Credit plays a big role in our culture; therefore, it is important that individuals understand the various types of credit products that are available to them. The following will demonstrate the various decisions a consumer must make as the approach the modern consumer credit marketplace.
Secured and Unsecured Credit
Credit can be secured or unsecured. Secured credit is backed by pledging an asset, which becomes known as collateral. The collateral acts as a guarantee that the borrower will repay the money loaned by the creditor. If the borrowed money isn’t repaid, the collateral that was pledged for the loan can be seized by the creditor. Secured loans typically will have lower interest rates because they have lower risk of default or failure to repay. The reasoning behind this is because individuals do not want to lose the collateral they have pledged for the loan. Some examples of secured credit products include; mortgages, equity lines of credit, equity loans, automobile loans, mobile home loans, passbook loans and secured credit cards (secured credit cards are attached to a personal bank account of at least equal value).
Unsecured credit means there is no collateral backing the money that has been lent by the creditor. The creditor is lending money only based on the credibility of the borrower’s application and credit history. It is for this reason that unsecured loans typically will have higher interest rates because they have higher risk of default or failure to repay. The reasoning behind this is because individuals are more likely to repay a secured loan before they repay an unsecured loan if facing financial difficulty. Some examples of unsecured credit products include; unsecured credit cards (not tied to a bank account), store charge cards, student loans and personal loans.
Installment Loans and Revolving Lines of Credit
An installment loan is one in which a specific amount of money is borrowed for a defined purpose and with defined repayment terms. Each payment and individual makes reduces the balance of the loan. The loan gets closed out by the creditor when it is paid off by the borrower. An individual would want to use this type of loan product when planning to finance a specific project or the purchase of a specific item. Examples of installment loan products include; automobile loans, home mortgages, student loans, mobile home loans, equity loans, personal loans and passbook loans.
Revolving lines of credit are agreements by creditors to lend a specific amount of money which can be accessed by the borrower at any time. As the outstanding balance is paid down by the borrower the funds become available to use again. An individual would want to use this type of credit product when planning to finance short-term projects or make general purchases. Examples of revolving lines of credit products include; credit cards (both secured and unsecured), charge cards, equity lines of credit and overdraft protection on checking accounts.
Fixed and Adjustable Interest Rates
A fixed rate loan is a loan where the interest rate will remain constant for the entire term of the loan period. The rate that the creditor sets at the beginning will remain until the borrower repays the balance in full. Typically, a fixed rate loan will have a higher rate. The reason for this is because the creditor is “locking” up that money and potentially losing the opportunity to lend it out at a higher interest rate. Examples of fixed rate loan products include; home mortgages, equity loans, mobile home loans, automobile loans, personal loans, and passbook loans.
An adjustable rate loan, also known as a variable rate loan, is a loan where the interest rate will change during the term of the loan period according to a specific benchmark. The initial interest rate that the creditor sets is normally fixed for a period of time after which it is reset periodically until the borrower repays the balance in full. Typically, an adjustable rate loan will have a lower initial rate. The reason for this is because the creditor knows that if the rate environment increases, they haven’t “locked” up their money and will be able to increase the rate and thus their profit potential on this loan. Examples of adjustable rate loan products include; home mortgages, equity lines of credit, credit cards (both secured and unsecured), charge cards and overdraft protection on checking accounts.