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What is credit and how does it work?

woman holding credit card while on laptop
What is credit and how does it work?

Understanding the basics of credit and debt

Credit is an agreement between a borrower and a lender, where the borrower agrees to pay the funds back to the lender at a later date. Lenders, also referred to as a creditors, will extend credit when they feel confident that a borrower will pay the debt back, along with any interest or finance charges.

A lender will use your credit history as a guide when deciding whether to extend credit to you. Your credit history is a record of your borrowing and repayment practices over time.

When you borrow money from a lender, the amount you owe is referred to as debt. Debt is an obligation to pay money back though a deferred payment or series of payments. As the borrower, you are the debtor, and the lender is the creditor.

Types of credit

Different types of credit serve different purposes. It’s important to understand the differences so that you choose the right credit product for your needs.

  • Credit cards: Credit cards are considered “revolving credit.” A credit card has a limit, which is the maximum amount that you can borrow. You can make purchases using your card up to your limit, but you’re required to make at least a minimum payment on the balance each month. As you pay down the balance, you free up more available credit. More about revolving credit.
  • Line of credit: A line of credit is another form of “revolving credit.” You can borrow funds up to your approved limit, any time, for any purpose, and you’ll have to make a minimum payment on the balance each month. You only pay interest on what you borrow. A line of credit usually has a lower interest rate than credit card.
  • A secured line of credit: This is a line of credit that is secured by collateral. For example: if you own a home, you can use the equity in your home to secure the home equity line of credit. Because there is less “risk” to the lender, a secured line of credit usually has a lower interest rate than an unsecured line of credit. More about secured debt.
  • Personal loan: A personal loan is also referred to as an installment loan. You borrow a set amount, and make regular payments over time. The loan will have an interest rate, repayment term and fees, which will affect how much you pay per month. The loan can be either fixed or variable.
  • Mortgage: A mortgage is another type of installment loan. Mortgage funds are used to buy a home or property, where the property becomes the security for the loan. A mortgage is a larger loan that you pay off over the longer term – up to 30 years. Learn more about mortgages.

Interest rates and credit costs

There is a big difference in the rate for different types of credit. Generally rates on mortgages and secured lines of credit are the lowest, and credit cards are the highest. There are a number of additional factors that will affect the rate you pay on borrowed funds.

  • Market conditions: The Bank of Canada rate (also known as the overnight rate) is the rate at which banks can lend funds to each other at the end of the day. Changing this rate has a domino affect on the rates you pay on your loans and credit cards. How interest rates work and how they affect you.
  • Your credit score: Your credit score is a method for lenders to gauge your financial health. It helps a lender understand how much risk they are taking by loaning you money. A good credit score means you’ve had a history of paying back the money you’ve borrowed, on time. Lower risk usually means a lower interest rate. Learn more about understanding your credit score.

Why use credit

Credit is a useful tool and there are lots of reasons to use it. Credit makes online shopping simple and convenient. Credit cards often come with perks and benefits, like travel rewards and insurance coverage. There is also a safety element, as using credit for purchases means you don’t need to carry cash.

Credit makes large purchases or owning a home a possibility for most people, even those with good income and savings habits. The ability to borrow and spread the payments out over time means less of a burden up front.

Using credit responsibly will help you establish your credit history and build a good credit rating. This means that lenders will be more likely to loan you money when you need it in the future, and potentially at a more favourable rate.

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