Personal finance and financial literacy encompass more than simply creating and growing wealth. It is also important to understand how to borrow money. Loans have a bad reputation because of the heavy toll of interest rates. But, borrowing money for situations like a real estate investment, for education, or to start a business are forms of positive debt that represent an investment in yourself. You should always live within your means, but when loans are properly understood, they can open up opportunities. This guide will help define the process and terms associated with borrowing money.
To get a loan, you must first qualify. This is in large part determined by your credit score which reflects how well you borrow money. Factors like income and collateral, valuable assets you pledge to your lender, can also help you qualify for a loan.
When you open up a credit card, you receive a line of credit which essentially tells you how much you can spend on the credit card. But, every dollar you put on your credit is not yours. It is a loan that you must pay back, in full or partially, at the end of every month.
Credit scores range from 200-850 and are determined by different credit agencies who track your history of on-time or late credit payments, the amount of outstanding debt you have, and the length of your credit history. To keep your credit score in good standing, it is important to always pay back your loans or lines of credit on-time. You should also start building your credit history early by opening up credit accounts and keeping your revolving utilization, or the amount of outstanding money remaining on your credit card, low. Credit card debt builds up easily, and can be very hard to repay, so remember to always be vigilant about your spend and repayment of your credit accounts.
Next, you must figure out how much you need or want to borrow. This is the principal, or the amount you are borrowing from a lender and agreeing to pay back in full on a monthly basis. Be mindful to not overextend yourself and determine an amount that you can borrow and partially repay monthly without fail.
Term refers to the timeframe in which you must repay your loan. The term of your loan is important in determining your monthly repayment as it will divide up your principal and determine the overall amount of interest you’ll pay. However, different types of loans can have different terms that might not affect your monthly payment. For example, credit cards are a revolving loan which means you are able to borrow and repay your loan as many times as you want without having to apply for a new loan, unless you want to increase your loan.
Annual Percentage Rate (APR)/Interest Rate
Both of these terms, APR and interest rate, are probably the most important concepts associated with loans. When you take out a loan, you are agreeing to pay back both the loan, and the cost of the loan, which is expressed as an interest rate. An APR is almost always greater than or equal to the interest rate as it expresses both the interest rate and any additional fees that may come with the loan. It is important to understand that, most of the time, interest and APRs are compounded monthly. This means that if you have a $13,000 loan with an APR of 6% and a term of four years, you are paying $1,654.66 in interest, not $780. With most loans, you will want to aim for the shortest term
Aside from the agreed principal and interest rates, certain loans also come with associated fees. These costs are often smaller, but nonetheless are important to consider when approaching the loan process. These fees can include
- Application/Processing/Origination fee: These fees are all associated with a loan application.
- Annual fee: These yearly fees primarily apply to credit cards and can unlock benefits that might come along with a credit account.l
- Late fee: Late fees are only charged for late payments on your loans. These can and should be avoided.
- Prepayment fee: For home loans or auto loans, lenders may charge a prepayment fee if you pay off your loan early. This makes up for the income lenders lose from the interest you are no longer paying.
This is part three of the four part series: Financial Literacy for Creators. Follow along for the next edition: Protect.