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CREDIT 101

What is credit and what types of consumer credit exist?

Credit is money that has been borrowed by an individual or organization and owed to the lender. It can be used to purchase something of value in exchange for the borrower’s promise to pay back the amount, usually over a period of time with interest (interest is a fee charged on the payback of principal over time).

The length of time borrowers have to pay back this credit (or loan) is referred to as the “term” of the loan. The term is usually determined by the lender, and can be based upon:

  • Needs of the borrower
  • Value and type of asset being purchased
  • Whether or not the asset is being used as collateral for the loan; and
  • Lender policies

If the loan has asset(s) pledged as collateral it is considered to be a secured loan. If it does not, it is considered to be an unsecured loan. If a borrower does not pay a secured loan according to the terms of the loan then the lender can take possession of the asset(s) pledged as collateral for the loan and sell it/them to pay off the outstanding loan balance.

What types of consumer credit exist?

There are three types of consumer credit:

  • Non-installment credit – a short-term loan that requires you to pay back the amount owed, plus interest, all at once within a pre-determined time and interest rate. These are commonly referred to as balloon notes.
  • Installment credit – or closed-ended credit, is a loan that is taken out for a set amount of money and paid back over time, usually monthly. It is used to purchase good(s) that can be pledged as collateral (such as a car, boat, motor home). Some installment loans can also be unsecured.
  • Revolving credit – or open-ended, is available on a continuous basis as long as borrowers abide by terms and conditions, including making sufficient payments on time. Revolving credit usually requires minimum monthly payments of interest only, or interest and principal, if the entire monthly amount is not paid in full. They may also require the amount owed be paid in full each month. These loans can be secured or unsecured, and lenders can increase or decrease credit lines based upon payment performance. In the case of credit/retail cards, poor payment history can result in suspended charging privileges.

What is a mortgage?

The term “mortgage” is used to describe both the process of getting a real estate secured loan from a traditional lender (i.e., loan application, loan approval, loan underwriting, real estate appraisal), and to describe the “Note” and legal instrument recorded at the courthouse where the secured real estate is located. This notifies the public of the indebtedness and the parameters under which the borrower negotiated the loan repayment.

It also defines the non-payment-related foreclosure options, including but not limited to non-payment of insurance premiums, lack of proper maintenance and repairs of the secured real property, non-judicial or judicial foreclosure proceedings, and incorporating the terms of the Promissory Note. The Promissory Note is the legally binding document under which the Lender can proceed with nonpayment remedies. The Note is the single most important document executed at the closing and legally requires the borrower to pay the lender, according to the specific terms set forth in the loan, the borrowed principal and accrued interest in installments stated in the Note.

The Note also gives the lender the right to collect late charges for any payment past the due date, collect penalties, and foreclose in the event of a default under the terms of the Note. The Note incorporates by reference the security instrument (i.e., Deed Of Trust, Deed to Secure Debt or Mortgage) recorded in the public land records in the county in which the property secured exists.

Automobile Loans

An automobile loan is used to purchase a new or used automobile. The automobile is normally used as collateral to secure the loan.

A simple-interest loan note is used to explain the terms of the loan and includes specific information about the automobile being purchased, including:

  • Vehicle Identification Number (VIN)
  • Make and model
  • Current mileage

The loan note also includes interest rate, monthly payment, what happens if the borrower is late making payments (or doesn’t make them at all), and other requirements and responsibilities of both borrower and lender. To secure the loan, the lender is named lienholder on the automobile title and has actual physical possession of the title until the loan is paid off, the automobile is sold, or the automobile loan is refinanced. The vehicle can be repossessed and sold to pay off any remaining loan balance if the borrower does not meet the required payment terms.

Automobile loans are normally made for an amount less than the value of the vehicle. They also require the borrower to make a down payment equal to the difference between the selling price of the auto and the loan amount. The term, or length, of the automobile loan can range from six months to 72 months. The newer the vehicle, the longer the term can be.

The opposite is also true. The older the vehicle, the shorter the term. It is the responsibility of both the lender and borrower to ensure the loan amount decreases at the same rate, or faster, than the declining value of the automobile. When this doesn’t happen and the value of the automobile declines faster than the automobile loan, the borrower may be “upside down” on the loan. This means that at some point the value of the automobile is less than the remaining balance on the loan.

Lenders require borrowers to maintain and provide proof of auto insurance. The insurance must be sufficient to either replace or repair the vehicle if it is in an accident. When a borrower doesn’t make the insurance payments, the insurance company notifies the lender and the lender “force places” insurance. This means the lender actually purchases the insurance and then charges the borrower for it. If necessary, the lender adds the premiums it to the outstanding loan balance.

Credit Cards

Credit cards represent a revolving-line-of-credit loan that is accessed by a card. Credit cards must be applied for, and approval is based on credit history. The cards include a magnetic stripe or chip that identifies the account associated with funding the card. Credit cards are used to make purchases at brick-and-mortar locations, or online. Credit cards have set limits for purchases and cash advances.

To illustrate this, imagine a credit card holder who has a cash advance limit of $2,500, a purchase limit of $4,000 and a combined limit of $6,500. The card holder requests a cash advance of $1,000. As long as the card is in good standing (not past due or over limit) and he/she doesn’t request more than the cash advance limit, or the amount requested doesn’t exceed the combined cash advance and purchase limits, the advance will normally be approved. However, interest for the advance begins accruing immediately and the card holder is usually charged a fee for the cash advance.

Credit cards are a convenient way to borrow money, but they also carry risks. Monthly payments with high interest rates (often at 18% or higher) may apply and borrowers will usually be charged an increased delinquency rate (6 – 8% higher) if they are unable to make their minimum monthly payments. Borrowers lose charging and cash advance privileges when they are 30 days or more delinquent making a monthly payment and it is up to the creditor if and/or when those privileges will be restored.

Student Loans

A loan incurred by students to pay for tuition, books and supplies, and/or room and board while pursuing post-high school education. Student loans are granted by traditional banks, credit unions, or government lenders. Payments are usually deferred until the student graduates and obtains a job.

If borrowers don’t make enough to meet the full monthly payment, they can apply for income-based payments based upon current income. The monthly amount will be reduced accordingly, but deferred interest will be added or capitalized to the principal loan balance. After that, interest is calculated on the increased loan balance meaning borrowers are charged interest on the capitalized interest plus the portion of the original loan amount that hasn’t been paid.

What are retail credit cards?

There are two types of retail credit cards:

  • Private label credit cards are tied to a specific retailer and can only be used at that retailer.
  • Co-branded credit cards are issued by a retailer in conjunction with one of the larger credit companies like Amex, Visa or MasterCard.

For those who want to establish a credit history, or perhaps rebuild an average or not-so-good-one, a private label retail card may be the place to start. Traditionally, they are easier to obtain in terms of credit history requirements. It is important to note, however, that you should never carry a high balance if you are using it to establish or improve your credit history. That’s because these cards often apply “deferred interest,” meaning if you pay late or don’t pay off balances in full by the end of the promotional period, interest charges will be retroactively applied to your entire original purchase amount for the full term of the promotional period. And interest rates on retail cards are usually higher than other credit cards.

Co-branded cards are usually harder to obtain because their requirements are more stringent than the private labels. Issuers typically price more for risk — the lower your credit score, the higher the interest rate. This is because the cards can be used anywhere that accepts the co-brand, not just the participating retailer. The long-term effect of having a co-branded card and using it responsibly can add points to your credit score, especially if you use it infrequently and pay off or keep balances low.

What is a home equity line of credit loan?

Traditional lenders provide a variety of borrowing opportunities for consumers, including Home Equity Line of Credit loans. In this type of loan, the amount is based on and secured by the equity or the percentage of the unsecured amount of current appraised market value of the property, minus any outstanding loans balances.

Home Equity Line of Credit loans typically benefit property owners who either own their real estate outright (have no outstanding loan payments) or who have sizable amounts of equity built up. For example, a homeowner who owns property with a current appraised value of $200,000 with an outstanding first-priority mortgage loan of $100,000 means the owner has an equity value of $100,000. Suppose the same owner wants to use part of that $100,000 equity to make improvements. The owner can go to a mortgage lender and apply for a Home Equity Line of Credit loan. This would typically be a second-priority mortgage loan with a revolving line of credit, and a credit limit accessible through various methods (please see details below). Once the loan is secured, the borrower/owner has direct access to the money as needed. Or, the borrower/owner can get a fixed-rate, second-priority mortgage and receive a check for the full mortgaged amount at the closing.

The total credit limit may be up to 80% of the current appraised value of borrower/homeowner’s primary residence, or up to 70% if the property is not the borrower/homeowner’s primary residence. The borrower/homeowner is charged a negotiated interest rate (fixed or variable based on the current prime rate plus one percent or more over prime). The monthly payment can be interest-only or interest-plus-principal and will vary by lender and loan programs available. Home Equity Line of Credit loans are typically accessed through checks, debit cards attached to the available line of credit, or via transfers through a checking account.

The benefit of these loans is that monies paid in excess of the monthly interest charge are applied directly to the principal balance, thereby reducing the amount owed. In contrast, additional payments on a thirty-year amortized mortgage loan won’t dramatically reduce the principal amount owed. Also, if interest is not paid on a typical Home Equity Line of Credit loan, it is rolled over into the gross loan amount. Non-payment of the full loan payment due would be considered a default, triggering foreclosure actions under a thirty-year fixed rate loan. If no additional payments are made on a thirty-year fixed rate loan, the principal is not remarkably reduced for as much as fifteen years.

What is healthcare credit?

Healthcare credit works much like a regular credit card, except the payment agreement is with either a healthcare provider, such as a doctor, dentist or chiropractor or with a private label issuer such as Synchrony Financial (formerly GE Capital). A payment schedule, which often ranges from six to 24 months with minimum payments, is agreed upon by both parties. Zero-interest promotional rates can be offered for a specific timeframe if the amount borrowed is paid off on time. The better your credit, the lower the interest rate charged at the end of the promotional period.

Credit extended for healthcare can only be used for healthcare. And when the agreed promotional period ends, you are charged deferred interest. This means that if you don’t pay off your bill within the promotional period, you owe interest on the entire amount over the full term of the promotional period, not just the balance.

If you are considering using a healthcare credit card, always make sure your insurance company is covering as much as possible.

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