Financial management is about managing the financing for consumption and investment. You have two sources for money: yourself or someone else. You need to decide when to use whose money and how to do so as efficiently as possible so as to maximize benefit and minimize cost. As with all financial decisions, you also need to think about the strategic consequences of your decisions and how they might impact your future.
You can use your own money as a source of financing if your income is at least equal to your living expenses. If it is more, you have a budget surplus that can be saved and used as a source of future financing while earning income at the same time. If your own income is less than the expenses, you have a budget deficit that will require another external source of financing—someone else’s money—that will add an expense. Ideally, you want to avoid the additional expense of borrowing and instead create the additional income from saving. The budgeting techniques discussed in Chapter 5 “Financial Plans: Budgets” are helpful in seeing this picture more clearly.
Your ability to save will vary over your lifetime, as your family structure, age, career choice, and health will change. Those “micro” factors determine your income and expenses and thus your ability to create a budget surplus and your own internal financing. Likewise, your need to use external financing, such as credit or debt, will vary with your income, expenses, and ability to save.
At times, unexpected change can turn a budget surplus into a budget deficit (e.g., a sudden job loss or increased health expenses), and a saver can reluctantly become a borrower. Being able to recognize that change and understand the choices for financing and managing cash flow will help you create better strategies.
Financing can be used to purchase a long-term asset that will generate income, reduce expense, or create a gain in value, and it may be useful when those benefits outweigh the cost of the debt. The benefit of long-term assets is also influenced by personal factors. For example, a house may be more useful, efficient, and valuable when families are larger.
Macroeconomic factors, such as the economic cycle, employment levels, and inflation, should bear on your financing decisions as well. Your incomes and expenses are affected by the economy’s expansion or contraction, especially as it affects your own employment or earning potential. Inflation or deflation, or an expected devaluation or appreciation of the currency, affects interest rates as both lenders and borrowers anticipate using or returning money that has changed in value.
Financial management decisions become more complicated when the personal and macroeconomic factors become part of the decision-making process, but the result is a more realistic evaluation of alternatives and a better strategy that leaves more choices open in the future. Financial management decisions, however, are difficult not because of their complexity, but because the way you finance your assets and expenses (i.e., lifestyle) determines the life that you live.
7.1 YOUR OWN MONEY: CASH
- Identify the cash flows and instruments used to manage income deposits and expense payments.
- Explain the purpose of cheque balancing.
Most people use a chequing account as their primary means of managing cash flows for daily living. Incomes from wages and perhaps from investments are deposited into this account, and expenses are paid from it. The actual deposit of paycheques and the writing of cheques, however, has been made somewhat obsolete as more cash flow services are provided electronically.
When incoming funds are distributed regularly, such as a paycheque or a government distribution, direct deposit is preferred. For employers and government agencies, it offers a more efficient, timely, and secure method of distributing funds. For the recipient, direct deposit is equally timely and secure, and can allow for a more efficient dispersal of funds to different accounts. For example, you may have some of your paycheque directly deposited to a savings account, while the rest is directly deposited to your chequing account to pay living expenses. Because you never “see” the money that is saved, it never passes through the account that you “use,” so you are less likely to spend it.
Withdrawals or payments have many electronic options. Automatic payments may be scheduled to take care of a periodic payment (i.e., same payee, same amount) such as a mortgage or car payment. They may also be used for periodic expenses of different amounts—for example, utility or telephone expenses. A debit card may be used to directly transfer funds at the time of purchase; money is withdrawn from your account and transferred to the payee’s with one quick swipe at checkout. An ATM (automated teller machine) card offered by a bank allows for convenient access to the cash in your bank accounts through instant cash withdrawals.
The bank clears these transactions as it manages your account, providing statements of your cash activities, usually monthly and online. When you reconcile your record keeping (i.e., your chequebook or software accounts) with the bank’s statement, you are balancing your chequing account. This ensures that your records and the bank’s records are accurate and that your information and account balance are up to date and consistent with the bank’s. Banks do make mistakes, and so do you, so it is important to check and be sure that the bank’s version of events agrees with yours.
- A chequing account is the primary cash flow management tool for most consumers, providing a way to pay for expenses and store cash until it is needed.
- Balancing your chequebook reconciles your personal records with the bank’s records of your chequing account activity.
- In your personal finance journal, inventory in detail all the vehicles you use for managing your cash flows. Include all your accounts that are mediated through banks and finance companies. Also, list your cards issued by banks, such as debit or ATM cards, and identify any direct deposits and automatic payments that are made through your savings and chequing accounts. How might you further enhance your cash management through the use of banking tools?
- Does your bank offer online banking services, such as electronic bill payment? View your bank and others online to learn more about Internet banking. What products and services do online branches and banks offer? Do you (or would you) use those products and services? Why or why not? Discuss online banking with classmates. What do they identify as the main benefits and risks of electronic banking?
7.2 YOUR OWN MONEY: SAVINGS
- Identify the markets and institutions used for saving.
- Compare and contrast the instruments used for saving.
- Analyze a savings strategy in terms of its liquidity and risk.
When incomes are larger than expenses there is a budget surplus, and that surplus can be saved. You could keep it in your possession and store it for future use, but then you have the burden of protecting it from theft or damage. More important, you create an opportunity cost. Because money trades in markets and liquidity has value, your alternative is to lend that liquidity to someone who wants it more than you do at the moment and is willing to pay for its use. Money sitting idle is an opportunity cost.
The price that you can get for your money has to do with supply and demand for liquidity in the market, which in turn has to do with a host of other macroeconomic factors. It also has a lot to do with time, opportunity cost, and risk. If you are willing to lend your liquidity for a long time, then the borrower has more possible uses for it, and increased mobility increases its value. However, while the borrower has more opportunity, you (the seller) have more opportunity cost because you give up more choices over a longer period of time. That also creates more risk for you, since more can happen over a longer period of time. The longer you lend your liquidity, the more compensation you need for your increased opportunity cost and risk.
The markets for liquidity are referred to as the money markets and the capital markets. The money markets are used for relatively short-term, low-risk trading of money, whereas the capital markets are used for relatively long-term, higher-risk trading of money. The different time horizons and risk tolerances of the buyers, and especially the sellers, in each market create different ways of trading or packaging liquidity.
When individuals are saving or investing for a long-term goal (e.g., education or retirement), they are more likely to use the capital markets; their longer time horizon allows for greater use of risk to earn return. Saving to finance consumption relies more on trading liquidity in the money markets because there is usually a shorter horizon for the use of the money. Also, most individuals are less willing to assume opportunity costs and risks when it comes to consumption, thus limiting the time that they are willing to lend liquidity.
When you save, you are the seller or lender of liquidity. When you use someone else’s money or when you borrow, you are the buyer of liquidity.
For most individuals, access to the money markets is done through a bank. A bank functions as an intermediary or “middleman” between the individual lender of money (the saver) and the individual borrower of money.
For the saver or lender, the bank can offer the convenience of finding and screening the borrowers, and of managing the loan repayments. Most important, a bank can guarantee the lender a return: the bank assumes the risk of lending. For the borrowers, the bank can create a steady supply of surplus money for loans (from the lenders), and arrange standard loan terms for the borrowers.
Banks create other advantages for both lenders and borrowers. Intermediation allows for the amounts loaned or borrowed to be flexible and for the maturity of the loans to vary. That is, you don’t have to lend exactly the amount someone wants to borrow for exactly the time she or he wants to borrow it. The bank can “disconnect” the lender and borrower, creating that flexibility. By having many lenders and many borrowers, the bank diversifies the supply of and demand for money, and thus lowers the overall risk in the money market.
The bank can also develop expertise in screening borrowers to minimize risk and in managing and collecting the loan payments. In turn, that reduced risk allows the bank to attract lenders and diversify supply. Through diversification and expertise, banks ultimately lower the cost of lending and borrowing liquidity. Since they create value in the market (by lowering costs), banks remain as intermediaries or middlemen in the money markets.
In Canada, there are currently five banks and the National Bank of Canada, often referred as the Big Six, which account for more than 90 per cent of the total banking assets in Canada. The National Bank of Canada is headquartered in Montreal, Quebec, and the five banks are headquartered in Toronto, Ontario. The five banks are classified as Schedule I domestic banks, which are banks that are Canadian-owned and have no more than 10 per cent of voting shares controlled by a single interest. These banks are: Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Scotiabank, and Toronto-Dominion.
Unlike the United States, which has hundreds of banks—some with only a few branches—Canada has a much smaller number of banks, many with hundreds of branches throughout the country. Schedule II banks may be domestically owned or foreign-controlled and do not meet the 10 per cent limit (Ebert, Griffin, Starke, and Dracopoulos, 2017). Schedule III banks are branches of foreign institutions that are authorized under the Bank Act to do banking in Canada. These foreign institutions are subject to certain restrictions that Schedule I and II banks are not subject to. Bank of America and Capital One are examples of such institutions.
Credit unions, or caisses populaires, function similarly, but are co-operative membership organizations, with depositors as members. Credit unions also tend to be more community-oriented in their overall mission. For example, Conexus Credit Union promotes financial well-being, its key priority, through its Community Investment Program. In partnership with non-profit and charitable organizations, credit unions support financial literacy education programs, capital projects, and programs that address basic human needs with regard to education, food, shelter, and health services. Another difference between banks and credit unions is that banks are federally regulated, while credit unions are regulated by the provinces or territories.
In addition to banks, other kinds of intermediaries for savers include pension funds, life insurance companies, and investment funds. They focus on saving for a particular long-term goal. To finance consumption, however, most individuals primarily use banks or credit unions.
Some intermediaries have moved away from the “bricks-and-mortar” branch model and now operate as online banks, either entirely or in part. There are cost advantages for the bank if it can use online technologies in processing saving and lending. Those cost savings can be passed along to savers in the form of higher returns on savings accounts or lower service fees. Most banks offer online and, increasingly, mobile account access via cell phone or smartphone. Intermediaries operating as finance companies offer similar services.
The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown corporation of the Government of Canada that protects eligible deposits at each of its member financial institutions up to a maximum of $100,000 (principal and interest combined) per depositor per insured category in case of a failure. There is no need to apply for this insurance or file a claim; coverage is free and automatic as long as deposits are paid in Canada and in Canadian currency. The CDIC does not cover foreign currency deposits, including U.S. dollars. If deposits are made at a branch or office of a CDIC member institution in Canada, that institution is eligible for CDIC coverage (CDIC, 2018a). Similar protection is provided to customers of credit unions. A provincial deposit insurer is present in each of Canada’s ten provinces and protects provincial credit unions; these provincial deposit insurers can be found on the . Currently, there is no credit union legislation in place in the Yukon, Northwest Territories, and Nunavut.
Eligible deposits covered by the CDIC include:
- Savings accounts,
- Chequing accounts,
- Term deposits (such as GICs) with original terms to maturity of five years or less,
- Debentures issued to evidence deposits by CDIC member institutions (other than banks),
- Money orders and bank drafts issued by CDIC members,
- Cheques certified by CDIC members. (CDIC, 2018b)
Member institutions include banks, federally regulated credit unions, as well as loan and trust companies and associations governed by the Cooperative Credit Associations Act. The CDIC is funded by premiums paid by its member institutions and does not receive public funds to operate (CDIC, 2018c).
The above-mentioned institutions are examples of deposit-type institutions.
The following are examples of non-depository institutions that also provide a variety of financial services: life insurance companies, investment companies, mortgage and loan companies, pawnshops, and cheque-cashing outlets (Kapoor et al., 2015).
Non-depository institutions provide non-depository credit, such as real estate credit, international trade financing, short-term inventory credit and loans, working capital credit, and agricultural credit and loans. Essentially, they make direct loans or extend credit through funds from sources other than deposits from the public.
Cheque-cashing centres are examples of a non-depository financial institution that offer financial services that are often utilized by those who are unable to open up accounts at depository institutions, largely because of their past financial history, those who wish to take advantage of their extended business hours, and those who wish to have immediate access to their funds. Some are critical of these centres because of the fees associated with them. Many centres charge an average fee of 3 to 5 per cent of the cheque amount. Long term, the fees charged by these centres are generally far more expensive than a traditional chequing account at a depository institution.
A pawnshop is an example of a non-depository institution that offers loans in exchange for personal property as a form of collateral. The personal property may be repurchased if the loan is repaid in an agreed-upon time frame at its initial price plus interest. The personal property “may be liquidated by the pawn shop through a pawnbroker or second-hand dealer through sales to customers” (BusinessDictionary, 2018).
Indigenous Banking and Financing
Historically, Indigenous communities and businesses in Canada have had a lack of access to debt financing due to a number of issues such as limited collateral, the challenge of using on-reserve assets as collateral, and a lack of local financial institutions. Equity financing has also been hampered by limited personal resources, a lack of access to venture capital and community funds, and the inability of family and friends to invest (Cooper, 2016). According to Cooper (2016), “perceived risk underlies most of these issues. In many cases this perception is shaped by a lack of accurate information about the governance and fiscal capacity of Aboriginal communities. . . . As a result, Aboriginal individuals and communities in Canada have been placed at a disadvantage to the rest of Canadian society” (pp. 163–164).
Instead of selling bonds or other large loans to capital markets, “Aboriginal entrepreneurs, businesses and governments rely more on financial institutions, such as banks, credit unions, and other structures to access capital” (Cooper, 2016, p. 165). Therefore, Indigenous financial institutions and banking play a critical role in closing the gap that has existed between Indigenous and mainstream communities with regard to access to capital. Many mainstream financial institutions and government initiatives, such as Aboriginal Business Canada, have also attempted to close the “capital gap” in recent years.
Below are some examples of Indigenous financial institutions that have been established in order to assist Indigenous communities, entrepreneurs, and governments in accessing capital.
First Nations Bank of Canada got its start with the Saskatchewan Indian Equity Foundation (SIEF). SIEF was established as an Aboriginal capital corporation in the mid-1980s. During the early 1990s, the settlement of land claims under the Treaty Land Entitlement Framework Agreement (TLEFA) in Saskatchewan was taking place. Many banks began to show a new interest in managing First Nations money because of these land claims. Seeing an opportunity, SIEF submitted a proposal to the Federation of Saskatchewan Indian Nations (FSIN)—now called the Federation of Sovereign Indigenous Nations—to create the First Nations Bank (Schneider, 2009).
In 1996, SIEF, the FSIN, and Toronto-Dominion (TD) launched the First Nations Bank of Canada (Cooper, 2016). The founders of First Nations Bank (FNB) had a vision to develop a federally chartered bank serving Indigenous and non-Indigenous people, corporations, and governments throughout Canada. The bank offers these customers a full range of personal and business banking services, including loans, mortgages, investments (registered and non-registered), transaction accounts, and cash management. The bank is primarily focused on providing financial services to the Indigenous marketplace in Canada and “sees itself as an important step toward Aboriginal self-sufficiency” (FNB, 2017a). Over 80 per cent of FNB is Indigenous owned and controlled; the bank now operates separately from TD (FNB, 2017b).
FNB is both an approved member of the CDIC and the Canadian Payments Association, and it is an approved mortgage lender with Canada Mortgage and Housing Corporation as well as the First Nations Market Housing Fund (FNB, 2017b). The bank is headquartered in Saskatoon, Saskatchewan.
Anishinabek Nation Credit Union, Caisse Populaire Kahnawake, and Me-Dian Credit Union are three examples of Indigenous credit unions in Canada. Caisse Populaire Kahnawake is located on reserve, twenty kilometres from Montreal. Kahnawake chose to open the credit union in the mid-1980s in order to develop their own source of capital for economic development purposes instead of being reliant on outside government. The credit union model was chosen “so they could tailor products and services to meet the members’ needs. The caisse populaire is headquartered on the reserve, so there is no question of taxability on interest earned. In 2004, 5,288 people from a reserve of 8,000 were members of the caisse” (Cooper, 2016).
Aboriginal financial institutions (AFIs) were created in the late 1980s and early 1990s by Indigenous leaders, the Government of Canada, and a Native Economic Development Program initiative in order to address the lack of available capital to finance Indigenous small-business development. Within the last thirty years, over fifty AFIs have been established throughout Canada, resulting in over thirteen thousand full-time equivalent jobs and $2.3 billion in developmental loans to Canadian Indigenous peoples (NACCA, 2016).
AFIs represent a network of loan corporations in Canada, structured as non-governmental financial institutions, which deliver a variety of Indigenous business and community development products and support services. AFIs offer developmental lending and their products are inclusive of small business loans to Indigenous small businesses engaged in all sectors of the Canadian economy. The National Aboriginal Capital Corporation (NACCA) serves the AFI network by supporting AFI capacity development and Indigenous business development in order to enhance “social and economic self-reliance and sustainability for Indigenous peoples and communities nationwide” (NACCA, 2016, p. 5). AFIs are generally composed of three different institutional structures:
- Aboriginal capital corporations;
- Aboriginal community future development corporations; and
- Development corporations.
For more information on these different types of AFIs, go to the website of the National Aboriginal Capital Corporations Association.
Banks offer many different ways to save your money until you use it for consumption. The primary difference among the accounts offered to you is the price that your liquidity earns, or the compensation for your opportunity cost and risk, which in turn depends on the degree of liquidity that you are willing to give up. You give up more liquidity when you agree to commit to a minimum time or amount of money to save or lend.
For the saver, a demand deposit (e.g., chequing account) typically earns no or very low interest but allows complete liquidity on demand. Chequing accounts that do not earn interest are less useful for savings and therefore more useful for cash management. Some chequing accounts do earn some interest, but often require a minimum balance. Time deposits, or savings accounts, offer minimal interest or a bit more interest with minimum deposit requirements.
If you are willing to give up more liquidity, GICs offer a higher price for liquidity, but extract a time commitment enforced by a penalty for early withdrawal if they are considered non-redeemable GICs. Some GICs can be redeemed prior to maturity, but these GICs will offer a lower rate of interest compared to non-redeemable GICs (Kapoor et al., 2015, pp. 129). They are offered for different maturities and some have minimum deposits as well. Banks can also offer investments in money market mutual funds. A money market fund is a “combination savings-investment plan in which the investment company uses your money to purchase a variety of short-term financial instruments” (Kapoor et al., 2015, pp. 123–124). Examples of short-term financial instruments are securities such as stocks and bonds.
Compared to the capital markets, the money markets have very little risk, so money market funds are considered very low-risk investments.
As long as your money remains in your account, including any interest earned while it is there, you earn interest on that money. If you do not withdraw the interest from your account, it is added to your principal balance, and you earn interest on both. This is referred to as earning interest on interest, or compounding. The rate at which your principal compounds is the annual percentage rate (APR) that your account earns.
The rate of return is the yield, namely “the percentage of increase in the value of savings as a result of interest earned” (Kapoor et al., 2015, p. 130). For example, if you invest $200 and earn 2 per cent annually, you will earn $4 the first year. You can calculate the eventual value of your account by using the relationships of time and value that we looked at in Chapter 4 “Evaluating Choices: Time, Risk, and Value,” where FV = future value, PV = present value, r = rate, and t = time. The balance in your account today is your present value, PV; the APR is your rate of compounding, r; the time until you will withdraw your funds is t. Your future value depends on the rate at which you can earn a return or the rate of compounding for your present account and can be determined using the following formula:
FV = PV × (1+r)t
If you are depositing a certain amount each month or with each paycheque, that stream of cash flows is an annuity. You can use the annuity relationships discussed in Chapter 4 to project how much the account will be worth at any point in time, given the rate at which it compounds. Many financial calculators can help you make those calculations.
Ideally, you would choose a bank’s savings instrument that offers the highest APR and most frequent compounding. However, interest rates change, and banks with savings plans that offer higher yields often require a minimum deposit, minimum balance, and/or a maintenance fee. Also, your interest from savings is taxable, as it is considered income. As you can imagine, however, with monthly automatic deposits into a savings account with compounding interest, you can see your wealth can grow safely.
Your choice of savings instrument should reflect your liquidity needs. In the money markets all such instruments are relatively low risk, so return will be determined by opportunity cost.
You do not want to give up too much liquidity and then risk being caught short, because then you will have to become a borrower to make up that shortfall, which will create additional costs. If you cannot predict your liquidity needs or you know they are immediate, you should choose products that will least restrict your liquidity choices. If your liquidity needs are more predictable or longer term, you can give up liquidity without creating unnecessary risk and can therefore take advantage of products, such as GICs, that will pay a higher price.
Your expectations of interest rates will contribute to your decision to give up liquidity. If you expect interest rates to rise, you will want to invest in shorter-term maturities, so as to regain your liquidity in time to reinvest at higher rates. If you expect interest rates to fall, you would want to invest in longer-term maturities so as to maximize your earnings for as long as possible before having to reinvest at lower rates.
One strategy to maximize liquidity is to diversify your savings in a series of instruments with differing maturities. If you are using GICs, the strategy is called GIC laddering. For example, suppose you have $12,000 in savings earning 0.50 per cent annually. You have no immediate liquidity needs, but would like to keep $1,000 easily available for emergencies. If a one-year GIC is offering a 1.5 per cent return, the more savings you put into the GIC, the more return you will earn, but the less liquidity you will have.
A “laddering” strategy allows you to maximize return and liquidity by investing $1,000 per month by buying a one-year GIC. After twelve months, all your savings are invested in twelve GICs, each earning 1.5 per cent. But because one GIC matures each month, you have $1,000 worth of liquidity each month. You can keep the strategy going by reinvesting each GIC as it matures. Your choices are shown in Table 7.2.1.
$ Invested in GICs
GIC Laddering Strategy
A laddering strategy can also reflect expectations of interest rates. If you believe that interest rates or the earnings on your money will increase, then you don’t want to commit to the currently offered rates for too long. Your laddering strategy may involve a series of relatively short-term (less than one year) instruments. On the other hand, if you expect interest rates to fall, you would want to weight your laddering strategy to longer-term GICs, keeping only your minimum liquidity requirement in the shorter-term GICs.
The laddering strategy is an example of how diversifying maturities can maximize both earnings and liquidity. In order to save at all, however, you have to choose to save income that could otherwise be spent, suffering the opportunity cost of everything that you could have had instead. Saving is delayed spending, often seen as a process of self-denial.
One saving strategy is to create regular deposits into a separate account such that you might have a chequing account from which you pay living expenses and a savings account in which you save.
This is easier with direct deposit of wages since you can have a portion of your disposable income go directly into your savings account. Saving becomes effortless, while spending actually requires a more conscious effort.
Some savings accounts need to be “segregated” because of different tax consequences—a retirement or education account, for example. In most cases, however, separating accounts by their intended use has no real financial value, although it can create a psychological benefit. Establishing a savings vehicle has a very low cost, if any, so it is easy to establish as many separate funds for saving as you find useful.
- Banks serve to provide the consumer with excess cash by having their cash earn money through savings until the consumer needs it.
- Banking institutions include retail, commercial, and investments banks.
- Consumers use retail institutions, including the following:
• savings banks,
• mutual savings banks,
• Aboriginal financial institutions, and
• credit unions.
- Savings instruments include the following:
• demand deposit accounts,
• time deposit accounts,
• guaranteed income certificates, and
• money market fund accounts.
- A savings strategy can maximize your earnings from savings.
- What are the benefits and drawbacks of guaranteed income certificates and money market funds for saving? Compared to savings accounts, what are their implications for liquidity and risk? What are their implications for cost and return? What advice would you give to someone who saved by keeping money in a piggy bank?
- You have $10,000 to deposit. You want to save it, earning interest by loaning its use in the money market to your bank. You anticipate you will need to replace your washing machine within the year, however, so you don’t want to surrender all your liquidity all at once. What is the best way to save your money that will give you the greatest increase in wealth without too much risk and while still retaining some liquidity? Explain your reasons for your choice of a solution.
- What Aboriginal financial institutions are located within your province or territory or are closest to where you live? Pick one and identify what banking services they offer.
- Go online to experiment with compound interest calculators (for example, at moneychimp.com or WebMath.com). Use real numbers based on your actual or projected savings. For example, based on what you have in savings now, how much could you have in five years? To see the effects of compounding, compare your results with the same calculation for simple interest (rather than compounded interest), using the simple interest calculator at WebMath.com.
BusinessDictionary. (2018). “Pawn Shop.” Retrieved from:.
Canadian Credit Union Association. (2017). “2017 Credit Union Community and Economic Impact Report.” Retrieved from:.
Canadian Deposit Insurance Corporation. (2018a). “About Deposit Insurance.” Retrieved from:.
Canadian Deposit Insurance Corporation. (2018b). “What We Cover.” Retrieved from:.
Canadian Deposit Insurance Corporation. (2018c). “About Us.” Retrieved from:.
Cooper, T. (2016). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp. 161–176. Sydney, NS: Cape Breton University Press.
Ebert, R. J., R. W. Griffin, F. A. Starke, G. Dracopoulos. (2017). Business Essentials (8th Ed.). Toronto: Pearson Canada.
First Nations Bank of Canada. (2017a). “Who We Are: FNBC at A Glance.” Retrieved from:.
First Nations Bank of Canada. (2017b). “Who We Are.” Retrieved from:.
Kapoor, J., L. Dlabay, R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
National Aboriginal Capital Corporation Association. (2016). “NACCA Annual Report 2015-16.” Retrieved from:.
Schneider, B. (2009). Reclaiming economic sovereignty: Native and Aboriginal financial institutions (unpublished PhD diss.). University of California, Davis.
7.3 OTHER PEOPLE’S MONEY: CREDIT
- Identify the different kinds of credit used to finance expenses.
- Analyze the costs of credit and their relationships to risk and liquidity.
- Describe the credit rating process and identify its criteria.
- Identify common features of a credit card.
- Discuss remedies for credit card trouble.
- Summarize government’s role in protecting lenders and borrowers.
The term “credit” derives from the Latin verb credere (to believe). It has several meanings as a verb in common usage—to recognize with respect, to acknowledge a contribution—but in finance, it generally means to allow delayed payment. According to Kapoor et al. (2015), credit is defined as “an arrangement to receive cash, goods, or services now and pay for them in the future” (p. 144).
Credit is not a new concept among Indigenous peoples in Canada. Trading posts, in what is present-day Canada, were largely established by the Hudson’s Bay Company in the late 1600s and throughout the 1700s and 1800s.
According to the Encyclopedia of Saskatchewan, Indigenous families would gather at trading posts in the fall, expecting the arrival of traders from the east with new stocks of goods. Indigenous families would obtain many of their supplies on credit and would then depart for their wintering grounds. These families would usually not return until the spring. It was at this time that they would bring winter furs to pay off their debts from the previous fall and would trade any remaining merchandise for other goods (Russell, 2006). Credit was used as a tool by Indigenous people in Canada to help meet their needs when cash wasn’t always on hand.
As pointed out by Oweesta and First Nations Development Institute, traditional resource management teaches us that our actions today affect the resources that we will have available in the future. For example, “hunting practices demonstrated an understanding of the costs and benefits of working within the natural cycle. The benefit of fresh meat year-round did not justify the cost” (FNOC and FNDI, 2016, p. 74).
When it comes to credit, traditional resource management also teaches us that we must not overextend ourselves and purchase goods that we are not able to repay in “the spring” (FNOC and FNDI, 2016, p. 74). Credit might provide us the benefit of fresh meat (i.e., various non-necessities and luxury items) all year long, but it is not worth the excessive interest payments that will arise if you don’t have the resources to pay off those interest charges on a monthly basis.
Kinds of Credit
Credit is issued either as installment credit or as revolving credit. Installment credit is a form of credit used to purchase consumer durables, usually issued by one vendor, such as a department store, for a specific purchase. The vendor screens the applicant and extends credit, bearing the default risk, or risk of nonpayment. Payments are made until that amount is paid for. Payments include a portion of the cost of the purchase and the cost of the credit itself, or interest.
Installment credit is an older form of credit that became popular for the purchase of consumer durables (i.e., furniture, appliances, electronics, or household items) after the First World War. This form of credit expanded as mass production and invention made consumer durables such as radios and refrigerators widely available. (Longer-term installment purchases for bigger-ticket assets, such as a car or property, are considered debt.)
Revolving credit extends the ability to delay payment for different items from different vendors up to a certain limit. Such credit is lent by a bank or finance company, typically through a charge card or a credit card. The charge card balance must be paid in full in each period or credit cycle, while the credit card balance may not be, requiring only a minimum payment.
While both the charge card and many credit cards operate on a line of unsecured credit that has been extended to you by the card’s issuer and both assess similar fees, such as annual fees, late fees, or foreign transaction fees, there are two key distinctions.
First, credit cards typically have a pre-set spending limit while charge cards do not, which allows charge card holders to put all their expenses on one card and take advantage of rewards points if these are offered on the card.
The other important difference (mentioned above) is that charge cards require customers to pay in full every month or face a fee, which can be as high as 30 per cent of the balance. However, paying interest on your balance is not required.
A charge card tends to be a good choice for those who travel frequently or have a lot of regular expenses for business. The card holder benefits from a much higher spending limit than a traditional credit card (Engen, 2013).
It is important to note that some credit cards are secured. For some consumers, this might be their only choice.
The credit card is a more recent form of credit, as its use became widely practical only with the development of computing technology. The first charge card was the Diners’ Club card, issued in 1950. The first credit card was the Bank Americard (now called Visa), issued by Bank of America in 1958, which was later followed by MasterCard in 1966. Retailers can also issue revolving credit (e.g., a store account or credit card) to encourage purchases.
Credit cards are used for convenience and security. Merchants around the world accept credit cards as a method of payment because the issuer (the bank or finance company) has assumed the default risk by guaranteeing merchants’ payment. Use of a credit card abroad also allows consumers to incur less transaction cost.
This universal acceptance allows a consumer to rely less on cash, so consumers can carry less cash, which is therefore less likely to be lost or stolen. Credit card payments also create a record of purchases, which is convenient for later record keeping. When banks and finance companies compete to issue credit, they often offer gifts or rewards to encourage purchases. In some situations, such as when it comes to purchasing airline tickets or hotel reservations, it’s difficult to complete the transaction without a credit card.
Credit cards create security against cash theft, but they also create opportunities for credit fraud and even for identity theft. A lost or stolen credit card can be used to extend credit to a fraudulent purchaser. It can also provide personal information that can then be used to assume your financial identity, usually without your knowing it. You should therefore, handle your credit cards carefully and be aware of publicized fraud alerts. Failure to do so may leave you responsible for purchases you did not make—or enjoy. Currently, there are a number of bank apps that can be utilized to review your credit card transactions in real time in order to ensure against cash theft or credit fraud, such as the TD MySpend app. Look to see if your bank has such an app.
Costs of Credit
Credit has become a part of modern transactions, largely enabled by technology, and a matter of convenience and security. It is easy to forget that credit is a form of borrowing and thus has costs. Understanding those costs helps you manage them.
Because consumer credit is all relatively short term, its cost is driven more by risk than by opportunity cost—that is, the risk of default or the risk that you will fail to repay the amounts advanced to you. The riskier the borrower, the fewer the sources of credit. The fewer sources of credit available to a borrower, the more credit will cost.
Measuring Risk: Credit Ratings and Reports
How do lenders know who the riskier borrowers are?
Credit rating agencies specialize in evaluating borrowers’ credit risk or default risk for lenders. That evaluation results in a credit score, which lenders use to determine their willingness to lend and their price.
If you have ever applied for consumer credit (a revolving, installment, or personal loan) you have been evaluated and given a credit score. The information you write on your credit application form, such as your name, address, income, and employment, is used to research the factors for calculating your credit score, also known as a FICO (Fair Isaac Corporation) score after the company that developed it.
In Canada, there are currently two major credit rating agencies: Equifax Canada and TransUnion. Each calculates your score a bit differently, but the process is similar. They assign a numerical value to five characteristics of your financial life and then compile a weighted average score. Scores range from 300 to 900; the higher your score, the less risky you appear to be. Although a number of factors can determine credit scores, the following five factors are most heavily weighted when determining your credit score:
- your payment history,
- amounts you currently owe,
- the length of credit history,
- new credit issued to you, and
- the types of credit you have received.
The rating agencies give your payment history the most weight, because it indicates your risk of future defaults. Do you pay your debts? How often have you defaulted in the past? CIBC has recently partnered with Fintech Borrowell and Equifax Canada to provide Canadians unlimited free access to their credit score, which will be updated quarterly, through CIBC mobile banking. The purpose of this app is to not only provide clients with access to their credit score, but also to improve their financial well-being and understanding with additional information that is provided on “factors that affect their credit score and advice on how to improve it” (CIBC, 2017).
CIBC recently conducted research that indicates “the majority of Canadians recognize the importance of knowing their credit score to safeguard against fraud, yet more than two-thirds do not know their credit score (69 per cent). Two-in-five (45 per cent) say they have no idea where to obtain their credit score” (CIBC, 2017). The credit available to you is reflected in the amounts you currently owe or the credit limits on your current accounts. These show how dependent you are on credit and whether or not you are able to take on more credit. It is important to keep your credit balance low because the lower your outstanding credit balances, the more points are awarded in terms of your credit score.
The length of your credit history shows how long you have been using credit successfully; the longer you have been doing so, the less risky a borrower you are and the higher your score becomes. Credit rating agencies pay more attention to your more recent credit history and also look at the age and mix of your credit accounts, which show your consistency and diversification as a borrower.
The credit rating process is open to manipulation and misinterpretation. Many people are shocked to discover, for example, that simply cancelling a credit card, even for a dormant or unused account, lowers their credit rating by shortening their credit history and decreasing the diversity of their accounts. Yet it may make sense for a responsible borrower to cancel a card. Credit reports may also contain errors that you should correct by disputing the information.
You should know your credit score. Even if you haven’t applied for new credit, you should check on it annually. Each of the credit rating agencies is required to provide your score once a year for free and to correct any errors that appear—and they do—in a timely way. If you should find an error in your report, you should contact the agency immediately and follow up until the report is corrected.
Beware of any other websites called “annual credit report” as these may be impostors. It is important to review your score regularly to check for those errors. Knowing your score can help you to make financing decisions because it can help you to determine your potential costs of credit. It can also alert you to any credit or identity theft of which you otherwise are unaware.
Please visit the webpage Credit report and score basics on the for more information.
If you wish to protest your credit score or ask for more information, you can contact the credit reporting agency regarding their dispute resolution process. After an investigation, if you do not agree with an item, you can visit either the or websites for more information on how you can add an explanatory statement to your report.
Identity theft is a growing problem. Financial identity theft occurs when someone poses as you by using your personal information, such as your social insurance, driver’s licence, bank account, or credit card numbers. The impostor uses your identity to either access your existing accounts (withdrawing funds from your chequing account or buying things with your credit card) or establish new accounts in your name.
The best protection is to be careful how you give out public information. Convenience encourages more and more transactions by telephone and Internet, but you still need to be sure of whom you are talking to before giving out identifying data.
As careful as you are, you cannot protect yourself completely. Checking your credit report regularly can therefore flag any unfamiliar or unusual activity carried out in your name. If you suspect that your personal information has been breached, you can ask the credit reporting agencies to issue a fraud alert. Fraud alert messages notify potential credit grantors to verify your identification by contacting you before extending credit in your name in case someone is using your information without your consent. That way, if a thief is using your credit to establish new accounts (or buy a home, a car, or a boat) you will know it. If a stronger measure is needed, you can order a credit freeze that will prevent anyone other than yourself from accessing your credit file.
Using a Credit Card
Credit cards issued by a bank or financing company are the most common form of revolving credit. This often has costs only after a repayment deadline has passed. For example, credit cards offer a grace period between the time of the credit purchase or “charge” and the time of payment, assuming your beginning balance is zero. If you pay before interest is applied, you are using someone else’s money to make your purchases at no additional cost. In that case, you are using the credit simply as a cash management tool.
Credit cards are effective as a cash management tool. They can be safer to use than cash, especially for purchasing pricier items. Payment for many items can be consolidated and made monthly, with the credit card statement providing a detailed record of purchases. If you carry more than one card, you might use them for different purposes. For example, you might use one card for personal purchases and another for work-related expenses. Credit cards also make it convenient to buy on impulse, which may cause problems.
Problems arise if you go beyond using your card as a cash management tool and use it to extend credit or to finance your purchases past the payment deadline. At that point, interest charges begin to accrue. Typically, that interest is expensive—perhaps only a few percentage points per month, but compounding to a large APR.
Credit card APRs today may start with 0 per cent for introductory offers and range from as low as 8.99 per cent (fixed rate) to between 20 to 23 per cent on popular credit cards (Barnea, 2017). These rates may be fixed or variable, but in any case, when you carry a balance from month to month, this high interest is added to what you owe.
As an example, if your credit card charges interest of 1.5 per cent per month, that may not sound like much, but it is an annual percentage rate of 18 per cent (1.5 per cent per month × 12 months per year). To put that in perspective, remember that your savings account is probably earning only around 1 to 3 per cent per year. Consumer credit is thus an expensive way to finance consumption. Consumers tend to rely on their cards when they need things and lack the cash, and this can quickly lead to credit card debt.
Choosing a Credit Card
You should shop around for credit just as you would shop around for anything that you might purchase with it, comparing the features and the costs of each credit card.
Features of the credit include the credit limit (or how much credit will be extended), the grace period, purchase guarantees, liability limits, and consumer rewards. Some cards offer a guarantee for purchases; if you purchase a defective item, you can have the charge “stopped” and removed from your credit card bill. Liability limits involve your responsibilities should your card be lost or stolen.
Consumer rewards may be offered by some credit cards, usually by rewarding “points” for dollars of credit. The points may then be cashed in for various products. Sometimes the credit card is sponsored by a certain retailer and offers rewards redeemable only through that store. A big sponsor of rewards has been the airline industry, commonly offering “frequent flyer miles” through credit cards as well as actual flying. Be aware, however, that many reward offers have limitations or conditions on redemption. In the end, many people never redeem their rewards.
Creditors charge fees for extending credit. There is the APR on your actual credit, which may be a fixed or adjustable rate. It may be adjustable based on the age of your balance—that is, the rate may rise if your balance is over sixty days or ninety days. There may also be a late fee charged in addition to the actual interest. The APR may also adjust as your balance increases, so that even if you stay within your credit limit, you are paying a higher rate of interest on a larger balance.
There are also fees on cash advances and on balance transfers (i.e., having other credit balances transferred to this creditor). These can be higher than the APR and can add a lot to the cost of those services. You should be aware of those costs when making choices. For example, it can be much cheaper to withdraw cash from an ATM using your bank account’s debit card than using a cash advance from your credit card.
Many credit cards charge an annual fee just for having the card, regardless of how much it is used. Many do not, however, and it is worth looking for a card that offers the features that you want with no annual fee.
How you will use the credit card will determine which features are important to you and what costs you will have to pay to get them. If you plan to use the credit card as a cash management tool and pay your balance every month, then you are less concerned with the APR and more concerned about the annual fee, or the cash advance charges. If you sometimes carry a balance, then you are more concerned with the APR.
It is important to understand the costs and responsibilities of using credit—and it is very easy to overlook them.
The Financial Consumer Agency of Canada’s credit card comparison tool helps consumers compare the features of different cards, including interest rates, annual fees, and rewards. Go to the Credit Card Comparison Tool on the Government of Canada’s website to find the card that best suits your needs.
Retailers also may offer credit, usually as installment credit for a specific purchase, such as a flat screen TV or baby furniture. The cost of that credit can be hard to determine, as the deal is usually offered in terms of “low, low monthly payments of only” or “no interest for the first six months.” To find the actual interest rate you would have to use the relationships of time and value. Ideally, you would pay in as few installments as you could afford and would pay all the installments in the shortest possible time.
Retailers usually offer credit for the same reason they offer home delivery—as a sales tool—because most often, customers would be hesitant or even unable to make a durable goods purchase without the opportunity to buy it over time. For such retailers, the cost of issuing and collecting credit and its risk are the operating costs of sales. The interest on installment credit offsets those sales costs. Some retailers sell their installment receivables to a company that specializes in the management and collection of consumer credit, including the repossession of durable goods.
Aside from installment credit and rotating credit, another source of consumer credit is a short-term personal loan arranged through a bank, credit union, or finance company. Personal loans used as credit are all-purpose loans that may be “unsecured”—that is, nothing is offered as collateral—or “secured.” Personal loans used as debt financing are discussed in the next section. Personal loans used as credit are often costly and difficult to secure, depending on the size of the loan and the bank’s risks and costs (screening and paperwork).
A personal loan may also be made by a private financier who holds personal property as collateral, such as a pawnbroker in a pawnshop. Typically, such loans are costly, usually result in the loss of the property, and are used by desperate borrowers with no other sources of credit. Today, many “financiers” offer personal loans online at very high interest rates with no questions asked to consumers with bad credit. This is a contemporary form of “loan sharking,” or the practice of charging a very high and possibly illegal interest rate on an unsecured personal loan. Some loan sharks have been known to use threats of harm to collect what is owed.
One form of high-tech loan sharking is the “payday loan,” which offers very short-term personal loans of small amounts at high interest rates. The amount you borrow, usually between $500 and $1,500, is directly deposited into your chequing account overnight, but you must repay the loan with interest on your next payday. The loan thus acts as an advance payment of your wages or salary, so when your paycheque arrives, you have already spent a large portion of it, and maybe even more because of the interest you have to pay. As you can imagine, many victims of repeated payday loans fall behind in their payments, cannot meet their fixed living expenses on time, and end up ever deeper in debt.
Payday lending is often viewed as a form of predatory lending; this type of lending is often characterized by excessive interest rates, unnecessary charges, and highly questionable terms. Some predatory lenders will charge interest rates as high as 59.9 per cent, just short of the 60 per cent legal limit in Canada. Payday lenders such as Money Mart (interest rate — 59.9 per cent) and Easyfinancial (interest rate – 46.9 per cent) are examples of predatory lenders (Freeman, 2015). The total fees result in an APR equivalent cost of over 300 per cent. In 2006, the federal government introduced legislation allowing provinces to lower the legal limit if they created a regulatory system to govern the industry. Bill C-26 (2006) exempts payday lenders from prosecution under Section 347 and defers regulation of these lenders to the provinces.
Personal loans are the most expensive way to finance recurring expenses, and they almost always create more expense and risk—both financial and personal—for the borrower.
Credit Trouble and Protections
As easy as it is to use credit, it is even easier to get into trouble with it. Because of late fees and compounding interest, if you don’t pay your balance in full each month, it quickly multiplies and becomes more difficult to pay. It doesn’t take long for the debt to overwhelm you.
According to the Advanced Planning Insurance Group (2018), the following are five warning signs of overindebtedness to watch for:
- You are spending more than 20 per cent of your after-tax earnings on debt. Total up all you owe, excluding your mortgage (e.g., student loans, car payments, and credit card bills). Now total up how much of your after-tax income is dedicated to servicing this debt.
- You are paying for daily essentials with credit instead of cash. Consequently, you are close to the credit limits on your cards. Credit cards charge notoriously high interest rates, which is exacerbated by compounding when credit cards are not paid off monthly. This can also increase your actual gross cost of goods purchased.
- You are deferring important expenditures. You may need maintenance work (on your car, your home, and your teeth) as you struggle to get by.
- You seem to spend your paycheque the day you get it. This may be a sign that you’re also overspending, an activity that leads to debt.
- You are not differentiating between “good” versus “bad” debt. Good debt is money borrowed for productive purposes to help generate wealth over time (through such things as education, building a small business, or purchasing real estate). Fancy cars, expensive vacations, restaurant meals, and overindulgent gift giving may indicate a lifestyle that is, for many, beyond the average household’s paycheque.
If you should become overindebted, the first thing to do is to try to devise a realistic budget that includes a plan to pay off the balance. Contact your creditors and explain that you are having financial difficulties and that you have a plan to make your payments. Don’t wait for the creditor to turn your account over to a debt collector such as a collection agency, a company that intervenes to recover money owed by people in debt. It is better to be proactive in trying to resolve the debt. Creditors—the people to whom money is owed—pay collection agencies to recover what is owed to them. If money is owed to a company or a supplier, and payments have not recently been made by an individual or company, that company or supplier can turn the file over to a collection agency.
In Canada, only a first party lender, debt buyer, or lawyer can collect money. Provincially, a licensed collection agency can collect consumer or commercial debt, and these agencies are subject to provincial laws (Priority Credit Recovery, 2017). You can refer to the Office of Consumer Affairs (OCA) on the Innovation, Science and Economic Development Canada website for helpful tips and information on how to deal with collection agencies.
Too much debt can create serious stress in your life and threaten your well-being and your future. You may want to use a credit counsellor to help you create a budget and negotiate with creditors. Many counselling agencies are non-profit organizations that can also help with debt consolidation and debt management. Some “counsellors” are little more than creditors trying to sell you more credit, however, so be careful about checking their credentials before you agree to any plan. You do not need more credit, but more realistic credit.
As a last resort, you may file for personal bankruptcy, which may relieve you of some of your debts, but will blemish your credit rating for six years, making it very difficult—and expensive—for you to use any kind of credit or debt. A second bankruptcy will stay on your credit report for fourteen years (Bankruptcy Canada, 2013). Each allows you to keep some assets, and each holds you to some debts. But the process gets complicated, and you will want legal assistance.
In Canada, insolvency—that is, “the inability to pay debts when they are due because of liabilities that far exceed the value of assets”—falls under the Bankruptcy and Insolvency Act and is governed by the Office of the Superintendent of Bankruptcy (Kapoor et al., 2015, p. 53).
A consumer proposal “is a maximum five-year plan for paying creditors all or a portion of a debt owed. To be eligible for this type of insolvency protection application, you must be insolvent and be less than $250,000 in debt (excluding a mortgage on your principal residence)” (Kapoor et al., 2015, p. 192). A Licensed Insolvency Trustee (LIT) is a qualified, experienced, federally regulated professional who administers a consumer proposal, which is a legally binding process, and can help guide you and get you discharged from your debt. One must work with a trustee if they are filing either a consumer proposal or for bankruptcy. The LIT works with you “to develop a ‘proposal’ to pay creditors a percentage of what is owed to them, or extend the time you have to pay off the debts, or both. The term of a consumer proposal cannot exceed five years. Payments are made through the LIT, and the LIT uses that money to pay each of your creditors” (Government of Canada, 2015). See the on the Government of Canada website for information on how to file a consumer proposal or for bankruptcy as an individual.
The effects of a bankruptcy can last longer than your debts would have, however, so it should never be seen as an “out,” but rather as a last resort.
Modern laws and regulations governing the extension and use of credit and debt try to balance protection of the lender and of the borrower. They try to ensure that credit or debt is used for economic purposes and not to further social or political goals. They try to balance borrowers’ access to credit and debt as tools of financial management with the rights of property owners (lenders).
Many provinces have their own legislation and oversight. These bankruptcy rules focus on personal bankruptcy exemptions.
If you feel that your legal rights as a borrower or lender have been ignored and that the offender has not responded to your direct, written notice, there are local, provincial, and national agencies and organizations that offer assistance. There are also organizations that help borrowers manage credit and debt.
Laws and regulations can govern how we behave in the credit and debt markets, but not whether we choose to participate as a lender or as a borrower: whether we use credit to manage cash flow or to finance a lifestyle, whether we use debt to finance assets or lifestyle, and whether we save. Laws and regulations can protect us from each other, but they cannot protect us from ourselves.
- Credit is used as a cash management tool or as a method of short-term financing for consumption.
- Credit may be issued as revolving credit (credit cards), installment credit, or personal loans.
- Credit can be a relatively expensive method of financing.
- Credit accounts differ by the following features:
• credit limit,
• grace period,
• purchase guarantees,
• liability limits, and
• consumer rewards.
- Credit accounts charge fees, such as the following: annual percentage rate, late fees, balance transfer fees, and cash advance fees.
- Credit remedies include the following: renegotiation, debt consolidation, debt management, and bankruptcy.
- Modern laws governing the uses of credit and debt try to balance protection of borrowers and lenders.
- Read the Maclean’s article “Drowning in debt is the new normal in Canada,” by Scott Terrio, on personal credit card debt in Canada. Record in your personal finance journal all the facts that pertain especially to you in your present financial situation. What facts did you find most surprising or most disturbing? Share your observations about these data with your classmates.
- Investigate online the sources and processes of debt consolidation. Sample debt consolidation businesses offering “free” advice and services. Visit the Financial Consumer Agency of Canada’s website and read the webpage Getting help from a credit counsellor. When seeking advice about your credit, why might you want to use an adviser or consumer centre?
- What is your credit rating or credit score? Apply for your credit reports from Equifax Canada or TransUnion.
Advanced Planning Insurance Group. (2018). “What are the warning signs of over indebtedness?” Retrieved from:.
Bankruptcy Canada. (2013). “How does bankruptcy affect my credit rating?” Retrieved from:.
Barnea, A. (2017). “Credit card interest rates in Canada are way too high.” Montreal Gazette, July 10. Retrieved from:.
CIBC. (2017). “CIBC introduces free mobile credit score for clients – a first for a major Canadian Bank.” Retrieved from:.
Engen, R. (2013). “Charge cards vs. credit cards: What’s the difference?” Toronto Star, June 30. Retrieved from:.
First Nations Oweesta Corporation and First Nations Development Institute. (2016). Building Native Communities (5th Ed). Retrieved from:.
Freeman, S. (2015). “Borrow $10,000, Owe $25,000: The Face Of Predatory Lending in Canada.” Huffington Post, July 31. Retrieved from:.
Government of Canada. (2015). “You owe money—Consumer Proposals.” Retrieved from:.
Kapoor, J., L. Dlabay, L., R. Hughes, and F. Ahmad. (2015). Personal Finance. Toronto: McGraw-Hill Ryerson.
Priority Credit Recovery Inc. (2017). “Comparison—Collecting Debt in Canada.” Retrieved from:.
Russell, D. (2006). “Fur Trade Posts.” Encyclopedia of Saskatchewan. Retrieved from:.
7.4 OTHER PEOPLE’S MONEY: AN INTRODUCTION TO DEBT
- Define debt and identify its uses.
- Explain how default risk and interest rate risk determine the cost of debt.
- Analyze the appropriate uses of debt.
Debt is something, often a sum of money, that is owed or due. One often has the ability to delay payment over several periods when taking on debt. Credit creates debt—either short- or long-term debt—in order to finance the purchase of assets. Credit is a cash management tool used to create security and convenience, whereas debt is an asset management tool used to create wealth. Debt also creates risk.
The two most common uses of debt by consumers are car loans and mortgages. They are discussed much more thoroughly in Chapter 8 “Consumer Strategies” and Chapter 9 “Buying a Home.” But before you get into the specifics, it is good to know some general ideas about debt.
Usually, the asset financed by the debt can serve as collateral for the debt, lowering the default risk for the lender. However, that security is often outweighed by the amount and maturity of the loan, so default risk remains a serious concern for lenders. Whatever concerns lenders will be included in the cost of debt, and so these things should also concern borrowers.
Lenders face two kinds of risk: default risk, or the risk of not being paid, and interest rate risk, or the risk of not being paid enough to outweigh their opportunity cost and make a profit from lending. Your costs of debt will be higher than the lender’s cost of risk. When you lower the lender’s risk, you lower your cost of debt.
Costs of Debt
Lenders try to protect themselves against default risk by screening applicants to determine their probability of defaulting. Along with the scores provided by credit rating agencies, lenders evaluate loan applicants on “the five C’s”: character, capacity, capital, collateral, and conditions.
Character is an assessment of the borrower’s attitude toward debt and its obligations, which is a critical factor in predicting timely repayment. To deduce “character,” lenders can look at your financial stability, employment history, residential history, and repayment history on prior loans.
Capacity represents your ability to repay by comparing the size of your proposed debt obligations to the size of your income, expenses, and current obligations. The larger your income is in relation to your obligations, the more likely it is that you are able to meet those obligations.
Capital is your wealth or asset base. You use your income to meet your debt payments, but you could use your asset base or accumulated wealth as well if your income falls short. Also, you can use your asset base as collateral.
Collateral insures the lender against default risk by claiming a valuable asset in case you default. Loans to finance the purchase of assets, such as a mortgage or car loan, commonly include the asset as collateral—the house or the car. Other loans, such as a student loan, may not specify collateral but instead are guaranteed by your general wealth.
Conditions refer to the lender’s assessment of the current and expected economic conditions that are the context for this loan. If the economy is contracting and unemployment is expected to rise, that may affect your ability to earn income and repay the loan. Also, if inflation is expected, the lender can expect that 1) interest rates will rise and 2) the value of the currency will fall. In this case, lenders will want to use a higher interest rate to protect against interest rate risk and the devaluation of repayments.
Interest Rate Risk
Because debt is long term, the lender is exposed to interest rate risk, or the risk that interest rates will fluctuate over the maturity of the loan. A loan is issued at the current interest rate, which is “the going rate” or current equilibrium market price for liquidity. If the interest rate on the loan is fixed, then that is the lender’s compensation for the opportunity cost or time value of money over the maturity of the loan.
If interest rates increase before the loan matures, lenders suffer an opportunity cost because they miss out on the extra earnings that their cash could have earned had it not been tied up in a fixed-rate loan. If interest rates fall, borrowers will try to refinance or borrow at lower rates to pay off this now higher-rate loan. Then the lender will have its liquidity back, but it can only be re-lent at a newer, lower price and create earnings at this new and lower rate. So the lender suffers the opportunity cost of the interest that could have been earned.
Why should you, the borrower, care? Because lenders will have you cover their costs and create a loan structured to protect them from these sorts of risks. Understanding their risks (looking at the loan agreement from their point of view) helps you to understand your debt choices so you can use them to your advantage.
Lenders can protect themselves against interest rate risk by structuring loans with a penalty for early repayment to discourage refinancing or by offering a floating-rate loan, a loan for which the interest rate “floats” or changes, usually periodically and relative to a benchmark rate such as the prime rate. In contrast, the interest rate of a fixed-rate loan remains the same until the loan is paid back. The prime rate is the rate that banks charge their very best (least risky) borrowers. The floating-rate loan shifts some interest rate risk onto the borrower, for whom the cost of debt would rise as interest rates rise. The borrower would still benefit, and the lender would still suffer from a fall in interest rates, but there is less probability of early payoff should interest rates fall. Mainly, the floating-rate loan is used to give the lender some benefit should interest rates rise. The real rate of return is what the investor receives as an annual percentage return on an investment once changes in prices, due to inflation or other external effects, are taken into account.
Borrowers may be better off having a fixed-rate loan and having stable and predictable payments over the life of the loan. The better or more creditworthy a borrower you are, the better the terms and structure of the loan you may negotiate.
Uses of Debt
Debt should be used to finance assets rather than recurring expenses, which are better managed with a combination of cash and credit. The maturity of the financing (credit or debt) should match the useful life of the purchase. In other words, you should use shorter-term credit for consumption and longer-term debt for assets.
If you finance consumption with longer-term debt, then your debt will outlive your expenses: you will be continuing to pay for something long after it is gone. If you finance assets with short-term debt, you will be making very high payments, both because you will be repaying over a shorter time and so will have fewer periods in which to repay and because your cost of credit is usually higher than your cost of debt; for example, annual credit card rates are typically higher than mortgage rates.
However, borrowers may be tempted to finance asset purchases with credit in order to avoid the more difficult screening process of debt. Given the more significant investment of time and money in debt, lenders screen potential borrowers more rigorously for debt than they do for credit. The transaction costs for borrowing with debt are therefore higher than they are for borrowing with credit. Still, the higher costs of credit should be a caution to borrowers.
The main reason not to finance expenses with debt is that expenses are expected to recur, and therefore the best way to pay for them is with a recurring source of financing, such as income. The cost of credit can be minimized if it is used merely as a cash management tool, but if it is used as debt—and if interest costs are allowed to accrue—then it becomes a very costly form of financing because it creates a new expense (interest) and further obligates future income. In turn, that limits future choices, creating even more opportunity cost.
Credit is more widely available than debt and it is therefore a tempting source of financing. It is a costlier financing alternative, however, in terms of both interest and opportunity costs.
Unlike grants, which do not have to be paid back, student loans are borrowed money and are legal obligations that have to be repaid once you complete your education. It is important that students understand the financial implications of taking out a loan for their education. How much will you have to repay once you graduate?
The Government of Canada provides lower interest rates than commercial lenders because the federal government subsidizes student loan rates. The two main student loan programs in Canada fall under federal or provincial and territorial jurisdiction. The federal program—the Canada Student Loans Program (CSLP)—can be accessed by both full- and part-time students. The provincial and territorial programs offer either integrated or stand-alone loans. Integrated loans mean that students not only have to apply to their province of residence in order to access federal and provincial student loans, but also have to go through the National Student Loans Service Centre in order to manage and repay the loan. Integrated loans exist in Ontario, British Columbia, New Brunswick, Newfoundland and Labrador, and Saskatchewan. All other provinces and territories, except the Yukon, offer stand-alone loans, which means that students apply to one place for assistance, but have to manage and repay two separate loans (Kapoor et al., 2015).
For more information on Canada Student Loans, the Repayment Assistance Plan, the National Student Loan Service Centre, provincial and territorial student financial aid offices, and how to manage and reduce student loan debt, visit the webpage on the Government of Canada website.
- Debt is an asset management tool used to create wealth.
- Costs of debt are determined by the lender’s costs and risks, such as default risk and interest rate risk.
- Default risk is defined by the borrower’s ability to repay the interest and principal.
- Interest rate risk is the risk of a change in interest rates that affects the value of the loan and the borrower’s behaviour.
- Debt should be used to purchase assets, not to finance recurring expenses.
- Identify and analyze your debts. What assets secure your debts? What assets do your debts finance? What is the cost of your debts? What determined those costs? What risks do you undertake by being in debt? How can being in debt help you build wealth?
- Are you considered a default risk? How would a lender evaluate you based on “the five C’s” of character, capacity, capital, collateral, and conditions? Write your evaluations in your personal finance journal. How could you plan to make yourself more attractive to a lender in the future?
- Use the Loan Repayment Estimator on the Government of Canada website to estimate the monthly payments you will need to make to repay your Canada Student Loan or other government student loans.