Understanding Credit

A common theme for the average Canadian is debt and process of eliminating it. However, many people do not fully understand credit and the process surrounding lending. I talk a lot about the use of good debt and many people are starting to recognize the benefits behind it. Often I see young people who understand the value of time in partnership with a quality leverage program. However, due to their situations they may not be in a position to participate due to their credit situation.

I was able to attend a seminar by a trusted Canadian investment lender this week and his approach was to educate financial advisors on understanding credit. He brought up a good way of understanding credit. He named it 'the 6 C's of credit'. I felt that not only should advisors know this but also the average Canadian investor.

He broke it down like this:

1. Capacity:
or Total Debt Servicing Ratio. This is the number by which lenders decide if you have the capacity to carry a debt or handle more payments based on current income. To arrive at this number you divide your total monthly payments (loans, mortgage, lines of credit, etc) by your gross monthly income. Most lenders are going to look for <40% of monthly income.

An example of where capacity might cause problems is for self employed people that don't show all of their income due to deductible expenses. While they may have the capacity for tax reduction, lenders may look at their earned income as insufficient for the capacity to carry extra credit.

2. Capital
This is your net worth. It is an easy calculation: assets minus liabilities.

Recently I am seeing many young people who may have entered into a mortgage with little down payment. However, many people may have existing debts and few assets. This may put someone in a negative net worth situation. Similarily renters often are in this situation due to the fact that they may not be saving.

Establishing net worth on the positive will always work in your favour even if this means simply establishing an emergency fund or a small investment portfolio through dollar cost averaging http://www.wisebread.com/dollar-cost-averaging-my-path-to-becoming-a-not-so-nervous-investor.

3. Collateral

Collateral is defined as a pledge of property or other assets that the borrower uses as security against borrowed monies. The relationship between the value of these assets and the amount of the loan is called the loan-to-value ratio (LTV). This number is expressed as a percentage (loan amount/collateral value=ltv)

Often the minimum assets pledged must be equal to the original loan amount.

4. Credit History

This is the area which I thought would be the most useful to every type of investor. Many people do not understand the concept of a Beacon Score. This represents an applicant's credit "worthiness" and likelihood of repaying debt based on statistical analysis of behaviour. This relates directly to a collection of information and statistics about past behaviour in meeting credit obligations which contributes to the development of the score.

Some factors that contribute to the development of a beacon score:
-time in file
-number and types of accounts
-residence status
-late payments
-bankruptcies, wage garnishments, liens, collection items
-too many requests for new credit and credit enquiries

TIP: when shopping for a mortgage use a broker rather than shopping around. A broker will have your credit pulled only once and shop around for you.

It is encouraged to take the time to check up on your credit history on a regular basis. Equifax gives you different options to receive your history. Identity theft has become a growing concern. For this reason alone you should check it out.

5. Character

While examining the other C's will help with character lenders are also going to look at things like:
-time at job
-occupation type
-time at residence

6. Comfort

You have to take the time to examine the threshold of debt that you are able to carry comfortably. For some this may be zero. However, taking the time to understand the different types of debt, what is tax preferential debt, and debt that can produce wealth will have a possitive effect on how you use it and carry it. Once you can see debt for what it is your threshold may significantly rise.

TIP: If you haven't read Rich Dad, Poor Dad , you should. It is an excellent story explaining how debt can work for you. Not only that but it will also show how to really get assets working for you as well.