The ability to borrow money is essential. Without access to loans, it would be next to impossible to buy a car, get a house or pay for a college education. The cost of these items is so high, that it would take years to save up to buy them.
The best part of getting a loan is that it allows you to enjoy the thing you are buying, before you fully pay for it. Which is truly an amazing idea!
The formal structure of lending goes back to ancient Rome where farmers would borrow money to plant crops and repay the loan upon harvest. Lenders would also reduce their risk through secured lending, where the borrower would put items up as collateral on the loan. This basic structure of lending still exists to this day.
Loans exist everywhere and are not always obvious. Mortgages, car loans and lines of credit are obvious. But credit cards, car leases, transit passes, many telephone contracts and gift cards are also types of loans.
Let’s go over a few things that you should know about loans.
When someone lends money, they expect that they’ll get that money back. Unfortunately this is not always the case. Borrowers sometimes don’t pay back their loans, thereby defaulting on them. So there are risks to lending money.
In order to protect themselves, lenders need to gauge how risky each loan will be. To do this they evaluate the borrower and try to figure out the odds of that borrower not paying back the loan . To do this they calculate something called a “default risk”.
So how do lenders calculate default risk? This is done through an analysis of a borrower’s credit history. They look at things like past bankruptcies, how often bills are paid late, how much credit is being used, how often the borrower is behind on payments and how long is their credit history is. All of these things are evaluated to calculate the default risk.
Secured vs. Unsecured Loans
But that’s not the only risk that lenders face. The loan itself can hold different levels of risk. For example, if a lender offers a loan, and the borrower posts something as collateral against the loan, these are considered less risky. This is because if a borrower defaults, the lender can keep the thing that was posted as collateral. So even on a default, the lender won’t lose all of their money. They’ll have an asset instead. This is called a “secured loan”. Mortgages are an example of secured loans.
On the other hand, if the borrower does not offer collateral, the lender only has the borrower’s word as a guarantee. This makes the loan much riskier. There is no asset to take upon default, so the lender has the potential to lose most, if not all of the loan. These are called “unsecured loans”. Credit cards are great examples of unsecured loans.
Revolving vs. installment credit
You should also know about different types of credit: Installment and revolving. Installment loans are the traditional form of lending, where you borrow money for a specific purpose, and have a fixed length of time to pay the loan back. This allows for clarity between the lender and the borrower by setting a point in the future where both the lender and borrower agree that loan will be entirely repaid. This is how mortgages are structured.
Revolving credit on the other hand, does not have a fixed number of payments or a set duration. The loan essentially allows the borrower to withdraw money, pay it back and borrow again, as many times as he requires. This is the how credit cards are structured.
The problem with revolving credit is its lack of clarity. Not only are the costs of the loan unclear, but without a set mechanism to pay the loan off, borrowers can get trapped in the loan. Without an end date or payment structure, there is little incentive to pay the loan off. If the outstanding balance of these loans is high, the interest payments can become quite substantial.
Paying for Risk
In order to insulate themselves from risk, lenders charge borrowers interest. If there is a low chance of default, lenders will offer a low interest rate. But if there is a high risk of default, they will ask for a high rate of interest on the loan. By charging a high rate of interest, lenders will be earning more money in interest to cover potential losses if the loan is not paid back.
So these are the things that are seen as higher risk and will result in higher interest rates: Poor credit scores, unsecured loans, revolving credit.
And the difference between the interest rates can be significant. So while the average 30-year mortgage rate for well-qualified borrowers in the US has not been over 10% in 25 years, and has been below 5% since 2010, you may see interest as high as 29% on a credit card,
So here are some basic tips:
- Start to practice good bill payment and credit use habits well before you look for a loan. It takes time to improve your credit score, so start early.
- Go to AnnualCreditReport.com. They give you free access to your credit reports at the three credit bureaus once a year. Make sure the reports are accurate. Errors in those reports can cost you when you look for a loan.
- Shop around for loans when you need them. Small differences in interest rates can add up a lot.
- Limit your use of unsecured loans. They cost a lot more than secured loans.
- Never, ever go to a payday lender. They are off the charts when it comes to interest rates, so avoid them at all cost.
Borrowing money can open your world to fantastic opportunities. Before you look for a loan, make sure you do all that you can to manage your finances, so that you can look as risk free as possible to a lender. And once you’re ready to borrow, shop around and do your homework. A little bit of work will save you a lot in the long run.