Before you obtain credit — of whatever type — it’s important to understand the basics of the loan you’re getting into.
A loan is a contract between you and the lender, by which you receive money now with the expectation that you pay it back later, usually with interest included.
Interest is the amount of money the lender charges you for the use of its money. There are two types of interest rates.
1. Fixed rate: The interest rate stays the same throughout the term of the loan.
2. Variable rate: The interest rate might change during the loan term, as written in the contract.
The rate is charged on the amount you have yet to pay back. So, for example, if you borrowed $1,000 with a fixed rate of 5 percent per year, you would need to pay 5 percent annually on the amount you still owe.
Generally speaking, there are three types of lending accounts.
1. Revolving agreement: You have a choice: Pay part of the outstanding balance or pay the balance in full. If you pay in full, you pay no interest. Either way, the next month you can re-borrow up to the approved credit limit without having to reapply. A common example of this is a credit card.
2. Charge agreement: With a charge account, you promise to pay the full balance every month. This means you do not have to pay interest charges. Charge cards and charge accounts with local businesses often require repayment on this basis.
3. Installment agreement: You receive a lump sum and sign a contract to repay a fixed amount in equal payments over a specific period of time. Mortgages are a well-known example.
In addition to interest, lenders may charge other fees. The Truth in Lending Act requires that these are disclosed in a clear and uniform manner:
Amount financed — the amount of the loan provided to you.
Annual percentage rate (APR) — the cost of your loan expressed as a yearly percentage rate. When shopping for loans, you should compare APRs, not interest rates, since APRs reflect the cost of interest and other finance charges.
Finance charge — the cost of your loan expressed in dollars. It includes items such as interest, service charges and loan fees.
Total payments — the amount you will have paid after you have made all payments as scheduled.
Credit cards: When you use your credit card, the issuer is essentially extending you a short-term loan. If you carry a balance month to month, you’ll pay interest on your balance. Credit cards often also have fees for a variety of services. Make sure you understand what these are before you agree to a new card.
Student loans: Federal student loans have a fixed interest rate, while private loans may have fixed or variable rates. The standard repayment period with federal loans is 10 years. When thinking about how to get a student loan, remember that you may qualify for grants and scholarships instead.
Auto loans: Auto loans are generally only for a few years with a maximum term of 84 months. The car itself is used as collateral, so the lender may repossess it (take it back) if you can’t make your payments.
Home mortgage: Mortgages may have a fixed or variable interest rate, with the home used as collateral. Failure to make mortgage payments may result in foreclosure.
Home equity loan: You borrow against the equity you have in your home, usually a fixed amount of money repayable over a fixed period. Many people take out home equity loans for specific purchases or projects, like an addition to the existing home. Your home is used as collateral.
Home equity line of credit: You borrow against the equity you have in your home in a form of revolving credit. You use the credit extended to you like you would with a credit card, but your home is used as collateral. The advantage over credit cards is that the rates are usually far lower.
Your credit score, or FICO score, ranges between 300 and 850. It gives lenders an idea of what kind of credit risk you might be. The higher your score, the more likely lenders will lend to you.
How your credit score is determined:
1. Past payment history: By paying your bills consistently on time, you can greatly improve your overall score.
2. Amounts owed: How much debt are you taking on compared with the amount you’re allowed. Your score will be higher if you aren’t close to being maxed out.
3. Length of credit history: The longer you’ve been using credit, the better. Opening multiple new accounts in the hopes of building credit quickly may reduce your “average account age” and therefore reduce your score. Instead, open one account and build upon that credit over time.
4. Applications for new credit: Every time you apply for new credit (cards or loans), that inquiry makes its way onto your credit report. If there have been too many inquiries on your report in a short period of time, it can lower your score. Some credit score models will allow for shopping around for a loan within a certain time period and count those inquiries as just one.
5. Credit mix: Credit cards and installment loans (like car loans or your mortgage) are examples of different types of credit. Your FICO score will be higher if you have more than one type of credit in your history — and lower if you have only one type or none.
It's important to research and understand what type of loan best fits your needs. Learn more about personal loans and lines of credit.