Getting a perspective on debt
Debt may sound like something you want to avoid. However, borrowing money is an important part of your overall financial health—as long as it's managed correctly. Instead of fearing it, you should understand the borrowing process and how it can benefit you.
What you should look for
Start out knowing your reason for borrowing money. Do you really need what you're purchasing? If so, do you have to purchase it now or can you wait to build up savings? Before going into debt, make sure you know what's ahead of you and that you can afford the overall cost.
Your credit score
Your credit score is how lenders determine if they're going to lend you money and, if so, at what interest rate. The higher your score, the lower the rate. Borrowing—and being consistent with paying on time—can lead to a higher credit score.
Start with checking yours. You can order a free report once a year from AnnualCreditReport.com. You can also order it direct from the credit bureaus:
An interest rate is how much it costs you to borrow money. Also called APR (annual percentage rate), it's the rate you pay if you borrowed money without paying it back for a year. So, if you borrowed $100 at a 15% rate, you'll pay $15 for borrowing that $100.
It can greatly change how much more you pay than the original amount of the loan. A 5% difference in interest rates might not look like much on a month-to-month payment, but over time, it can add hundreds—or even thousands—of dollars to your overall loan payment.
If you want to have lower monthly payments, you can increase the time to repay the loan. However, you need to understand how much extra that'll affect the total loan amount you pay in the long run.
For example, on a $20,000 loan with a 10% interest rate, a 48-month loan payment will be $507/month and only $425 for a 60-month loan. However, you'll pay an extra $1,148 in interest on the 60-month loan.
The fine print
Many people skip reading the fine print of a loan agreement, but that can lead to expensive surprises in the future. There you'll find important points such as if you can prepay the loan and if there's a penalty charge. They could also discuss late fees if you don't make payments on time.
If the fine print seems confusing, ask rather than avoid.
What lenders are looking for
When you know what lenders are looking for, you can be prepared to avoid any hurdles. They generally look at the five Cs:
- Credit history. They'll review your credit score which reflects how long you've had credit and whether you pay your bills on time.
- Capacity. To determine your ability to make payments on the loan, they'll review your employment, income and debt-to-income ratio—that's your monthly bills divided by your gross income.
- Capital. This is the amount you can put down toward the purchase plus the funds you have in your safety net—your total assets such as savings, stock and investments.
- Collateral. To secure credit for an auto loan, your collateral is your car. If you default on your loan, your lender can assume ownership of it.
- Conditions. These can include what you plan to do with the funds, economic conditions and if you have a co-signer.
Making a plan
Once you understand borrowing, you need to have a strategy to pay off the debt. Paying on time will not only help your credit score but also help avoid fees. Managing your finances with a household budget can ease the anxiety of month-to-month bills.
The bottom line
Be a smart shopper and never rush into a major financial decision. Find the best loan and interest rate for your situation. Ultimately, you can save money and avoid last-minute surprises by being well prepared.