an inquiry against you. So just be very aware as a customer or consumer when you're looking at different options, whether they be credit cards, a car, even potentially looking at renting a place, those could all have a negative impact on your credit score if that person is checking your credit.
Jason Pereira: Yeah, so that makes sense. I mean the more different credit facilities you're applying for, especially in a short period of time, is a signal to the lenders that this guy needs credit or he's coming into difficulty with credit. So I get that. So just what I was saying is don't go for the free t-shirt. So what's the next factor?
Cato Pastoll: Yeah, so the last factor in the continuum of the things that people look at is the types of credit that you have. So when we talk about types of credit, I just mentioned store credit cards. And those are actually looked at more negatively by a credit bureau than something like a mortgage. And you were kind of talking about this a little bit earlier today as well, is that the different types of debt, for example, higher cost debts, are also higher risk, and come with more interest. The same thing from a credit file perspective. So if you're borrowing on things that are more risky, like a credit card that's charging a higher interest rate, that's more likely to actually have a negative impact on your credit score as well.
Jason Pereira: So wherever possible, try to not have the riskiest credit card out there, even if it is a store credit card. And those typically do have some of the highest rates I've seen. So let's talk about again, how to improve that credit score. So we gave out little pieces of advice here and there. What are your top five factoids or little bit of hints that you basically give people that say, okay, this is how you go from a position that might be not as good to a better position.
Cato Pastoll: Yeah, I think the first thing is making sure that you're aware of the things that impact your credit score. So knowing those five magic points that we talked through today is the first thing that we always advise people to know. These are the things that actually impact your score, because then you know how to control them. The second thing is then being very conscious of probably the most important factors. So I mentioned that utilization and payment history are the two most important factors.
Cato Pastoll: I think if you're looking at improving your credit score, those are the two places that we always recommend that people look to first. Are you making sure that you're reducing your balances, making sure that you're paying close attention to that. And making your payments on time every month, and making not just the minimum payment, ideally making above the minimum payment every single month. And then I'd say the third thing that we like to really recommend is if you are in a position to change your history of credit borrowing facilities, for example, by refinancing, so you can get that done. Do that. So just to give you an example of that, as a company, we work with people who might want to refinance things like credit card debt. So we actually had one of our first customers when we started the business as a restaurateur.
Cato Pastoll: They had actually borrowed a lot of money to start that restaurant.
Jason Pereira: Like so many entrepreneurs. Yeah,
Cato Pastoll: Exactly. And so they ended up with about $50, $60,000 of credit card debt that they couldn't repay right away. So what we helped them with was actually a loan that within 18 months they became debt free, because they got it into a way that they can repay a stable monthly payment.
Jason Pereira: Not at 18%. But also I'd say keep that credit card, because you have a long established history now, right?
Cato Pastoll: Yeah.
Jason Pereira: I have one credit card that I infamously have not used for God knows how long now, but it is the oldest credit card I have. And I keep it because I know that credit history matters. So, getting rid of that, I would lose that history.
Cato Pastoll: Yeah, exactly.
Jason Pereira: Good. So Cato, where can people find you?
Cato Pastoll: Yeah, so our website is www.getloop.ca. And that is a completely free service that we offer to business owners, where they can check their personal and business credit scores for free. So if you're interested in finding out more about your personal credit score, your business credit score, definitely check us out at getloop.ca.
Jason Pereira: Yeah, and I want to encourage everyone to do that because frankly, being aware of what your credit score is, is one of the best pieces of information you can have, because you can then start to monitor it. In addition to that, you guys update everybody on a monthly basis. So if something weird happens with identity theft or whatever it might be, then essentially you can get ahead of that. You can detect it very early. So definitely check out, getloop.com and start tracking your credit score improving. So thank you for coming in again today, Cato, and thank you for joining us for today's episode of the Wisdom of Wealth. And we hope you continue to join us here every week as we seek to improve your financial literacy. Until next time.