Contents
Personal Finance Basics
How to Create a Budget
How to Save Money Effectively
How to Open a Checking Account
How to Manage Credit Cards, Charge Cards, and Debit Cards
How to Invest Your Money
How to Get a Loan
Personal Finance Checklist
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How to Get a Loan
A loan is a sum of money offered to you by a lender, which can be any person or business, such as a bank. When you take out a loan, you’re the borrower, or debtor, and your lender is the creditor. Though debt might seem undesirable, it would be impossible for most people to make major purchases, such as a new car or home, without taking out a loan and going into debt. Indeed, the two most common types of loans are auto loans and home loans.
How Loans Work
Lenders issue loans under a contract, known as a loan agreement, which states that you will pay back the lender for the full amount of the loan plus interest. Interest is charged at a particular interest rate—a percentage of the principal (the original amount of the loan) that you pay back each year. Most (but not all) loans also have a term, a fixed timeframe in which you must repay the entire principal. For instance, a $1,000 loan with a 10% APR and a five-year term requires you to pay the creditor an average of $100 in interest annually for a period of five years.
Collateral
Some loans involve collateral, which is an asset that the lender can seize and sell should you fail to pay back the loan. Home loans and auto loans are collateralized loans:
if you fail to meet your obligations under the loan agreement, the lender can repossess your car or home and sell it to pay back your loan. Loans that use collateral to guarantee the repayment of the loan (or a portion of it) tend to have lower interest rates than loans with no collateral.
Down Payment
For auto and home loans, most lenders require you to make a down payment, an initial lump-sum cash payment equal to a percentage of the value of the car or home. For home loans, the down payment usually equals 10–20% of the property’s purchase price (though you often can pay a lower down payment). For auto loans, it’s generally much less, such as 5% or so.
APR
Lenders incur various expenses in approving and processing loans. Typically, lenders bundle these expenses into the cost of your loan by increasing the loan’s interest rate somewhat. The interest rate on a loan is the “raw” rate without these costs. The annual percentage rate (APR) does include these costs and is the rate that you’ll actually pay. All lenders are required by law to disclose the APR of the loans they issue.
As a borrower, you should focus on the APR of the loans that you consider applying for, rather than on the “raw” interest rate, since the difference between the two can be substantial. In addition, when comparing loans from different lenders, always compare their APRs—assuming all else is equal, the loan with the lowest APR is most likely the best deal.
How Lenders Determine Your APR
APRs can vary widely. Lenders determine the APR that you pay based on two factors:
- Overall interest rates: The U.S. government sets interest rates based on various factors, such as the health of economy and the unemployment rate. The range of the rates you can get will vary based on these overall rates. For instance, when rates are low, you might be able to get a home loan with an APR of 6–7%. When rates are high, that same loan might have an APR of 8–10% or even higher.
- Your creditworthiness: The specific rate you get within the overall range of available rates depends on your creditworthiness, or your reliability as a borrower.
How Lenders Determine Your Creditworthiness
Your credit history is a record of how you have used and managed credit over the past 7–15 years, including your payment history on your credit card, your reliability in paying off your previous loans, tax liens or bankruptcies you’ve had, and so on. Lenders examine your credit history to determine whether to issue you a loan, and if so, at which rates.
Credit Bureaus, Credit Reports, and Credit Scores
Private, for-profit companies called credit bureaus or credit reporting agencies collect and keep records of the credit history of every American consumer. The three major credit bureaus are Equifax, Experian, and TransUnion. Using the data they gather about your credit history, each credit bureau creates a credit report and credit score for you.
- Credit report: A written report that includes entries about your credit accounts, credit “events” (such as tax liens or bankruptcies), and any other information that may affect your credit.
- Credit score: A numerical score that is based on your credit history and reflects your creditworthiness. The score can range from 300–850, with 850 marking absolutely perfect credit.
Good Credit and Bad Credit
- If your credit score is over 650: You’re said to have good credit and should qualify for loans with the lowest possible APRs.
- If your credit score is under 650: You’re said to have bad credit and will likely have to pay relatively high APRs and make larger down payments on car or home loans than borrowers with scores over 650.
If you have bad credit, there are steps you can take to improve it. For more on how to improve your credit, see the Quamut guide to Improving Your Credit, available in Barnes & Noble bookstores and online at www.quamut.com.
Free Credit Reports
Every U.S. citizen is entitled to one free copy of his or her credit report from each credit reporting agency once every twelve months. It’s a good idea to request a copy from a different bureau every four months throughout the year—that way you can monitor your report more often, and still at no charge. You can download a free copy of your credit report at www.annualcreditreport.com, or you can request to receive a copy in the mail by calling 877.322.8228.
How to Get a Mortgage
A mortgage is a home loan—a loan used to finance the purchase of a home in which the home itself serves as collateral. There are two main types of mortgages:
- Fixed-rate mortgages: Mortgages with interest rates that don’t change
- Adjustable-rate mortgages (ARMs): Mortgages with interest rates that change periodically, usually after an initial fixed-rate period
In generally, ARMs have considerably lower rates than fixed-rate mortgages during their initial fixed-rate period. However, the ARM’s APR can shoot up after the fixed-rate period ends, causing your monthly payments to skyrocket.
How Lenders Determine Mortgage APRs
The APR that you pay on a mortgage depends not only on overall rates and your creditworthiness but also on the size of the loan. In most states, mortgages that total more than $417,000 (as of 2007) are considered jumbo loans. Loans below this amount are called conforming loans. In general, jumbo loans have higher APRs than conforming loans do.
How to Choose Between a Fixed-Rate Mortgage and an ARM
The most important factor in deciding whether to choose a fixed-rate mortgage or an ARM is how long you plan to live in the property.
- If you plan to live in the property for more than 5–7 years: A fixed-rate mortgage is usually the better choice. Since most ARMs start adjusting after 5–7 years, having a fixed-rate mortgage will protect you from the prospect of paying higher rates.
- If you plan to sell within 5–7 years: You can benefit from the low initial rates of an ARM without facing the risk of adjusting interest rates if you sell the property before the initial fixed term of the mortgage ends. If you choose an ARM for this reason, though, be sure that you really will sell before the fixed term ends.
How to Choose a Mortgage Lender
A mortgage lender is a bank or other financial institution that issues mortgages. You can find a mortgage lender either on your own or through a mortgage broker, a professional who specializes in finding lenders for prospective home buyers. Since brokers typically charge 0.5–2% of the home’s purchase price for their services, it’s generally best to work directly with a lender. The mortgage business is a relatively unregulated industry, so if you encounter a lender that seems at all shady, move on. If you’re uneasy about choosing a lender on your own, either work with a broker or stick with big-name banks that offer mortgages, such as Washington Mutual or Wells Fargo.
Mortgage Lenders and Advertised APRs
Don’t choose lenders based on their advertised rates—since rates depend on your personal situation, the rates you receive will likely differ from these rates. Instead, choose a lender that offers realistic rates that are also competitive with those of other lenders in your area.
The Process of Getting a Mortgage
The process of getting a mortgage has many steps and usually takes at least 4–6 weeks. For more on mortgages, including a complete breakdown of each of the steps required to get a mortgage, see the Quamut guide to Mortgages, available in Barnes & Noble bookstores and online at
www.quamut.com.
How to Get an Auto Loan
Unless you plan to pay for your car in full with cash, you’ll need to get an auto loan. There are two main ways to get auto loans:
- From the dealer: Most dealerships offer dealer financing, in which the dealer typically does a quick check of your credit history and then matches you with a third-party lender who provides the actual loan. The dealer itself does not issue the loan.
- On your own: You secure financing independently from a third-party lender, such as a bank or credit union, and pay for the vehicle with a loan check issued by the lender and made out to the dealer. If you’re a homeowner, you also have the option of using a home equity loan—a loan borrowed against the equity you own in your home—to finance a car purchase.
In general, you’ll get the lowest APR by securing a loan on your own rather than through dealer financing. Credit unions typically offer the lowest APRs on auto loans. One advantage of using a home equity loan to pay for a car is that the interest you pay on home equity loans is generally tax-deductible (whereas interest on all other types of auto loans is not tax-deductible). The disadvantage is that you’re using your home as collateral, which puts your home at risk of repossession by the lender if you fail to pay back the loan.
The Process of Getting an Auto Loan
In general, the process of getting approved for an auto loan and receiving your loan check is much quicker and less stringent than the mortgage application and approval process— in many cases, you can apply for an auto loan and get
your check within one day. To apply for an auto loan, you’ll need to choose a lender and then fill out a few forms. The lender will run a credit check to assess your creditworthiness and will either approve you for the loan or reject you.
Questions to Ask Before Getting an Auto Loan
Before you sign an auto loan agreement, be sure to ask the following questions:
- What’s the APR? Always use the APR—not the “raw” interest rate—to compare auto loans.
- Does the loan include prepayment penalties? Make sure your loan does not include prepayment penalties—fines that are charged if you pay off the loan balance early.
- What are the loan’s finance charges? Some, but not all, auto loans include extra fees that the lender charges to process your loan. Don’t get a loan with fees that exceed 1–2% of the loan amount.
- Is the rate fixed or variable? Auto loans can have fixed or variable interest rates. Fixed-rate loans have APRs that don’t change—your payments are the same amount for the life of the loan. Variable-rate loans have APRs that do change, so your payments can change from month to month—and potentially rise significantly.
- What is the payment schedule? Ask to see a complete payment schedule in writing, which should show the total number of payments, the amount of each payment, and the breakdown of principal and interest that each payment contains.
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