3 Keys to Getting a Loan – My Financial Wellness Guide, Part XIV
There are three keys that influence your ability to get a loan and what the loan will cost you in the long run. Getting your first loan is kind of like getting your first job – you need “experience” before you have “experience”.
The primary factor is YOU. The Credit Department will need to know your financial story so they can determine how likely you are to honor the loan agreement. They will need to know your income, your work history, other sources of funds and other financial obligations. This will help them determine your “Debt to Income Ratio” and your Credit Score.
Start building your own borrowing history with small loans or revolving credit. Pay it off every month or according to the agreement. You do not need to carry a balance. Keep at least two credit lines active, even if you don’t use them very often. (For more on this topic go here.)
Your “Debt to Income Ratio”(DTI) will show what percentage of your gross (before taxes)monthly income goes toward debt payments. This would include student loans, car loans, credit cards and any other liability. If you are buying a home, that payment would be included in the calculation. The maximum DTI you should have is 36%. Your Credit Score is a rating system based on your borrowing history. You can increase your Credit Score by borrowing only what you can afford and paying back on time.
The second factor is the PURPOSE for the loan. A Credit Department will issue a loan based on the value of what is called “collateral”. They will actually take an ownership in the item purchased, until you have paid off your loan in full. They want security in case you default on your loan. They will recover some of their loss by selling the item to another party.
Collateral can be a car, house, furniture or any other thing that has a monetary value. Some companies will lend up to 80% of the resale value of the item, requiring you to invest some of your own funds up front. The more you pay up front, the lower the interest rate you will have. The interest rates will be significantly higher if there is no collateral.
Every Credit Department has different offers and terms, so compare at least two or three before making a decision. Once you establish a good payment history and a solid credit score, you will begin to receive offers with lower rates and potentially better terms.
The third factor includes the TERMS of the loan. The loan will specify an annual interest rate and length of payments, usually stated in months. Be sure to read the fine print on extra fees or penalties that can be charged if paid late or paid off early – yep “early termination fees” are a thing. Negotiate with the lender. Find out what you need to do in order to reduce the interest rate or length.
Higher interest rates means that a larger portion of your payment will be going towards the interest (profit for lender), not the principal (loan amount). After two years the actual principal may have changed very little, putting you in a poor position, especially if the item has lost value and you may owe more than what it is worth.
Wow. That was a little lengthy for sure. I’d love to hear any specific questions of comments you might have. At the end of the day your Credit Quality is based on what you put into it, no one else can build it for you.
Great article. We were wondering how refinancing works. For example a $300,000 morgage has been paid to $150,000 and is now worth $530,000, if we decided to refinance would we be eligible to receive the equitity or does that get rolled up into the now loan?
What a great question Gabriel! First of all – Congrats on paying down your mortgage!
Two things to consider:
How long do you plan to keep your home?
How does the equity fit into your overall financial strategy?
Short answer: When you refinance the balance due, look at going the shortest term to pay the least interest. Think about keeping the same payment you already have budgeted. At the time of refinance consider setting up a Line of Credt against your existing equity (do not exceed 80% debt against your home). It’s there if you need it. Keep in mind to not overextend yourself. Markets, jobs and economy will change.