the low-down on loans, interest and keeping your head ... · let’s start with the people you...

The low-down on loans, interest and keeping your head above water

Loan Lessons

Financial Education Powered by U.S. Bank

Financial Genius

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What is a loan?

A loan is a business contract between a borrower and lender, covering an extension of credit over a certain period of time including a percentage fee as the cost of borrowing.

Loan lessons

LOAN LESSONS U.S. BANK

Not all loan programs are available in all states for all loan amounts. Interest rates and programs terms are subject to change without notice. See the Consumer Pricing Information brochure for terms and conditions that apply to U.S. Bank checking accounts. The creditor and issuer of these cards is U.S. Bank National Association, pursuant to separate licenses from Visa U.S.A. Inc. and American Express. American Express is a federally registered service mark of American Express. Credit products are offered by U.S. Bank National Association and subject to normal credit approval. Deposit products are offered by U.S. Bank National Association. Member FDIC.

Key types of lending agreements

Let’s start with the people you borrow from. Creditors – that is, the banks, retailers, car dealerships, and other companies that loan you money – usually lend with three types of accounts.

• Revolving agreement. A common example of a revolving agreement is a credit card agreement. With revolving accounts, the consumer has a choice: He or she pays the balance in full each month, or pays part of the outstanding balance. The consumer can then re-borrow up to the approved credit limit without having to re-apply. Department stores, gas and oil companies, and banks typically issue credit cards based on a revolving credit plan. Another type of revolving account is a home equity line of credit.

• Charge agreement. Unlike revolving accounts, a consumer with a charge account promises to pay the full balance every month. This means the borrower does not have to pay interest charges. Charge cards and charge accounts with local businesses often require repayment on this basis. For example, American Express® offers charge cards.

• Installment agreement. When a consumer signs a contract to repay a fixed amount of credit in equal payments over a specific period of time, it’s called an installment account. Automobiles, furniture and major appliances are often financed this way. Common examples of installment accounts are mortgages and car loans. Personal loans usually are paid back in installments, too.

There are two common lending channels for loans:

• A borrower who takes out a direct loan does so by applying directly to a bank or other financial institution for a loan. Examples of direct loans are mortgages and home equity loans.

• With an indirect loan, there are three parties instead of two. The borrower takes out a loan with a retailer, such as a dealership for a car loan. The retailer then gets the money from a direct loan with a bank or other financial institution.

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Auto loans

• Auto loans can be direct or indirect loans. When you borrow through the dealership, it’s indirect; when you go to your bank and arrange the loan yourself, it’s direct.

• Auto loans can have a fixed or variable rate of interest. A fixed rate of interest works just the way it sounds. It means that the interest rate will remain the same for the duration of your loan. A variable interest rate means your interest rate could go up or down during the term of your loan.

• Generally, the maximum term is seven years or 84 months.

• In a car loan, the vehicle is used as collateral. That means that if you can’t pay the loan back, the lender may repossess it (take it back).

Student loans

• Student or education loans are usually arranged either with a financial institution or the federal government.

• 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.

Home mortgage

• Mortgages are usually direct loans, arranged through a bank or other financial institution.

• They may have a fixed or variable interest rate.

• In a mortgage, the home is the collateral, and may be repossessed if you can’t keep up on payments.

Home equity loan

• With home equity loans, you borrow against the amount of equity you have in your home. The amount of equity is the value of your property minus the amount you owe on your mortgage.

• The home is the collateral and may be repossessed if you don’t pay it back.

• You usually borrow a fixed amount of money, which is repayable over a fixed period.

• Many people take out home equity loans for specific purchases or projects, like an addition to the existing home.

Common types of loans

U.S. BANK LOAN LESSONS


Home equity line of credit

• Like home equity loans, with a home equity line of credit, you borrow against the amount of equity you have in your home.

• A home equity line of credit is a form of revolving credit.

• The home is the collateral and may be repossessed if you don’t pay it back.

• You are approved for a certain amount of credit, much like a credit card.

• The credit limit is set by taking a certain percentage of the appraised value of the home and subtracting the balance on the existing mortgage. Let’s say your home is appraised at a value of $100,000, and you owe $40,000. If the percentage is 75%, that amounts to $75,000; when your mortgage debt is subtracted, that leads to a potential credit line of $35,000.

Applying for a loan

So you’re ready to apply for a loan. There are two tasks ahead of you. The first is to pull together what you’ll need to have on hand as you apply. The second is to make yourself the most attractive possible borrower.

Here’s what you’ll need to have:

Information for applications. Make applying easier by making sure you have vital information like your Social Security number, permanent home address, employment history, and checking or savings account information (including your account numbers and balances) on hand.

Be prepared to fill out more than one application. If you’re planning on shopping around for the best deal on a loan, you may have to fill out several.

Co-signer. If you don’t have a credit history, you may need a co-signer. A co-signer is someone who is willing to accept responsibility for your debt if you aren’t able to pay it back.

Regular source of income. Creditors want to know that you are able to pay back your loan, so it’s important to have a steady job when applying for credit. Some creditors may ask for proof of employment, such as a pay stub.

Credit check. If you’ve never applied for a credit card or loan before, you probably don’t have a credit history. But it’s a good idea to check with one of the three major credit reporting agencies before you apply for credit. You may discover a debt in your history that shouldn’t be there, because creditors and credit agencies can make mistakes.



How do I qualify for a loan?

The amount of money a lender will let you borrow will be determined, primarily, by your income and credit score or FICO score. This score is a three-digit number between 300 and 850 that gives lenders an idea of what kind of credit risk you might be. The higher your score, the more likely lenders are to lend to you.

How your credit score is determined

1. Past payment history: The most important category in your credit score is your payment history – or, how promptly you pay your bills. As discussed above, the higher your score, the more credit-worthy you are. But every time you pay a bill late, it lowers your score.

Your credit report will indicate how late you were with a payment: 30, 60, or 90 days, or more. A history of late payments across several accounts will lower your score more than multiple late payments on a single account. This doesn’t mean you’ll never be able to borrow if you’ve had some problems in the past. It does mean that by paying your bills consistently on time, you can greatly improve your overall score.

2. Amounts owed: Add up all of your outstanding balances and compare that number to the amount of credit that is available to you (your credit limit on each card). Your score will be higher if you aren’t close to maxed out on your credit cards. It also helps if the credit extended to you isn’t out of proportion to your income.

3. Length of credit history: Obviously, the longer you’ve been using credit, the better you’ll look in a lender’s eyes. But it also matters how long you’ve had individual accounts, and how long it’s been since you’ve used each account.

Don’t make the mistake of opening multiple new accounts in the hopes of building credit quickly. This will reduce your “average account age,” and therefore reduce your score. Instead, it’s better to 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 hard 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. This doesn’t apply when you’re shopping around, however if you are shopping around (say, for the best rates on a car loan), some credit score models will allow for some level of shopping around within a certain time period and count those inquiries as just one. Do some research on your own and check your credit report to help you get in the best position to get a great deal.

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 only have one type – or none.

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Below are four borrowers and their current financial and credit situation. Read each, and use the information above to decide who is most likely to be approved for the loan. (The answer can be found on page 12 of this workbook.)

• Tim pays his bills on time, but he has $9,500 of debt on a credit card with a $10,000 limit.

• Mary is working on paying off her credit card balance of $2,500. She has paid off $750 of that debt, and she is in otherwise good financial standing.

• Nick normally is very good about making timely payments on his debts. However, this month, he was unable to pay any of his bills.

• Carrie recently applied for an additional credit card. The credit limit is well within her means, and she has a solid credit history.

How to borrow

If you haven’t taken out loans before, it can seem a little daunting. Here’s the lowdown on how to keep your borrowing within good limits.

1. Be realistic: Borrow only what you need, and remember that you must pay back — with interest — whatever you borrow. If you’re taking out a student loan, consider your earning potential after you graduate. Will you be able to earn enough to make your student loan payments? Regardless of what kind of loan you’re considering, it’s smart to prepare a budget to see exactly how much you can afford to spend on monthly loan payments.

2. Stay within an “acceptable” level of debt: One way to determine this is your debt-to-income ratio. This ratio compares how much debt you carry each month to how much money you have coming in.

When you calculate this ratio, your debt has to include all loan or credit payments: Rent/housing, credit card balances, and other installment loan payments. Your income has to be after-tax; that is,

what you actually get paid once taxes have been taken out.

Consider this example:

Total monthly expenses: $500

Total monthly after-tax income: $2,200

Debt-to-income ratio: 500 / 2,200 = 22.7%

The ideal number is zero. But at the very least you want to keep your debt — including car loans — to 25% or less of your after-tax income.



3. Read your loan application carefully: Make sure you understand the terms of your loan. Some important questions are:

• How long do you have to pay it back?

• What is the interest rate?

• Does it change?

• What’s considered a late payment?

• What happens if you have late payments?

• What fees might you have to pay?

Once you sign the application, you’re committing yourself to a real debt. You’ll have to repay your student loan whether or not you finish school, and you’ll have to pay off the entire balance of your auto loan even if you decide to sell the car for less than you owe.

4. Make extra payments when you can: Adding even a little extra money to your loan payment can pay big dividends in the long run. How? The faster you pay off of your principal (your original loan amount), the less interest you pay.

Student loan basics

You’ve made the decision of a lifetime – you want to go to college. Now it’s time to figure out how to pay for it.

Scholarships, grants and federal loans should be the first financial aid options you consider, and for good reason. Scholarships and grants do not have to be paid back at all, and federal loans may have a lower interest rate than private loans. Some federal loans can be forgiven, too.

If you have unmet needs after considering these resources, a student loan from a bank or other lender can help cover the rest of your costs.

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How to apply for federal loans

Here’s how to apply for federal loans. You’ll need to follow this process to determine how much debt you and your family will assume if you go back to school, and how much federal aid you can qualify for.

Step 1: Complete a Free Application for Federal Student Aid (FAFSA). Since some schools also require you to use their applications, check with your school to ensure that you have all the forms you need.

You can get a FAFSA:

• Online at fafsa.ed.gov

• At your high school guidance office

• From the college you plan to attend

• By calling 800.433.3243

Complete the FAFSA and submit it as soon as possible. A few weeks after submitting your application, you and the schools designated on your application will receive your FAFSA Student Aid Report, which will show how much you are expected to contribute for your college education.

Step 2: Review your financial aid award. The financial aid office at your chosen school will use your FAFSA Student Aid Report to create a custom financial aid package for you. They will send you this information in an award letter, which will explain how much aid you will get and how much your family will have to contribute. You will need to let the financial aid office know if you are going to accept or reject the aid offered in the package.

You may not have the amount that your family has to contribute. If this is the case, you may need to arrange a private loan.

Step 3: If needed, apply for a private loan. Private student loans are credit-based loans. That means they are based on your ability to pay them back. Private student loans must be certified by your school’s financial aid office, and should be used only when federal loans, grants and other forms of financial aid aren’t enough to cover the full cost of education. Banks, schools and education loan organizations provide these loans, and they will determine the interest rate and any fees.

Remember, both federal and private student loans must be repaid even if you don’t finish school or aren’t

happy with the education you received. So choose both the loan and the education carefully.



Student loan tips

1. Don’t assume that your income makes you ineligible for financial aid. You may be surprised to see what’s available. Apply for every financial aid choice you can find.

2. Complete and submit your FAFSA early! Most financial aid is awarded on a first-come, first-served basis. You should submit your application in January or February for the fall term.

3. Call your school’s financial aid office for their application deadlines.

4. Keep a copy of every form you complete.

5. Record the dates on which you submitted forms and note the names of everyone with whom you spoke.

6. Remember to re-apply for financial aid each year.

Credit cards: The other loan

A credit card is just that — a card that extends a line of credit to the cardholder. When you use your credit card, the issuer is essentially extending a short-term loan to you. If you pay on time each month, you’ll begin to build solid credit – especially if you pay your full balance every month. If you carry a balance month to month, you’ll pay interest on your balance.

One smart way to manage your credit card balance is to pay more than the minimum payment. Pay off as much of your balance as you can, especially on cards with high interest rates. This will save you money on interest charges, and keep your debt-to-income ratio low.

Make sure you watch out for fees. There are many fees associated with credit cards, but many borrowers don’t know about them until it’s too late. These include the more obvious fees, such as annual fees and fees for late payments and returned payments.

But some companies charge fees for “additional” services, such as withdrawing cash, ordering a replacement card, using a “convenience check,” requesting an extra account statement, transferring a balance and more. Before you commit to a credit card, make sure you sit down and read the terms and conditions of your new card so you won’t be surprised by fees.

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Defining interest

Interest is the amount of money the bank charges for letting you use its money. As you learned earlier, rates of interest can be either variable or fixed.

• Variable rate means the interest rate might change during the loan term, as written in the contract.

• Fixed rate means the interest rate stays the same throughout the term of the loan.

Interest on a loan is often referred to as simple interest, and is calculated using three criteria in an easy formula.

Principal = the amount you borrowed from the bank.

Rate = the interest rate the lender will charge you.

Time = how many years it will take you to pay back the loan.

Simple interest = principal x rate x time (in years).



Which car loan is best for you?

Okay, you’ve been pinching pennies for months, and you finally have $2,800 saved up for a car. You find a great used car for $10,800. Now all you need is a loan to cover the extra $8,000 and you’re set. Take a look at each one of your loan options, and decide which loan is the best deal for you.

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Truth in lending

In addition to interest, lenders may charge other various rates and fees. The Truth in Lending Act requires banks to state all charges in a clear and uniform manner, so that consumers can easily compare prices. Lenders must disclose:

• 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.

In the examples to the left, the simple interest is as follows:

Lender

Principal

Number Interest

Monthly payments payment

Dealer $8,000 42 13.5% $240.06

Bank $8,000 36 6.9% $246.65

Finance $8,000 48 18.0% $235.00 company

Lender Principal Rate Time

Simple interest

Dealer $8,000 13.5% 3.5 $3,780

Bank $8,000 6.9% 3 $1,656

Finance $8,000 18.0% 4 $5,760 company

x x

x x

x x

=

=

=



Annual percentage rate (APR): The APR is an expression of the costs of a loan as a percentage. This rate is likely to be higher than the advertised interest rate. That’s because it includes points and other credit costs, such as loan discounts and origination fees. For example, while you may pay an interest rate of 6%, the APR on a given loan may be 8%, because it includes both the interest you’ll be charged and fees you’ll pay.

The APR allows borrowers to compare different types of loans based on the annual cost for each loan.

Borrower: An individual who receives funds in the form of a loan with an obligation to repay the principal with interest.

Co-signer: Someone who signs a credit agreement along with the borrower. The co-signer is legally obligated to assume responsibility for paying the loan back if the borrower fails to pay the loan back.

Collateral: Anything of value (an asset) which is pledged to a lender until a loan is repaid. “Pledged” means that the asset can be seized by the lender if the loan is not paid.

Deposit: A sum of money (earnest money) given by the borrower to secure a loan.

Fixed interest rate: An interest rate that does not change during the entire term or life of the loan.

Gross monthly income: The total monthly income earned before taxes and any benefit deductions are taken out.

Interest rate: The interest rate expresses the interest cost of a loan, expressed as a percentage.

Loan balance: The outstanding balance of a loan not paid in full. This does not include any accrued interest.

Loan term: The total number of payments required to pay the loan in full. This is also known as an amortization term.

Maturity: The termination or due date on which final payment of a loan must be paid in full.

Payment schedule: The payment schedule shows the amount and due date of all payments required to be made over the life of the loan. The dollar figures represent principal and interest. This schedule does not reflect payment for any taxes and insurance the borrower has to carry on the asset.

Pre-qualification: When you pre-qualify, you ask the lender to determine whether you would probably qualify under their lending standards. Pre-qualification usually includes the amount of credit you would probably qualify for. But it is generally not a commitment, either to lend or to borrow.

Term: A period of time (usually months) during which a loan must be repaid.

Glossary



Answer: Mary is most likely to get approved for the loan, and Nick is least likely to get approved

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LOAN LESSONS –

THE LOW-DOWN ON LOANS, INTEREST

AND KEEPING YOUR HEAD ABOVE WATER

U.S. BANK

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the low-down on loans, interest and keeping your head ... · let’s start with the people you...

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