Understanding a Loan is a Must Before Applying for One

Sunday, April 26, 2009

WHAT MAKES ONE LOAN DIFFERENT FROM ANOTHER?

A good number of people think that a loan is simply a loan, and that's it, but the facts are quite different.

So assuming that you're looking for a loan, let's take a quick look at the different types, and at the different decisions that you'll need to make, and that way you'll soon understand what makes them different.

Starting with the broad brush strokes, there are secured and unsecured loans, and there are personal loans, home loans, and loans for various purchases such as an automobile. Then there are commissions, fees, and interest rates, plus additional things like the duration of the loan that must also be taken into account.

SECURED LOANS

In essence, a secured loan is simply a line of credit that is guaranteed by some kind of personal collateral, and the collateral will typically be more valuable than the amount that's being borrowed, and if it isn't then the interest will most likely be a little bit higher.

A classic example of a secured loan would be a home loan, but as you most probably know, nearly all the banks are in big trouble right now because they assumed that house prices could only keep going up, and they offered loans to almost anyone that they could tempt into buying real estate.

They merely required deposits that were nonsensically low in order to encourage people to borrow, and it was a terrible business practice that was simply rooted in greed, and it's now causing a lot of distress to everyone that got caught up in it.

To add insult to injury, the banks have now gone in completely the opposite direction, and made it so difficult to qualify for a home loan, that even people with very high credit scores are failing to qualify. It's still possible to get a home loan of course, and it's obviously easier if you already have a property that has a large amount of equity in it that will allow you to put down a good sized deposit on your new purchase.

Most lenders now require a minimum down payment of 20%, and if it's anything less then you'll need to obtain private mortgage insurance.

Home loans can basically be split into two categories, a fixed interest rate loan, which means that the interest rate that you agree to when you take out the loan will remain the same for the life of the loan, and a variable rate loan that will float according to market conditions, and it's pretty clear that the only direction in which a variable rate loan is likely to go right now, and it's up.

Home loans are usually for 15, 20, 25 or 30 years, and the shorter the better as far as cost is concerned, because you'll pay far less in interest.

On a thirty year loan for example it's not unusual for the first fifteen years to be exclusively interest, meaning that after fifteen years, that you won't have reduced your indebtedness one iota.

An automobile loan is another example of a secured loan, with the car itself being the collateral, so if you stop paying, then the bank repossesses your car and sells it, for hopefully more than you owe on it.

It's common for the auto-dealer to arrange financing for the buyer, but unless the loan is being subsidized by the manufacturer you'll more than likely get a better rate from a bank, or a third-party lending agency.

A car loan will most likely be for between 1-7 years, and perhaps surprisingly, they can even include a period of time when no interest at all is charged.

Once the interest does start accruing however, it will generally be between 7-14%, and if you decide on a shorter period of time, then you'll pay quite a lot less interest, not just because of the shorter repayment time, but also because the interest rate will be lower too.

UNSECURED LOANS

An unsecured loan, by definition requires no collateral, but unless you have excellent credit, then the interest rate will be extremely high.

The best illustration of an unsecured loan, would be what is most commonly known as a personal loan, and not only does this kind of loan usually have to be paid off very quickly, but the interest rate will be around 12%, and if you don't pay the loan back on time then the accumulated interest will escalate extremely quickly.

THE BOTTOM LINE

Which type of loan you apply for will depend on your personal circumstances, and also on what you want to buy, but before you make any final decision, please make sure that you understand exactly what you're getting into, and how much it will cost you.