Getting a loan or obtaining new credit when you’re already in debt isn’t easy – especially if your credit rating has suffered for any reason in the recent past.
But it is possible to obtain credit – either a personal loan, a credit card or even larger loans like a mortgage – if you know all your options and you understand some key financial terms related to credit and debt.
You might have heard of some of these financial terms before; but others may be new to you.
Either way, it’s important to fully comprehend the financial lingo that lenders are using, or that debt specialists may suggest, when they talk to you about becoming debt free.
So here are 5 financial terms you must know if you’re in debt and need a loan or credit, or you just want to get rid of your debts once and for all.
Secured Card or Secured Credit Card
Some people deep in debt have been through the financial ringer and have poor credit as a result. Maybe your excessive debt problems have caused you to have late payments, collection accounts, charge-offs, or even more serious credit issues like foreclosure or bankruptcy – and now you’re trying to rebuild your credit rating. If so, someone may have offered you a secured credit card.
Unlike a debit card, a secured credit card can be used to re-establish your credit track record, as long as the bank or creditor issuing the secured card actually reports the account to one of the credit bureaus: Equifax, TransUnion or Experian.
Here’s how a secured card works: You put up a specific amount of money with a bank, say $500 or maybe even as much as $1,000. Whatever amount you set aside with the bank becomes your credit limit. Then you use the secured card, which often carries a Visa or MasterCard logo, just like you would use any other type of unsecured card.
By charging on the card monthly and paying the bill on time, even someone in debt or an individual with past credit problems can begin to restore his or her credit rating.
Are you looking for a mortgage or a car loan? If so, be prepared for a lender to pull your credit report and calculate your debt-to-income ratio.
Your debt-to-income ratio, or DTI, as some lenders call it for short, is expressed as a percentage of your monthly bills compared to your monthly income. Some lenders will compare your monthly obligations to your net, or take home pay. Others will look at your bills in comparison to your gross income (i.e., your salary before taxes and other payroll deductions are taken out of your check).
Here’s a quick example of how to calculate your DTI.
Let’s say you want to buy or refinance a house. Lenders will figure out both a “front-end” debt-to-income ratio, and a “back end” debt-to-income ratio.
Your front-end DTI is comprised of only your housing related costs: that is, your principal, interest, taxes and insurance.
Assume your housing costs are $2,500 and your income is $6,000. Then your front-end housing ratio, or your front-end DTI, is 42%, since $2,500 divided by $6,000 = 41.66%.
If you wanted to get your front-end debt-to-income ratio to 33%, you’d need to lower your monthly housing debt to $2,000 per month, since 2,000 divided by $6,000 = 33%.
Your back-end debt-to income ratio measures ALL of your debts (housing plus other credit obligations) and then sees how affordable they are compared to your income.
So let’s now assume that your housing costs, your credit card bills, your auto loan and your student loan payments all total $3,400 per month. If your income is $6,000 per month, your back-end debt-to-income ratio is 57% because 3,400 divided by $6,000 = 56.66%
Many home lenders will balk at approving your loan under this circumstance because they often have guidelines limiting how much debt you can have. Most banks will want your total, or back-end, DTI to be in the 36% to 45% range. Some lenders will permit loans if a borrower has a debt-to-income ratio as high as 50%, but that’s the exception rather than the rule.
Peer-to-peer lending has grown tremendously over the past five years in America. A peer to peer loan is one where you bypass a traditional bank and instead rely on “social lending” in order to get money you need.
With peer-to-peer loans, an individual or a group of individuals provide the loan you need. Increasingly, institutional investors and corporations are functioning as lenders in the peer-to-peer lending universe as well.
Loans can range from a couple hundred dollars to several thousand. Many people get P2P loans, as they’re known, in order to pay off credit card debt. But borrowers also tap P2P lenders for a variety of reasons, like obtaining money to start a business, pay medical bills or even cover wedding expenses.
Examples of peer-to-peer lending companies include LendingClub.com and Prosper.com.
Debt settlement is a process of settling your debt for less than you owed to a creditor. When you hire a debt settlement company, they advise you to stop paying your bills for several months in order to “save up” the money with the goal of letting the debt settlement firm later try to negotiate a cash, lump settlement with your creditors.
Debt settlement specialists may try to get a “deal” for you where your creditor will accept anywhere from 10 cents to perhaps as much as 50 to 75 cents on the dollar for what you owed.
Unfortunately, during the period when you’re not paying your bills, your creditors are reporting your accounts as late to the credit bureaus. Those delinquencies wreak havoc on your credit score.
It’s also a crapshoot as to whether or not debt settlement will work at all, since some creditors may refuse to negotiate and will, instead, just pursue collections activity against you.
What’s more, there is one other thing that many debt settlement companies don’t mention to consumers: the tax bill you’ll later face. Let’s say you have a $5,000 debt that is settled for just $1,000. You might think: ‘Great, I saved $4,000!’
Well, not so fast.
The IRS considers that $4,000 “saved” to be “loan forgiveness.” As a result, your creditor will send you a 1099 Miscellaneous Income form, and then the $4,000 is taxable income to you.
Because debt settlement further damages your credit, often involves paying high fees to a debt settlement company, and can leave you with a monster tax bill at the end, I don’t recommend using debt settlement to get out of debt.
There is a process to consolidate your unsecured debts, like credit card bills, and make one payment to all your creditors – and that’s by entering a DMP or a Debt Management Program.
Don’t confuse debt management with debt settlement. They are two totally different things.
With debt management, you do pay all your bills that you owe. But you’re able to get out of debt much faster because a debt management company, or a credit counseling agency, will pre-negotiate lower interest rates on your behalf.
So instead of you paying higher interest rates to a credit card company, a debt management firm may get your interest rates down to 0% or in the low single digits.
Furthermore, debt management doesn’t hurt your credit rating.
Hopefully, now that you know these five key financial terms, you’ll be better prepared to secure credit or a loan you may need, or to simply get out of debt a lot faster.