How to manage your credit

Know the difference between good credit and bad credit

Credit is one of your most powerful financial tools. Managing it properly can help you achieve significant personal goals like home ownership, a major renovation, or acquiring that coveted vacation property. If not carefully handled, however, it can result in financial hardship. Here are a few things to think about when managing your debt load.

For many of us, debt is just part of life. Canadians have become more comfortable carrying debt and a decade-long trend of low interest rates has prompted more of us to save less and borrow more than ever before. With the high cost of real estate in the province as a key factor, BC household debt is one of the highest in the country.

But this can be a dangerous way of life. Things change – interest rates may rise or your employment income may be interrupted or reduced. For some households with large mortgages, this could mean big trouble. For example, a $750,000 25-year mortgage at 2.2% requires payments of about $3,250 a month. A 1% interest hike adds another $375 in costs; a 2% increase bumps this expense up by nearly $780 a month.

Credit counsellors suggest that total debt payments – including your mortgage – should consume less than half your after-tax income. Realistically, that figure will be a bit higher in much of British Columbia where real estate is expensive. Managed well, your debt and subsequent credit rating can help you move towards building financial security.

But first, you need to be able to distinguish between "good" debt and "bad" debt.

Good debt is an investment

Good debt consists of loans aimed at building long-term financial security, ideally at reduced cost thanks to tax breaks.

Here are some examples:

Student loans

Studies have found that, on average, university graduates earn 20% more than those without degrees. Many people already in the workforce boost their earnings potential by returning to school to upgrade their skills. Graduate degrees like MBAs are especially popular. Note that there's a tax credit for interest paid on loans granted under government programs. In addition, as a student you may be able to claim tuition, textbooks, and education tax credits.

Home mortgage

A well-chosen residential property will likely increase in value, particularly in the greater Vancouver market. Even better, the gain is tax-free if the property is your principal residence. Meanwhile, you get the enjoyment of living in it. Plus, home mortgages are normally the cheapest loans around if your down payment is at least 20% of the home's value.

Business loans

Prudent borrowing makes it possible for entrepreneurs to start and build their own businesses. If the business is a qualified small business corporation, the shares may be eligible for a lifetime capital gains exemption of up to $1,250,000 (as of 2024).

RRSP loans

Short-term RRSP loans can help build retirement savings while potentially resulting in a tax refund which can be used to reduce the debt. Longer-term RRSP catch-up loans can help by imposing discipline, such as an automatic monthly repayment plan.

Borrowing to invest

An investment loan can be good debt if you invest wisely. Under current regulations, the interest may be tax-deductible if the investment has the potential to generate taxable income. You need to consult with a financial advisor to determine when this might be the case.

Bad debt costs you in the long run

The most obvious example of bad debt is a high-interest credit card where you carry a balance, month after month. The best strategy for minimizing your exposure to this kind of debt is to use credit cards for convenience, and then pay them off in full each month, or transfer your balance to a lower-interest line of credit.

Other examples of what might be considered bad debt are any other loans that aren't contributing to your long-term goals or have high interest rates. If you have funds sitting in low-interest savings accounts or cashable term deposits (outside of your emergency fund), use them to pay down these debts. This will deliver an instant return on your money that's hard to beat.

Remember if you don't pay your credit card balances in full, everything you charge could eventually cost you more than the original price you saw. Before buying an item, ask yourself how it will enhance your life over the long term. That's the basic question in distinguishing between good debt and bad debt.

Credit strategies determine borrowing potential

Credit ratings are key to whether you can get a loan, rent an apartment, or open a utility account without posting a deposit. A high score can translate into lower borrowing costs when you apply for a loan. Two services – Equifax and TransUnion – compile your credit history and score your reliability in paying it back.

How do these credit reporting companies get this information? From you! The fine print on each loan or account application you sign authorizes that company to provide data to a credit reporting agency. The agency maintains a file that other vendors can check whenever you apply for credit.

For a small fee, you can take a look at your own credit history and find out your own score. Even if you have a clean credit history, it's important to know your credit score and know which organizations have checked your record. Review your report for errors. Uncorrected mistakes can affect your credit profile, lowering your credit worthiness.

How to improve your credit rating

If you find that your score is less than ideal, you can improve it. Limit the number of loan and credit accounts you have and avoid getting too close to your borrowing limits. Applying for credit too often and pushing against your loan limits can raise alarm bells about your ability to repay your debts.

Wise use of credit cards can also play a role. Here are some essentials for managing your credit and your credit card.

• Pay the credit card’s full balance amount on time each month and you'll build a solid payment history that will benefit your credit rating. If you aren't able to do this, pay at least the required minimum amount shown on your monthly statement.
• Make sure your monthly statement is correct. Report any unauthorized transactions on your account. Contact your credit issuer if your bill includes items you didn't buy. Keep up to date on any fee increases or changes in your card's terms and conditions.
• Deal with companies you know and whose security measures you trust.
• Get a copy of your credit report from one of the two credit-reporting agencies at least once a year and make sure they're accurate.
• Contact your creditors if you're having trouble making payments.
• Don't go over the credit limit on your credit card.

If you are having any challenges with debt management or credit issues, talk with your financial advisor.