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What is a loan?
A loan is a sum of money borrowed by a person or business that needs to be repaid sometime in the future.
Lenders typically charge interest on their loans, a percentage of the overall loan that borrowers pay in addition to returning the loan itself (principal).
Types of loans
There are two types of loans: secured and unsecured.
Secured loans have some type of asset (like a house or car) pledged to the loan that can be sold by the lender to ensure payback.
The most common of secured loans are mortgages -- loans taken out to help pay for a house. The house itself is secured by the lender -- typically a mortgage bank -- and can be liquidated in case the borrower doesn’t pay back the mortgage.
Car loans are similar in that the vehicle itself can be sold off by the lender in case the borrower defaults on a loan.
Because these loans don’t have assets pledged to them, they’re considered higher risk by the lender. The most common unsecured loan is the credit card, which is essentially a high interest rate line of credit.
Sanity check: Do you really need a loan
Before you head down this path, it’s probably a good idea to perform a sanity check. In 2012, the average American had $15,950 in credit card debt and personal bankruptcies are very common.
Not all debt is created equal and there’s good -- and bad -- debt. Sometimes, paying your bills can best be handled by managing your money better, not by taking on more debt.
There’s a cost to borrowing money. Just make sure you work the numbers.
Source: CNNMoney, CreditCards.com
Getting a Loan
To borrow money, there are a few things you’ll need to understand about the loan process:
Determine appropriate type of loan: Before you do anything, it makes sense to decide which type of loan is appropriate for your needs. If you’re buying a house, you’re going to want to use a mortgage -- a loan that was specifically designed for home buyers. Understanding which loan is most appropriate for your situation will depend a lot on your credit. We discuss credit -- and how credit affects your ability to get a loan -- below.
Decide on a lender: With today’s Internet, there are many different places to borrow money. Whether you go to your local bank or apply for a loan online from places like CreditLoan.com, there are lots of choices. It’s important to take your time and read through all the fine print.
Apply for the loan: Most lenders have a formal process to apply for a loan: a series of questions that ask about your income, your credit history, and your spending. It’s a good idea to have this information handy when you begin your loan application.
Different type of lenders
Banks: When we think of loans, banks are generally the first type of lenders we think of. There are national banks with local branches as well as small local banks with just a few locations. Banks make money by lending so they’re pretty interested in getting new business.
Credit Unions: Credit unions are financial cooperatives that are owned by the people who have accounts with them. Credit unions bill themselves as community-friendly and provide similar financial services to banks.
Online lenders: Like CreditLoan.com, these companies allow applicants to apply for loans online and either provide the loan directly or work with other lending institutions to supply money to users.
Friends, families, peers: Much of the money that goes towards loans in our economy comes from friends and families lending to one another. It’s easier and faster than borrowing through financial institutions. With the rise of the Internet, you can also apply to borrow money through a peer-to-peer lending site: these companies allow users to apply for loans and to fund them, they turn to a community of individuals who collectively fund the loans in increments as small as $25.
Credit makes the loan world go round
Credit refers to the borrowing capacity of an individual or company. What that means in plain English is that financial institutions calculate how much money you can borrow safely. That’s your credit.
Taking this concept a step further, credit scoring agencies issue credit reports that assign individuals a number (from 300 to 850). That number is used by banks, credit cards and other financial businesses to assess your creditworthiness -- how likely you are to repay a loan.
A quick history of credit
1860s: Cooperative credit bureaus emerge in the U.S. and around the world
1898: Founded by 2 brothers, Equifax is founded, a company that would become one of the largest credit scoring agencies
1956: Fair Issac Corporation launches FICO scores, numbers between 300-850 that are used by lenders to assess individuals for all kinds of loans
1997: The Fair Credit Reporting Act (FCRA) was amended to allow individuals to fix incorrect information on their credit reports and removed negative credit events after 7-10 years
2003: The FCRA was amended once again, providing all people free access to their credit reports from the major 3 credit agencies once a year
Sources: InvestorWords, FreeScore.com
Why is credit so important?
For banks to offer a lot of credit, they needed a way to create a system to score everyone who applies for a loan. That’s your credit score and it’s essential to getting a good loan. That’s not to say you can’t qualify for a loan with poor credit. You can, but you’ll probably pay higher interest rates on the loan.
What’s revolving credit
Some lenders will provide what’s called revolving credit or a line of credit. This is a loan that borrowers can draw down when needed and pay back when it works for them. Credit cards are a form of revolving credit, as are home equity lines of credit (HELOCs).
At the end of 2012, there was almost $850 billion in outstanding revolving credit in the U.S. and roughly 31% of all consumer debt is termed revolving credit.
Source: Ycharts, Money-Zine
Different credit scores
It’s important to recognize that there’s not one true credit score. There are threemajor consumer credit scoring agencies and your credit score may fluctuate up to 50 points between them.
There are four different ways your credit score is calculated:
The median credit score (50% have a higher score and 50% less) in America is a 723 FICO score.
Nevada has the lowest credit score at 660 – that’s 27 points below the U.S. average.
Minnesota has the highest at 718 – which is 31 points above the U.S. average.
The spread between the lowest and highest state is 58 points.
Credit scores typically go up as people get older because they typically make more money and have longer credit histories.
Here’s how the average credit scores break out by age
Source: Credit Card Forum, Credit Karma
The advantages to having good credit
One of the major advantages to having good credit is the ability to borrow money at good rates. Lenders will be more likely to lend at do so at good rates if you have good credit.
It’s also easier to qualify for new credit cards when you have good credit. With good credit scores, you’ll also have an easier time qualifying for higher balance limits. You’ll be able to borrow more money at better rates when you have good credit.
7 ways to improve your chances of getting a loan
Make payments on time: It takes debt to have a good credit score. Your score is based on how well you pay back that debt. Do it on time.
Reduce your outstanding balance: It’s not great (and it’s expensive) to carry around a balance on credit cards. Try to pay down your monthly balance beyond just your minimum monthly payment. Even $25 a month helps. A good rule of thumb is not to use more than 30% of the total available credit on a single credit card.
Keep old credit cards: Longer credit history helps boost your credit score. Leave open old cards to get their beneficial effect on your credit.
Good behavior on different types of credit: Lenders want to see that you have good financial behavior on different types of loans (cars, mortgages, credit cards, etc.). Consider adding an installment loan (one that requires periodic payments) to your mix.
Limit how frequently you apply for new credit: If you apply for new credit too frequently, your credit score may be negatively impacted.
Check your credit reports: Sometimes credit reports show lower credit limits than you actually have. Make sure they reflect the truth.
Ask for goodwill: If you’ve been a good customer, consider asking your credit card company to erase any blemishes of late or missed payments in the past. You never know if you don’t ask...
Source: Forbes, Wall Street Journal, MSN Money
Qualifying for a loan is very much dependent on your personal credit. To get bigger and better loans, you’ll need to have good credit. There are many different sources of loans and the competition is good for individuals. So, do your homework and work to keep your credit score high.