All about that loan.
Applying for your first loan is an exciting step on the way to financial independence. At the same time, loans can be confusing… and making a mistake with your finances early on can have long-term consequences on your credit. We’ve put together this primer on how loans work so you can make the right decisions for your situation. We’ll start out with some basics and then move on to tips for building a solid credit history that will help you create a healthy financial future.
First of all, what is credit?
When you apply for credit (in this case, a loan), you’re asking a lender (usually a bank or credit union) to give you money in exchange for two things:
- Your promise to pay the money back according to the lender’s terms
- Interest, which is the lender’s profit from the transaction
Once your loan is approved and you’ve received the money, you’ll start making scheduled payments that go toward two things: principal (the actual amount loaned to you) and the interest (we’ll talk about this more below).
Should you take on credit?
Any time you take on credit by getting a loan or a credit card, both you and the lender take on risk. That means you both have to decide first whether the risk is worth it.
For the lender, the risk is that the borrower can’t or won’t pay the loan back on time with interest. To decide whether a borrower will repay the loan, the lender will look at the borrower’s income and credit history when they apply.
For the borrower, the risk is that you’ll have trouble making your payments. Missing payments for any reason damages your credit score, making it harder to get credit in the future. Being in debt can also make it harder to deal with a financial emergency, such as losing a job or being in a car accident.
So, before you even apply for a loan, you should decide whether you actually need one. Make sure you know exactly what you’ll use the money for, whether it’s really worth the investment, and whether there’s another way to pay for it.
Remember that taking on credit always involves risk to your finances and credit history. Plus, after paying interest, whatever you’re buying now with a loan will cost a lot more than the price tag shows. Consider saving up for the purchase instead, if you can.
Loan types and terms
The type of loan you apply for will depend on what you plan to do with the money. For example, buying a car usually means applying for an auto loan, while college tuition is usually paid through education loans that require proof that you’re a student. Once you know what you’ll use the money for, you can decide what kind of loan your purchase qualifies for.
Different types of loans come with different terms, which is the length of the loan or how long you have to repay or pay it off. Auto loan terms can be anywhere from three to seven years. Mortgage terms are usually up to 30 years. Student and personal loan terms vary. Generally, a loan with a longer term will have lower monthly payments, but you’ll end up paying more interest overall.
Understanding interest
Interest rates are quoted as an Annual Percentage Rate (APR), which is a good way to compare the amount it costs you in a year to use credit. A lower rate is better, and you should compare interest rates and fees at several different lenders before you apply. (Here’s a look at Linn Area Credit Union’s loan rates.) Keep in mind, too, that interest rates change often. (Just because a lender posted a certain interest rate last month, doesn’t mean the rate will be the same this month. Or even the next day.)
When you start comparing interest rates between potential lenders, you’ll notice that even the same type of loan might have several different interest rates listed. For example, you might see a range of interest rates for auto loans. The rate you get if you’re approved depends not just on your credit score and history, but also on the age of the car you’re borrowing and the loan term.
Let’s compare two loans for the same amount with different interest rates. Let’s say you borrow $5,000 at a 9.00% APR. The total you would repay over five years, including interest, is $6,228. The same amount borrowed at 12.00% APR would cost you $6,673 over five years. So, you would pay about $445 more at 12.00% APR than at 9.00%. The higher the amount of the loan, the bigger the difference. Linn Area Credit Union has several loan calculators to help you figure out how much you’d pay for the loan you’re considering.
Applying for your loan
Like most lenders, Linn Area has an online loan application. Before you get started, make sure you have some information ready. Besides your basic name, address, phone number, and email address, most lenders will ask who your employer is and how long you’ve worked there.
They’ll also ask about your current income and how much you already spend on rent and other debt, like credit cards. These types of payments will impact your debt-to-income ratio, which is how much you’re paying in relation to your income.
For lenders, a high debt ratio generally means a higher risk that the borrower won’t be able to make their payments. That could lead the lender to deny the application altogether, or to offer a less favorable loan with a shorter term or higher interest rate.
Once you’ve filled out an application, the lender will review the application and check your credit history. They might have some questions, and you may need to submit some additional forms. Don’t be afraid to ask questions and make sure you understand everything you’re signing.
Following the review of your application, the lender will approve or deny your loan. If you’re approved, you’ll receive your money and start making payments according to the terms.
If you’re denied, it’s not the end of the world. It won’t be recorded on your credit history, and you can always apply again. Make sure to ask why your application was denied and what you can do to improve it for next time. Maybe you need to improve your credit score, or maybe you need to find a cosigner.
Paying back your loan
Once you have your loan, you’ll need to make payments on time throughout the term of the loan. Payments are generally made monthly, and you can do it one of several ways.
Automatic payments
When you set up automatic loan payments, your payment will be automatically withdrawn on the same day each month from an account you choose. This is by far the easiest way to make sure your payments arrive on time. You do have to make sure there’s enough money in the account on the withdrawal date.
Bill payer
With Linn Area’s online bill payer service, you can use online or mobile banking to schedule your loan payment each month. You can even set up reminders to let you know when it’s time to make your payment. This can be a good option, especially if you’re using it to pay other bills as well.
Check
You’ll receive a loan payment book with monthly payment stubs (and sometimes envelopes). You can write a check, stick the check and the payment stub in the envelope, put a stamp on the envelope, and drop it in the mail. Every month. (Sounds complicated, right? It’s really not, but we seriously recommend making your monthly payments electronically.)
If you aren’t able to make a loan payment on time, contact the lender right away to discuss options so you can avoid damaging your credit. Linn Area is a fabulous place for a first loan because you’ll get a good interest rate, and we’ll work the payments around what you can afford.
Start building good credit now
To improve your chances of being approved for good loans with low interest rates, you have to have good credit. Follow these tips to begin building a great credit history right away so you can take advantage of it later.
- Always make your payments on time. We can’t stress enough how important this is, whether it’s your store credit cards, VISA card, car payments, house payments, or other loans.
- Only borrow what you can afford to pay back. This might seem obvious, but it’s easy to lose track of how much you spend every month unless you pay close attention and keep a budget.
- Start out small. Get a credit card and charge a couple small purchases each month, then pay the entire balance on the statement before the due date. (Here are some great tips on how to handle your first credit card.) Or if you get a car loan, make sure every payment is made on time.
- Be prepared for emergencies. Keep some money in your savings account to make your payment(s) in case you lose your job or have some unexpected expenses come up.
- Pay off debts as quickly as you can. You can make bigger loan payments than required, which will help you pay off the loan more quickly and save money on interest. At Linn Area, there’s never a penalty for paying off a loan early, and an early payoff looks good on your credit report!
Ready… set… APPLY!
Follow these tips, and you’ll be well on your way to proving that you are a responsible person who takes repaying their debts seriously. That’s the key to building good credit, which will lead to better financial footing in your future. If you’re ready, apply for a loan today!