Credit Basics: Four Key Points about Loans

by Cindy Diccianni RN, CSA, CLTC, Financial Advisor

The reason for having good credit is to get a loan when you need one. A loan can be large or small, have a long payment schedule similar to a mortgage, or a short payment period, like a demand note. Loans can also be instantly available through a credit card or they can require you signing a contract with many documents. Generally, there are four key points to all loans.

1. How much you can borrow

The amount you borrow is called the "principal." Sometimes you borrow the principal all at once, and other times, for example with credit cards, you have a "line of credit" that lets you borrow up to your "credit limit" at any time.

With credit cards and charge cards, if you pay off the balance in full each month, there are no interest charges and any principal you repay becomes available to be borrowed again so long as your credit remains in good standing. This agreement to let you borrow, repay, and borrow again is called "revolving credit." In a loan document and on most card statements, you may see the words "amount financed", which is simply the amount that you have borrowed.

2. Cost

The most common cost of a loan is the interest or finance charges. Usually, your payments are split with part going to repay the principal and part going toward the interest charges. Often there are fees of various kinds. Some credit cards charge annual fees (like dues) that can sometimes be waived for special promotions or upon your request. Many also charge fees for cash advances, mortgage lenders charge "points" and other connected fees for appraisals, closing costs, and more.

All lenders are required to show you the annual percentage rate (APR). This takes into account the interest rate plus certain fees to show the actual cost of the loan for the first year. This is why the APR is slightly higher than the loan rate.

3. The payment plan

A payment plan has three parts: the length of time you're given to repay the loan, the schedule of payments, and the amount of each payment. Charge card issuers give you the shortest time 30-60 days. Mortgage lenders give you the longest-up to 30 years. Credit card issuers let you take as long as you like; if you always make the minimum payment required, the loan can go on for what seems to be forever. Most payments are made once a month with the amount fixed or adjustable based on the balance and interest rate (if it is a variable interest rate).

4. What if you do not repay

Failing to repay a loan on schedule can put you in default with the lender who is then faced with finding another way to get repaid. The lender can place the loan in collections or sell any collateral associated with the loan. If your credit report shows you to be a risk, the lender will want "security." In a secured loan, you will give the lender the right to sell a specific property, home, car, etc. in order to recoup the money owed. By law, creditors cannot ask you to pledge as security any clothes, furniture, or other person belongings unless they are the actual items you are buying on credit. Also, if your car is repossessed, you are entitled to anything left in it (within 24 hours). This gives the lender a sense of security and some incentive to lend you the money. Generally, the collateral is the property you are buying with the loan-homes, cars, or large household items. In an unsecured loan, there is no collateral and the lender must trust that you will repay the loan as promised.

Types of Loans

There are many types of loans and virtually anyone can lend you money, from a family member to a large banking institution. Choose the lender based on your reason for wanting the money. Some lenders will extend credit only if you will use the money in ways that further their business. These include department stores, retail chains, and car dealerships. Basically, they are middlemen or dealers for their products. They arrange loans to facilitate the sale of their goods.

Mortgage lenders lend money only if it is used to buy a home. The money they have to lend has been earmarked for home loans and is priced accordingly. They secure their interest by using the home as collateral and by the increase in value the home will gain over time.

Student loan lenders insist you use the money for this specific purpose. There is no tangible property to secure which is why the federal government backs many of these loans through agencies like Sallie Mae.

Asset-backed loans are loans through banks, securities brokers, or insurance companies. They are backed by some type of underlying security such as savings or checking accounts, stocks, and/or life insurance cash values. Home equity lines of credit are loans that are backed by the equity (increased appreciation) of your home.

As you can see there are many ways to borrow money. The key point is to remember that these loans must be paid back in a timely fashion and by the specific terms of the loan. Failure to do this will result in a lowering of your credit worthiness and that will result in higher loan rates or the possibility of not getting a loan. With a good credit rating you can borrow at the lowest rates available and save even more. To check on your credit report log on to www.freecreditreport.com for more information. As always, it is best to consult with your financial advisor before making decisions that will impact your financial situation. S/he will know what is best for you given your situation.

Cindy Diccianni is a Registered Nurse, a Certified Senior Advisor (CSA), a Certified Long Term Consultant (CLTC), a Registered Investment Advisor and a Registered Representative with Leigh Baldwin & Company member NASD and SIPC. She is a co-founder of Nurturing Your Success, Inc. Her passion is assisting clients in creating financial independence. You may visit Cindy at www.nurturingyoursuccess.com, write to her at Cindy@nurturingyoursuccess.com or call her directly at (610) 251-9393.