Be credit healthy.

Hi, I’m Bron Lawson from Westpac’s Davidson Institute, and I’m here to talk to you about being credit healthy. This video is one of a series that we’ve produced in conjunction with Ruby Connection aimed at helping women improve their financial confidence and wellbeing.

This video is about the basics of borrowing money or using credit. Borrowing is an integral part of our financial journey – however, if we don’t borrow well, it can have a detrimental effect on our finances instead of enhancing them. By understanding the basics, we aim to help you get on the right footing when using credit.

In this video we’re going to talk about using credit effectively to achieve our financial goals. The three key areas that we’re going to focus on are: • Why borrow? Looking at the reasons people borrow money. • Types of credit. Different types of debt have different purposes and should be matched to the purpose of the borrowing. • Some of the ins and outs of borrowing to be aware of if you’re thinking about borrowing.

Before we go on, I do need to let you know the information in this video is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information to your own circumstances and, if necessary, seek appropriate professional advice.

Firstly, I want to look at “Why borrow?” because a common reason for people getting into financial difficulty is because they’ve borrowed for the wrong reason, or they’ve used the wrong type of borrowing for their original purpose. There are three main reasons we borrow money.

• The first and most common reason for borrowing is to buy things to enjoy or that we need now rather than later. Whether it’s a house, a car, furniture, computers, or simply that new pair of shoes or the latest tech … we want these things and are not always prepared to save up to buy them because the time taken to save means we potentially miss an opportunity.

• The second reason people borrow is to invest to boost wealth generation. This may be to buy an investment property, share portfolio, increase our super contributions, or invest in a business. Investing is a way to increase wealth so we can buy more stuff in the future by selling the investment for more than we paid for it or using the income from the investment.

• The final reason people borrow is to cover a mismatch in cash flow timings. For instance, perhaps your pay is due to be deposited in the bank account on Thursday, but a bill, such as rent, rates, school fees, insurance and so on, needs to be paid a few days beforehand. You will have the cash in a few days’ time, but you need it today. This is where credit cards and short-term debt may be useful. You can pay for stuff now, knowing that you can repay the debt when you receive your pay.

Whatever the reason for borrowing the key thing you need remember is it does need to be repaid, and it does come at a cost. Credit is a useful tool when used wisely however, unfortunately, it isn’t always used well.

Essentially, both saving and borrowing are two different ways of achieving the same goal: getting something that you need or want. The key to determining whether to use your savings or get a loan lies in understanding when you need to have the thing that you are purchasing and how borrowing will change the total cost of the purchase. Ultimately, it’s about getting the right balance between saving and borrowing, then borrowing well to ensure the credit supports your overall goals.

So, let’s have a look at the example of buying a car. If you wanted to buy a car that cost $25,000 and worked out that you could save $414 a month, it would take you roughly 5 years to save up that $25,000 … but in 5 years’ time is your $25,000 going to purchase the same type of car that it will now?

On the other hand, if you were to borrow to purchase the car now, on an unsecured loan, it would take you roughly 7 years to pay off the loan at the same rate as you are saving, that is $414 a month. Including interest and fees this would actually use about $34,784 of your money.

Don’t forget, whether you save or borrow, during the time of ownership you’ll also have to pay for the running of the car … fuel, maintenance and so on, which is another thing that needs to be budgeted for. This may mean you’re not able to repay at the same rate as you were saving and it may take you longer to repay the loan and cost even more.

As I said, borrowing provides you with the opportunity to have things sooner rather than later, but it does cost significantly more in the long run. The key is to find the right balance between saving and borrowing.

The second reason we borrow is to invest. Borrowing increases the amount of capital we have available to invest with the intent of also increasing returns. Some examples of borrowing to invest include taking out a loan for an investment property or borrowing money on a margin loan to purchase shares. Let me take you through a simple example to illustrate the benefits of borrowing to invest.

Let’s say you have $100 of your own money to invest - this is sometimes referred to as your equity. Keeping the maths simple, say that you can get a return of 10% … this will make you a profit, or return, of $10. However, if you use your $100 equity as a 20% deposit and borrow $400 you would have $500 to invest. If you could still get a 10% return, this calculates out to earnings of $50.

Of course, you will have to pay interest on the $400 borrowed. Again, for ease of calculating, let’s say the interest rate on the loan is 5% therefore costing $20, and leaving a profit of $30 – higher than the original $10 in earning on your $100. Borrowing to invest can provide a positive outcome where the returns are higher than the cost to borrow.

The third reason people borrow is to cover mis-timings in cash flow … that is, when you have an expense, sometimes unplanned, that needs to be paid before you have the cash available to pay for it. Many people will ration their money from payday to payday to ensure they have enough for known expenses, but what if the car breaks down? Or you need to have some emergency plumbing done? If you don’t have enough cash available, then you may choose to borrow to cover the shortfall.

For example, Josie gets paid on a fortnightly basis, so she has her rent set up to come out of her account the day after payday; she does her grocery shopping and any general errands the weekend after she gets paid; as well as allocating money for her phone, electricity bill and car rego. So, the balance of her account tends to fluctuate like the graph on the screen.

But then last week her car needed some emergency repairs and while she knew she would have the money once she got paid again, right now she needed to pay for the repairs and she didn’t have enough cash available, so she needed to borrow to cover the shortfall, but then repaid it as soon as she got paid.

This is where people can sometimes run into trouble. If these little mis-timings are not repaid as soon as possible but continue to accumulate, say on a credit card, it’s possible to end up with an unnecessary debt that can become costly and even detrimental to your financial profile.

Debt created by cash flow mis-timing should be repaid as soon as possible, and if the shortfalls are becoming a regular occurrence then it might be time to look at how your spending your money and whether your budget needs to be adjusted. Now that we know why we borrow, let’s take a quick look at the different types of credit available.

Now before I talk about the different types of borrowing, a cardinal rule you should always remember when borrowing money is to ‘Match the life of the loan to the life of the asset’. That is, use short-term debt for short term needs and long-term debt for items that will last longer.

As an example, some years ago, my friends Zac and Kiara wanted a new car but didn’t have enough cash to buy it, but they did have the money available in a redraw facility on their home loan. They thought using this money was a great idea, as the home loan had a lower interest rate than they would have paid on a personal loan, and they didn’t have another repayment to make.

On the downside though, the car died recently, however they still have another 10 years left to pay off the home loan. Because they didn’t increase the repayments on the home loan to cover the amount for the car, they’ll need to continue to pay this car off and be charged interest on it for the remainder of the home loan.

And because they now had no room left on the home loan, or savings, to buy another car, they’ve had to borrow for a new car and is now effectively paying off two cars. It’s important to think about what you are buying and how long it’ll last and aim to pay it off before it reaches the end of its useful life.

The first type of credit we’ll look at is short-term loans. These types of loans are best suited for timing differences. I need to pay something now, that I can afford to pay from my regular income, but I won’t get paid for a few days. A pay day lender advances money from your next pay. The interest rate is often high and the penalties for not repaying may also be high.

You may be able to get an overdraft on your bank account. This may be arranged or unarranged. Unarranged means a payment comes out of your bank account which does not have enough money in it, but the bank allows it to go through putting your account balance into debit. You’ll be charged a fee and interest until you put enough money back into the account.

An arranged Overdraft on the other hand is an overdraft you apply for and a limit is put in place. You will generally be charged a lower interest rate than an unarranged overdraft and it would be unlikely that an overdrawn penalty fee would be applied as long as you stay within your approved limit. The interest rate on an overdraft varies according to whether it’s secured or unsecured, and your personal financial position.

Credit cards are another form of short-term credit, though unfortunately they often turn into longer term debt. There are a number of different types; some with interest free periods and a higher interest rate or no interest free period but a lower interest rate. Some offer different reward programs, but these are generally the most expensive in terms of fees and rates.

If you have a card with an interest free period and will pay the balance off within that period, then you should only need to pay the regular card fee. If you don’t think you’ll pay it off in full in the interest free period, you would most likely be better off with a card that has a lower interest rate.

A more recent addition to short- term borrowings are buy now pay later services such as AfterPay, ZipPay, and the likes. These services are often offered by the retailer, who gets paid directly by the lender, and then the borrower (you) repays the lender via a series of direct debits to your bank account, which is set up when you register with the lender. The attraction to these services is that some offer interest-free purchases with no credit checks and automatic repayments.

While this might seem like a great deal, if you are going to use these services, please make sure you understand the terms and conditions and ensure you have the money available in your account when repayments are due. You don’t want your purchase to end up costing you more in the long run due to late payment fees from the lender, and dishonour fees from your bank.

When buying larger items, that will take more than one pay period to pay back you may still use your credit card, but it may be more appropriate to use some type of personal finance, or vehicle finance if you are purchasing a car.

Personal loans are mid-term finance (often 2 to 5 years) with regular repayments that can be used for a variety of purposes – travel, furniture, debt consolidation and so on. They often have a fixed interest rate which means repayments are fixed for the term of the loan too. Very handy when you’re working with a budget. They may be secured or unsecured but when unsecured may have a higher interest rate, which may mean higher repayments too.

Another type of personal finance is ‘Rent to Buy’. With this type of finance, you are paying a rental for the item with the intent of buying the product at the end of an agreed term. This is often used for furniture or household appliance purchases. Take care to add up the total rental and the amount to pay at the end to see how much it will actually cost you. A consumer lease is like rent to buy, but you may not have the option to buy it at the end.

With Interest Free Periods or buy now pay later you should look closely at the terms and conditions. You may get charged ongoing fees instead of interest and there can be severe penalty rates if you miss a payment. Similar to a Rent to Buy, you should check if the repayments add up to the total cost or whether you may have a large payment to make at the end.

Car loans are like personal loans and are often secured by a charge over the car being purchased. Home loans are just longer-term personal loans secured by a mortgage over your home. They may have a loan term of up to 30 years.

An investment loan is used to purchase income producing assets or assets that will get capital growth. The interest rate will be higher than a home loan and the term of the loan may be shorter than a home loan but generally longer than a personal loan. As we looked at earlier, if you’re borrowing to invest, check whether the investment is likely to return you more than cost of the borrowing and be careful of investing in assets whose value fluctuates a lot.

These are the main types of borrowing, now let’s look at some of the things to be aware of if you do make the decision to borrow. First of all, borrowing doesn’t come free. There are various costs, including interest and fees, that’ll need to be paid and you will have to pay the money back. The costs can generally be broken up into. • Set up or establishment fees – the financier will charge to set up the loan. The amount will vary depending on the complexity of the transaction.

• Interest – the premium you pay to use someone else’s money. • Ongoing Fees or Charges – many financiers will apply a monthly account keeping fee or something similar. • Exit Fees – because a financier borrows the money for your loan and may break that borrowing when you repay early there is often an early exit fee. • Penalty Fees – are applied if you don’t pay on time or breach the conditions of the borrowing.

The amount and type of fees charged will depend on the type of borrowing, the terms and conditions of the borrowing and the security provided for the borrowing. When comparing different types of borrowing or different financiers’ offerings make sure you have taken into account all interest, fees and charges as some lenders may make it sound better by offering you a cheaper interest rate, but their fees and charges may be higher.

Look for ‘comparison rates’ when comparing lenders as these include fees and charges as well as the interest rate to help you make an informed choice.

Once you enter into a borrowing arrangement with a lender it’s important to ensure you meet the repayment arrangements. Make sure you know when your payments are due and that you have the money available. Let’s face it sometimes we do run short and may not be able to make a repayment. Instead of just hoping for the best, be proactive and let them know you are going to be late. By making other arrangements they know you are committed to making the payment but just can't make it now.

The more you communicate with the lender the less likely they are to take action that could be detrimental to your credit history. The key pitfall or cause of bad borrowing is when our repayments and interest can’t be met from our regular cash flow. Some people have a tendency to pay for this shortfall with their credit cards. Let me tell you this is a slippery slope that can lead to financial ruin.

If you find yourself in this situation, go back to your budget and work out what expenses you don’t need or can cut back. Remember all borrowing should be repaid from your regular income or sale of assets. If you understand why you borrow and know it fits within your income, then you will generally be engaging in good borrowing.

Be wary of just paying the minimum repayments on your credit cards. If you had $10,000 outstanding and you paid the minimum 2% with a 20% interest rate, it will take you 77 years to pay it off and cost you $43 thousand in interest. By paying as much as you can you reduce the interest cost and show yourself to be a good borrower.

When it comes to borrowing, your credit history is incredibly important as this forms a large part of the credit providers’ decision to lend you the money or not. Your credit history is simply a record that is kept by credit reporting agencies, such as Equifax, Experian, and Illion, of all your past credit enquiries and applications, details of any existing borrowings, your repayment history, and if there are any court judgements or bankruptcies filed against you.

These records are accessed by a credit provider whenever you apply for a loan or take out a mobile phone payment plan. It tells the credit provider about your past conduct and helps them decide whether you are a good risk and are likely to repay a loan. These records are often summarised as a credit score. The higher your credit score the better.

You are also able to access the information kept about you and it’s advisable that you do so on a regular basis to ensure it stays accurate and healthy. You’re entitled to a free credit report each year which you can obtain directly from the credit agencies online. Some even offer a subscription service to advise you when your credit report is accessed to help reduce instances of fraud.

Given the vital role it plays in any loan application. it’s important to keep your credit history clean and your credit score healthy. You can do this by keeping your repayments and bills paid on time, not making unnecessary credit applications, and reducing any unused limits on credit cards or loans. To find out more, visit creditsmart.org.au or the credit reporting agencies’ websites.

Borrowing money to buy things, to invest or just to cover timing differences can enhance your life, but please make sure you are getting the right type of loan for what you are borrowing for and remember the cardinal rule ‘Match the life of the loan with the life of the asset’. It’s important to understand the full cost of any finance and ensure you can afford the repayments from your regular income.

Finally, make sure you pay all your commitments to keep a clean credit record to ensure you can continue to borrow money as and when you need to.

Thanks for watching ‘Be credit healthy’. We hope you found this video helpful and encourage you to check out the other resources on the Davidson Institute and Ruby Connection websites to help build your financial confidence. Bye for now.