Borrowing money
Sometimes people buy things they can’t pay for all at once, like a car, a home or university. They use credit: borrowing money now and paying it back later.
Credit can be useful, but it comes with a cost: interest.
Types of credit
| Type | How it works | Example |
|---|---|---|
| Credit card | borrow up to a limit; pay back monthly | buying clothes or groceries |
| Loan | borrow a set amount; repay in regular payments | car loan, student loan |
| Mortgage | a long-term loan to buy a home | 25-year home mortgage |
| Line of credit | borrow as needed up to a limit | home renovation |
| Buy now, pay later | split a purchase into installments | online shopping |
Understanding interest
The principal is the original amount borrowed. Interest is the extra amount paid for borrowing, usually shown as a yearly percentage, the annual percentage rate (APR).
Simple interest
Interest is calculated only on the principal.
Interest = principal × rate × time
Example: $1,000 at 5% for 3 years = $1,000 × 0.05 × 3 = $150 in interest.
Compound interest
Compound interest is calculated on the principal plus interest already added. It makes money grow faster, which is good when saving and costly when borrowing.
| Year | Savings of $1,000 at 5% compounded yearly |
|---|---|
| 0 | $1,000.00 |
| 1 | $1,050.00 |
| 2 | $1,102.50 |
| 3 | $1,157.63 |
| 10 | about $1,628.89 |
Albert Einstein is often (probably wrongly) quoted as calling compound interest the "eighth wonder of the world." Whoever said it, the idea is powerful.
The cost of credit card debt
Credit cards often charge high interest, around 20% or more per year.
Example: You owe $1,000 on a credit card at 20% interest and pay only the small minimum each month. It could take many years to pay off, and you could pay hundreds of dollars or more in interest.
Tip: Pay your full credit card balance every month to avoid interest.
Good debt and bad debt?
Some people describe borrowing as "good" or "bad," but it depends on the situation.
- Debt that may build value: a reasonable student loan for education or skills, a mortgage on an affordable home
- Riskier debt: high-interest credit card balances for things you can’t afford, payday loans with extremely high fees
Ask: Will this purchase increase my future income or value? Can I afford the payments? What’s the total cost including interest?
Credit scores
A credit score is a number that shows how reliably a person repays borrowed money. Lenders use it to decide whether to lend and at what interest rate.
- In Canada, scores usually range from 300 to 900; in the U.S., common scores range from 300 to 850.
- Higher scores usually mean better loan terms.
What improves a credit score:
- paying bills on time
- keeping credit card balances low compared with the limit
- having a longer credit history
- not applying for lots of new credit at once
Debt problems
Debt becomes a problem when payments are more than a person can afford. Warning signs include using one credit card to pay another, missing payments, and only making minimum payments. Help is available from non-profit credit counselling services.
Smart borrowing
- Borrow only what you need and can repay.
- Compare interest rates and fees.
- Read the terms carefully.
- Make payments on time.
- Build an emergency fund so you don’t need to borrow for surprises.
Try it yourself
- Calculate the simple interest on $500 at 6% for 2 years.
- Use an online compound interest calculator to see how $100 per month grows over 10 years.
- Compare two credit cards’ APRs and fees. Which is better and why?
- Explain three ways to build a strong credit score.
Answer to 1: $500 × 0.06 × 2 = $60.
Quick recap
- Credit lets people borrow now and pay later, but it costs interest.
- Simple interest is based on the principal; compound interest grows on interest too.
- High-interest credit card debt can grow quickly.
- Credit scores show how reliably someone repays debt.
- Smart borrowing means borrowing only what you can afford to repay.