KNOW THE RULES

All about credit

Credit is a powerful tool

Credit (borrowed money) comes in many forms - from credit cards and personal loans through to home loans. It can be enormously useful, letting us buy the things we want in life sooner, helping us to manage our cash flow, and it can be especially useful in emergencies.

But credit is also a big responsibility. It should be used wisely, because using credit to spend beyond your means can lead to unmanageable debt and serious financial trouble. The more you know about credit – how it works and how to use it effectively, the easier it is to use this powerful tool wisely.

First and foremost though, remember that credit is not the same as cash in your pocket. Not only does it have to be repaid, it also comes at the price of interest.

Types of credit

Many different types of credit are available. To maximise the usefulness of credit, and minimise the interest cost, you should determine which ones are best suited to your needs.

Credit cards

  • Let you borrow money from the card issuer on an ongoing basis.
  • You can choose to either repay the amount you borrow in full each month, or repay only part, but be charged interest on the outstanding balance.
  • Unpaid balances are carried over to the following month, together with an interest charge.
  • Click on ‘How credit cards work’ in this section to learn more.

Charge cards

  • Let you borrow money from the card issuer on an ongoing basis.
  • You must repay the full amount you use each month.
  • You should only put on your charge card what you can afford to repay in full each month.
  • Useful for managing a monthly budget.

Store cards

  • Credit cards provided by department stores or retailers.
  • Check all details before signing as requirements and guidelines differ for each card.
  • Generally more expensive than traditional credit cards.

Personal loans

  • These loans are useful for buying one-off big-ticket items like a computer, a car or even a holiday as well as for consolidating multiple debts into one regular repayment.
  • They have fixed monthly repayments over a set period of time.
  • Helpful for budgeting as you have a regular repayment.
  • Click on ‘Personal loans’ in this section to learn more.

‘Interest-free’ and ‘no repayment’ financing

  • This type of credit is often offered by retailers, though the actual lender is often an independent finance company.
  • The deal may sound generous, but unless you can pay the full balance before the interest-free period expires, high interest charges may apply to the unpaid balance.
  • Always read the fine print before signing.

Line of credit loans

  • Let you draw on an available amount of credit up to a pre-determined limit.
  • Funds are accessed by cheque and/or ATM card.
  • Interest is only payable on the funds drawn down.
  • Generally lower interest rates than for personal loans or credit cards.
  • Click on ‘Line of credit loans’ in this section to learn more.

Overdraft

  • Lets you borrow money up to a pre-set limit from your bank account.
  • The funds are often accessed by an ATM card or Debit card, through a cheque account or over the counter.

Mortgages

  • Generally used to purchase property.
  • Involve large sums of money and they have a longer repayment term – usually twenty years or more.
  • The interest rate on these loans is generally the lowest of any type of credit.

Pay day loans

  • Short term loans usually for small sums of just a few hundred dollars.
  • The interest rates are extremely high, so they should be used with caution.

Secured versus unsecured credit

Credit can be ‘secured’ or ‘unsecured’. A ‘secured’ loan is one where the lender has rights to an asset that is usually of at least equal value to the loan – for example, a car or your home, until the loan is repaid. The secured asset is the ‘collateral’ or ‘security’ for the loan.

Providing security is one of the best ways to reduce the cost of credit as the interest rate is lower than for unsecured credit. But if you fail to keep up the repayments on a secured loan, the lender has the right to take possession of the secured asset to recover the amount you owe. Before a lender can do this, they need to issue a ‘default notice’ setting out why they are taking action. You then have 30 days to make the outstanding repayments, or to renegotiate the debt with your lender before they take further action.

Note though, a lender will usually insist that you take out insurance over the secured asset.

An ‘unsecured’ loan is one that is not guaranteed by an asset or security. This involves the lender taking on more risk, which is generally reflected by higher interest rates.

Even on an unsecured loan though, the lender may have the right to recover the amount you owe, either by applying to have you declared bankrupt (if you owe more than $2,000), or by applying for a Court Order that allows them to take possession of sufficient assets to cover the debt.

Good debt versus bad debt

Most of us don’t want to be in debt - but not all debt is bad. To achieve many of our goals in life – like owning a car or home, it is often necessary to borrow money. And using credit to purchase things that will appreciate in value, like shares or property, makes good financial sense. If you can comfortably meet the repayments, borrowing money for these purposes can be regarded as ‘good’ debt.

‘Bad’ debt, on the other hand, is the type of debt that builds up quickly, and which allows us to live beyond our means. Credit cards, if not used carefully, can be an example of bad debt, as they can be used to spend more than you earn.

Credit can be very useful, but the key is to spend only what you can afford to repay and to keep track of the debt you are building up.

Remember you will be required to repay what you spend – along with interest, as well as fees associated with late payment, not paying the required amount or paying later than the required due date.

How much credit can you afford?

When you apply for credit it is important that you only borrow what you can comfortably repay. Taking on too much debt can be disastrous - creating undue stress and even financial hardship. Being unable to make the repayments required by the lender can damage your credit bureau file. This will affect your ability to take out a new loan, and in more serious cases it can even lead to legal action.

So, the first step in using credit wisely is to determine how much credit you can afford. This involves taking a good look at your income and living expenses. You need to be realistic both in terms of what you are capable of repaying now – and in the future. Be honest with yourself – don’t rely on a ‘best case’ scenario.

One approach to take is that followed by lenders when they determine your eligibility for credit. As a general rule, they will look at the percentage of your monthly take-home pay that goes towards repaying debt. This is called the ‘expense ratio’. If the percentage of your debt repayments – including rent/mortgage repayments exceeds 30% of your after-tax income, they may refuse to approve the loan.

It makes sense to take this approach yourself – after all, if a lender thinks you may be taking on too much debt, so should you!

Protect your ability to repay credit

For anyone using credit it can be a good idea to consider one of several types of insurance designed to help you meet your debt repayments in the event of an unforeseen emergency.

Income insurance – also known as disability insurance, will cover you for up to around 80% of your regular pay packet if illness or disability prevents you from working. Premiums vary with your age, sex and occupation, but on the plus side they are usually tax deductible, which lowers the cost.

Credit card insurance can also provide protection for the repayment of your card debt up to specified limits or for a set period. Premiums are generally paid monthly, based on your outstanding balance.

Reducing the cost of credit

We pay for the convenience of credit through both interest rates and other fees and charges. And just as you probably take steps to reduce the cost of other good and services you use, it makes sense to take a few basic steps to trim the cost of credit.

Choose the credit best suited for your needs

Different types of credit are better suited to some situations than others, and choosing the appropriate form of credit can help you minimise interest payments and manage your money better. A personal loan, for example, with fixed repayments and a set term is better suited to large purchases than, say, a credit card.

Let’s say for example that you want to buy new furniture costing $3,000. Here’s what it will cost you, once interest is included, using three different types of credit.

Type of credit

 

Interest rate

 

Monthly repayments

 

Time taken to repay credit

 

Total interest charge

 

Credit card

 

15%

 

Minimum repayment of 2% of outstanding balance

 

317 months

 

$4,456

 

Personal loan

 

10%

 

$63 monthly

 

5 years

 

$824

 

Home loan redraw

 

7.25%

 

An extra $23 per month when $3,000 is added to an existing mortgage of $200,000 payable over 20 years.

 

20 years

 

$2,691

 

Shop around between lenders

These days you don’t have to be a bank customer to get credit, and with a wide range of lenders to choose from, it pays to shop around for the best rates and terms. On long term loans in particular, even a small difference in interest charges can make a substantial difference to your interest bill. For example, on a $200,000 home loan repayable over twenty years, opting for a lender charging 7.25%, rather than one charging 7.5%, can cut your overall interest charge by $9,700.

Maintain a healthy credit bureau file

The best rates are offered to consumers with a healthy credit track record. Maintaining a good credit repayment history will give you a wider choice of lenders when you need finance. This means being able to choose from your preferred lender, rather than being limited to lenders charging higher rates. For more on your credit bureau file take a look at ‘Your credit bureau file’

Pay more than the minimum

Wherever possible, repay more than the minimum specified by your lender. This may not always be possible with some personal loans, but on long term debts like a home loan, or higher interest options, like a credit card, making extra repayments will not only reduce your interest bill, it will also mean being debt free sooner.

Go for a shorter term

Reducing the term of a loan means paying interest for a shorter period, and while your monthly repayments may be higher, it’s a surefire way to trim the cost of credit. For example, on a personal loan for $4,000 repayable at 10%p.a. opting for a three year term rather than a five year term, will see you reduce the total interest you pay from $1,099 to $646.

Don’t pay for features you won’t use

Different types of credit often come with added features – but more options generally means higher fees. Whether it’s redraw facilities on a home loan, or reward programs on a credit card, don’t pay for features you are unlikely to use.

Ten tips for managing debt

It’s easy to let debt build up. But paying it off can be hard. The following tips can help you manage your debt.

1. Choose the type of credit that best suits your needs.

2. Never treat credit like cash in your pocket.

3. Shop around for the best credit deal. Don’t just compare interest rates – look at fees and charges too.

4. Don’t take on more debt than you can comfortably repay.

5. Shop as carefully with credit as you do with cash – set a spending limit and stick to it.

6. Don’t build up debt now on the basis of income you expect to earn in the future.

7. Every dollar you pay in interest is money you could be saving. Reduce your interest bill by repaying more than the minimum.

8. Make paying off debt a priority – even set up a direct debit that allows for regular repayments to be drawn from your account to pay off the debt.

9. Don’t be flattered into taking on more debt. Make sure that you can meet the repayments before accepting a higher credit limit.

10. Pay with cash whenever you can.