Factors to consider before borrowing

Important factors to consider before borrowing

Credit is a tool, just like a hammer is a tool. These tools are neither good nor bad. They can help you in achieving objectives if used properly. However, there may be negative consequences if credit is not used responsibly.

In this section you will learn about some of the important factors that you, as a potential borrower, should consider so that you can use credit as an effective tool. One of the most important factors to consider is the cost of borrowing money.

Cost of borrowing

The two main components to consider when determining the cost of borrowing money are the principal amount and the interest.

Principal amount is the original amount borrowed or the amount that remains unpaid.

Interest is the additional amount owed to the lender based on the outstanding balance.

Borrowing money allows you to get what you want today, but at an additional cost. When borrowing money, people are able to make a purchase today by “renting” someone else’s money. The expense of renting this borrowed money is called interest. An important question to ask is whether the cost (interest) of borrowing someone else’s money is worth the benefit of making the purchase today instead of at a later date.

If you make a purchase now using a loan, then this will cost you the purchase price plus interest. However, if you make the same purchase at a later date using your savings, then you will only have to pay the purchase price. Therefore, the overall purchase will cost you less if you make the purchase with your savings at a later date.

For example, financing a $20,000 car could cost approximately $4,000 in interest only. This means the total cost of the $20,000 car would be $24,000. (8% interest, 5 year amortization.)

Comparing the costs of borrowing of different types of credit products

Let’s assume that you have made the decision to purchase something now and pay the additional borrowing cost. Interest often makes up a large part of the total purchase cost.

The challenge is that there are various ways to calculate interest and the cost of borrowing can vary significantly depending on the method used. The annual percentage rate (APR) is designed to provide a common measure for comparing the interest rates of different loan products.

The APR is a standard way of expressing the interest. It can help you compare rates from one loan to another because it's calculated using standardized rules.

For example, suppose your oven breaks down and you need to buy a new one. The new oven costs $1,000 at your local department store. You are considering different options, including a credit card, a store credit card, a line of credit from your bank, a rent-to-own contract, or using your emergency fund.

Comparing different financing methods

Comparing different financing methods
Description

This infographic has a turquoise background and the image contains a large title at the top of the diagram which says “Comparing Different Financing Methods” in white bold letters. The title is written on a horizontal navy blue strip which stretches across the entire infographic.

In the top right corner of the graphic, along the navy blue strip, there is a small circular image. The circular image has a blue background and the circle is outlined in white. Within the circle there are three people standing around a stove oven. Two of the three people in the image are debtors. On one side of the stove oven, there is an image of a salesman with dark hair wearing a white shirt with a light grey vest and dark pants. The salesman is holding up a piece of paper in one hand and is pointing to the piece of paper with his other hand. Standing on the other side of the stove oven, the two debtors are looking intently at the piece of paper that the salesman is holding. The person on the far left of the circular image is a dark haired man with a smile on his face, and he wearing jeans and a dark t-shirt. Slightly to the right of the dark haired man, there is a blonde haired woman with a slight smile on her face and she is wearing a pink shirt.

Directly below the horizontal navy blue strip, there is a large chart that is divided into five columns and five rows. Each column has a title written in white letters on a black background. The first column on the far left side of the chart is titled “Type of Credit”. The second column from the left is titled “Cost”. Below the word “Cost” there is small dark blue square with the word “Principal” written directly to the right of the square. Slightly to the right of the word “Principal”, there is a small pink square with the word “Interest” written directly to the right of the square. The center column is titled “Terms”. The second column from the right is titled “Months of Payment”, and the last column on the far right side of the chart is titled “APR”.

Under each of the column titles, there are four equal rows. The top row is shaded in blue, the second row down is shaded in red, the third row down is shaded in orange, and the bottom row is shaded in green.

Within the second column from the left titled “Cost”, there is an image of a pie chart within each cell in this column. The pie charts are to the right of the total dollar amounts. Each pie chart consists of two colours: pink and dark blue. Dark blue is used to represent the percentage of the total cost that is the principal amount, and pink is used to represent the percentage of the total cost that is the interest amount.

In the ‘Cost’ column, within the ‘Regular Credit Card’ row there is an image of a pie chart with just over three quarters of the pie chart coloured in dark blue and the remaining piece of the pie chart is coloured in pink. “79%” is written in dark blue in the center of the pie chart and “21%” is written in pink above the pie chart.

In the next row down called ‘Store Credit Card’, there is an image of a pie chart in the “Cost” column with two thirds of the pie chart coloured in dark blue and the remaining piece of the pie chart is coloured in pink. “66%” is written in dark blue in the center of the pie chart and “34%” is written above in pink the pie chart.

In the next row down called ‘Line of Credit’, there is an image of a pie chart in the “Cost” column that is almost completed coloured in dark blue and the remaining piece of the pie chart is coloured in pink. “94%” is written in dark blue in the center of the pie chart and “6%” is written in pink above the pie chart.

In the next row down called ‘Rent-to-Own’, there is an image of a pie chart in the “Cost” column with approximately half the pie chart coloured in dark blue and the remaining half is coloured in pink. “52%” is written in dark blue in the center of the pie chart and “48%” is written in pink above the pie chart.

Type of credit Cost (principal and interest) TermsMonths of paymentAPR
Regular credit card $1,262.70 Assuming you make the minimum monthly payment of $40, or 4%* of the purchase price.3218%
Store credit card $1,518.00 Assuming you make the minimum monthly payment of $40, or 4%* of the purchase price.3828%
Line of credit $1,064.00 Interest is tied to the prime rate, which can change. Assuming the interest rate stays at 6% and you make the minimum monthly payment of $40, or 4% of the purchase price.276%
Rent-to-own $1,920.00 2-years contract with payments of $80/month.2472.5%

*With credit cards, the minimum monthly payment may be up to 10% of the amount owing.For this example, we are using 4%

The best option is almost always to use your savings to pay for an unexpected expense such as this one. If you don’t have enough savings to cover the cost of the oven, then the next best option in this case is to pay for it using a line of credit. However, it's important to note that a line of credit is not always the least expensive loan option. There are many situations in which other types of credit might actually be less expensive and/or less risky than a line of credit. You should always explore options specific to your situation. Above all, consider all of the factors, such as what the total cost of the purchase will be.

Ask the lender about the fees and interest you will pay before you sign a loan agreement.

To understand the cost of a loan, make sure that you ask:

  • What is the total cost of the loan including interest? This will help you determine whether buying now versus later is worth the additional borrowing cost.
  • What is the APR on the loan? This will help you choose between various borrowing options.

Remember that there may be other fees, charges and conditions associated with borrowing money, on top of the interest. Before deciding to borrow, make sure you understand all of the terms and conditions of the loan.

image of debtor with counsellor

If you have questions, write them down and bring them to your in-person counselling session.

Payday loans

Payday loans are short-term loans, approximately 14 days in length. A payday loan is typically a small-dollar loan of up to $1,500. These loans are offered by a non-traditional financial service provider.

The cost of a payday loan is typically based on a set dollar amount per $100 borrowed. For instance, let’s assume that a $100 payday loans costs approximately $18. If someone borrows $100 from a payday loan and repays it in 2 weeks, this borrower will need to pay $18 on the $100. If the borrower continues to do this for an entire year, that is 26 payday loans. The original $100 loan will cost $468, and therefore the APR of this payday loan is 468%. Also, borrowers who are unable to repay their loans in full and on time may have to pay additional fees. When comparing the APR of payday loans to the APR of the financing products listed in the infographic above, payday loans are generally the most expensive financing option.

Consider your other options before resorting to payday loans:

  • use your emergency savings fund
  • negotiate with your creditors and discuss alternate payment arrangements
  • get a loan from your family or friends
  • cash in your vacation days at work
  • ask your employer for a pay advance
  • obtain a line of credit

Be aware of payday loans. Payday loans typically have very high interest rates and charge costly fees so it's important that you understand all of the loan terms. Payday loan interest rates and fees vary by province. Before taking a payday loan, consider all other options.

Auto financing

Auto financing is another type of credit that many people need to consider. Buying a car is typically the second biggest purchase after a house and it often requires borrowing money.

The length of the loan and the amount of the payments are other important factors to consider when borrowing money to buy a car. These considerations are particularly important when buying something that will go down in value, such as an automobile.

Transcription — Auto Financing

[Steve is standing at the front desk of a car dealership.]

Narrator: This is Steve.

[Steve begins to walk away from the front desk as the receptionist of the car dealership waves to him.]

Narrator: Steve has just decided to purchase a new car.

[Steve walks by a sign in the car dealership which says “Pay $375/month!” in very large print. Below the large print, the sign says “*for 96 months *conditions apply” in very small print.]

Narrator: He is paying $375 per month for the next 96 months, which is equivalent to 8 years.

[The screen zooms in on the sign.]

[The scene changes to an image of Steve in the driver’s seat of his new car.]

Narrator: After Steve purchases his new car, he realizes that the monthly payments are only part of the total cost.

[The screen zooms in on Steve and he looks surprised. Steve begins to scratch his head in confusion.]

[The scene changes to a blue background. An image of a calendar appears on the left side of the screen and the words ‘Monthly Payments’ are written above. An addition symbol appears to the right of the calendar. The following three images appear in consecutive order on the right side of the addition symbol: a fuel pump, a piece of paper with the words ‘Auto Insurance’ and a tire with tools.]

Narrator: In addition to his monthly loan payments, Steve also has to pay for things such as gas, car insurance, and maintenance costs.

[The scene changes back to Steve in the driver’s seat of his new car.]

Narrator: Steve begins to realize that the cost of his new car is more expensive than what he had originally budgeted for.

[Steve is holding his wallet and negative dollar signs float out of his wallet. Steve looks concerned.]

[The scene changes to an image of a graph. The bottom horizontal axis of the graph begins at ‘Year 0’ and ends at ‘Year 8’. In the top left corner of the graph there is an image of Steve’s new car. Extending from the bottom of the image of the car there are 2 lines, one blue and one red. The blue line represents the car value and the red line represents the loan balance of the car. The red line is a straight downward diagonal line which intersects with the bottom horizontal axis at ‘Year 8’. The blue line is a downward diagonal line as well which interests with the bottom horizontal axis at ‘Year 8’, however the blue line is not straight. The blue line starts above the red line at ‘Year 0’ and the lines intersect just after ‘Year 1’.]

Narrator: In addition to his car costing him more than he had anticipated, Steve’s car has depreciated in value over time.

[The image of the car moves down the graph from ‘Year 0’ to ‘Year 2’. The amount ‘$27,000’ appears next to the red line and the amount ‘$22,000’ appears next to the blue line.]

Narrator: After about 2 years, Steve’s outstanding loan balance is more than the actual value of the car.

[The scene changes to Steve and Emilie in their living room of their house. Steve is playing with their child and Emilie is rocking their baby.]

Narrator: After a few years of owning the car, Steve gets married and has children.

[The scene changes to an image of Steve thinking about his family.]

Narrator: Now that Steve has a wife and children, he needs a larger vehicle that is more family friendly.

[The image of Steve’s family disappears and the screen zooms out. An image of Steve’s car appears next to him and a red circle with a diagonal line through it appears on top of Steve’s car. The image of Steve’s car with the red circle overtop shrinks in size and an image of a larger sports utility vehicle appears next to Steve.]

[The scene changes to an image of Steve’s car with the text “Car value = $22,000” written below the image. An arrow is pointing from Steve’s car to an image of a larger sports utility vehicle.]

Narrator: Steve wants to trade in his current car for a larger vehicle, but unfortunately he owes more than his car is worth.

[The text ‘Loan balance = $27,000’ appears below the image of Steve’s current car.]

[The scene changes to Steve back the front desk of the car dealership. Steve looks upset at the receptionist is talking to him.]

Narrator: Steve did not understand all of the risks associated to the longer-term car loan and he realizes now that the longer-term loan was not the best option.

[The scene changes to Steve sitting at the desk in his home office and he is typing on his laptop. Steve types the following into his search bar: ‘Financial Consumer Agency of Canada – financing a car’.]

Narrator: Steve should have done some research on financing before agreeing to the loan terms of his car.

[The screen zooms out and splits in half. On the right side of the screen there is a white background where Steve is typing. Steve types the title ‘Tips on using auto financing’.]

Narrator: Before Steve purchases his new larger vehicle, he does the following…

[Steve creates the first bullet point and he types the following: ‘realistic budget’. The left side of the screen changes to an image of Steve’s monthly budget.]

Narrator: Steve creates a realistic budget so he knows how much he can afford before visiting the dealership.

[The left side of the screen changes back to Steve sitting at the desk in his home office typing on his laptop.]

[Steve creates a second bullet point and he types the following: ‘shop around and negotiate’. The left side of the screen changes to a blue background divided into four quadrants. An image of Steve talking to an auto financing expert appears in the top left quadrant. An image of a laptop with the words ‘Financing options’ appears in the top right quadrant. An image of a bank appears in the bottom left quadrant, and an image of Steve talking to a bank teller appears in the bottom right quadrant.]

Narrator: Steve shops around and negotiates for the best financing possible. He researches different financing options through the dealership and his bank, and he negotiates based on the total price of the vehicle, rather than focussing on a low monthly payment.

[The left side of the screen changes back to Steve sitting at the desk in his home office typing on his laptop.]

[Steve creates a third bullet point and he types the following: ‘shortest-term loan possible’. An image of a thinking bubble appears next to Steve’s head and an image of a clock and money appear within the thinking bubble.]

Narrator: Steve chooses the shortest-term loan that his budget will allow because he knows that the longer-term car loans can leave him owing more than his car is worth.

[Steve creates a fourth bullet point and he types the following: ‘total cost of the vehicle’. The left side of the screen changes to a blue background and an image of a large sports utility vehicle appears. Five bubbles appear on the screen below the image of the vehicle. The first bubble contains an image of a cheque with the words ‘principal amount’ written below. The second bubble contains an image of an irregular arrow with the word ‘interest’ written below. The third bubble contains an image of a tire with two tools above and the words ‘expected maintenance’ written below. The fourth bubble contains a small piece of paper with the words ‘Auto Insurance’ written on it and the word ‘insurance’ written below. The fifth bubble contains an image of a fuel pump with the word ‘gas’ written below.]

Narrator: Lastly, Steve focusses on the total cost of the vehicle including the principal amount, interest, expected maintenance, insurance, and gas.

[The scene changes to Steve standing outside of his house next to his new sports utility vehicle as he is waving to his family. There is a chain attached to the back of his vehicle which is pulling a sac with the words ‘old car debt’ written on it.]

Narrator: Steve purchases a larger vehicle for him and his family, while also still paying off the money that he owes on his previous car.

[Steve drives away in his new vehicle.]

[The scene changes to Steve and Emilie sitting in an office setting with their BIA Insolvency Counsellor.]

Narrator: At your in-person counselling session discuss auto financing with your BIA Insolvency Counsellor.

image of debtor with counsellor

If you have questions, write them down and bring them to your in-person counselling session.