Photo: David M. Goehring

I posted a question on my Twitter account a few weeks ago and I was pleasantly surprised to get dozens of answers to my impromptu credit quiz. In fact, I got so many that I decided to fashion it into an article and hopefully prompt some more discussion on the matter. Here’s the pop quiz…

“Name an installment loan (fixed payments for a fixed period of time) where you DON’T own the asset when you’re done making payments.”

Here are the top five answers I received, in order of frequency;

1. Student Loans

I was surprised to see this as the number one answer, but not that surprised. The topic of whether or not to borrow a lot of money to go to college, thus incurring installment debt, is a lightening rod, to say the least. Here’s an article I wrote for Mint last year where I blasted the idea of taking on a lot of student loan debt for the sake of going to an expensive school. And, in turn, got blasted back by about a fourth of the 130 comments that were posted.

I don’t think you can say that an education and a degree aren’t assets. But, I do think you have to consider the “I didn’t got to college and I’m still successful” argument, which is possibly why so many people think student loans don’t yield any sort of asset. In the strictest definition of an installment loan, an education isn’t tangible and it doesn’t secure any sort of loan obligation. I mean, a lender can’t repossess your knowledge for non-payment. Semantics, I know.

2. Auto Leases

Now we’re talking. Borrowing money to buy a car is one of the worst investments you can make because of the quickly depreciating value of the asset. But, at the very least you’ll own the car after 36, 48 or 60 months of payments. With a lease you’re essentially renting a car for some fixed period of time.

Even when you’re done making lease payments you don’t own a thing. In fact, in many cases you’ll owe still more at the end of the lease because of mileage that exceeds the maximum contractual allotment. If you like a new car every few years then leasing is a good option but you’ll be making car payments perpetually. If you want to drive something supercool every once in a while then call HERTZ instead. You can give it back at the end of the weekend.

3. Rent

Correct. You own nothing after satisfying your rental agreement, which is technically an installment agreement. The tenant gets a place to live (the “extension of credit”) and makes an equal payment to the landlord (the “creditor”) for a fixed number of months per contract (the “loan term”).

Don’t get me wrong; there are tens of millions of homeowners who would rather be home-renters right now because they’re upside down on the home loans. That’s a familiar position to be in with auto loans, but not mortgages. Tax deduction notwithstanding, renting ain’t a bad deal right now.

4. Title Loans

Good one. You know what these are, right? You take your car title (yes, you have to have clear title in hand) to this vulture of a lender who then gladly let’s you borrow about 50% of your car’s appraised value and expects you to smile about it while he hopes you default.  You make payments of some amount over some period of time and you get your title back.  I fully agree that a car’s title is a tangible asset, but you’ve already earned it by paying off another loan.  Buying it back again…not so much.

5. P2P Lending

Yes, and no. P2P loans (peer-to-peer) occur when you borrow money from another person or group of people who act as the “lender” in the transaction and cobble together the funds to lend. There are several sites that facilitate P2P loans but since I’m not a fan of them I’ll let you find them on your own.

Peer-to-peer loans are, in fact, installment loans and some of them are attached to an asset. Some P2P loans are taken out to pay for orthodontic work, business equipment and yes, even plastic surgery. Still, just as many are taken out to pay for vacations and other non-tangible items. Regardless, defaulting on a P2P loan won’t result in the consumers/lenders showing up at your door. I think that’s a contributing reason for their high default rate … it’s hard to think about Joe the Consumer Lender like you think about Wells Fargo or Citibank.

What about plastic?

I’m a little surprised, and worried, that nobody listed credit card debt as not being tied to an asset. Have you ever heard of a credit card issuer repossessing clothing, vacations, dinner out, or anything else charged on a credit card?

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. Follow him on Twitter here.

How familiar are you with Regulation B of the Equal Credit Opportunity Act? Wait, wait! Don’t stop reading because I threw out an unfamiliar legal reference. What I’m about to tell you will change how you think about applying for credit, forever.

When you walk into a financial institution and apply for some sort of credit, you have to fill out an application. That application contains language giving the lender permission to pull your credit reports and scores. This gives them what’s referred to in the Fair Credit Reporting Act (FCRA) as Permissible Purpose to get your credit data.

The lender pulls your credit reports and scores. Then they use that information to determine if they want to approve your application and under what terms. If they approve you, you’re welcomed into the family.

If, however, they deny your application, you’re sent on your merry way empty handed and a week or so later you get the rejection letter in the mail. That letter is called a “Notice of Adverse Action” and it provides you with notice of your right to get a free copy of the credit report the lender used to reject your application (after July 22 that notice will also include the score they used to deny you). You can either claim your free credit report, or you can do what most people do, which is nothing.

What I just described happens tens of thousands of times every single day. It has become the typical process of applying for credit. In fact, it has become so common that almost nobody knows that we, the applicants, actually are forgoing a very significant right.

Shoebox Credit

Let’s go back to Regulation B of the ECOA. Reg B requires that creditors, when evaluating the creditworthiness of an applicant, consider ANY information an applicant presents that reflects the applicant’s creditworthiness. Further, at the APPLICANT’S request (that’s you) creditors MUST consider credit information not reported through a credit bureau if it’s a similar type of credit account that they would consider if it were to be reported through a credit bureau.

That was confusing, I know. Here’s the low down: if you walk into a bank and apply for a loan and you hand the lender a shoebox full of receipts proving that you pay rent, cable, cell phone, insurance, electric power, natural gas, or any other credit obligation they MUST consider it per ECOA Reg B. What does that mean to you? It means you better go find a shoebox.

Don’t feel bad if you didn’t know all of this. Almost nobody knows their rights under Reg B. In fact, so few people know it that the National Credit Reporting Association says that they believe “ECOA Reg B has been conveniently forgotten by both the industry and the regulators at a cost to many credit challenged consumers.”

“ECOA Reg B provides every American with the Federally protected right to build a credit history and credit score simply by paying everyday accounts on time, such as cell phone bills, rent and utilities,” says Michael Nathans, President of Trycera Financial Credit Services. “A large segment of the population doesn’t receive the most favorable rates or offers because they either don’t have credit scores or their credit scores are too low. Having even one or two ECOA-qualified credit accounts added to your traditional credit reports and scores could change you from a denial to an approval, and save you thousands of dollars on an auto loan, for example.”

The bottom line? The next time you walk into a bank, bring your cable bills and cancelled checks in a shoebox. Hand them to the loan officer and tell them you’re choosing to leverage your rights under ECOA Reg B and you want them to consider your cable payment history. They’ll look at you like you’re crazy, but if they give the box back without considering the paperwork, they’ll be violating Federal law.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit.

Photo: quaziefoto

With faith in banks and credit card companies on the decline, more consumers are turning to social lending as an alternative to existing financial institutions for their borrowing needs. The worst offenders, credit card companies, have been lowering credit limits and increasing penalty fees and interest rates on even their most loyal customers. For this reason, frustrated credit card holders comprise one of the largest sectors looking into lending sites to refinance credit card debt. With interest rates as low as 7.8% at some social lending sites, 10% to 15% less than credit card companies and banks, consumers are giving this option a hard look.

One reason lending communities can offer such low interest rates, is because they operate only online. The higher overhead and operating costs associated with brick and mortar facilities are not there. These savings are then transferred to both lenders and borrowers in the form of lower service fees and higher returns.

Lending Club, one of the most popular person-to-person (P2P) lending sites, facilitates the selling of loans in the form of unsecured notes registered with the Securities Exchange Commission. The loans can be used for funding many of life’s necessities such as a baby on the way, buying a car, purchasing a home, paying off student loans or to cover medical bills. The site has become increasingly popular since 2007, mostly due to both the lending options it offers borrowers with various credit backgrounds and the investing opportunities it offers lenders.

Advantages

Borrowers who might not be able to get a loan through a bank because of a spotty credit history may have a better chance of getting one through a lending site, although it will cost more in terms of a higher interest. Sites like Lending Club offer a range of possibilities for consumers with varying credit scores. Those who have a good credit score can expect to pay around 7.89% per loan. Borrowers on the other end of the spectrum can pay as much as 21%. All loans have 3-year terms. Borrowers can take out from $1,000 to $25,000 for higher credit worthy customers.

Investors who want to gain a higher return than a CD or a stock can earn on average 9.64% in annualized returns on these P2P loans. A service charge of 1% however, will be subtracted from the interest gained on the loan, reducing the note yield. According to Lending Club, if an investor purchases 50 notes each with an original principal amount of $200 and an interest of 8%, assuming all loans perform till term of 12 months without defaulting, the investor will get a net annualized return of 7.8%.

Fees imposed on borrowers for use of this service range from 1.25% to 3.75% of the loan amount depending on the borrowers creditworthiness. A loan grade based on credit history information provided by a consumer-reporting agency is applied to each borrower. The loan grade is then used to determine how much processing fees a borrower will be responsible for and how much interest they will pay on their loan. Collection fees are steep for borrowers who don’t pay back on time. Late payment fees start at 30% of a member loan if a borrower pays less than 60 – 90 days past due.

The way that interest rates are set is different among sites. Prosper.com for example, uses a bidding system where both parties determine the interest rate. Borrowers post the highest interest rate they are willing to pay for a loan and lenders post the lowest rate they will accept. When both lender and borrower concur on an interest rate, an agreement between the two is formed. According to Tiffany Fox, Communications Director at Prosper, the average estimated lender yield is 14.85%, average estimated loss rate (default) is 5.47% and average estimated lender return is 9.38%. Other sites are Loanio, Fynanz Inc. and Zopa.com.

Requirements

Borrowers looking for a loan need to meet certain requirements before applying. For sites like Lending Club, a borrower must be a US resident, have a FICO score minimum requirement of 660 and a debt to income ratio (excluding mortgage) below 25%. Also, they must make available three years of credit history showing no delinquencies and no bankruptcies for the past 7 years, in addition to showing no more than 10 inquiries on the credit report for the past six months and a revolving credit utilization of less than 100%.

Lenders also have certain criteria to meet. As stated in their website, Lending Club lenders are required to be a resident of the states listed on their site, they must have an annual gross income of at least $70,000 and a net worth of at least $70,000 excluding home, home furnishings and automobiles or have a net worth of at least $250,000 with the same exclusions. Residents of California need to have an annual gross income of at least $100,000 and a net worth of $100,000 with the same exclusions or a net worth of at least $250,000. The site restricts individual lenders from making loans of more than 10% of their net worth.
What happens if a borrower doesn’t pay back the loan?

For investors, lending to borrowers through these sites provides a good opportunity for those looking for a moderately high return, but it does come with risk. Investors might lose part or all their money if a borrower defaults on the loan. In cases of default, the lending company will try and recoup some of the money but there is no guarantee they will get it back. Some lending sites will work out a new payment plan with borrowers or in more severe cases; send the loan to a bill collector.

There is also the risk of lack of transparency. Some borrowers might not be completely forthright, holding back certain facts about their credit history if this will diminish their chances of obtaining a loan. Lending sites try to obtain as much background financial information possible but there is no check system in place to completely prove the validity of information provided by borrowers. However, interested lenders can directly ask borrowers questions through the site. Some questions might be about their background, employer, why they are requesting a loan and with what income they plan to pay the loan back.

Investors can also spread the risk by obtaining a variety of loan notes rather than focusing on one loan from an individual borrower. For example, since the minimum note size is $25 for most sites, an investor can loan out $100 in $25 notes to 4 different borrowers as a way of increasing risk diversification. Funding several borrower accounts instead of one will enable a lender to considerably decrease their default exposure.

Lending sites might be the answer to those looking to borrow money or invest some funds. For investors, it’s important to look carefully at how each site determines the interest rates for the loans and what fees they will charge. Fees can cut into the yield of a loan’s return. Also, invest only funds you can do without if you lose all of it, remember this is a numbers game.

These loans come in many varieties. Some have very attractive provisions and guarantees, but others can spell trouble for even the most responsible young adults.

The cream of the crop
The federal government provides the best student loans. The most common form of federal loan is the Stafford loan, which supplies money either directly from the federal government, or through a private lender.

The primary benefit of Stafford loans is that their costs and interest rates are regulated by law. That means that the fees you’ll pay when you first get a loan — including origination and default fees — can’t be more than a certain amount, recently around 2.5%. New loans also carry fixed interest rates that are usually pretty attractive.

In addition, some Stafford loans are subsidized by the government, meaning that the government pays the interest while the student is in school. In contrast, on an unsubsidized loan, interest accumulates while the student is enrolled, resulting in higher payments once loan repayment begins.

Another federal loan is called the Perkins loan. Reserved for students who have the greatest need, Perkins loans have no origination fee and an even lower fixed interest rate.

Many parents are also eligible for federal loans for their kids’ education. Known as PLUS loans, these generally have somewhat higher rates and fees than Stafford and Perkins loans.

The bottom of the barrel
At the other end of the spectrum are so-called private student loans. Students can get these loans from a variety of private lenders. Large banks usually offer them, and there are also specialty lenders that focus on student loans.

Unlike federal loans, terms on private loans vary widely. Some lenders offer rates below their prime lending rates; others have rates that go into the high teens. Origination fees also come in a wide range, with some lenders charging as much as 12% just to take out a loan.

Your best strategy
It’s important to get the best loan deal you can. With college costs rising far faster than inflation, students can take on tens or even hundreds of thousands of dollars in debt while they earn their degrees.

And it’s difficult to fix the credit problems that can result from taking on too much debt. Because of changes to bankruptcy laws, it can be incredibly difficult to get rid of student loan debt — even when you have a good reason. The consequence of these changes is that students and parents must be just as careful when considering student loans as they would be with credit cards or any other type of debt.

It’s most important to understand which kind of loan you have — the same lenders offer several types of loans, so it’s easy to get confused. Federal loans tend to offer better terms than private loans.

In addition, thinking about college as an investment may make it easier to weigh the costs involved with education. A college education increases earning power, but a more expensive, big-name school may not enhance a student’s prospects enough to justify the pressure of higher debt. A less expensive school may supply the flexibility to pursue the same wide variety of career options, and perhaps the same opportunities, after graduation.

Whatever you decide, student loans can be a valuable tool to get your degree. If you avoid the pitfalls along the way, a student loan may be the right decision on your path to success.