Borrowing

In a perfect world, we would all be debt free, but the world is not perfect. For instance, to get a job, you might need to have a car, but to get a car, you need to have a job. A car loan can help you get the car so that you can get the job. Understanding how to wisely and responsibly borrow money is important to financial success.

Note: Not all lenders are reputable, and some are even predatory—offering unfair, deceptive, fraudulent, or abusive loan terms. Beware of apparently “free money,” variable interest rates, balloon payments, and offers that seem too good to be true. Deal only with reputable and fair organizations.

Developing a Credit Score

Your ability to borrow money is based on a variety of factors. One very important factor is your credit score. You are not born with a credit score. You must develop it by creating a credit history: borrowing and paying back small loans, gradually building up to larger loans. Here are some suggestions for developing credit:

1. Consider a secured loan or a secured credit card. If you’re having trouble getting a loan, you can set one up by providing the collateral—money or a valuable object that you will give up if you default on the loan. Check with a loan officer at a bank (or with a credit card company) about getting a secured account. (Note that a secured bank loan is considered “closed-end credit,” while a secured credit card is considered “open-end credit.” Having both builds your credit score faster than having just one kind.)
2. Find a cosigner. You can also apply for a regular credit card with a cosigner who has an established credit rating. You must be the primary person on the account, however, or you won’t be building your own credit score.
3. Borrow up to 10 percent of your limit, and pay it back each month. By borrowing only up to 10 percent, you make repayment manageable. Also, having a maxed-out credit card or loan hurts your credit rating.
4. Make payments on time. Your payment history is 35 percent of your overall credit score—the single biggest factor—so pay promptly each time.
5. Apply for an unsecured credit card. After six months of solid payments to secured loans or to a cosigned credit card, you should have enough credit to get a regular credit card. Often, unsecured cards offer lower interest rates and annual fees than secured cards do.

Understanding Credit

Credit comes in two basic varieties—closed-end credit and open-end credit. The next two pages discuss each type.

Closed-End Credit—Loans

Closed-end credit (sometimes called installment debt) refers to a specific amount of money lent for a specific purpose to be paid back in regular amounts at regular times. Car loans, student loans, and home mortgages are closed-end credit, and they usually involve much lower interest rates than open-end loans do. Here are some key terms to understand:

• Secured loans require collateral—money or valuable property that you offer to the lending institution in case you default on the loan (fail to make your monthly payments).
• Unsecured loans do not require collateral but often ask for a substantial down payment, money you pay up front, which you will lose if you default.
• Principal refers to the amount of money you are borrowing.
• Interest refers to the amount of additional money you pay the lender, based on an annual percentage rate.
• Annual percentage rate (APR) is the percentage of a debt that you pay in interest.
• Prime lending rate refers to the annual percentage rate offered to borrowers with excellent credit.
• Points refer to percentage points or tenths of a point added to the prime lending rate to borrowers with less than perfect credit ratings.
• Fees are charges for arranging and processing the loan. These can be paid up front or included in the loan.
• Amortization is the way that interest and principal are paid off over the lifetime of a loan. Most loans are structured so that you pay off more interest near the beginning of the loan and more principal near the end.
• Penalties are extra amounts that you must pay for making late payments or otherwise breaking the terms of the loan agreement.
• Repossession of property purchased by the loan (a car or a home, for example) occurs if you default on the loan (failing to make your monthly payments for a number of months in a row).

Open-End Credit—Credit Cards

Open-end credit refers to an account with a specified credit limit that the person can draw upon at will, causing the principal and interest to fluctuate with purchases and payments. Open-end accounts such as credit cards usually charge much higher interest rates than closed-end loans do. In addition, interest is compounded daily or monthly, making the total interest rate even higher. When wisely managed, credit card accounts can help improve your credit rating. When poorly managed, however, credit cards can get you into financial trouble. Here are some key terms to understand:

• Credit limit refers to the amount that can be charged against a specific account—for example, $1,000. It is best not to charge more than you can fully pay off during each pay period.
• Interest rates refer to the percentage of interest charged on purchases using the credit card. There are different types of interest rates:
  • ▶ Introductory interest rates may be set as low as 0 percent for a certain period of time or for specific purchases, but these rates later shift to a standard interest rate.
  • ▶ Standard APR is usually set between 6 and 36 percent, depending on the credit risk of the cardholder.
  • ▶ Penalty rates that are even higher apply to late payments.
  • ▶ Variable interest rates change as the prime lending rate changes.
• Minimum monthly payment refers to the amount you are required to pay each month to avoid penalties. Usually, most of this payment is applied only to the interest you owe, so making only minimum monthly payments will not quickly reduce your debt.
• Balance refers to the amount you owe on the account, a combination of principal and interest, usually compounded daily.
• Penalties and penalty rates apply to late payments.

Applying for Loans

The only way to get a loan is to apply for one. The types of loans vary widely—from unsecured loans to car loans to mortgages. In each of these circumstances, you will work with a loan officer to complete a loan application.

Loan Applications

A loan application requires you to provide certain information about yourself and your financial status. Expect to provide the following information:

1. Your name, social security number, marital status, and contact information
2. Your employment information—current and sometimes past job information
3. A list of your assets (money and possessions) and your liabilities (debts)
4. Your monthly income and expenses

Note: The application also asks for the type of loan and the terms you seek, plus information about the lending agency, which is usually provided by the loan officer.

Credit Report

The application process will require your credit report as well. This report gives your credit score—a number ranging from 300 to 850 that indicates your likelihood of paying back a loan. Many loans use credit scores from Equifax, Transunion, or Experion. Mortgages use credit scores calculated by the Fair Isaac Corporation (FICO). Here is a listing of FICO-score levels and what each means.

Note: The figures shown here are guidelines. Values may vary from lender to lender.

Student Loans

Student loans can be acquired from individual institutions or directly from the federal government. In order to apply for student loans, you need to complete a Free Application for Federal Student Aid (FAFSA). (See page 124.)