There are times in your financial life when you will need a loan. There are a lot of good reasons for this, from purchasing real estate to starting a business. There are all kinds of debt out there, from the revolving debt of credit cards to personal loans, equity loans, and more. How do you sort through them all and figure out which one is right for your situation?
The answer lies in answering a few questions, ones that will help you determine if the loan you are about to take out is good debt vs. bad debt. There are essentially two kinds of loans at the heart of things. One is a signature loan or unsecured loan and the other is a secured loan. Both work in different instances in different applications. What do those terms mean, and how do you determine what is right for you?
Whether you are starting a business or buying a car, here are some insights in figuring out which loan is right for you.
Every type of loan comes with some kind of interest. Most of the time this interest rate is related to your credit risk. The lower your credit score, the higher risk you are considered, so usually your interest rate is higher as well.
This is why interest rates are usually lower on secured loans, especially home loans or home equity loans. The risk is considered lower, as the bank has something to secure the loan in case you default. While not the most desirable outcome they do have a means for recovering their money should they need to.
This is why when evaluating any loan, you need to look at the interest rate. How much is it and how often is it compounded? The more often it is compounded the higher the cost of the loan in the long run. New guidelines require lenders to be up front about these things, so be sure to read all of the details about the interest carefully before signing the bottom line.
What is Collateral?
So what is collateral? What can you secure a loan with? Collateral is essentially something you own that either has monetary value or equity you can leverage to secure a loan. Some common examples besides home loans are pawn loans or car title loans. The problem with those loans is that they often carry high interest rates as well as the risk of losing your collateral should you default on them.
A better, and more common example is a home loan. A mortgage is secured by your home or another real estate purchase. The property is the collateral, so the terms of the loan will be longer and the interest rates will be lower. The same is true of home equity loans as well. Other examples include loans taken out against your 401k, investments you own, or business equipment.
The downside of a secured loan is that your property is at risk. If you default, the bank can seize your assets. The key is to not borrow more than you can afford to pay back and be careful about why you are borrowing to minimize your risks.
Let’s Talk Terms
Another factor in every loan is the term of the loan, or how long you can get a loan for. For instance, a mortgage might span 15 or 30 years, while a car loan will typically be 60 or 72 months long. The reason relates to the amount of the loan, how long the car is expected to last, and the payments you can afford.
The longer the term of the loan, the less the payments are, but the larger the cost of the loan in the long run. For instance, if you have a car loan that is 8% A.P.R. compounded annually, the payments on a 72-month loan will only be slightly lower than that of a 60 month loan. Why? As the interest is compounded, the overall cost of the loan goes up, so the payments go up accordingly.
The difference is much larger between a 15 and 30-year mortgage at a fixed rate of around 4%. The additional 15 years of compounding interest make a huge difference in the overall cost of the loan, however because that cost is spread over 15 years, the payment on the 30-year mortgage is much lower than that of the 15 year. Still, it is not half as much as you would expect.
This is why it is vital to look carefully at the terms of any loan before you agree to it.
For a moment, let’s talk about credit score. The same credit score will get different rates and be more or less likely to be approved depending on if your loan is a secured or unsecured one. You can get unsecured personal loans even with bad credit, but usually your interest rates will be higher than if you have better credit.
However, even when it comes to mortgages and car loans, lenders are usually more forgiving with approvals because the loan is secured by an asset. Not only are interest rates lower, but you can get approved even with a lower credit score. Often the difference will be the terms you’re offered.
As stated above, the higher your credit risk, the more difficult it is to get approved and the higher interest you will pay. One of the biggest keys to increasing your credit score is to make payments on time. Do this, and your score will improve along with your choices when it comes to loans.
Debt to Income Ratio
Not only does debt to income ratio affect your credit score, but it also affects your ability to pay your bills if anything were to go wrong. Many Americans have very little in savings, and so use the credit they have available in case of emergency.
However, when it comes to getting a secured or unsecured loan, your debt to income ratio is one of the things companies look at first, right after your credit score. If you have too much debt, you will struggle to qualify or pay a higher interest rate with less desirable terms.
The key is to pay off debt when you can and keep the amount of credit you are using compared to what you have available as low as possible.
Determining which kind of loan is right for you depends on what you are using the loan for, your credit score, and how much you can afford to borrow. Use this guide to help you make the right choices.