The Basics of Borrowing - Part 1

Credit - we sure do love to use it. But unfortunately, credit products do not always come with an instruction manual explaining the finer details of how to use them wisely.

Let's face it - we've all made mistakes.

One reason for this is that credit is still a relatively new product in Canada (Credit cards, for example, weren't introduced here until the mid-'60s.) If you grew up in a household where credit was considered taboo, you probably didn't have any practice managing it until you started doing some serious shopping of your own.

But there's no reason why you need to muddle through, always learning the hard way. Knowing the basics of borrowing will go a long way in helping you become a smarter shopper and a better money manager.

All credit is not created equal

The first thing to understand about credit is that it comes in many different shapes and sizes, from the familiar credit cards to personal lines of credit and loans. Each has its own pros, cons and unique features.

And they have different terms – some credit products have a variable interest rate (the rate fluctuates with the market during the term of the loan) while others have a fixed interest rate (the rate stays the same during the term).

The key is to choose the right credit at the right time, a decision that boils down to three main factors.

Factor 1: Purpose

Specifically, why do you want to borrow the money?

Financing a car or other big purchase? You'd likely think about a personal loan. It's a structured credit arrangement – you borrow a set amount and pay it back over a set period of time.

Need access to a credit source for renovations or investment purposes? A personal line of credit might just be the ticket. With a PLC, the lender gives you access to a reserve of credit and you draw on it when you need it. You pay interest only on the amount you use.

Then, of course, there are all those daily transactions that are so much more conveniently paid for on a credit card.

But keep in mind that there's not always just one right answer here. Every situation is unique.

Factor 2: The interest rate roller-coaster

Where interest rates are, and where they are going, may also have an impact. At the same time, most loans and lines of credit are open so you can usually make a change without too much difficulty.

If rates are rising, you might avoid a variable-interest loan, because the interest you'd pay would go up. Choose a fixed-interest rate loan and you lock in the current rate for the chosen term.

Of course, the opposite is true in periods when interest rates are falling. Then you'd likely want a variable loan so you can pay less interest as rates fall.

Factor 3: Your cash flow needs

The other thing to think about is how the loan repayment affects your monthly budget and overall cash flow. The main factor here will be the size – and flexibility – of the regular payments.

Pick a PLC and you'll have the flexibility of making payments in any amount (subject only to the minimum amount.) Not only does this help you manage your cash flow, you have control over how quickly the loan will be repaid.

If you need to know exactly how much you'll be paying every month, and for how many months, then you might want a fixed-rate loan. While your interest rate will never go up and there'll be no nasty surprises, you should be careful about becoming complacent and then paying too much interest if there's been a big drop in interest rates.

In some circumstances, lenders may offer interest-only repayment options for certain types of borrowing. This could be something to consider if you are tight for cash.

Keep asking questions

Before making a final choice, there are a few more questions to ask yourself:

How much will this loan cost if I pay it off over two years? Three years? Four years? (Your financial institution is obliged to help you understand this when you take out your loan).
Will my cash flow survive a short-term repayment period? How short-term?
Do I have the household income to qualify for a personal line of credit? (Depending on the institution, you may need $35,000 to $50,000 or more.)

To err is human

If you already have some loans, this is a good time to re-evaluate your position. Here are some indications that your past decisions might not be the best ones:

you're still paying your installment loan at the original interest rate even though rates have fallen by four per cent;
you're paying premium interest on your PLC when you have available equity in your home that could be used to secure your line and reduce your interest rate.

It's a big decision

When borrowing, never be afraid to ask more questions. If you're stuck, you can always pay a visit to your local bank branch. A conversation with your personal banker can help you understand all the options before you make a commitment.

Asking for money

Once you've figured out what you need (and what you'd like), it's time to ask for it. Next month, we'll discuss the ins and outs of the borrowing application.

May 2002

The information in this article is general only; it is not intended as specific investment, financial, accounting, legal or tax advice for any individual.