“Debt Is Bad?” Or “Buy Now, Pay Later?”

When it comes to debt, many think in extremes. Either “debt is bad - avoid it at all costs!” or “why wait - buy now, pay later!”. 

Neither extreme is correct, but elements of each are valid. Debt can get a person into an enormous amount of trouble, but it's unrealistic and even imprudent to live completely debt free. 

Let's start with credit worthiness

Lenders, credit card companies, landlords, employers, insurance companies, mobile phone companies, and more, can access your credit report to view your credit history and credit score. From this report, they see the type of credit you're using and how responsibly you're using it.

Your report contains information about your credit cards, lines of credit, and loans. It also records whether you've had an ‘insufficient funds’ charge, if an account has been closed for cause due to money owing, if you’ve declared bankruptcy, and more.

Information generally stays on your credit report for six years. However, some information may stay longer or shorter. For instance, a declaration of bankruptcy may remain on a credit report for longer. On the positive side, good credit behaviour, such as making regular payments on time, can also remain on your report for longer.

Your credit score is a three-digit number that falls between 300 to 900. The higher the score, the more creditworthy you are. This score helps creditors assess how risky it will be for them to lend you money.

Factors that impact your score include how long you've had credit for, if you have an outstanding balance on your credit cards (including joint credit cards, by the way), if you regularly miss payments, the amount of your outstanding debts, being close to your credit limit, the number of times you tried to get more credit, and more.

A good credit score will help you access a loan more readily when you need it. Additionally, having a good score will often result you paying lower interest rates.

Now, we’ll cover credit cards.

Credit cards allow you to spend money based on your promise to repay the issuer of the credit card. When you make a purchase using a credit card, the issuer is providing you with the funds directly, which they collect from you later.

Credit cards are generally easier to obtain than other forms of debt. They’re widely accepted as valid forms of payment, can often be conveniently used internationally, and have a variety of rewards and loyalty programs to attract your business. And they allow you to easily track what you’re spending your money on and where. 

Using your credit card responsibly by making regular payments in full helps you establish a good credit history, which will be incorporated into your credit score. We'll cover this later. 

Before applying for a credit card, you should compare the different types of cards available to you. Different credit cards may vary significantly. Some of the important features that you'll want to compare are the annual fees, charges for transactions like foreign currency transactions, and annual interest rate if you carry a balance. 

Annual interest rates for credit cards are generally between 15% and 21%. 

There are cards that charge lower interest rates, but they may have annual fees. 

And there are cards charge higher rates, but have other benefits worth considering, especially if you never carry a balance and therefore never pay interest anyway (I hope this is you).

When you make a purchase there's a minimum period of about 21 days during which interest does not accrue. 

If you were to only pay the minimum balance (which I hope you never do), interest would begin to accrue on whatever remains unpaid, starting back from the date of purchase. That last part is very important: since the date of purchase. 

This means that NOT paying your full credit card balance each month is very costly.

Now let’s move on to Lines of Credit

A line of credit is essentially a loan that allows you to borrow a predetermined amount of money. The characteristics are like a debit card in that you can take out cash, pay for things directly, and transfer money to other accounts to pay bills.

Unlike credit cards, the money you use from your line of credit starts accruing interest immediately. And it accrues interest until it's paid off in full.

If you have not used your line of credit, the balance will be zero. You will not accrue interest and will usually not pay a fee (keep an eye on this though). 

There are different types of lines of credit: personal, home equity, student, secured, unsecured. The differences will usually relate to the credit limit and the interest rate. 

The major benefit of a line of credit over a credit card is that the interest rate is often (but not always) lower for a line of credit than for a credit card. 

A major risk with a line of credit is that it is easy and tempting to dip into this available pot of money and lulled into paying it paying slowly. 

Next, we’ll talk about Mortgages

A mortgage is a loan that's specific to real estate properties. The property you buy serves as collateral and secures this loan. In order to obtain a mortgage, a minimum down payment is required.

When you consider a mortgage, you need to select various terms, which will usually be set for the term of your mortgage. A common mortgage term is five years in Canada. 

Once the mortgage term expires, you'll need to either renew the mortgage, refinance the loan, or pay it off in full.

An important mortgage feature is the amortization period, which is the length of time it will take you to repay the entire mortgage including both the principal and interest. Every payment you make towards your mortgage includes an interest and principal component. 

If you have a mortgage of $300,000 and every month you pay $1,500, by the end of the year, you will have paid $18,000. However, your mortgage balance will not have gone down by $18,000 unfortunately. The payments make in the earlier years will mostly be interest, but as you approach the end of the amortization period, more will go to paying down the principal component of your loan.

The total amount of interest that you will pay on a mortgage by the end of the amortization period is significant. 

Another important mortgage feature to consider is the type of interest rate. You'll need to decide whether a fixed or variable interest rate is most appropriate for you. The primary benefit of a fixed interest rate is that your mortgage payments will remain the same for your entire term regardless of changes in market rates. 

Variable interest rates are subject to change depending on market interest rates. If market rates increase, your mortgage payments also increase. If rates decrease, your mortgage payments decrease. 

Usually, variable rates are lower than fixed rates offered to compensate you for the risk of uncertainty. 

Another mortgage feature you will need to consider is the frequency of your mortgage payments: every week, every two weeks, every month, every two months. 

Online mortgage calculators allow you to see how different variables affect your overall mortgage payment, the total interest you will pay on your mortgage, and the time it will take you to repay the mortgage in full. 

Finally, some general tips for how to smartly use debt. 

The first tip is to live within your means. Before you buy something on credit, question whether the benefits outweigh the cost of borrowing. Insure you are using debt wisely by paying off your credit card in full every month and paying the lowest interest rate possible when you do have to borrow. 

The second tip is to repay the debt you have accumulated according to a disciplined plan. Commit to making every scheduled payment in full and on time and make extra payments when you can, no matter how small.