Know Your Loan Basics

Key Takeaways

  • Four basic components of any type of loan are time, interest rate, loan amount and payment.
  • Young adults tend to have four types of loans: student, auto, credit card and mortgage.
  • A good credit score will give you much better terms on any type of loan—and save you thousands of dollars over your lifetime.

If you’ve ever applied for a loan, I’m sure acronyms such as MPV, PMT, ARM and AUM have made your head swim. We don’t need to get into all the math and legalese here; just understand some of the important basics of borrowing.

There are four key elements to any loan:

  1. Time.
  2. Interest rate.
  3. Loan amount.
  4. Payment.

And there are four basic types of loans for people your age:

  • Student and education loans.
  • Car loans.
  • Credit cards.
  • Mortgage loans.

Interest rates and loan duration vary for each type. Student loans average about 6 percent a year, with a typical range from 2 percent to 12 percent. Credit cards charge about 15 percent interest on the outstanding balance but can range anywhere from zero percent to as high as 30 percent—yes, that high. Interest on auto loans averages about 4 percent, with a typical range from zero percent to 13 percent. Mortgages average about 4 percent today, with a typical range from 3 percent to 6 percent.

There are different loan time frames that you need to understand as well. Student loans are typically for 10 to 30 years, while auto loans are for two to five years, credit cards zero to seven years and mortgages typically five to 30 years.

The key is to build and maintain good credit no matter what type of loan you are seeking.
Let’s compare two borrowers—one with poor credit and one with good credit—to see how much a good credit score helps. Good credit is generally above a 700 FICO score and poor credit is generally below a 600 FICO score.

Borrower #1 (Poor Credit)

  • Student loan: $40,000. Expect to pay 8 percent interest over 10 years (i.e., $485 per month).
  • Car loan: $25,000. You’re looking at 5 percent interest ($472 per month).
  • Credit card balance: $10,000. You’ll pay around 22 percent interest ($283 per month).
  • Mortgage: $180,000. Expect to pay 5.5 percent. That’s another $1,022 per month.TOTAL: $2,262 per month

Borrower #2 (Good Credit)

By contrast, if you have good credit:

  • $40,000 student loan: At 5 percent, not 8 percent, you’re paying $424 per month instead of $485.
  • $25,000 car loan: At 3.5 percent, not 5 percent, you’re paying $449 per month rather than $472.
  • $10,000 credit card balance: You’re looking at 15 percent. Still pretty high, but a lot better than 22 percent, so your average monthly payment will be only $225 per month instead of $283.
  • $180,000 mortgage: You’re paying 3.75 percent instead of 5.5 percent, so your monthly payment drops to $834 per month—a lot better than $1,022.

All in all, you’re paying $1,938 per month rather than $2,262 per month—that will save you about $4,000 a year!

Don’t underestimate the importance of maintaining good credit.

Enjoy. Gary

Please note: I reserve the right to delete comments that are offensive or off-topic.

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