The fictionalization of the US and the global economy since the 1970’s has given rise to largely interconnected banking sector with behemoth Central banks and large investment and retail banks. The proliferation of well-paying jobs in the financial sector is what led to the diversion of the best-brains including Math PhD’s into Wall Street with profound implications for your ability to choose the right loan.
Abundance of products, plenty of pitfalls
The result has been a seeming abundance of loan financing products available for a wide range of purposes including education, home-buying, car purchase and personal tasks. But just like Wall Street’s runaway innovation on sub-prime mortgages that resulted in the Great Recession of 2008, the loan financing market is laced with booby-traps. One wrong step, and you could be trapped in the vicious cycle of high-interest debt.
You are not “too big to fail”
Do you remember the people out of work who defaulted on their loans in 2008? And the home foreclosures that people who did not make the effort to choose the right loan had to go through?
Taking a loan out is an important decision. You can never be “too big to fail” and will not be bailed out like the banks were in 2008 so be cautious.
The first half of this article will talk about the generic principles you should bear in mind when you embark on the process to choose the right loan. The second part will provide a brief overview of major loan financing categories.
How much do you really make
Your job contract may say you’re making $75,000/year, but how much of it really ends up in your bank account. Think about federal, state and local taxes. Some states in the US do not have state taxes but others do. What is the final net income that comes into your bank account every month. As a rule of thumb, your loan interest repayment must not exceed more than 30% of your net income.
Can you hold off on buying that new car for another year or upgrading from a condo to a single-family home? You need to leave no ambiguity here as your purpose will dictate the loan financing structure (total amount borrowed, interest rate etc.). Every time you borrow money for a purpose, there is an opportunity cost you pay for other purposes for which you could have borrowed. So, is your purpose for loan financing the most pressing one among all your other purposes? Even as you leave no stone un-turned to choose the right loan, also remember to choose the right purpose.
What is your credit score
If your credit score is below 580, know that the interest on the capital made available to you by the institutional lender will be higher than your neighbor with a score of 740. If you have a low credit score, it may be wise to repair your credit first (loan a cheap, used car and keep making regular payments).
Is your daughter still in college? She might be having financial aid today, but will this last into the next semester? You may be asked to help her out temporarily. Your health insurance may not cover that root canal you badly need and need to pay out of pocket. You must to the extent practicable, visualize such scenarios and make sure you retain your repayment capacity even as you deal with such expenses.
Your lender’s credibility is of the essence. The Federal Reserve, Moody’s and non-governmental websites such as nerdwallet are sources of information you can pool together to construct a risk profile of your lender just like they do of you. When you choose the right lender, you’ve already succeeded in a significant way in your bid to choose the right loan.
Ok, now for the specifics.
These are usually 15 to 30-year commitments. An important consideration is whether you want to go for fixed-rate loans or variable rate loans. Fixed rate mortgages have the advantage of predictability (you will be charged 10% interest over 30 years) but do not allow for savings if the underlying prime rate that influences your fixed rate changes. On the other hand, variable interest loans may allow you to pay a lower interest rate if the prime rate plunges but carry the risk of higher rates if the prime rate shoots up. Most borrowers prefer fixed-rate loans.
The key here is to have a good credit score, a car with a good resale value and a loan financing structure that allows you to pay down your loan balance faster than the depreciation of your new car. You must make every attempt to ensure that your car is not valueless junk by the time your overly long 7-year loan ends. Choose the right loan and you’ve acquired an asset that’s useful and can be sold if needed.
If you’ve maxed out your high-interest credit cards and are caught in a debt trap, a personal loan can be especially useful as it offers money at a standard (usually lower) interest rate. Again, a good credit score, repayment capacity and exhaustive liability analysis are crucial. Look carefully for hidden fees. The dirty little secret known to all is how loan financing institutions often rely on escalating late fees as almost a passive income source.
You will face the same fixed versus variable rate conundrum like home loans. Also, crucial to find out is whether the loan allows for immediate repayment of interest or deferred payment. This will have a significant impact on the total amount you end up repaying. What is the grace period after the completion of your degree for you to find a job and begin repaying? 6 months? A year? You need to know with certainty. And finally, does the bank consider exceptional situations and allow extensions of the grace period?
Getting a loan is easy. But to choose the right loan with terms that don’t give you that nasty surprise years down the line requires careful research. Good loans and loan financing institutions exist in this diverse market and your ability to find them using various conventional and unconventional indexes could save thousands of dollars and headaches.