A chance of defaulting on the debt repayment. 2

A loan is the act of giving money,
property or other material goods to another party in exchange for future
repayment of the principal amount along with interest or other finance charges.
A loan may be for a specific, one-time amount or can be available as an
open-ended line of credit up to a specified limit or ceiling amount.

 

The terms of a loan are agreed to by each
party in the transaction before any money or property changes hands. If the
lender requires collateral, that is outlined in the loan documents. Most loans
also have provisions regarding the maximum amount of interest, as well as other
covenants such as the length of time before repayment is required.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

 

Loans can come from individuals,
corporations, financial
institutions and governments. They offer a way to grow the overall money supply in
an economy as well as open up competition and expand business operations. The
interest and fees from loans are a primary source of revenue for many financial
institutions such as banks, as well as some retailers through the use of credit
facilities.

 

There are two
types of loans:

 

1. Prime Loans-

 

Prime is a classification of borrowers,
rates or holdings in the lending market that are considered to be of high
quality. This classification is placed on those borrowers that are deemed to be
the most credit-worthy and the prime rate is the rate that a lender will lend
to its high quality borrowers. Lenders use a credit scoring system to determine
which loans a borrower may qualify. A major variable in this credit scoring
system is a borrower’s FICO score (which may range from 300 to 850). In general
a borrower with a FICO score greater than 620 is considered to be eligible for
a prime loan; however, other variables, such as past payment history,
bankruptcy, foreclosure and the loan-to-value ratio are also considered. Since
a lender’s incentives are not always aligned with a borrower’s incentives, it
is important for consumers to shop for the best loan at the best rate.

 

2. Sub-Prime
Loans-

 

A
subprime loan is a type of loan offered at a rate above prime to individuals
who do not qualify for prime rate loans. Quite often, subprime borrowers are
turned away from traditional lenders because of their low credit ratings or
other factors that suggest they have a reasonable chance of defaulting on the
debt repayment.

 

 

 

2

Subprime loans tend to have a higher
interest rate than the prime rate offered on conventional loans. On large term
loans such as mortgages, the additional percentage points of interest often
translate to tens of tens of thousands of dollars’ worth of additional interest
payments over the life of the loan. However, getting a subprime loan can still
be a good idea if the loan is meant to pay off debts with higher interest
rates, such as credit cards or if the borrower has no other means of obtaining
credit.

 

The specific amount of interest charged on
a subprime loan is not set in stone. Different lenders may not evaluate a
borrower’s risk in the same manner. This means a subprime loan borrower has an
opportunity to save some additional money by shopping around. However, by
definition, all subprime loans have rates higher than the prime rate.

 

Credit Score:

 

A credit score is a statistical number
that depicts a person’s creditworthiness. Lenders use a credit score to
evaluate the probability that a person repays his debts. Companies generate a
credit score for each person with a Social Security number using data from the
person’s previous credit history. A credit score is a three-digit number
ranging from 300 to 850, with 850 as the highest score that a borrower can
achieve. The higher the score, the more financially trustworthy a person is
considered to be.

 

The Fair Isaac Corporation, also known as
FICO, created the standard credit score model for use by financial
institutions, and a FICO score is the most commonly used credit scoring system
as of 2016. There are other providers of credit-scoring systems, such as the
insurance and mortgage industries. Consumers can possess high scores by
maintaining a long history of paying their bills on time and keeping a low
amount of debt.

 

A credit score plays a key role in a
lender’s decision to offer credit. For example, a borrower with a low score
that is under 600 is not eligible to receive a prime mortgage loan and receives
a referral to a subprime lender for a subprime mortgage, which offers a higher
interest rate; however, a borrower with a high score of 700 or above is
creditworthy and is eligible to receive a lower interest rate, which results in
paying less money in interest over the life of the loan. When information is
updated on a borrower’s credit report, the borrower’s credit score changes
based on whether he makes a payment or misses a payment.

 

The five main factors evaluated when
calculating a credit score are payment history, total amount owed, length of
credit history, types of credit and new credit. Payment history counts

 

3

for 35% of a score and shows whether a
person pays his obligations on time. Total amount owed counts for 30% of a
score and shows the number of accounts a person has open and how much money he
owes on each account. Length of credit history counts for 15% of a score and
shows how long a person has had a credit history dating back to the first
account opened.

 

Types of credit used counts for 10% of a
score and shows if a person has a mix of instalment credit, such as car loans
or mortgage loans, and revolving credit, such as a credit cards. New credit
counts for 10% of a score and shows if a person opens multiple new accounts at
the same time.