Thursday, October 22, 2009

Understanding loans and their features

Loans can have a fixed or variable rate of interest, be secured or unsecured, negotiable interest rates and payment terms. There are many different types of loan available.

Fixed or Variable Interest
1) Fixed Interest – Interest is fixed for the duration of the loan, from the time it’s taken out to the day you pay it off.

2) Variable Interest- The rate changes either up or down depending on the market rate (which varies depending on the loan type eg: LIBOR, Bond, Central Bank rates).

Secured or Unsecured
1) Secured – Then lender can sell whatever asset you’ve secured the loan against if you default and can’t pay the loan. Assets typically used as security are houses, cars, stock portfolios and personal possessions. Loans that are usually secured are car loans, mortgages, mortgage line of credit accounts

2) Unsecured- The lender has no recourse. You’ve got not asset with the lender as a collateral. If you default on the loan, the lender considers you a bad debt and will most likely pass you along to the debt collection agency as a last resort. This loan is riskier for lenders so they usually charge a higher interest rate because of this increased risk. Examples of unsecured loans are credit cards, store cards, personal loans and personal lines of credit

The different type of loans available are:

Car Loans
Car loans are usually secured against your vehicle. They may insist on car insurance as well. You should shop around for the best financing deal first before going shopping for a car because car yards will always have their own financing but this may not be the best deal around.

Car loans are usually for a fixed amount of money, organised upfront with a fixed interest rate, repayment amount and period. Example: $10,000 car loan at 10% interest, repayable by monthly instalments for the duration of 4 years.

Credit Cards
If you can’t pay off a credit card every month before the interest free period ends, then don’t use a credit card. If you don’t listen to this wise and sagacious advice, then it will ultimately be your downfall. You only need one or at the most two credit cards ever at any period of time.

These beasts come in various structures with interest free period ranging from 0 days or 55 days to 6 months typically. Read the fine print! Understand what you are signing up for. Don’t be fooled into thinking that it’s worth spending on the credit card because you get reward points or frequent flyer points. Wow, you’ve gone and spent $3,500 so that you can collect 3500 points, the equivalent of $25-$30 in rewards – if you can't pay that $3,500 off before incurring interest charges then it's a bargain with the devil.

If you can’t pay them off by the interest free period, you will be paying through the roof with rates ranging from 11% to a more typical rate such as 18% and 28% per annum interest. Usually the banks will have a 'minimum payment' amount of around $25 or $30. The problem with paying only the minimum amount is that you will end up paying interest on the balance owing and it will take you 25-40 years to pay off the credit card at the minimum amount that they request you to pay.

I will re-iterate myself because credit cards have been at the root of marital breakdowns, stress, tears and bankruptcies – if you can’t pay them off by the interest free period, don’t use them. Otherwise, you are best off looking at other financing options such as lines of credits or personal loans which charge lower rates of interest.

Debt Consolidation Loans

Debt consolidation is a process whereby you take out a new loan (or increase an existing loan) in order to close off several smaller, separate loans. This can be done by organising a new personal loan, refinancing your mortgage and rolling those debts into your mortgage or withdrawing equity out to pay off your multiple loans.

Why do people consolidate their debts? They consolidate in order to close off the loans with a higher interest rates onto a new loan with a lower interest rate. Credit card debts may be incurring interest at anything between 9% - 38% and by consolidating and refinancing, you replace the debt with a new debt with a lower rate such as 9%. It's also sometimes done to simplify repayments, instead of multiple payments to multiple loans, you make just one single payment for that new consolidated loan.

Margin Loans
Loans that are taken out usually to buy stocks and invest in portfolios. It can also be utilised when trading CFDs. The margin loan is usually secured by your stock portfolio and they will have different loan to valuation ratios (LVR) depending on what stock you buy. The average LVR could be up to a maximum of 70-80%, this varies depending on the lending institution but the higher the LVR, the more you expose yourself to margin calls.

I'll be writing a separate article regarding margin loans due to it's complexity and how it operates.

Mortgage Loans
Mortgage loans are used to buy residential and commercial properties. It's usually for an established amount (eg $380,000) with either a variable or fixed interest rate. Your loan contract will determine the period of the loan (eg: 25 years, 30 years or 40 years) and the monthly repayment amount, which may vary depending on the interest rate charged.

I will be writing articles about how to pay your mortgage off faster, amortisation schedules and techniques to pay your mortgage off faster.

Mortgage offset and redraw facilities

A mortgage offset account works by offsetting your mortgage balance by the amount in your offset account. The interest that is charged is on the net balance amount between these two accounts. To illustrate, assume Sally's mortgage on the 1st of March is $380,000. If Sally has $100,000 in her offset account, then the bank will charge Sally interest on only $280,000.

Lending institutions will usually not approve your loan without a deposit however, they may lend anything from a maximum of 80% to 105% of the property's value depending on your income and repayment abilities. The smaller your deposit and the greater your LVR, you may have to pay lenders mortgage insurance on your loan.

A redraw facility may be a component of your mortgage, depending on whether your mortgage loan has this facility or not (check your mortgage contract). With a redraw facility, if you make any extra repayments then you can withdraw the extra repayment anytime you wish.

Again, this is a complex area and I will write a full article dedicated to mortgage loans. If you don't understand the complexity of a mortgage loan then you will not know what features of the mortgage that you will need. Also, do you really want to be spending the next 30 years of your life paying off your mortgage? Understanding the finer points will allow you to establish the appropriate loan for your circumstance and be flexible enough to cater for your repayment ability.


An overdraft is usually an extension of your normal account, allowing you to have a negative balance. Businesses commonly have overdraft enabled on their account to cater for cash flow imbalances throughout the year. Some individual accounts has overdraft facilities enabled, but be sure to check if you are being penalised for the usage of this facility everytime your account drops below a $0 balance.

Payday Loans
Payday loans are the biggest rort ever. This has got to be the very last resort! The moment you start using payday loans, you are probably closer to insolvency and bankruptcy than you realise. If I could say which loan to avoid at all cost, it would be this one.

Personal Loans
These loans are either secured or unsecured. If the loan is secured, the rate will usually be lower than credit card rates and loans that are unsecured. They usually have a fixed interest rate and a set amount established at the beginning of the loan. The loan will have a payment schedule with fixed repayments, normally monthly, until the loan is paid off. You cannot vary a personal loan without creating a brand new personal loan.

Commonly used for buying cars, consolidating various loans, purchasing white goods, renovation, holidays and multitude of things. Normally classified as a bad debt and not used for investing but for aiding personal spending.

Revolving Line of Credit / Line of Credit Accounts
Similar to an oversized credit card, except they are usually secured. There is an established limit such as $100,000 and you can spend from the line of credit as much and as often as you wish until you have spent your limit – which is $100,000 in this example.

Monthly payments are based only on the component that you’ve used and may vary from a certain percentage to interest only. So if you have a $100,000 line of credit (LOC) and you’ve spent $50,000 on renovation, then you will usually have to pay the interest or minimum percentage on only that $50,000 that you’ve spent. Don’t fool yourself though. You will have to pay that $50,000 principal debt eventually, so be wise and spend only what you can afford.

Store card loans and credit

This basically covers vendor financing. It's where a retail store will offer you their store credit card (eg David Jones or Macy etc). Depending on the terms and conditions, these credit varies markedly. Some whitegood stores selling furniture, for example, may offer a 'buy now, interest free for 2 years' type of deal. If you don't pay the balance off before the interest becomes applicable then they commonly back date the interest charge to the very first date that you bought the goods.

It can be a very expensive lesson to learn. Be wise and if you can't afford to pay for it today, then don't buy it.

Student Loans
These differ from country to country. I’ll only be covering Australian student loans. In Australia they’re called HELP or FSS debts. Which is Higher Education Loan Programme debts.

I'll be writing about HELP debts in depth in a separate article due to it's complexity regarding the discounts that are applicable depending on how you pay the HELP debt.

There are so many type of loans out there. Basically everything and anything could be financed nowadays by the stores or by the shops. The terms and conditions of each loan differs and repayment structures also differ. If you don't understand the loan, don't borrow until you've done your due diligence and understand what you are signing up for.

No comments:

Post a Comment