Bridging The Gaap

What Is A Credit Card?

A credit card is a plastic card that allows a person to buy things on credit, allowing them to buy some things now and pay for them later. You can check out some other definitions here.

What Is The Difference Between A Debit Card And A Credit Card?

A debit card is a card linked to a bank account. You must have money in the bank account to use your debit card, and every time you make a purchase with your debit card. The amount of the purchase is taken directly from your bank account. For example, if you have $100 in your bank account and you make a $20 purchase with your debit card, $20 will be deducted from your account, leaving you with $80.

A credit card is different. A credit card is not linked to a bank account, and purchases are made on credit. Whoever issues the credit card is saying that they allow you to make purchases now, even if you don’t have the cash, but that you must pay them back later.

How Does A Credit Card Work?

Let’s say you qualify for a credit card from your local bank, with a $500 limit per month. You decide to go out to dinner and spend $50. You decide to pay for your meal with your credit card. This means that you have used $50 of your $500 credit. This means you now have $450 worth of credit available to you to use this month, and that at the end of the month you will be required to pay back this $50. Notice you did not need to pay cash, nor did you need to remove cash using your debit card from your bank account. You will however need to pay back this $50 at the end of the month.

What Is A Credit Limit?

Your credit limit is the maximum amount of money that you are allowed to charge your credit card. The credit limit in the example above was $500.

What Is A Credit Card Balance?

Your credit card balance is how much you have charged you credit card. The credit card balance in the above example was $50.

What Happens If I Can’t Pay Off My Credit Card?

What happens if you can’t pay back the $50 at the end of the month? The credit card company will then charge you interest on whatever amount you haven’t paid back at the end of the month. Let’s say that of the $50 charge that you have in your credit card. You could only pay back $20. You now have a $30 balance left on your credit card at the end of the month, meaning you still owe the credit card company $30, because you only paid off $20. The credit card company will now charge you interest on the remaining balance, in our case $30.

What Are Interest Charges?

When a person fails to pay off their credit card balances in full, they are charged interest. Interest charges are percentage of the total balance that has not been paid. This means that the person must now pay back the amount they still, owe, plus whatever amount of interest the credit card company is charging them for being late.

Let’s say your credit card carries an 18% annual interest charge. If we don’t pay off our $30 balance by the end of one year, we will owe a total of 30 x 18%, or $35.40. The extra $5.40 is interest we were charged because the $30 took a whole year to pay off.

Calculating monthly interest charges is a little bit more complicated and will be the subject of another article. For now it is enough to say that if you do not pay your balance off in full every month it will cost you money in the form of interest charges. Always strive to pay off your balance every month in full.

What If I Am More Than 30 Days Late In Paying My Credit Card?

If you are late by more than 30 days in paying off your balances not only will you be charged interest, but your personal credit rating will also suffer. Your personal credit rating will be discussed in another article, but for now you should know that paying off any debt late (or not at all) will lower your credit score, which can make it more difficult to access credit in the future. This applies to credit cards, but also to any bills you may have (utilities, cell phone, gym memberships etc…) and any other loans (car, mortgage, etc…). The key thing to remember is that you should always pay off your balance in full, every month!

How Many Different Types Of Credit Cards Are There?

Credit cards are big business, so you will find it kind of credit card for almost every kind of consumer. There are credit cards that give you reward points that you can redeem for stuff, credit cards that give you air miles credit cards for people with bad credit, and yes, even credit cards that will give you cash back on all your purchases.

Some retail stores offer their own credit cards, but these often carry a very high rate of interest and in most cases can only be used at that store.

How Do I Get A Credit Card?

Most banks, credit unions and caisse populaires will all offer their own line of credit cards. You can also contact one of the credit card companies such as Capital One, American Express, MasterCard, or Visa online or by phone.

Remember, ALWAYS DO YOUR RESEARCH! Not every card is right for everyone! Some people will be able to handle having a large amount of credit available to them, others will need only a small credit limit. Some people will prefer to earn Airmiles, while others may want to earn cash back. There’s no rush to get a credit card, so take the time to look at all the options and determine what’s best for you!

BTG Birthday Shout Out:

This article is dedicated to BTG reader Lisa P! Lisa’s comments were instrumental in creating the improved version 1.1 of BTG’s popular “Where’s My Money” Excel Budget Template, so I thought I’d return the favour. Happy Birthday Lisa, and thanks for the great comments!

What is overdraft?

Overdraft is when your bank account has a negative balance.

What causes someone to go into overdraft?

To put it simply, people go into overdraft on their accounts if there is not enough money in the account to cover a certain request for money. Many things can cause someone’s account to go into overdraft, but the basic problem is that there isn’t enough money there to cover a request, causing you bank balance to run into the negative.

Some of the major reasons people may go into overdraft include:

1. Poor money management skills: Purchasing things when you don’t have enough money to buy them is not only dangerous to your financial well being, it’s also an excellent way to put yourself into overdraft, incurring hefty fees.
2. Automatic withdrawals: If you have authorized automatic withdrawals form your bank account, you need to make sure you have enough money in the account to cover the withdrawal. If you don’t, most of the time the transaction will not go through because there is not enough money to do so, and you can be charged a hefty fee. This happened to me once, as I forgot about an automatic withdrawal from my account into an ING sub-account for my christmas budget, and the overdraft fee was $40, which I was able to get reversed.
3. Bank or account fees: For those who do not have low-fee or no fee bank accounts, monthly or annual automatic fee withdrawals from your account can cause you to go into overdraft. The bank will take its fee when it is due, and if there isn’t enough money in the account to cover it, you will be sent into overdraft and will have to pay a fee. One should always have a “float” of $50-$100 in their accounts at all times to make sure their bank fees will never cause them to go into overdraft.
4. Bank or Merchant error: It rarely happens, but sometimes a purchase or charge that was $5 can accidentally be charged as $50. It doesn’t happen a lot, but sometimes banks and merchants make mistakes, which can cause you to go into overdraft. If this is the case however, the charges can usually be reversed, but always remember to keep those receipts and bank and credit card statements!

How much will I be charged if I go into overdraft?

Overdraft fees can range from a few dollars to upwards of $40 or $50 dollars. These fees are incurred every time your account balance dips below zero.  Also, some banks may charge you a hefty fee PER DAY that you are overdrawn (source). This cost can sometime be offset by purchasing overdraft protection, though that`s not the solution for everybody (more below). 

The important thing to remember is that it doesn’t matter by how much you are over drawn: simply being a few cents below a zero account balance is enough for them to charge you a large fee: this woman was charged 28 pounds ($56 CAD) for going 37p ($0.74 CAD) into overdraft (source, 2nd testimonial).

What can I do if I’ve been charged overdraft fees?

If you have incurred an overdraft fee, it never hurts to call the bank to see if you can negotiate a reduction or even a reversal of the fee. I was able to have my $40 overdraft fee reversed, but this was partly due to the fact that I hadn’t had any overdraft problems for at least 90 days and I believe due to the fact that I politely implying that I would be willing to take my business elsewhere.

Not every customer is a customer worth keeping however, and overdraft fees are big business for banks, especially in rough times such as we’re seeing with the Credit Crisis. (source) 

While there is some question as to the legality of overdraft fees, for now it is important to be aware of them, and to be aware that there is a high price to pay for dipping into overdraft, by accident or by design.

How can I protect myself from going into overdraft?

There are two ways:

1. Practice good money management skills: never spend more than you can afford, and always try to have some 50 or 100 dollars (or more as need be) extra in your account as a float in case you forget about bank fees that are coming due, or that automatic withdrawal you have into your emergency fund at the beginning of every month.
2. Most banks will allow you to purchase overdraft protection, which can be useful for some people, especially if you have to deal with many deposits and withdrawals that are difficult to time. Overdraft protection can be purchased for a monthly fee in addition to your current account fees, for which you will receive a certain amount of leeway should you run into overdraft. Some banks waive the fee for months where you do not use the overdraft protection. 

Overdraft protection is very similar to a line of credit, however, because in most cases you can write checks for the amount of overdraft protection your have, and you will pay interest on any amount within your overdraft protection that you do use.

Let’s look at an example: if you have $5000 worth of overdraft protection, it works in much the same way as a line of credit from a bank. You could write one or many cheques if you needed too for any amount, so long as it doesn’t exceed that $5000. Any amount that you do use will be subject to interest charges.

If you have overdraft protection and you manage to exceed even that (ex: you have $5000 worth of overdraft protection but you are $6000 into overdraft, you will pay overdraft fees as soon as you pass the limit of your overdraft protection (so in our example, you’d be hit with a hefty fee at $5000.01 and over).

What has your experience been with overdraft and overdraft charges? Leave a comment and let us know!

What Is A Debit Card?

A debit card is a plastic card that is linked to one or more of your bank accounts. Issued by a bank or financial institution, a debit card can be a useful replacement for cash, and in some cases can make buying things, and depositing or withdrawing cash much more convenient. They are not without their problems, however, which can include hefty NSF fees, and a risk that you will not be reimbursed if you are a victim of fraud.

How do I use my debit card?

You can use your debit card in a few ways:

1. At ATMs: You can use your debit card at most ATMs to withdraw cash at any time. Note that ATMs that do not belong to your particular bank branch will charge you fees, so try to cut down o the number of times you have to use and ATM to withdraw cash. You can also use your debit card at your bank’s ATM to deposit cash or cheques directly into your bank account.
2. At the store: if the retailer is equipped to accept debit cards, you may use your debit card to make purchases, just as you would cash. 
3. Online: some retailers now allow you to use your debit cards for online transactions. Personally, I feel a credit card makes for a safer online transaction, but it is worth mentioning that in some cases you can use your debit card to make purchases online.

How does a debit card work?

The debit card is linked to one of your bank accounts. Every time you make a purchase with your debit card, the amount of the purchase is automatically deducted from your bank account.

Let’s look at an example:

Say you have $50 in your bank account, and you buy $20 worth of food at the grocery store using your debit card. $20 will automatically be taken from your bank account and sent to the grocery store as payment for the food you bought, leaving you with $30 in your bank account.

What happens if I use my debit card and there’s no money in my bank account?

Two things will happen:

1. You will be informed that the transaction could not take place when you try to buy something: a little message will pop up on the screen that says INSUFFICIENT FUNDS, or something else that also means that you didn’t have enough money to make the purchase.
2. You may be charged a fee for trying to use your debit card when you don’t have enough money in your account to complete the transaction (some banks will simply block the transactions and not charge you this fee: you should always ask you bank first). These fees, called overdraft fees can be HUGE, sometimes as large as $40!

What’s to stop people from using my debit card?

Some people will read the last few paragraphs and worry that their bank account can be compromised by using the debit card? What’s to stop a thief from stealing your card and emptying your bank account? A very smart man thought of this, and came up with a protective measure called a PIN code.

What is a PIN code?

PIN stands for Personal Identification Number. Think of your PIN as the password to your debit card. When you first obtain your debit card from the bank, they will likely ask you to choose a PIN code right then and there. You will input your PIN into a pad, the teller should not ask you to tell them your PIN out loud, after all, it’s secret!

You will need to use your PIN every time you use an ATM, make a purchase, or go to the bank. The debit card cannot be used without this PIN code, so should you lose your wallet or have your debit card stolen, the thief will not be able to use your card to make purchases or withdraw money from your accounts.

Debit cards are relatively safe SO LONG AS YOU KEEP YOUR PIN CODE SAFE.

How do I keep my PIN code safe?

The following will help you keep your PIN safe:

DO:

• choose something easy for you to remember, but difficult for others to guess
• choose something you can memorize
• use your hands to cover your PIN when you are pressing the numbers, as the photo below shows:

DO NOT:

• write your PIN down (if you absolutely must, rearrange the numbers and keep it in a fireproof, locked box with the rest of your important documents).
• write your PIN down and leave it in your wallet
• write your PIN ON YOUR CARD >.<
• tell ANYONE your PIN (you don’t HAVE to tell anyone your PIN, ever; this includes family members, bank employees, friends, co-workers, etc…)
• choose birthdays, social insurance numbers, addresses, phone numbers and so on for your PIN…if someone steals your wallet they can easily access this information!

What should I do if I have lost my wallet or debit card?

Tell the bank immediately. Most big banks will have 24hrs service, so as soon as you notice your debit card or wallet is missing, tell the bank. They will immediately make it impossible for anyone to use that card. You must tell the bank as soon as possible, because the more time you wait, the more time thieves have to steal your money (and they work FAST).

What should I do if I am a victim of debit card fraud?

If you have been a victim of debit card fraud, immediately contact your bank and let them know the situation. The likelihood of you getting refunded if you are a victim of fraud increases if the bank and the police are able to catch the perpetrators, for which they need you and your experience.

For more information, click here to access Canada’s Office of Consumer Affairs, which has some great information about what to do if you are a victim of fraud.

Will I be refunded if I am a victim of debit card fraud?

Maybe, but maybe not.

The bank may not refund debit card fraud. The reasoning behind it is that a debit card has that extra layer or protection by requiring the user to input a PIN whenever it is used. The banks may not refund debit card fraud, because it’s your responsibility to keep your PIN safe.

As for whether or not you will get your money back, that’s a difficult matter. It seems the burden of proof is on Canadian Financial Institutions to prove that you were negligent in your use of your debit card or PIN code:

“Be aware that if - as a result of the investigation - your financial institution is not reimbursing your full losses, they are responsible for showing that, on the balance of probabilities, you contributed to the unauthorized use of your debit card. If you are not satisfied with this explanation, speak with your branch manager.” (source)

Still, “negligence” is a broad term. In some cases, doing anything that I told you NOT to do is enough to be considered negligent: for example, it is considered negligent on your part to write down your pin and keep it close to your card, to using a pin that is your telephone number (or other easily identified PIN), not notifying your bank as soon as you find out you were scammed, and so on (source).

For a complete list of what is considered negligence on your part, check out this list at Canada’s Office of Consumer Affairs.

For More Information:

Canada’s Office of Consumer Affairs’ website  about debit cards is quick, conscise and easy to understand. You should definately check out the following links from their site:

1. How can you protect yourself against debit card fraud?
2. How does fraud occur?
3. What should you do if you are a victim of debit card fraud?
4. When would you be liable for losses?
5. How much could you lose?

Now It’s Your Turn! 

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What Is The Credit Crisis Part 4: The CRISIS

Why do businesses need credit?

Many businesses need credit for their day to day business operations. Some companies simply don’t have the cash to pay their suppliers, and do so with credit, while others simply prefer to do so for various reasons.

Remember how I said lots of institutional investors bought and held CDOs in their portfolios? Some big businesses ended up owning CDOs as well, and also saw their worth vanish with the default of the mortgages backing the securities (is this all greek to you? You probably haven’t read part 2 of this series!). With the decrease in the value of their assets, the companies had less that they could sell off or leverage during a crisis, and so became more likely to rely on credit.

Unfortunately, due to the credit crunch this credit became more difficult and more expensive to obtain (see why in part 3!).

Why is it a problem if big/small businesses can’t access credit?

During a credit crunch, it becomes far more difficult for companies, big or small, to get the credit they need from banks. This credit may be necessary to sustain day-to-day operations, therefore, if a company cannot obtain this credit it risks going out of business.

Let’s take the case of hypothetical automaker, which at this point in time needs credit from a bank to survive. If the automaker cannot access this credit, it risks going out of business. If the automaker starts having trouble, or goes out of business entirely, two things can happen:

1. Employees of the automaker no longer have a job.
2. Suppliers to the company might also risk going out of business.

1) Employees of the automaker no longer have a job: This is a problem because the unemployed no longer draw a salary, and therefore don’t have any money to spend. This means there may be a decrease in the overall level of consumer spending, which can spell trouble for an economy, especially one with recessionary fears.

This is because when consumers don’t have any money to spend on products, producers don’t make any money either: fewer people are buying their products, leading to a decrease in revenue. Firms that produce items that people aren’t buying risk going out of business, which leads to further unemployment: it’s a vicious circle. People need to have jobs to make money, and people need to make money to buy things; but when people lose their jobs, they stop making money, and can no longer afford to buy things, which leads to more producers going out of business, which leads to more job losses. And so it goes.

2) Suppliers to the company might also risk going out of business: we touched on this briefly in the preceding paragraph, but let’s take a more detailed look. Let’s say our automaker goes out of business, what other kinds of businesses might this collapse affect?

What about the company that provides electronics for the cars? If the automaker was a big customer of this firm, the electronic company might see its sales decreased substantially. This can put the firm in a precarious position depending on how big of a customer the automaker was: sometimes it’s a big enough customer such that if the automaker collapses, the electronics company would collapse as well. And that’s just the company that makes the electronics for the automaker’s cars: what about the company that provides the upholstery? What about the company that manufactures the CD players? The wheels? The seats? All of the supplier companies risk going out of business if the automaker collapses. As we touched on before, every firm that collapses creates more unemployment, which means less consumer spending, which in turn creates more unemployment.

So why are my investments being affected?

When a company starts getting into trouble, frequently it share price decreases and if a company gets into enough trouble in share price can drop dramatically. If a company’s shares become rapidly devalued, it’s a little bit like a sinking ship: everyone wants to get off, and no one wants to get on. People start selling their shares in this company, which in turn leads to greater devaluation of the company stock. If this happens, then even more people start selling their shares, which leads to greater devaluation: again it’s a vicious circle.

This is a problem for companies, because share equity (the money they get when they sell shares of their firm to ordinary people) can be an important source of financing. Cut off this source of financing and the company might find itself in trouble. An inability to obtain credit to make up for this loss of share equity only makes things worse. At this point, worthless assets, worthless stock, and an inability to obtain credit, the company becomes almost entirely dependent on the revenue from selling products to keep itself afloat; as we’ve seen, it doesn’t take much to effect a decrease in consumer spending.

Oh Jeez!

Yeah, I know.

So what can we do?

Ordinary people can do two things:

1. They can take a good, hard look at the economic policies of the political parties
2. They can continue to pay taxes

1) Observing economic policy: Ordinary people should take a good look at the credit crisis from a political standpoint as well, especially with the upcoming November 2008 elections (Canadians had their chance on October 14th 2008). You should look at economic policies and histories (such as their view and history of implementing regulation in the financial markets) of both major parties and then decide whether or not this affects your view your chosen candidate (it may, it may not). The economy is, of course, only one thing you should consider when voting, but it is important to realize that, in the words of my father: “Democracy is hard”, meaning you need to take the time to look at all parties, all policies, and your own feelings, which will allow you to make a more informed decision.
2) Continue to pay taxes: at this point, fixing the credit crisis is in the government’s hands as the crisis has simply grown too big, and too complex to be affected by individuals. So-called “bailout” plans, if properly thought out, may have a very positive effect on the current crisis gripping the global economy. But to fund such endeavours, the government needs money, and all the governments money comes, ultimately, from ordinary people like you and me.

What’s important now is that we make sure, through our votes and our tax dollars, that we never repeat the mistakes of the past.

For More Information:

You can check out this excellent video about General Motor’s current woes here and another one here. For more on GM plant closings, click here.

Follow this link for more infor about GM and several other automaker’s rapidly devaluing share price. 

A Note About This Article:

Gosh, it seems so simple in retrospect…but what did YOU think? Was this series helpful? Have I missed something you thought should be included? Are you still unclear about something? Let me know by leaving a comment below!

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What is the Credit Crisis Part 3: The CRUNCH

Why is it a problem for banks to have worthless assets?

The problem is that banks must trade with other banks to help sustain the stability of the economy. Banks, owing to the nature of deposits and withdrawls, can sometimes be short at the end of the day. Banks then often loan to one another overnight (the lender is often repaid the next day) because it is cheaper than borrowing from the Federal Reserve or The Bank of Canada. This represents a huge source of liquidity for banks and the economy as a whole (remember that liquidity just means how easy it is to access money).

When banks started seeing worthless assets on the statements of other banks, they became much more wary about loaning to one another (source).

Why are banks afraid to loan to one another?

Think of it this way: would you loan someone money if you didn’t think they could pay it back?

The banks see it the same way; a bank is not going to want to loan any money to another bank that has heavy losses: it would be like loaning money to someone who has already run themselves deeply into debt, someone who could not afford to repay you. Banks won’t loan other banks any money if they are afraid the borrower will never be able to pay back the loan.

When banks become unwilling to lend to one another they must borrow money from other sources such as the Federal Reserve or The Bank of Canada, which is more expensive and more difficult than borrowing from each other (this is purposeful on the part of the national banking institution, to encourage banks to loan to one another). Now that banks have increased expenses however, they must increase their revenue to compensate, and it’s at this point that the economy experiences a Credit Crunch.

What is a Credit Crunch?

A Credit Crunch is a period of time in which credit becomes more expensive and more difficult to obtain (source). Should one need to seek credit from a financial institution during a credit crunch, one would find that interest rates are higher on the loans (making credit more expensive), and that the qualifications for obtaining a loan are more strenuous (making credit more difficult to obtain, especially for people with below average credit histories).

Why do we enter a credit crunch when banks refuse to loan to one another?
When banks become unwilling to lend to one another they must borrow money from other sources such as the Federal Reserve or The Bank of Canada, which is more expensive than borrowing from each other (this is purposeful on the part of the national banking institution, as it encourages banks to loan to one another). Now that banks have increased expenses, they must increase their revenue to compensate. This mean loans with higher interest rates (ie: loans that are more expensive) and loaning money only to people who are likely to pay it back. 

What are the effects of the credit crunch on ordinary people?

Ordinary consumers will feel the effects of the credit crunch in 3 major ways;

1. Credit becomes more expensive: Because the banks must borrow at more expensive rates, they must also loan at more expensive rates to compensate. This translates to higher interest rates on consumer loans such as mortgages.
2. Credit is more difficult to obtain: Banks will still loan to consumers, just not to EVERY consumer. Just as people can lose faith in banks, banks can lose faith in some of their customers, and this is exactly what happened with the sub-prime section. Banks are no longer able or willing to extend credit to any yahoo who asks for it, not like they could (and did) before with the whole sub-prime mess. Therefore, if you pose an above average risk to the bank (or even an average rick) you may find it difficult to obtain credit, as banks are no longer willing or able to take a chance on you.
3. Oh yeah, there’s the little issue of a tanking economy…but we’ll talk about that in a second…

            

But again, the economy doesn’t care if Joe and Jane Smith aren’t eligible for a big mortgage: the economy cares when businesses, big or small, are unable to get the credit they need to survive.

And that, my friends, is where the CRISIS begins…let’s find out why in Part 4: The CRISIS!

A Note About This Article:

Banks and how they work are particularly fascinating subjects. Should you become interested in understanding how banks operate, consider checking out a good economics textbook at the library. Online sources can be very helpful, but you must beware: there’s a lot of very biased media (usually video) circulating that will claim to offer the “truth” about banking and banking institutions. It’s not the fact that some of the information may be controvercial that sets of warning bells, it’s when the “truth” is being used to push an agenda that bothers me. As a general rule, I tend not to pay too much to anything that a) is very clearly biased and/or b) can’t give any good sources/is not published by a credible source itself. Critical thinking caps on everyone!

This article was included in the 34th Money Hacks Carnival, hosted by Where You Are Now.

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis (Coming Oct 14th)

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What is the Credit Crisis Part 2: The COLLATERAL

Why didn’t the banks just change the terms of the loan?

Banks couldn’t change the terms of the loans because, in most cases of sub-prime loan debt, the original mortgage lenders no longer owned them. The original mortgage lenders had packaged up the mortgages they owned and sold them to other banks, to investment banks and to hedge funds as Mortgage Backed Securities (source).

What is a Mortgage Backed Security?

A mortgage backed security (MBS) is a type of asset backed debt security.

Recall that debt securities (ex: bonds) represent a type of security which must be repaid by the issuer: if a company issues bonds, it must come up with the money to make the interest payments, and the money to pay you the full value of the bond once the bond term has ended. This is different from equity securities (ex: shares of a company), in which there is absolutely no obligation by the company to pay you anything (though some do in the form of dividends to sweeten the deal).

The key part of a MBS is understanding that it is a form of debt security: whomsoever packages up these loans and sells them is promising the buyer that the issuer has money coming in to make sure the mortgages backing their investment do not default: this cash flow depends on average people making their mortgage payments on time and not defaulting on their loans.

How were the banks able to sell all these mortgages?

Here’s what happens: oridinary people take out loans from their local bank. The bank can package up these loans into mortgage backed securites. The MBSs are then put in a portfolio called a Collateralized Debt Obligation (CDO) with other asset backed securities. For a detailed look at how MBSs and CDOs work, you can check out this interactive presentation by the Washington Post (it’s slightly more complicated than I’m letting on, for example, I have elected not to talk about things like “tranches”).

CDOs are then sold by the local bank to investment banks, with the local bank earning a fee or a commission with every sale. The investment bank now owns the mortgages of the ordinary people, and in essence their mortgage payments go to the investment bank instead of their local bank (the payments may go through the local bank on the way to the investment bank, again perhaps earning transaction fees and commissions along the way).

The investment bank then sets up a corporation, called a Special Purpose Entity, whose cash flows are entirely dependent on the mortgage payments of ordinary people.

What is the purpose of a Special Purpose Entity?

The “special purpose” of this “Special Purpose Entity” is simply to sell investors the CDOs. The issuing investment bank earns transaction fees on every sale, and also earns management fees for the life of the investment (think of how a mutual fund company operates). Think of it as a company that doesn’t sell anything or provide any service: this company’s revenue comes entirely from the mortgage payments of ordinary people. 

Buying a CDO from a Special Purpose Entity is very much like buying a bond: you’re buying a promise of steady cash flow from the issuer. You’re investing because you believe that people will make their mortgage payments, and that by buying a CDO with a huge number of mortgage backed securities in it, a little of that expected cash flow from all of those mortgage payments made by ordinary people will trickle down to you (once it has passed through the hands of the bank, the investment bank, and the special purpose entity, each taking their cut).

What happened to the CDOs when people stopped making mortgage payments?

When ordinary people were unable to make their mortgage payments, the mortgages themselves became worthless: they became loans that no one could repay, and due to the downturn in the price of housing, even if the bank could sell the house, they’d likely have to do so at a loss.

When the mortgages became worthless, the mortgage backed securities became worthless, as there was no longer a steady cash flow from people making their mortgage payments. As the mortgage backed securities became worthless, many CDOs that had invested heavily in MBSs also became worthless. Anyone who had invested in CDOs now saw part of, if not all, their investment become worthless.

You may not consider that this would have much of an impact, and indeed it probably wouldn’t if CDOs were only sold to individuals. But they weren’t. CDOs were sold to institutions who put them in their hedge funds, in their pension funds, in their endowment funds. Unfortunately, CDOs were also sold to other ordinary banks.

And that was the real problem: the banks incurring such heavy losses. The economy doesn’t care if a company’s pension fund takes a nosedive or if a college’s endowment fund is down, but the economy does care if banks suddenly have worthless assets.

Why? Let’s find out in Part 3: The CRUNCH! 

For More Information:

For a very detailed look at how CDOs work, check out this interactive presentation by the Washington Post

Youtuber “Khan Academy”, a Harvard MBA graduate, has an very interesting (though occasionally quite confusing) series of videos on Mortgage Backed Securities (in three parts) and on Collateralized Debt Obligations. 

A Note About This Article:

N.B: This was probably the most complex of the four parts of BTG’s Credit Crisis series, simply because the subject matter itself is complicated (mortgage backed securities? collateralized debt obligations? huh?!?). I have elected to do a broad overview rather than get into very specific details about each item: for example, I don’t discuss the splitting of CDOs into “tranches” (the french word for “slice”). For those who are interested in more details, I have included resources above, under the heading of “For More Information”.

This post was included in the 174th Carnival of Personal Finance, hosted by  Greener Pastures

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What is the Credit Crisis Part 1: The CREDIT

WHAT IS A SUBPRIME LOAN?

A sub-prime loan is a high risk loan, a “loan that is offered to individuals with poor credit” (source).

Banks give their best (ie: lowest risk) customers a mortgage with an interest rate very close to the PRIME rate, which is the lowest rate a bank is allowed to offer. “Sub-Prime” refers to the fact that customers with poor credit ratings are below the status of prime customers as they are much more risky to the lender.

When I say high risk, I mean HIGH RISK. Sub-prime loans didn’t just involve people with below-average credit histories: at the height of the sub-prime frenzy, it was entirely possible to obtain what is called a NINJA loan from an unscrupulous lender: people with No Job, No Income and no Assets were able to qualify to buy a home. Standards were incredibly lax, with a sub-prime product to meet almost anyone’s needs (check out this Washington Post article for a cool overview). Homeownership shot up from 65% to 69% (source), and home prices began to increase with the increase in demand, necessitating the need for larger mortgages to sub-prime lenders.

Compounding the problem was the fact that some of these sub-prime loans were Adjustable Rate Mortgages.

What is an Adjustable Rate Mortgage?

An Adjustable Rate Mortgage (ARM) is a mortgage with an interest rate that changes. This is different from a Fixed Rate Mortgage, which is a mortgage that holds the same interest rate for the life of the loan. ARMs usually offer lower initial interest rates, which is attractive to the homebuyer. This increased reward comes with greater risk however: ARMs can be attractive if interest rates stay steady or decrease, but if interest rates increase, so too does your monthly mortgage payment.

In Canada tend towards a type aof Adjustable Rate Mortage that is a little different: we have VARIABLE RATE MORTGAGES, in which a change in interest rates only impacts the percentage of your payment which goes to pay off the principal. With a VRM, when your interest rates change, your monthly payments do not, but it will take longer to pay off your mortgage as a greater percent of the monthly payment is now going to pay off interest rather than the actual outstanding balance of the loan (source). It’s an important distinction that, I believe, may have in part saved our economy from the woes the US is currently undergoing.

Why Did It Take So Long For ARMs To Cause A Problem?

ARMs have interest rates that adjust, but they do so at different times. There are ARMs that adjust monthly, quarterly (every 3 months), annually, or every 1, 3, or 5+ years. ARMs that adjusted every few years meant that people didn’t have a problem making their mortgage payments before 2004, when interest rates were low (when a US bank’s prime rate, the rate the offer their “best” customers, was 4.00%; source). When interest rates rose from 2004 to 2006 (at which point the prime rate had shot up to 8.25%; source), many ARMs were slated to readjust.

And when I say some, I mean A LOT. By Q3 2007, sub-prime ARMS represented only 6.8% of all loans in the economy, but represented a whopping 43.0% of all foreclosures (source). This is because ARM loans were readjusting when interest rates were rising, which meant increased monthly payments for the mortgage holders.

What Does A Person’s Credit Rating Have To Do With All This?

Your credit rating impacts the interest rate you get when you take out a loan. It works on the idea that the better your credit rating, the less likely you are to default or miss payments on a loan. People with good or excellent credit scores therefore present less risk to the lender, and the lender is then willing to loan money out at a lower interest rate. A bank’s PRIME is set by the Bank Of Canada (or Federal reserve in the States) and is the rate they offer their best (ie: their PRIME) customers: those with above average to excellent credit scores.

People with low credit scores represent a higher perceived risk to the lender. The lender cannot be certain that a person with a low credit score will be able to make payments or to not default on the loan. Lenders willing to loan to these “sub-prime” customers will only do so at higher interest rates. This is because the risk to the lender on a sub-prime loan is higher than on a loan to a customer with good credit, and because there is increased risk, there must be increased reward for lenders to even consider loaning out the money. This also allows the lender to recoup some of their money through higher proportions of interest should the lendee default: even if the loan defaults, at least they will have made more interest than they would have if they offered sub-prime customers prime rates on the loan.

What Happened When The Loans Readjusted?

Unfortunately, these sub-prime loans were on the rise during the last decade, which was fine when interestrates were relatively stable. When interest rates rose, however, sub-prime customers (who were already paying very high interest rates because of the risk to the lender) saw their rates readjust to unmanageable levels.

And so sub-prime loans began to default in record numbers.

Why Didn’t The Banks Just Lower The Interest Rates?

Some may ask why, if people were beginning to default in record numbers, didn’t the banks just lower the interest rates on the loans?

The banks couldn’t do this because they sold these loans to OTHER banks, investment firms, and hedge funds.

I still firmly believe that even though it was a monumental F-up to offer sub-prime loans in an already poorly regulated market, the damage could have been mitigated if someone, anyone, at the big investment firms had stopped for a second and wondered if selling high risk debt was, perhaps, a little too risky even for the possible rewards.

But apparently, nobody did. And it’s right about this time that the poop hits the fan…

How so you ask? Let’s find out in part 2: The COLLATERAL!

For More Information:

For more information on how the interest rate on ARMs is calculated, click here, and scroll down until the subject heading “The Index” and “The Margin”.

For more information about US interest rates (including a complete list of changes for the past several years), click here to access the Federal Reserve’s list of interest rate releases.

A Note About This Article:

N.B: The credit crisis is a very complex issue, which is one of the reasons I decided to write this article in the first place. I have done my best to coallate and undertsand exactly what has been happening over the past few years, using high quality sources that are verifiable by the reader. I want this article to be as complete and credible as possible, and guess what: YOU can help! If you have information, or an understanding of the subject that could help improve this article, please leave a comment below! Just have an opinion on the subject? Leave a comment, and let your voice be heard!

This article was also featured in the 173rd edition of The Carnival of Personal Finance, hosted by Girls Just Wanna Have Funds!

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What Is A Credit Card Cash Advance?

A credit card cash advance is a way to get cash from your credit card. This can be used in cases when you have no cash or debit card, and the retailer does not accept credit cards.

How is it done?

A credit card cash advance can be done at most ATMs. In the options screen, there may be an option to “withdraw” from your credit card, or it may even be labelled as “cash advance”.

Say you wish to take a cash advance from your card in the amount of $20. The ATM will charge $20 to your credit card (which will show up on your next bill just as any other purchase would) and give you cash, in our case, a $20 bill. Now you can pay the retailer for your sweet comics!

Though my example makes cash advances seem innocuous, credit card cash advances are generally a very, very bad idea. There’s two reasons why.

So…What’s the catch?

There are two, and they are IMPORTANT. Credit card cash advances are bad ideas for two reasons:

1. Fees
2. Interest charges

1) Fees:
Most, if not all, credit card issuers will charge a fee for cash advances. These fees can be calculated in three ways:

1. Percentage Fee - The fee will be based upon a percentage of the amount of the cash advance. If the percentage fee is 5%, for example, a $20 cash advance will cost you $1 in fees.
2. Flat Fees - The fee is a “flat fee” regardless of the amount of the cash advance. In this way, they are much like the fees you would pay at an ATM: regardless of the amount of money you take out, you’ll usually pay the same flat ATM fee of a few dollars. If, for example, your credit card issuer charges a flat $10 fee for cash advances, then you’d have a $10 fee for your cash advance regardless of whether you took out $20, $40, or $200.
3. Combination Flat and Percentage Fee - This combination usually results in higher fees than the percentage or flat fees alone. In such cases, there may be a minimum flat fee (ex: ten dollars), but if the cash advance is in an amount whereby a percentage fee would give the credit card issuer more money (ex: more than $10), then the percentage fee would be used and charged to you instead. For example, if you only advanced yourself $20, at a 5% percentage fee, you would likely be charged the flat $10 fee (the card issuer would make $9 more this way). If you advanced yourself $220, the fee would be calculated using the percentage method (for a total fee of $11, $1 more than you would pay on a flat fee).

2) Interest charges

Credit cards can carry different interest rates for different uses of the card. Take, for example, the Capital One Gas and Grocery card, which I discuss in my analysis of 7 Canadian cash back credit cards, which illustrates three different categories of interest rates.

Notice the cash advance category: in this case it is set at 19.8 percent (coincidentally the same as the rest of the interest rates offered on that card).

Be aware that interest rates on cash advances can, and usually are, higher than the normal interest rate on the card.

In addition, cash advances are NOT like your credit card: with your credit card, you are generally given at least 30 days before payment of the balance is due. This means that on a credit card, you have usually 30 days to pay off your balance before they start charging interest.

This is NOT the case with cash advances: with a cash advance, interest begins accruing IMMEDIAELY, from the moment you take the advance. Many people do not realize this, and are surprised and shocked to find this out only when the bill comes some time later, by which time the interest has begun to add up.

So, should I take out a Cash Advance?

NO: the combinations of fees and interest charges make cash advances an extremely expensive way of getting quick cash. The example at the beginning of this article, buying comic books, was my first and last experience using cash advances. Cash advances are unsuitable for anything but the most severe cash only emergencies, and even then you should always look to your emergency fund first.

If you find yourself NEEDING to take out cash advances, you’re doing something wrong. You are either using the cash advance from your credit card to buy unnecessary things (ex: comic books, lunch, drinks, etc…) or you have a serious money management problem. Consider consulting a financial planner, and using BTG’s Excel Budget Template to figure out where your money is going every month.

For more information:

Financial Consumer Agency of Canada - A great government run website with multiple numerical examples of how fees and inetrest rates add up on a cash advance.

Credit Card Cash Advance Pitfalls @ Youngmoney.com - A neat site that explains the above somewhat more concisely.

Personal Finance by Kapoor et al. - Great book which details many things about credit cards, including cash advances.

Slice.ca - Til Debt Do Us Part - Full episodes of a great show that deals with debt repayment and money management.

Part 1 - Analysis of 7 Canadian Cashback Credit Cards - Part 2 - 5 Things To Keep In Mind

After reading A Million Bucks by 30 by Alan Corey, in which Mr Corey talks about his great experiences with cash back credit cards (when used wisely, of course!), I began to think about switching from my current card, which offers reward points, to a card that would offer cash back.

I came across this great post over at Million Dollar Journey that is a good starting point for finding some cash back credit cards in Canada. This was my starting point. I developped an excel model for the following cards, which you can download and manipulate as you please to fit your situation.

DOWNLOAD BTG’S CASHBACK CARD EXCEL MODEL!

I looked at the following seven cards:

• Capital One Card Lab (Create  A Card)
• Capital One Guaranteed Cashback Gas and Groceries
• Citi Enrich Mastercard
• Capital One Platinum Cashback Mastercard
• TD Canada Rebate Rewards Visa Card
• CIBC Dividend
• Amex Costco Platinum Cash Rebate Card

Here are some of the assumptions I made in order to create/use the model for my particular situation:

1. I assume purchases of $100 a month, ie: $1200 a year.
2. Groceries are between $700-$800 a month (for a family, not an individual), which is $175-$200 a week. This is equivalent to between $8400-$9600 spent on groceries per year.
3. I have not factored in gas as I do not own a vehicle. I have included a space for gas where appropriate however, so if you would like to factor that into the model, everything should work correctly.

Here was the result of my analysis, for my particular situation (your results may vary):

1) BEST BET FOR CANADIANS…if you can get a US credit card!

If you’re eligible to obtain a credit card from the United States, the Capital One Card Lab, with the following specifications gave me the most money back for my purchases:

• Limited History
• 1% Cashback On Purchases
• 2% Cashback on Gas and Groceries
• 29$ Annual fee
• 14.65%  Annual Percentage Rate

Plugging this into my excel model gave me a proft range of $151-$175. That’s after taking out the reasonable $29 annual fee! This card offers 1% on all purchases and 2% on gas and groceries at participating retailers.

Selecting the 25% bonus cashback instead of the %2 on gas and groceries caused my profit range to drop to  $91-$106.

2) BEST BET!…if you’re not living in Quebec, Nunavut, the Northwest Territories or the Yukon Territories!

A close second was the Capital One Gas and Groceries with a profit range of $101-$125, but I would then be foreced to shop at Loblaws (or other stores aside form the store I use now). The only other problem is that these cards are not avaliable everywhere in Canada. It has an annual fee of $79. It offers 1% on all purchases, and 2% gas and groceries purchased at participating retailers.

3) BEST BET FOR ALLLLLL CANADIANS! (Yay!)

The Citi Enrich Mastercard came in third with a profit range between $96-$108. This card has no annual fee. It offers cashback of 1% on EVERY purchase.

4&5) THE TIE-BREAKER!

The next two cards, the Capital One and the TD Canada Rebate Rewards Visa Card, each yield a profit range of between $81-$93. The capital one card has no annual fee. It offers 0.05% cashback on the first $3000, then  1% cashback on everything after that.

However, the Capital One Guaranteed Gas and Grocery Card is the better bet, because the TD card will only rebate a maximum of $250 per year, meaning that no matter how much you may spend, the maximum amount of cash you will receive is $250. The TD card has no annual fee. It offers 0.5% cashback on the first $3000 and 1% cashback after that. But as stated before, the maximum you can earn is $250.

6) THE SECOND TO LAST

CIBC dividend came in 6th with a profit range of $77.25 - $89.25. It has no annual fee. You earn 0.25% on the first $1500, 0.5% on the next $1500, and %1 cashback on all purchases after that.

7) THE LAST

Amex Costco came in sixth and frankly, dead last, with a profit range of $34 - $52 (that’s after I deducted the costco memebership fee, as I have done with all annual fees in reporting the profit ranges above). The AMEX card actually would have ranked much higher if they didn’t make you pay the Costco membership fee, of, I believe, $55. It hugely affects your cashback rewards, and unfortunately losing such a huge chunk of my rewards paying the annual memebership fee caused this card to wind up last. Remember though, this is for my situation, if you already have a Costco membership, or if you spend more every year, you may have a different outcome. You’ll earn 0.25% on the first $2000, 0.5% on the next $3000, and 1.5% on everything after that.

There are some very important things you must keep in mind when considering whether or not a cashback credit card is right for you. In part 2 we’ll take a look at 5 of the most important things to keep in mind about cashback credit cards.

DOWNLOAD BTG’S CASHBACK CARD EXCEL MODEL!

Part 1 - Analysis of 7 Canadian Cashback Credit Cards - Part 2 - 5 Things To Keep In Mind