What is Credit?
Financial literacy is an important skill every Canadian should be equipped with. One important aspect of financial literacy is understanding how credit works.
Let’s start with understanding what exactly credit is. In the simplest terms, credit is an arrangement between a consumer and a lender to obtain goods or services that are paid for at a later date. For this type of contract, it is expected for the consumer to repay the loan in full in addition to any interest or other fees that might have accumulated over time. The interest rate, the length of the repayment period, how much these payments will be and when they must be made will be outlined within the contract and should be understood by the consumer before any purchases with the loan are made.
Types of Credit Accounts
There are two main types of credit accounts: installment credit and revolving credit. Each works a little differently in regards to how they are reported and how they process payments.
An installment credit account is recognizable by a few defining characteristics. It is a close-ended loan with specific payment terms; a repayment schedule is clearly outlined and there is a definitive agreed upon end date when the loan must be repaid. You might hear the term “utilization ratio” when discussing installment credits, which simply means the ratio of the amount owed to the amount already paid. Meaning, the utilization ratio will be higher in the beginning before you’ve paid off the majority of the loan. Examples of installment credit include car loans, mortgages, student loans, traditional business loans and personal loans.
The most common example of revolving credit is a credit card. This type of credit account offers a set credit limit with required minimum monthly payments. If any balances are carried from month to month, interest is charged to the borrower. Revolving credit allows flexibility to the borrower as you don’t have to wait until you have a cash supply in order to make purchases. However, the convenience of not having to pay for goods and services right away is exchanged for high-interest rates, making this credit account type a little risky.