Common Credit Questions Answered

Many people are confused about the different types of loans offered by lending institutions and just how these loans will affect the borrower’s credit. Here are the answers to a few questions about the most basic types of loans:

Q. How can I get a loan?

A. There are three basic types of loans:

1. Secured loans—these loans can be for large sums of money, but they will require some type of collateral. Examples of secured loans are auto loans and mortgages where a car or house is used as collateral. You can borrow a significant amount of money, but if you default on the loan creditors have the right to repossess your car or house depending on the loan. These loans can extend over a term of as much as 10 years.
2. Unsecured loans—these loans have no collateral attached to them. The amount of money you can borrow and the interest rate on an unsecured loan will depend on how risky the institution feels it is to lend you money, so your credit will make this loan more or less expensive for you. These loans are usually for $1,000 – $25,000 and they are repaid over a term that will be decided with the lender but usually range from 1 – 5 years.
   1. Bad Credit loans—this is a type of unsecured loan designed for people with bad credit. Many lenders will grant a loan to an individual with less than ideal credit if they can prove they have a reliable source of income. These loans are typically for less money than unsecured loans that require a credit check. Their rate of interest is also going to be very high because they are considered risky to lenders. The term of this loan will also vary.
   2. Payday loans—sometimes called “cash advances,” this type of loan is for a small amount of money to be repaid over a very short term, usually no more than a month. Typically, a pay day loan will be for no more than $1,000. These loans do not require a credit check, so their rates of interest are very high.

Q. How will getting a loan affect my credit?

A. It depends on what kind of loan you get and how many loans you get. Pay day loans are a bit different, so we’ll talk about them later. Each time a lending company checks your credit to see if you are worthy for a loan, your credit score goes down 5 points. If you are approved for a loan, you will be able to make up that loss of points through making timely, monthly payments on your loan—that is, if you are below a certain amount of debt. If you are borrowing more than 40% of your total available credit, that will also hurt your credit score. So, for example, if you have a credit limit of $1,000 and you get a loan that requires a credit check for $600, then you will likely loss a significant number of points from your credit score, though this loss will be mitigated if you make consistent payments.

Payday loans are the exception to this rule. Getting a pay day loan will not affect your credit score because they do not require a credit check. If you repay your loan according to the lender’s terms, then a pay day loan will not show up on your credit report, so it will not affect your credit score. If you violate the terms of the loan, then that will show up your credit report and negatively affect your credit. But this is a double edged sword. A pay day loan will not hurt your credit if you pay it back on time, but it will not help your credit either. Pay day loans that are paid off according to the lender’s terms are not recorded on your credit report, so it will not improve your credit score by strengthening your history of consistent payments.

One way of thinking of credit is as measurement of the probability that you will repay your debt.  High scores mean that you will almost certainly pay back your loan, whereas a low score means you have a high risk of defaulting. The low risk of lending to people with good credit allows them to get lower interest rate, pay less in fees, and borrow more money.  A credit score is kind of tricky to manage, however, because the more you take advantage of a good credit score, the lower it gets. Kind of.

Here are three things to remember when you consider getting a loan.

1. Inquiring for a loan will lower your credit

Every time you fill out paper work to ask for a loan, you create what is called an inquiry. Credit companies keep track of these inquiries and use them to determine part of your credit score. So whether or not you actually get the loan you are asking for, your credit score is reduced by roughly five points with each inquiry. The theory here seems to be that the more debt you acquire the less likely you are to be able to pay it back, so an individual inquiring for more loans is less likely to be able to repay loans and their credit score is lowered to reflect that. In order to avoid this five point reduction, many people advise that you don’t inquire for any new loans, but that advice is problematic because it can make establishing and rebuilding credit very difficult.

2.Sometime you need a loan to raise your credit

Credit is calculated as a FICO score, a number that ranges from 300 to 850, 850 being the best and anything lower than 650 being labeled “subprime.” Your credit score is generally calculated according to the following criteria:

Payment History 35%

Amounts Owed 30%

Length of Credit History 15%

New Credit 10%

Types of Credit Used 10%

These criteria show the problem in avoiding inquiring for a loan. If you don’t inquire for a loan, your payment history and the length of your history may suffer. Without a loan, you will not have a credit score at all, and without making timely payments on a loan, you will not be able to replace a troubled payment history with a good one. Whether or not to get a loan is again a delicate balancing act because the amount of debt you have is the second most important factor in determining your credit score.

3.Remember the 40% rule

When creditors calculate your FICO score, they look at the amount of debt you owe. Now remember, a credit score is a measure of how likely you are to repay your loan, so a person with a lot of debt is going to have a lower score than a person with little. But what counts as a lot of debt? Most financial advisors would say that an appropriate amount of debt is less than 40% of your available credit. If you are using more than 40% of your available credit then your credit score is less than it could be. Using 40% of your available credit is the right amount to balance a healthy payment history with a manageable amount of debt.

You might be hesitant to apply for a loan if you have bad or no credit, but realize that obtaining a loan or a credit card is the only way to establish credit. True, inquiring after a loan will initially lower your credit score, but consistent payments over time will boost your credit above any lost points if you utilize less than 40% of your available credit. Always be cautious in your decisions to get a loan and consider the unique situation of your family and goals before taking on a loan.

Everyone knows that times are tough right now and with the holidays just around the corner, you certainly aren’t the only one who is hurting for cash. Whether you are young or old, working or not, man or woman, we are all in the same boat – things are costing more and more and none of us, it seems, are making enough money to keep up. It is in times like these that many people apply for a personal loan to help them get through the hard times.

There is certainly no shame in applying for a personal loan – they are there to help you out when times are bad. If you want to apply for a loan, here are a few key points to get you started:
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