Making Borrowing Decisions

To Borrow or Not Borrow?

Borrowing can be a risky and costly proposition. However, it can be a powerful tool for achieving your financial goals when used wisely. The concept of credit is simple:  you borrow money from a lender today, with the promise to repay it later, plus interest. The lender’s decision to extend your credit is based on their assessment of your creditworthiness. This assessment considers your income, debt-to-income ratio, and payment history.

You can borrow money at lower interest rates with a good credit score. This can save you a significant amount of money over the long term. There are many types of credit, including credit cards, student loans, and mortgages. Each type of credit has its benefits and drawbacks. Understanding the different kinds of credit before you start borrowing is essential.

This chapter aims to empower you with the skills to manage your credit successfully, such as building a credit history in early adulthood, reading your credit report, and improving your credit score. It also explores using credit responsibly and establishing a personal debt limit.

Source: Florida State College at Jacksonville, https://fscj.pressbooks.pub/financialliteracy/chapter/making-your-borrowing-decisions/
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 License.

Loans

A loan is a form of debt where one party agrees to lend money to another with an agreement to pay it back.

Debt is the total amount of money you owe to another party. Debt covers any amount owed to another, whereas a loan refers to an agreement where one party lends to another. (e.g., assume you have a student loan and an auto loan. Your debt is the sum of these two loans).

Components of a Loan

In addition, the lender may charge additional fees, such as an origination fee, servicing fee, or late payment fee.

When discussing loans, it is essential to recognize the components of typical loans.

Principal

This is the original amount of money that is being borrowed.

Loan Term (or repayment period)

The amount of time the borrower has to repay the loan.

Interest Rate

The rate at which the amount of money owed increases is usually expressed as an annual percentage rate (APR).

Loan Payments

The amount of money that must be paid every month or week to satisfy the loan terms.

Types of Loans

Loans fall into two categories: unsecured and secured.

Unsecured Loan

Requires no collateral. These usually have higher interest rates than secured loans because they are riskier for lenders (e.g., personal loans).

Secured Loan

Uses an asset you own as collateral; the lender can take the asset if you do not repay the loan (e.g., auto loan, mortgage, home equity loan).

Most Common Loans Used in Our Daily Lives

Personal Loans

A personal loan is a type of loan that allows borrowers to borrow a lump sum of money they can repay over time in monthly installments. Personal loans are typically unsecured, meaning borrowers do not need to put up any collateral to qualify for the loan. This makes them a flexible option for borrowers who need cash for various purposes, such as consolidating debt, paying for unexpected expenses, or making a significant purchase.

Personal loans can be found through various lenders, including banks, credit unions, and online lenders. The interest rates and terms of personal loans vary depending on the lender, so it is vital to shop around before you apply. To learn more, visit What Is a Personal Loan?

Auto Loans

An auto loan is a secured loan used to purchase a vehicle. When you take out an auto loan, the lender gives you the money to buy the car, and the vehicle itself becomes collateral for the loan. If you default on the loan, the lender can take the vehicle back to recoup their losses.

Auto loan terms typically range from 36 to 72 months, and the interest rate on an auto loan is typically lower than the interest rate on a credit card. This is because auto loans are considered lower risk since the lender has the car as collateral.

When you take out an auto loan, you will make monthly payments to the lender. These payments will include both the loan's principal amount and the interest charged on the loan. The amount of your monthly payment will depend on the terms of your loan, such as the loan amount, the interest rate, and the loan length.

Making all of your auto loan payments on time is essential, as missing a payment can damage your credit score. If you cannot make a payment, you should contact your lender as soon as possible to discuss your options.

Student Loans

A student loan is a type of loan used to finance the cost of post-secondary education and the associated fees, such as tuition, books and supplies, and living expenses. Student loans can be federal or private and have various terms and conditions.

The U.S. Department of Education offers federal student loans, which typically have lower interest rates and more flexible repayment options than private student loans. Some benefits of federal student loans include deferment, forbearance, and income-based repayment options.

Banks and other financial institutions offer private student loans. They typically have higher interest rates than federal student loans, but they may offer more flexible repayment options.

Mortgages

A mortgage is a loan used to purchase a home. The property that is being purchased acts as collateral for the loan, which means that if the borrower defaults on the loan, the lender can take the property back.

Mortgages are typically repaid over 10, 15, 20, or 30 years. The interest rate on a mortgage can be fixed or adjustable. A fixed-rate mortgage means that the interest rate will stay the same for the entire life of the loan. An adjustable-rate mortgage means the interest rate can change over time based on market conditions.

The amount of money a borrower can borrow for a mortgage will depend on their income, credit score, and other factors. Borrowers will also need to make a down payment on the property, which is typically 20 percent of the purchase price.

Mortgages are a significant financial commitment, so shopping around and comparing rates before choosing a lender is essential. You should also ensure that you understand the loan terms before you sign any paperwork.

Home Equity Loan

A home equity loan is a type of loan that allows homeowners to borrow money against the equity they have built up in their homes. The loan amount is typically limited to 75 to 80 percent of the home's appraised value, and the loan terms can range from five to 30 years.

Home equity loans are often called second mortgages because the borrower's home secures them. If the borrower defaults on the loan, the lender can foreclose on the home and sell it to repay the debt.

Home equity loans typically have fixed interest rates, which means that the borrower will pay the same interest each month over the life of the loan. This can make it easier to budget for the loan payments.

Home equity loans can be used for various purposes, such as home improvements, debt consolidation, education expenses, medical expenses, and retirement savings.

Before taking out a home equity loan, it is essential to compare interest rates and terms from different lenders. You should also make sure that you can afford the monthly payments.

Credit Builder Loans

Credit-builder loans are a type of loan that can help borrowers with low or no credit scores build their credit history. These loans typically have a small amount, such as $300 to $1,000, and a fixed monthly payment term of 6 to 24 months.

The borrower makes monthly payments to the lender, and the lender reports these payments to the credit bureaus. This shows lenders that the borrower can make on-time payments, which can help improve their credit score.

Credit-builder loans can be a good option for borrowers looking to improve their credit score but do not have a lot of credit history. However, it is important to note that these loans may have higher interest rates than other types of loans.

Credit

Credit comes from the Latin verb credere, which means "to believe." In finance, it refers to the ability to borrow money now and repay it later. There are two main types of credit:

Revolving Credit

Credit is where you can borrow up to a specified maximum amount and repay what you borrow as you use it. Examples of revolving credit include credit cards and lines of credit.

Installment Credit

A loan is where you receive the money you borrow in a single lump sum and then repay it in pre-determined monthly installments. Examples of installment credit include car loans, mortgages, and student loans.

Credit Bureaus

Credit bureaus collect information about your credit history and create credit reports. This information includes your credit accounts, payment history, and credit inquiries. Lenders use credit reports to assess your creditworthiness, which determines how likely you are to repay a loan.

The three major credit bureaus in the United States are Equifax, Experian, and TransUnion. By law, you can receive a free credit report from each of these bureaus once per year.

AnnualCreditReport.com  is the only website authorized by the federal government to issue free annual credit reports.

Credit Reports

It is important to check your credit reports regularly to ensure accurate information. If you find any errors, you should dispute them with the credit bureaus. You can also use your credit reports to track your credit score, which is a number that lenders use to assess your creditworthiness.

Here are some tips for using your free credit reports wisely:

• Request a report from each of the three credit bureaus every four months. This will allow you to see how your credit report looks from different perspectives.
  
  
• Review your credit reports carefully for any errors. If you find any errors, dispute them with the credit bureaus immediately.
  
  
• Track your credit score over time to see how it is changing. This will help you identify areas where you need to improve your credit.

What Information Is On Your Credit Report?

• Report number, date, and name
• Identifying information (name, birth date, SSN, etc.)
• Bill payment history
• Loans
• Current debt
• Bankruptcy history
• Lawsuit records

In most cases, your credit report will not include your credit score.

Who Uses Credit Reports and Why?

Credit bureaus can sell the information on your credit report to:

• Lenders
• Potential employers
• Insurance companies
• Rental property owners

These businesses may use the information on your credit report to decide if you qualify for credit, loans, rental property leases, employment, and insurance.

Credit Scores

A credit score is a number that lenders use to assess your creditworthiness, determining how likely you are to repay a loan. Credit scores are based on information in your credit report, which includes your credit accounts, your payment history, and your credit inquiries.

Types of Credit Scores

There are two main types of credit scores: FICO scores and VantageScores. FICO and VantageScore create credit scores using information from your credit reports.

Lenders use FICO scores more widely than VantageScores. However, FICO scores and VantageScores are important factors in determining your creditworthiness.

Both FICO scores and VantageScores use similar factors to calculate your credit score:

Main Factors in a FICO Score

Main Factors in a Vantage Score

Interpreting Credit Scores

Both FICO scores and Vantage Scores range from 300 to 850, and each divides the ranges into five categories. A higher credit score means that you are a lower-risk borrower.

Your Credit Score

There are four main ways to obtain your credit score:

1. Check your credit or loan statements.
   
   
2. Talk to a credit or housing counselor.
   
   
3. Use a credit score service (e.g., Credit Karma).
   
   
4. Buy your score from one of the three major credit reporting agencies: Equifax, Experian, or TransUnion.

How Your Credit Score Impacts Your Financial Future

Each individual has their own credit score - this includes you! Lenders use it to decide whether you get a mortgage, a credit card (or some other line of credit), and the interest rate you are charged for this credit.

The score provides a picture of you as a credit risk to the lender at the time of your application.

• A lower score implies a riskier borrower.
  
  
• A higher score implies a less risky borrower.

Your credit score is a reflection of your credit risk to lenders. The lower your score, the riskier you appear to be, and the less likely you are to get credit; or, if you are approved, you will pay more to borrow money. Lenders will look into your credit history in more detail if you are trying to borrow money. They could deny your application or offer higher interest rates if you have had a previous negative remark, such as a foreclosure, or if you owe a debt to collection agencies.

Ways to Improve Your Credit Score

Here are some ways to improve your credit score:

Have a long credit history.

Pay your bills on time.

Keep your debt low.

Reduce debt.

Review your credit report.

Credit Cards

A credit card is a revolving line of credit that allows you to borrow money up to a pre-set limit. You can use a credit card to pay for your living expenses, but you must make at least the monthly minimum payment. If you do not pay the entire balance by the end of the grace period, you will be charged interest on the unpaid balance. Credit cards may also charge annual fees and late payment fees.

Characteristics of Credit Cards

Here are some of the key terms associated with credit cards:

• Credit Limit: The maximum amount of money you can borrow on your credit card.

• Overdraft Protection: A service that allows you to make purchases even if you have exceeded your credit limit. This may involve paying a fee or having your bank transfer money from another account to cover the purchase.

• Annual Fee: Some credit card issuers charge a fee each year for the privilege of having their card.

• Grace Period: The period between the purchase date and the payment due date, during which you do not have to pay interest on your purchases.

• Interest Rate: The percentage of interest charged on your outstanding balance each year.

• Cash Advances: The ability to withdraw cash from your credit card. This may involve paying a fee, and interest begins to accrue immediately.

Understanding these terms is essential for using your credit card wisely and avoiding unnecessary fees.

Advantages and Disadvantages of Using Credit Cards

It is important to be aware of the advantages and disadvantages of using credit cards before applying for one. Using your card responsibly can be a valuable tool for building your credit score and managing your finances. However, if you are not careful, it can also lead to financial problems.4

Types of Credit Cards

There are two main types of credit cards: bank credit cards and store credit cards.

Bank-issued credit cards

Banks, credit unions, or other financial institutions issue bank credit cards. They can be used anywhere that accepts the card's network, such as MasterCard, Visa, Discover, or American Express.

Store-issued credit cards

Retailers can issue credit cards that can only be used at the retailer who issued the card. For example, a department store or gas station credit card can only be used at that store or gas station (e.g., Target RedCard, Shell Card).

FYI: Some large retailers also offer co-branded major Visa or Mastercard credit cards that can be used anywhere, not just in the retailer's stores. For example, the Walmart Mastercard can be used at Walmart and anywhere else that accepts Mastercards.

Credit Cards With Rewards for Everyday Purchases

A rewards credit card offers customers travel rewards and other perks with everyday purchases. There are many credit cards available with rewards programs available.

Travel credit cards offer rewards like points or miles that can be redeemed for flights, hotel stays, and other travel expenses. These cards often have annual fees but can be worth it if you travel frequently. To learn more, read How Do Travel Credit Cards Work?

Entertainment credit cards offer rewards for spending on entertainment, such as movies, concerts, and sporting events. These cards often have lower annual fees than travel cards but may offer fewer rewards.

Factors to Consider When Choosing a Credit Card

• The Rewards Program: Some credit cards offer cash back, travel, or other rewards.
  
  
• The Interest Rate: The interest rate is the percentage of interest you will be charged on your outstanding balance if you do not pay your bill in full each month.
  
  
• The Annual Fee: Some credit cards have a yearly fee, while others do not.
  
  
• The Credit Limit: The credit limit is the maximum amount of money that you can borrow on your credit card.
  
  

Credit Card Payments

Minimum payments are the smallest amount you can pay on your monthly credit card bill without incurring late fees or other penalties. However, even if you pay the minimum, you will still be charged interest on your outstanding balance. The amount of your minimum payment will vary depending on your credit card issuer and your credit card agreement. You can find your minimum payment on your monthly credit card statement.

What Is a Minimum Payment?

Compounding interest can work wonders for your savings, but it can also work against you if you carry credit card debt. When you only make the minimum payment on your credit card, you essentially pay interest on your debt and draw on your interest. This can quickly snowball your debt and make it much harder to pay off.

How to Use Your Credit Cards Responsibly

Here are some tips on how to use your credit cards responsibly:

• Limit the number of credit cards you have.

  • Having too many credit cards can make it challenging to track your spending and lead to overspending.

• Pay your credit card balance in full each month.

  • This is the best way to avoid paying interest on your purchases.

• Be aware of your APR and all fees.

  • This information is typically found on your credit card statement.

• Limit cash withdrawals.

  • Cash withdrawals typically have high finance charges, so it's best to avoid them if possible.

• Read your credit card statement carefully.

  • This is important to ensure there are no errors and to dispute any charges you do not recognize.

• Pay attention to your credit utilization.

  • Your credit utilization is the percentage of your credit limit that you are using. Keeping your credit utilization low is important, as this can impact your credit score.

By following these tips, you can use your credit cards responsibly and improve your financial health.

When to Borrow

Borrowing can be costly, but it is not always a bad thing.

Sometimes, you must borrow because you need money to fund your purchase. For example, if you want to buy a house, you may need to borrow money from a bank.

Other times, you can choose between your own money and other people's money. For example, if you want to buy a new car, you could save up for it and pay cash or take out a loan and finance the purchase.

The decision of whether or not to borrow depends on the specific situation. If borrowing makes you better off financially, it may be the right decision. However, if borrowing will only make you worse off, then it is best to avoid it.

Reason 1

Using your own money is not free.

Reason 2

Because you can have the asset sooner rather than later.

Example 1: Taking Out a Mortgage to Purchase a Home

You can borrow money to purchase a home in your early 30s rather than save enough to purchase a home in your later 60s.

Example 2: Taking Out Student Loans to Attend College

Education is a valuable investment that can increase your potential earnings. If you do not attend college, you will likely start working immediately. However, the opportunity cost of going to college is the foregone earnings that you would have made if you had started working instead. Therefore, starting college as soon as possible is important when the opportunity cost is lowest. This will give you the most time to benefit from the increased income you will earn after graduation.

Debt-to-Income Ratio

Key Takeaways