Finances can be a complicated aspect of many people’s lives. Aside from the day-to-day grapple of making sure you meet the monthly payments of your bills, understanding the different factors that determined why you got the interest rate you did on your credit card, why you were limited to a $200K home loan, or why one lender wouldn’t give you a loan, but the other one would, can be confusing and frustrating.
Just like any other aspect of your life, if you want to find a credit card or loan that works for you , instead of trapping you in a cycle of bills, you need to be actively engaged and understand what kind of money you need, and what factors will play into determining your final terms. It all starts with education, and this guide will serve as an introduction to define and clarify some common terms that you will run into while shopping for shopping for money.
Line of Credit
To begin with, a line of credit is an extension of money from one or more agencies, such as a bank, that you can spend when you need it, up to a certain amount. They are most commonly used to fund projects where it can be difficult to determine the final amount needed (such as a home renovation) and where the credit agency doesn’t want to process hundreds of recurring applicants for a loan.
A credit card is the most prominent example of a line of credit. Lines of credit are referred to as a revolving account, in contrast to an installment loan, which we’ll discuss later. A revolving account, means that, in most cases, the money will always be available to you (the borrower) as long as you remain in good standing with that agency.
The two main advantages of having a line of credit are that it is available to you at any time, and you will only pay interest on the amount of your credit limit you use. This is important, since lines of credit are unsecured, another term we’ll explore more in depth later. For now, understand this means that there is a strong potential for varying and high interest rates. By intentionally using only a portion of your credit, and making your minimum payments on time, a line of credit is a great option to strengthen your credit score, and allow you access to money you need on a recurring basis.
Home Equity Loan
A home equity loan, also sometimes referred to as a ‘second mortgage,’ is a loan that creditors will give you against the appraised value of your home; in essence they will pay up you up to most of what your home is worth. Home equity loans are beneficial for borrowers because they both have lower interest rates than credit cards and other lines of credit, and payments made on their interest rates are tax deductible. In fact, according to bankrate.com, home equity loans are most commonly used to pay off credit card debt.
Though lenders look at several factors to determine if you’ll get a loan, and under what conditions, most lenders will be willing to extend anywhere from 80 to 90% of the home’s value. The risk to borrowers when considering a home equity loan is hinted at in the name itself – if you default on your loan, your lending agency will most likely lay claim to your home to pay off your outstanding balance.
Unsecured Loans
Earlier, I mentioned that a line of credit was unsecured, and as promised, I’ll clarify what this means now. An unsecured loan is a loan in which the borrower is not obligated to anything other than paying back the full amount of the loan, along with any interest they accumulate, in a set amount of time.
While fairly straightforward in terms of conditions for paying them back, unsecured loans can present some challenges. To begin with, interest rates in unsecured loans tend to be much higher. The reason for this is because, in essence, the lender is risking more by giving you money, since outside of your monthly payments, they have no other options to get their money back without going to a debt collection agency. To compensate for this, they charge higher interests so they make a greater profit against the increased risk.
There are ample options for getting an unsecured loan with bad credit, but to help reduce your interest rates, and get better loan conditions, get your credit score as high as possible before applying for an unsecured loan.
Secured Loans
In contrast to an unsecured loan, a secured loan is a loan given under the condition that the lender will take something of value from the borrower, known as collateral, if the borrower defaults on their loan. Common examples of collateral can include your home, your car, or a ownership in stocks.
Despite the obvious risk that a secured loan presents, there are several advantages that a secured loan can offer you. To begin with, interest rates in secured loans tend to be far lower than unsecured loans, because your creditor has an alternate source to repay the loan, presenting less risk to them. Additionally, secured loans are typically easier to get than an unsecured loan, and at higher credit limits, because the borrower is willing to give up something of value to ensure they’ll get the loan.
Despite the advantages, the risk in taking a secured loan is self-evident: if you default on the loan, even despite your best effort, you will most likely lose your house, car, or whatever collateral you promised.
In addition, both secured and unsecured loans tend to be fixed-rate installment loans, meaning that you’ll get one lump some, with the same interest rate and minimum payments, that you’ll have to pay over the life cycle of the loan. In both cases, once you’ve used up the loan, you can’t draw any more money from that account, and will need to apply for a new loan if you need more money.
Do Your Homework
There’s a wealth of information about different loans, more than we can discuss in the length of this article, but I hope this is enough to get you started. It’s critical that you do your own research, and look very closely at your own financial situation, before you decide which of these loans is right for you. It’s all out there for you to find, and as I said before: if you want to control your money, without it controlling you, you need to understand how it works first. You can find a wealth of finance knowledge throughout our blog.