Credit report vs. credit score. A credit report brings together details about your financial life. Many of those details relate to various ways that you’ve borrowed, such as mortgages, car loans and credit cards. A credit score is a measure of your creditworthiness based on the information in your credit report.
Debt ratios. This is the amount you pay to service your debts each month as a percentage of your pretax monthly income. Mortgage lenders typically don’t want to see borrowers take on mortgage payments, including property taxes and homeowner’s insurance, that are much above 28% of income. Lenders also prefer that borrowers limit total debt payments to 36% of income.
Secured vs. unsecured debt. If you take out a mortgage that’s backed by your home’s value or an auto loan that is collateralized by the car you bought, it is considered a secured loan. Because the lender has an asset it can seize if you fail to make your loan payments, the interest rate should be relatively low. By contrast, if you carry a credit card balance or take out a personal loan, there is no collateral backing the loan and hence the interest rate is typically higher.
Deductible vs. nondeductible interest. The interest paid on mortgages, margin borrowing and student loans may be tax-deductible. Interest on other debt, notably credit card balances and auto loans, can’t be deducted on your tax return.
Fixed vs. adjustable-rate mortgage. A fixed-rate mortgage charges the same interest rate throughout the life of the mortgage, allowing the monthly payments also to stay the same. By contrast, the interest rate on an adjustable-rate mortgage changes periodically, often once a year, resulting in changes in the monthly payment. Hybrid mortgages combine features from both mortgages, charging a fixed rate for perhaps the first five years and then adjusting every year thereafter.
Principal vs. interest. On most mortgages, part of each monthly payment goes toward interest and part toward paying down the loan’s principal value, which is the amount borrowed. As the loan balance shrinks, less of each monthly payment should go toward interest and more toward principal. Because the amount originally borrowed is gradually repaid over the life of the mortgage, these are sometimes called amortizing loans.
Loan vs. credit line. With a loan, the specified amount is borrowed all at once. With a credit line, the maximum amount that can be borrowed is set when the credit line is established. The borrower can then tap the credit line as needed.
Refinancing. If interest rates fall after you take out a loan, you might be able to refinance the loan, thereby taking advantage of lower rates. This is a particularly popular strategy among fixed-rate mortgage borrowers. The advantage of the lower rate needs to be weighed against the cost of the refinancing. Student loans are sometimes also refinanced.
Prepayment. To pay off a loan more quickly, borrowers will sometimes make extra principal payments. The return earned on these prepayments is equal to the loan’s interest rate. Some lenders charge a prepayment penalty if you pay off a loan too quickly.
Debt consolidation. If you have high-interest debt, notably credit card debt, or you have an overwhelming number of loans outstanding, you might consolidate these debts into a single loan. For instance, you could consolidate your debts using a home equity loan, which should have a relatively low interest rate. The interest on the home loan may also be tax deductible. Similarly, students often end up with multiple federal student loans. To avoid having to pay so many loans every month, they often consolidate these debts into a single loan after they graduate.
Chapter 7 vs. Chapter 13 bankruptcy. These are the two main forms of bankruptcy for individuals. Chapter 7 bankruptcy deals with your debts by liquidating available assets or, if your debts are secured by particular assets, by returning these assets to lenders. Chapter 13 bankruptcy is for those with regular incomes. It deals with debts through monthly payments that might last three to five years.
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