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What You Need to Know before Taking out a Loan

What You Need to Know before Taking out a Loan - TaxAct Blog

Before you apply for any kind of financing, it’s important to understand how loans work so you know which type is best for your situation.

Here are some common questions and answers about loans.

What are the most common types of loans people get?

Home equity lines of credit; mortgage, car, business and personal loans; credit cards; and student loans are among the most common types of loans people get.

The terms of the loans depend on a number of factors including your credit score, the lender’s risk and how long the loan will be outstanding.

What types of loans are easier to get and why?

Typically, financing for a car purchase and home improvements may be easier to get and carry a lower interest rate.

For example, if you get financing for a car while you’re on-site at the dealership, you should assume that some or all of the “interest” expense is built into the cost of your purchase.

Another example of financing that’s easy to get are credit cards from department stores and other merchants.

In most cases, these outlets are anxious to get you started with a credit card so you’ll buy things at their stores. They’re happy to take a small risk giving you credit so you’ll buy from them.

Some government programs make getting a loan easier.

The government guarantees that the banks won’t lose money on certain mortgages or student loans, which makes lenders more willing to approve loans they otherwise would find too risky.

What’s the difference between a secured and an unsecured loan?

A secured loan is attached to something, such as a car or house. This gives the lender a ready recourse if you default.

For example, say you have a car loan and you quit making the payments. The lender may repossess your car and sell it to pay their expenses and the balance on your loan. If they can’t sell it for as much as you owe, you may still have to pay the remaining balance.

Some credit cards are secured; for instance, by an attached savings account.

An unsecured loan doesn’t give the lender the same ready remedy. If you have an unsecured credit line and you stop making payments, the lender can start taking legal steps to collect from you.

Eventually, the lender may be able to seize your assets or money from your bank account, but it’s a much more involved process than that of a secured loan.

Secured loans are generally easier to get than unsecured loans.

How can I improve my chances of getting a loan?

Before you apply for a loan, make sure your financial house is in order.

A lender wants to know that you can and will make your payments (use this simple loan calculator to estimate your monthly loan payment amount).

Depending on the type of loan, lenders predict the likelihood that you’ll pay back the loan based on your income, stability (length of time in your occupation, for example), and your history of paying bills in the past.

To impress a lender, you’ll need a good track record of paying bills and no outstanding delinquent bills.

You should also be able to prove you have a steady income and that you don’t have too many debt obligations already.

Lenders typically ask for your income and other information on your loan application.

They find out your bill paying habits and the amounts you owe various lenders by looking at your credit report and credit score.

What is a credit score and what does it mean?

A credit score is a number lenders calculate based on the information in your credit history. It does not consider information not on your history.

For example, income is not included in your history. You can have a top-notch credit score on a relatively modest income, as long as you pay your bills on time and pay attention to other factors.

Your credit score is based on how long you’ve had credit, your debt utilization ratio (total debt compared to available credit, with less debt being better), whether you’ve recently opened new credit, the types of credit you have and your payment history.

Of these factors, your payment history is the most important.

You don’t have just one credit score. Lenders use different scores for different purposes.

A credit score when you apply for a car will be different from your credit score when you apply for a mortgage. Your score will also vary from day to day.

Small differences in your credit score are insignificant and you shouldn’t worry about them. It’s the bigger picture that counts.

How is interest calculated on a loan?

Interest is stated as an annual amount but it is usually calculated on a daily or monthly basis.

For example, say you have a loan with a 12 percent annual interest rate. If your balance is $10,000 at the beginning of the period, your interest expense for the month will be $100 ($10,000 X 12 percent divided by 12 months).

Credit card interest is usually calculated by the day. That means the sooner you pay your credit card bill in the monthly cycle, the less interest you will pay.

Should I avoid all debt to keep from paying interest?

Too much debt is bad. Piling up on high-interest debt may be the quickest way to sabotage your financial future.

Once people start living on next month’s or next year’s salary and paying high interest rates to do so, it’s very difficult to get out of debt and make progress on their financial goals.

That doesn’t mean all debt is bad. If you need a reliable source of transportation to get to work, for example, buying the cheapest dependable car you can find and paying it off as quickly as you can, may be a wise decision.

Similarly, most of us could never buy a house without taking out a loan. If we tried to save up the money first, the prices of housing may rise faster than we can stash money away. Taking on mortgage debt to buy a house can be a sound financial move.

Going into debt to live beyond one’s means is a bad thing. A prudent amount of debt, taken on as part of your total financial plan, is not.

What happens to my outstanding loans if I file for bankruptcy?

If you file for Chapter 7 bankruptcy, your debts may be discharged. If you have some cash and other nonexempt assets, your creditors may receive partial payment.

In most cases, however, you cannot have student loans or secured loans discharged in bankruptcy. If you have secured loans, such as a car payment, the courts may allow you to reaffirm the debt and continue paying so you can keep your car.

Use this simple loan calculator to help you determine your monthly payments for home, auto, personal, business, student and any other fixed loan type.

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About Sally Herigstad

Sally Herigstad is a certified public accountant and personal finance columnist and author of Help! I Can't Pay My Bills, Surviving a Financial Crisis (St. Martin's Griffin). She writes regularly at CreditCards.com, Bankrate.com, Interest.com, RedPlum, and MSN Money. She is an experienced speaker and a member of Toastmasters International. Follow Sally on Twitter.

Comments

  1. I’ve been on the fence for too long about whether I should get a secured, or unsecured loan. I’ve been getting into programming, and it’s sparked my interest in going to school. It is time to take action, and I think this article did a good job demystifying the whole thing for me. It’s a bit daunting thinking about getting a variable loan, but it seems like many situations involve a certain amount of risk to get back a good result. So far I haven’t dug myself into any holes so I think it’s appropriate that I take advantage of my stability to get the best deal I can, but this article also makes me think I should maybe try to save up and pay for it all up front. Thanks for the great information.

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