Part I: The Basics Behind Loans and Credit Scores

This is Part I of the guide, Understanding Loans and Credit At Every Stage of Life.

Navigating the financial challenges that we face during different life stages often requires that we borrow money. However, there are right and wrong ways to go about taking out loans. A realistic assessment of your available resources and future goals can indicate that borrowing money is a good choice. It pays to understand the loan process, the types of loans you may encounter, how they affect you in the long term and the pitfalls that you should avoid.

What Is a Loan and Why Would I Need One?

A loan at its most basic definition is an amount of money extended from one party to another party where repayment is delayed. Federal, commercial, private banking and institutional lenders charge interest, which is the cost the borrower pays for the privilege of temporarily using the lender’s funds. A contract is agreed upon that includes the interest to be paid, extra fees and the repayment time frame. The framework is standard, but the components differ depending on the type of loan and the lender’s terms. While lenders do have considerable leeway in the terms they may offer, the loan marketplace is federally regulated.

Your needs at particular times in life may spur you to take out loans to cover expenses. For example, student loans assist with the cost of education (see Part II: Loans and Credit During the College Years); mortgage loans are designed to facilitate property purchases (see Part IV: Loans and Credit Options for New Families); short-term lines of credit can help with emergencies; and personal loans can cover expenditures such as a wedding, a vacation or a new boat. Even though the process is easy, it is easy to fall into debt by not repaying your lender as quickly as possible. All lenders profit by loaning funds, and they make more money when repayment is delayed.

The Application Process

Applying for a loan is a standard procedure. Lenders need to mitigate their risk of non-payment, and they have developed standards by which your financial worthiness is measured. The lender’s goal is to ensure that you are financially able to repay the loan plus interest and fees. You should be prepared to offer personal, sensitive information to the lender during this process.
Standard items of disclosure to a potential lender include:

  • Proof of income, usually in the form of recent consecutive pay stubs: These prove that you have sustainable current income.
  • Employment history and contact information: This is an indication of your job stability and will be verified by the lender.
  • Recent banking statements and proof of assets: This data details your personal financial worth.
  • Social Security number: This proves your identity.
  • Birth date and contact information: This will be used to verify all items listed above.

Some loans also require credit checks, proof of collateral or other items like proof of insurance, depending on the type of loan (see Part III: Budgeting and Taking Out Loans as a Young Adult). All these factors are weighed by the lender’s underwriting department to determine whether you are a good loan risk. These variables may also help the lender determine how much interest to charge for your loan. If you are approved, the lender will provide a legal document called a disclosure statement. This document, which must be adhered to by the lender and the borrower, clearly defines the principal loan amount, interest rate, finance charges and any extra costs of the loan.

Secured vs. Unsecured Loans

Secured loans are the most common type of loan. An item of value, such as a car or a piece of property, is used as collateral to secure a loan. This means that if the loan is not repaid within the terms of the contract, the lender may seize the collateral in order to recoup costs. There are three components of a secured loan.

  • Proof of ownership of the collateral asset must be provided to the lender. In the case of a car, this may be the car title or proof of intent to purchase the car. A real estate deed, a bill of sale or a savings account statement can also be used as proof of alternative means for the lender to be repaid.
  • A contract that clearly states the terms of the loan, the interest rate, fees, payment information and the length of the repayment term is also required.
  • A security document is filed as a matter of public record. This document legally states that in the event of default on the loan, you and the lender agree your collateral may be seized and returned to the lender.

Unsecured loans, or personal loans, are less common. These loans are not held by collateral, but instead are granted based on credit-worthiness and proof of ability to repay. Often referred to as personal lines of credit, these loans are offered by banks and credit unions. Since there is no collateral, the lender carries more risk of nonpayment. To account for this risk, interest rates and fees are much higher than on secured loans.

Personal loans can be a quick source of cash, as they are often approved within a few days. If you have good credit with a low debt-to-income ratio, a personal loan can be a useful tool in an emergency. Some banks offer open lines of credit for a period of one to three years that can be used at the borrower’s discretion; these can be helpful backup for unplanned expenses.

Individuals with large personal wealth may use these lines of credit as gap coverage when investing. For example, if you purchase a house with an $850 mortgage as an investment property and plan to rent it for $1100 per month, there will be a gap between the time you purchase the house and when you begin to receive rental income. A personal loan can provide ready cash until your investment starts returning profit. Though personal loans can be useful, the price for this convenience is high; the average personal loan in fall of 2011 charged 10.52% in interest.

Credit Scoring

Loan terms are generally heavily impacted by your credit history. Your track record of meeting prior contract terms is a direct indicator of the risk a lender assumes when loaning you money. Most lenders verify your credit history with a credit report from at least one of the “big three” credit agencies: Experion, TransUnion and Equifax. These entities maintain records of loans and payment histories; an amalgamation of your credit history is reflected as your FICO score.

The Fair, Isaac & Co. (FICO) score uses five types of data that allow lenders to mathematically predict your credit risk:

  • Payment history with prior lenders
  • Current outstanding balances
  • The amount of time that you have successfully managed credit
  • The number of inquiries into your credit status
  • The types of credit you have been granted

All of the five types can work for or against your FICO score. These scores range from 300 to 850, and are a determining factor when lenders evaluate whether to offer you credit. Your score is considered a prediction of the  likelihood that you will successfully repay your loan. Though each lender has different criteria for approval, generally the higher your credit score is, the better. Most Americans’ credit scores are between 600 and 750, and a score of 700 indicates a history of good credit management.

Everyone needs a credit history, even for something as simple as opening a utility account, and having no credit is as detrimental as having bad credit. As a young adult you should begin to establish good credit as soon as possible. If you have bad credit, this can be rectified by showing that over time, you have improved your bill-paying habits and are a better credit risk than when you were younger.

What Happens If I Default on a Loan?

A loan is a business contract between you and the lender. When you fail to pay the loan as you agreed to do, you do not meet your end of the contract; this is known as loan default. The loan contract will state the lender’s rights if you default; for example, the entire balance may become due immediately, and the lender may have the right to pursue legal proceedings against you.

The consequences of loan default can be devastating. Your FICO score will reflect it, and drastically lowered credit scores take time to rebuild. Depending on the terms of your original contract, your account may be reported to collection agencies that are famous for harassment of customers with defaulted accounts. You may also be subject to litigation, which means that in addition to the original balance and late fees you could be liable for court costs. Ultimately some creditors retain the right to garnish your wages or income tax returns to reclaim their original investment.

Continue to Part II: Loans and Credit During the College Years.
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