Credit allows you to buy something today and pay for it later. But you need to be careful, because you might not have the money to pay for it later.
When you borrow wisely, going into debt can help you. Smart borrowing choices include a government-sponsored student loan, a mortgage for a house, or a start-up loan for a well-planned business venture.
But using credit - including credit cards, lines of credit, payday loans, and buy-now pay-later consumer deals - can lead to ongoing financial struggles which could cost you for a very long time.
The real cost of borrowing
Let’s say you borrow $1,000 from a bank or have a $1000 charge on your credit card.
Here’s what will get added to that original $1,000 you owe, when it’s calculated at different monthly interest rates:
At a 6% interest rate on the total amount of a bank loan, you would owe:
- after 6 months: $1,030.38
- after 1 year: $1,061.68
- after 2 years: $1,127.16
At a 20% interest rate on the total amount owing on a credit card, you would owe:
- after 6 months: $1,104.26
- after 1 year: $1,219.39
- after 2 years: $1,486.91
And interest rates are just a part of the issue. You also need to be on the lookout for term length, hidden fees, and other factors that can increase the true cost of borrowing. Play the Shady Sam game, created by American non-profit Next Gen Personal Finance, to learn how to spot which loans will cost you more in the long run.
If I could do it over again, I would do things differently. Right now, I owe about $1,000 on my credit card. I can’t afford much more than the minimum payment of about $24 on it each month. At 19% interest, it’s going to take me around 6 years to pay it off – and that’s if I stop using it. It’s tough.
Good debt vs bad debt
Not all borrowing is bad. For example, getting a student loan is often necessary. But if you are able to work during the school year and summers, chances are you’ll be able to pay off that student loan when it’s due at the end of your program.
You have a money problem if you’re:
- Always late paying your rent
- Constantly overdrawn on your chequing account
- Frequently bouncing cheques
- Unable to make the minimum payment on your credit cards
- Using credit-card cash advances to pay other bills
If any of this happens to you, it’s time to cut your spending or up your income.
Know the difference between what you want and what you need. You need to decide what spending is essential to you now, and what spending you can plan for later. Ask yourself these questions:
- How does buying this item or service support my educational goal?
- If it doesn’t support my goal, how important is it to me?
- Am I buying this because I am buying the lifestyle, feelings, or status that comes from owning it?
Sarah still lives at home with her parents. She’d love to rent her own apartment but doesn’t think she can afford it. Even though she works full time, she never seems to have any money left over at the end of the month.
Sarah decided to keep track of how she was spending her money. She was shocked to see how much money she was spending on lattes, eating out and going to movies and clubs with her friends. She also became more aware of how much money she spent on cell phone charges, buying clothes and shoes or having her nails and hair done. She realized that her habit of only paying the minimum amount on her credit cards each month was costing her a lot of money.
Sarah knew she needed to make some changes. She created a budget and set out to live within her income, without using her credit cards or depending on her parents for help. She cut back on shopping sprees and her extra cell phone charges. She eventually decided to share an apartment with her best friend. This allowed Sarah to keep her costs low enough so she could afford to work part time and go to college.
If you still can’t decide whether this is a need or a want, try these strategies:
- Take time to think about it. Leave the store or close the website. Stop scrolling through social media. Turn off the TV. Do what you can to distance yourself from the item or service you’re thinking about buying.
- Wait 72 hours (3 days) before making the purchase, and then ask yourself if you really need it. You might decide you don’t need it after all.
- Take a look at your budget. Can you afford to pay in full for this? What would you have to give up in order to buy it? Would that be worth it?
- If you can’t afford to pay in full for the item or service, ask yourself how you will pay for it.
- Consider whether there’s another less-expensive purchase you could make instead.
Credit card caution
Getting a credit card isn’t difficult. Managing one is much harder. Here’s how to make your credit card work for you:
- Limit the number of credit cards you have. Just having one is enough.
- Pay your credit card balance on time and in full each month
- Keep track of all your credit card transactions
- Keep your credit card limit (the amount you’re allowed to spend on your card) low. If your bank wants to raise it, say no.
- Avoid using the card for cash advances. The interest rate is usually higher for cash advances and begins the minute you take cash out on your credit card.
- Be careful who you give your credit card number to. Don’t give it out on the phone unless you made the phone call. If shopping online, make sure it’s a secure site (look for a locked symbol next to the website address), and only shop with reputable online businesses.
Smart debt can pay off
If you take out a loan or use a credit card and make payments in full and on time, you are establishing a good credit rating. A good credit rating is valuable to have when it comes time to making big purchases or asking for big loans, such as a mortgage for a house or a loan for your business idea. It tells potential creditors that you can be trusted to repay what they lend you.
Visit the Government of Canada’s site Debt and Borrowing site for more information on debt, borrowing, and credit.