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Borrowing Fundamentals - 101

Sometimes it almost seems like the world of loans and mortgages are over-complicated on purpose - and that's a valid, debatable issue.

But regardless, you need to know what you're getting into - and if you're navigating through your first major loan or mortgage, then this is an essential starting guide to read, study and apply...

• • •

What is Credit?

You can think of credit in many different ways, but at its core I would define it as “the level of confidence and trust a lender places in a borrower ability to repay back monies lent to that borrower”. Now, the more confidence the lender has in the borrower, the lower the interest rate the borrower will be charged. On the flip side, as the lenders confidence in the borrower decreases the interest rate that is ultimately charged increases. This is the golden rule of credit, one which 99.9% of lenders base their decisions on.

Why Do We Need Credit?

Without credit very few of us would ever be able to acquire any major assets such as houses and cars. Credit allows us the privilege of being able to fully utilize and enjoy the full use of the item we have purchased prior to owing it outright. If everyone was suddenly forced to pay cash for everything the economy as we know it would come to a complete stand still. Now don’t get me wrong I’m not saying you should charge everything, on the contrary, in my opinion credit should be reserved for the purchase of significant items, such as houses & cars. Keep in mind cash forces us to live within “our means” and credit for some allows them to live to the “extreme”.

How Are We Doing With Credit?

Unfortunately, not so hot! There has never been a time in history when both as a nation and citizens have we been more indebted. There are very few out there who have any savings to speak of. Credit can be a wonderful tool in helping build wealth if used wisely; in fact it’s the use of credit by many entrepreneurs throughout our history that has created tremendous wealth for them. Too few of us today however today are carrying “good debt” most of us are only carrying “bad debt”. The difference between these two is that good debt helps you prosper while bad debt sets you back.

How Do Banks and Financial Institutions Actually Work?

Well, they start out by taking money from depositors (this can be in the form of savings accounts, term deposits, etc) and for doing so they agree to pay us interest on those deposits. Of course the bank has to find a way to pay for the interest that they’ve promised us and they do this by loaning out our money on deposit to qualified borrowers at a higher rate than the one they’re paying you and me. The financial institution generates a profit from the difference, this is known as getting a spread.

Now in some cases the financial institution is also able to leverage against these deposits on a greater than one to one margin. In essence they are able to borrow many times the value of these deposits and lend out this money to make more money and spread. This practice was one of the contributing factors in the recent global financial crisis.

What Should I Borrow For and Not Borrow For?

Earlier I mentioned that there is such a thing as good debt examples of this would be borrowing for a home. As a general rule, a home makes a good long term investment plus of course it provides much needed shelter for you and your family. Borrowing to enhance your education would also make a lot of sense provided what you’re studying for is in demand by employers and increases your value to them. A car loan can be looked at either way, of course you need a reliable vehicle to get you back and forth to work and for daily living but going hog wild and buying a “Hummer” may not be the best decision financially. As a general rule, for day to day items such as, food, utility bills, car insurance, cable etc, get in the habit of paying cash these are not good debts.

How Do I Know What I Can Afford Per Month?

The first step to take before going out and taking on a new monthly obligation is to get a handle on the ones you already have. This is done by preparing a household budget, if you don’t have a clue on how to go about doing this visit your local financial institution, find the nearest credit counselling agency or go online, any one of these can point you in the right direction. If you aren’t sure you can afford a new monthly loan payment, try taking it for a test drive.

If you’ve ever been shopping for a car at a car dealer you’ll know that you get a chance to take the car you like for a “test drive” prior to ever committing to buy it. Well you can do the same with the loan you’re thinking of taking on. Calculate what the monthly payments would run you then setup a separate account and each and every month for a few months on a predetermined date pay yourself the payment into this new account. Now if after a while you find yourself dipping into that account then more than likely you probably cannot afford the loan. You can do this with loans that are big or small, it doesn’t matter if it’s for a car or a house, at the end of the day it will help you avoid a lot of stress and grief plus it’s an excellent way of saving for a down payment.

What Does Borrowing Really Cost Me?

Earlier I mentioned that lenders generally charge higher interest rates for loans that pose more risk, but what does this actually mean in terms of dollars and cents. Well let’s take a look at the following example.

Let’s say you borrowed $200,000 for 35 years, in one example I’ll use 5% and in the other 6%, now I know a lot of you are thinking what difference could 1% possibly make.

Be prepared to be shocked:

$200,000 mortgage for 35 years at 5%
Total interest paid = $211,193.69 (total cost of home $421,193.69)
$200,000 mortgage for 35 years at 6%
Total interest paid = $274,815.44 (total cost of home $474,815.44)
1% difference results in total Savings of $53,621.75

(What could you do with an extra $53,621.75? I’m sure all of us can come us with better uses for it than paying it in interest.)

What can I do to Build My Credit so I can Qualify for the Lowest Rates Possible?

Start with baby steps; begin establishing your credit with small manageable loans and or credit card accounts. Be careful and don’t fall into the same trap that most good meaning consumers do that is the one of actually worsening their overall financial situation by taking on too much too fast. These folks figure if a few credit accounts are good for their rating, than a lot will do wonders for it. This is a recipe for disaster as having so much available credit so quickly can be quite a temptation to those who have yet to learn the mastering of it.

Keep in mind also that cell phone providers and common utility providers don’t generally report to the credit bureau that is up until you miss a payment, so even though you made 59 on time the 60th one you missed is the one that the lenders will see. So make certain that the lender you’re getting the starter loan or credit card from reports to the credit bureau each month. Now don’t forget to do what any wise consumer would do, keep in mind that terms and conditions can vary vastly from lender to lender. It’s up to you to review the interest rate, fees, and penalties that may apply from lender to lender and of course and do as much comparison shopping as possible, it’s your money!

In addition it’s a good idea not to acquire more than one credit card in any 6 month period, and once you have 3 or 4 cards within an 18 to 24 month, you need to stop acquiring cards. Most folks will not need anymore than 3-4 any more and you’re asking for trouble both in the way of temptation to yourself and a nightmare if you’re wallet or purse is stolen. Also when lenders see that you’re acquiring a litany of new cards, they look less favourably on your loan request as you now have the potential of accumulating a whole bunch of new debt very rapidly.

Another way of establishing credit is to have someone with an established credit rating and history co-sign for your initial loan or credit card. When a friend or family member does co-sign a debt for you, it now means the loan will report on their credit and they are dually responsible for the repayment. So whatever you do, don’t let them down as any screw ups on your part will also impact their credit rating.

So let’s recap, first, never, never, never miss a monthly payment. Second, always pay on or preferably before the due date. Some cards consider you to be in default if you are one day late- causing you to pay a higher interest rates, and fees. Also with many credit card companies there is a 30 day grace period on interest, so if you pay you’re balance in full month to month you will never incur any interest). Lastly, don’t charge or borrow more than you can payoff each month. If you take the steps we’ve discussed here, they will help begin and establish your credit rating. Always remember that credit is a privilege not a right, and if you neglect to take care of your finances, it’s a privilege you will both quickly lose and or wind up paying exorbitant amounts for.

What can I do to Repair Past Credit Problems?

Unfortunately most of us tend only to learn by making mistakes. For many consumers, thisholds especially true when it comes to credit. If you truly want to correct your past or current credit problems, it’s really quite simple, you have to change your everyday spending and money management habits.

First you need to ask yourself, how did I get into this mess? What habits or choices caused me to manage my money so poorly? If you need help determining these answers, talk to a friend or family member who is good at managing money, or get in touch with a credit counselling service there are many resources to help you get these answers. The key is to get pointed in the right direction.

When starting down the road of credit repair, don’t make the same mistake so many make that’s making temporary fixes instead of addressing the root problem. Root problems such as poor spending habits, reckless and impulsive decisions, failure to make and or stick to a budget of any kind. Borrowing more money to help dig out of borrowing money in the first place which may solve things in the short run but only makes the situation worse in the long run.

In closing it’s critical that you recognize that the process of rebuilding your credit will take some time and a lot of sacrifice depending on the severity of your situation. Only when you get a complete understanding of your individual situation, will you be able to take the next step. That’s implementing a budget and finding ways to change your spending habits daily so that you’re able to live within your budget and means. This is the only road to financial freedom, and if you’re truly committed to changing there is no past financial obstacle you can’t truly overcome.

About the Author:

Kam Brar is a licensed mortgage broker and has been directly involved in the lending industry over the past 10 years, bringing with him a wealth of knowledge and experience. His particular specialty throughout his career has been working with "challenge" customers, where it takes creative financing (and sometimes private loans) to accomplish their goals.

His role with ShangriLoan is that of a consultant and mortgage industry liaison.



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