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A Simple Guide to Credit and Loans
Whether you’re buying a new home or car, starting a new business, financing your education or just trying to keep up with the Jones’, credit is a convenient way to to get money now to cover our immediate expenses.
But not all credit is the same, and knowing the differences is an important step towards making smart financial decisions.
What is Credit?
Credit allows you to borrow another person’s money to cover expenses you can’t currently afford, while promising to pay the lender in full plus interest.
When people think of credit, the first thing that comes to mind is a credit card. But the reality is that all forms of debt are, in some sense, credit.
However, not all credit is the same. Credit is broken into two broad categories: open-ended and closed-ended.
Open-ended credit, also known as revolving credit, is when you’re given a fixed amount of credit that you can borrow, spend, pay back and continue spending as much as needed. A credit card is the most common form of open-ended credit.
Let’s say you have a credit card that has a credit limit of $2,000. If you use up all of your credit you’ll be maxed out, meaning you can’t spend any more money. However, if you were to pay your balance down to $1,000, you would have freed up the remaining $1,000 to be used all over again.
In other words, so long as you have credit available, you can keep spending.
In contrast, closed-end credit is typically a loan that’s used for a specific need and must be repaid through an installment plan over a set period of time. Common forms of closed-ended credit are auto and home loans.
Types Of Loans
Since most loans are closed-ended, let’s go over the various types of loans that fall under this category.
Auto loans are used to purchase a new or used vehicle. Auto dealers typically provide their own financing services, but you can also get auto loans from banks, credit unions and third party auto finance companies.
Most consumers don’t buy their vehicles outright, and instead pay part of the cost and borrow the rest. Therefore, auto loans are very popular
Even if you decide to lease a vehicle, your leasing agreement will often offer a purchase option at the end of (and in some cases during) the leasing period. At that time, you can get what’s commonly called a lease buyout loan.
It’s no different than a typical auto loan, but it goes towards buying a vehicle that you’ve leased.
When you purchase a vehicle through an auto loan, the lender keeps a lien until the loan is paid off. A lien is a legal document that grants the holder a claim to a property. In this instance, that property is the vehicle.
It’s a way for the lender to protect itself in case you decide not to make payments. If you don’t make your payments, the auto lender can take possession of the vehicle and sell it to .
Mortgage Loans Home
Mortgage (or home) loans are used to purchase residential real estate. Most people get their mortgage through a bank or credit union, but you can also find a mortgage loan through online lenders such as Quicken Loans or LendingTree.
Commercial real estate loans are also available, but they are offered to business entities rather than individuals.
Just like an auto loan, a lien is kept by the home loan lender until your debt is cleared. If you don’t keep up with your payments, the lender can evict you and force a sale on the home in order to cover the remaining debt.
Home Equity Loans
Home equity loans are loans that use the equity value of your home as collateral. In contrast with with a mortgage, a home equity loan does not have go towards a specific purchase. Oftentimes the loan is used towards home repair, medical bills or other large payments.
A home equity loan is usually closed-ended, but can also come in a open-ended form that’s commonly called a home equity line of credit (or HELOC).
Like a credit card, a HELOC can be spent, repaid and spent over and over again. But the availability of the credit is usually limited to a fixed period of time that can be as long as 30 years.
You can get a home equity loan or HELOC from a bank or credit union.
Student (or education) loans provide financing for college and university costs such as tuition, room and board, books, tutoring and other related needs. Student loans can come from the federal government or a private lender like a bank, credit union or a student loan company (e.g. Sallie Mae).
Federal loans are often better, as they offer lower interest rates, income-based repayment plans and even the possibility of complete debt forgiveness if certain criteria are met.
In contrast, private student loans tend to have higher interest rates and very limited ways to manage the debt. In fact, private student loan debt is one of the only forms of debt that can’t go away through bankruptcy.
Once you have it, it’s with you forever.
Business loans are provided to entrepreneurs to help them expand or start a new business. They come in both open-ended and closed-ended forms and are offered by banks, credit unions, private lenders and federally subsidized community development organizations.
The U.S. Small Business Administration (or SBA) is a federal agency that offers various loan programs to qualifying small businesses. But it does not offer direct loans.
Instead, the SBA helps business owners acquire loans by promising lenders to pay back part of the loan if the borrower is unable to. This minimizes the overall risk of default to the lender and makes it easier for entrepreneurs to get loans.
Consolidations loans allow you to bundle together various debts into a single loan. In effect, it’s a loan that goes towards paying off all of your other loans.
The purpose of consolidating various loans into one is to make one’s finances simpler and more manageable. It often leads to a smaller monthly payment at a lower interest rate.
Personal loans are simply loans you take out for any purpose you see fit. Many people use these loans to consolidate other loans. But they’re not restricted to this purpose.
However, while the loan does not have to go towards a specific purchase, it is not open-ended. Therefore, it must be paid back according to a set installment plan.
Payday loans are small, very short-term loans that are notorious for being very high-interest compared to other loans. They are mostly sought out by those who have a desperate need for quick cash or can’t make ends meet in between paychecks.
The loan is usually paid off anywhere between two weeks and two months. Yet the excessively high interest and finance charges are why many consider payday lenders predatory in nature.
According to the Consumer Financial Protection Bureau, the cost of payday loans can be as high as 400% of the borrowed amount. That’s in spite of the fact that these loans are typically no more than $500.
Given the unreasonable costs, it’s strongly advised that you avoid payday loans at all costs.