Borrowing money gives you more spending power to buy a car, a house, or to finance a college education.
Borrowing money also puts you in debt which limits your future spending power.
Balancing these two realities can help you maintain a healthy financial life if you’re shopping for a loan.
Table of Contents
- When You Should Get a Loan
- Basic Principles of Borrowing Money
- Interest Rates vs. Principal
- Unsecured vs. Secured Loans
- Down Payments
- Credit Scores
- Debt-to-Income Ratio
- How to Get A Loan
- Getting a Mortgage
- Getting a Car Loan
- Getting Student Loans
- Getting a Home Equity Loan
- Getting Consumer Loans
- How to Get a Personal Loan
- Where to Get a Personal Loan
- Personal Loans from Peer to Peer Lending Networks
- Personal Loans from a Bank or Credit Union
- Balance Transfer or Credit Card Cash Advance
- What About Borrowing Money from Family or Friends?
- Bottom Line: Balance Your Current and Future Needs
When You Should Get a Loan
Some people believe in avoiding debt at all costs. On the surface you can’t really argue with this premise.
Debt can be debilitating, especially high interest credit card debt. When you owe someone a lot of money you no longer have full control over your budget.
In a perfect world, we’d all be debt free. We’d all save up our money for a car. We’d pay off our monthly credit card balances and use our cards only for the rewards.
In reality, most of us will need to borrow money at some point. Learning when to borrow (and when it’s best to find another solution to a problem) can save a lot of money.
Good Reasons to Get a Loan
A loan makes the most sense when the money you borrow can lead to a more stable financial future:
- A Mortgage: The money you’re paying in rent may keep you safe and dry, but it will not benefit your long-term financial health. On the other hand, buying a home turns your monthly housing budget into an investment in your future. A mortgage loan gives you access to hundreds of thousands of dollars to invest in a home.
- An Auto Loan: A car isn’t an investment, but having safe and reliable transportation can improve your job outlook. Most car buyers rely on loans to finance the purchase. Try to keep costs at a minimum when you get an auto loan. And if you can save up money to buy a car, do so.
- Student Loans: Borrowing for college still makes sense, especially if your degree will open up earning opportunities in the future. Avoid borrowing more than you need, though. It’s hard paying off student loans.
- Home Equity Loans: When you already have a mortgage but your home needs updates or repairs, you can get a home equity loan. Equity refers to the portion of your home you’ve already paid off. An equity loan lets you tap into this paid-off value. You should always direct this money back into your home and not into credit card debt or a new car.
Not-So-Good Reasons to Get a Loan
Borrowing makes less sense when you’re using the spending power to fix past mistakes or pay for an unexpected expense. And borrowing can be harmful if you’re using the money to buy things you don’t really need.
At times you may have no other choice, but use these options sparingly:
- Credit Cards: Unless you’re paying off your monthly credit card balances, you’re risking a dangerous cycle of debt using credit cards to make purchases.
- Pay-Day Loans: Someone with a cash flow issue may turn to a payday lender, but the interest rates and late fees can make your financial life miserable. Stay away from these loans.
- Medical Lines of Credit: Many medical providers now encourage their patients to open lines of credit to pay off their account balances. These lines of credit usually offer a low- or no-interest introductory offer, but then higher rates kick in and you could spend years paying off your root canal.
- Fixed Convenience Loans: Your bank or credit union may offer unsecured, fixed loans. While these may be the safest options on this list, you’re still paying borrowing fees that will not likely bring long-term financial gains.
Basic Principles of Borrowing Money
Whether you’re borrowing for a good reason or a not-so-good reason, you can save a ton when you know what you’re doing. Let’s look at some basics:
Interest Rates vs. Principal
Your loan’s principal amount refers to the actual amount you borrow. The interest rate determines how much extra you’ll pay back in borrowing fees. Your interest payments become profit for your lender.
Higher interest rates mean you’re paying more to borrow. Lenders measure interest in percentages rates which fluctuate with the market. You’ll usually pay a lot more interest on an unsecured loan.
Unsecured vs. Secured Loans
A secured loan is connected to a specific item. A car loan, for example, is secured by the car itself. If you take out a car loan but don’t pay it back, the lender will repossess the car to help pay off your debt.
You can borrow money without attaching it to a specific item with an unsecured loan. A credit card or a convenience loan will be unsecured. Because lenders can’t reclaim property, they typically charge a higher interest rate on unsecured loans.
A car or home loan may require a down payment. The bigger your down payment, the less you’ll have to borrow.
With a home loan, putting down more than 20 percent of your new home’s value can keep you from paying Private Mortgage Insurance which protects your lender in case you default.
With a car loan, a healthy down payment can keep you from borrowing more than your car is worth.
Depending on your credit score, lenders decide whether to approve your loan application and how much interest to charge.
Your score reflects your payment history and your current debt load. A higher credit score makes you more eligible for a loan with a more favorable interest rate.
You can increase your credit score by making payments on time and strategically choosing your debt. An app like Credit Sesame, Credit Karma, or Wallet Hub can guide you through this process and track your credit score.
Lenders, especially mortgage companies, may also consider your debt-to-income ratio. This number compares what you owe each month to what you make.
Someone with a large mortgage, two car loans, heavy student loan debt, and several credit cards will have a high debt-to-income ratio.
Lenders may balk at adding more debt to your plate if you have a high debt-to-income ratio — not because they’re concerned about your well-being but because the high ratio indicates you may not be able to repay the loan.
You can decrease your ratio by paying off some loans or finding a way to earn more income.
How to Get A Loan
Here’s a quick recap. When you’re thinking about borrowing money, you should:
- Borrow for a good reason: Borrowing to create a more stable future makes the most sense.
- Borrow just what you need: Any borrowing is risky. Over-borrowing is even riskier.
- Look for the best terms: Lower interest rates mean you’re paying less to borrow.
We haven’t discussed how and where to get a loan. Consumers have a lot of options available for just about any kind of borrowing.
Getting a Mortgage
Online mortgage brokers like Rocket Mortgage and PrimeLending make the mortgage process easier for many borrowers. These brokers’ intuitive apps and web sites guide you through the process from beginning to end.
You can also ask your neighborhood bank about mortgage lending. Your bank may not be as technologically advanced as the nation’s leading online brokers, but you may benefit from an in-person relationship with a loan officer.
If you’re using a local bank or credit union, make sure it can offer the kind of loan you need:
- Federally Subsidized Loans: The federal government helps people get mortgages every day. Programs such as VA loans for veterans, USDA loans for people in rural areas, and FHA loans for lower-income buyers work with your lender to get better loan terms. This process makes home buying more accessible by lowering down payments and credit score requirements. Your lender must be authorized to issue subsidized mortgages.
- Conventional Loans: Buyers who don’t qualify or prefer to avoid government red tape can opt for a conventional mortgage. Banks usually require a down payment between 3 and 10 percent and higher credit scores for conventional borrowers.
- Fixed Rate or Adjustable Rate: Most mortgage loans have a fixed interest rate for the duration of the loan. But you can get an adjustable interest rate, too. After an introductory period at a fixed rate, your interest rate will change with the market. Borrowers hoping to re-sell a home within the first couple of years can save with an adjustable-rate mortgage (ARM).
- Jumbo Mortgage: If you’re buying a house that costs more than $484,350, you may need a jumbo mortgage. (This figure changes every year, and it’s even higher in some high-value markets such as New York City and San Francisco.)
Here’s how the mortgage process usually works:
Pre-approval: With many lenders, you can get pre-approved for your mortgage which will help you define a price range as you shop for a home.
Home shopping: Once you’ve found a home and entered into a contract to buy it, you’ll need to start finalizing your mortgage by documenting your income and going through the underwriting process.
Closing: After you close on your new home, you’ll start making monthly mortgage payments, including premiums for your homeowner’s insurance coverage and payments toward your local property taxes.
Repayment: Depending on the length of your loan, you could have the mortgage paid off in 10, 12, 20, or 30 years. Some lenders offer additional term lengths. Your interest rate will help determine your payment amount, and so will your loans’ term: a longer term gives your bank more time to charge you interest, which means you’ll pay more.
Getting a Car Loan
Arranging your car financing before choosing a car can save money and give you more control over the process.
Online services like CapitalOne Auto Finance, Lending Tree, and Credit Karma offer great options for auto financing. Your local bank or credit union can usually help, too.
Like with a mortgage, your interest rate and the length of your loan will influence your monthly payment and the total amount you’ll pay over the life of the loan.
It’s a good idea to put down some amount — ideally 10 percent at least — as a down payment. Otherwise, you may owe more on the car than it’s worth, meaning you’d have a harder time selling it if needed.
Getting Student Loans
Your university’s financial aid office can help facilitate loans through the federal government or your state government. You can also seek private student loans online and in person from many banks.
Public student loans, also referred to as federal student loans, usually offer better terms for most students. If you reach your borrowing limit and still need money to cover living expenses, a private student loan may help.
Or, if you’re going back for a second degree or a terminal degree which costs significantly more, you may need private loans to help cover your costs.
For the sake of your long-term future, try not to borrow more than you need. When you’re young it may feel like nothing matters beyond covering your costs this semester. But your future self will thank you for keeping your borrowing under control.
Getting a Home Equity Loan
Home equity loans work a lot like mortgages. You can find several options for financing home repairs or refinancing your entire loan with more favorable terms:
- A Second Mortgage: Most mortgage brokers, both online and in person, offer second mortgages. With these loans, you’d be borrowing against the part of your house you’ve already paid off. With the borrowed money you could improve your property as needed and then repay the loan over time. You’d still have your original mortgage payment plus a second payment on the new loan.
- An Equity Line of Credit: This option also allows you to tap into your home’s equity for repairs and updates, but you wouldn’t be taking out a fixed loan. Instead, you’d have the ability to spend money as needed, up to a limit, on your home. Repaying the loan would work like a credit card — a revolving loan with a minimum monthly payment. Paying down the balance quickly will save on interest charges.
- A Cash-Out Refinance: When you refinance your entire mortgage loan, you’re getting a new loan to pay off the original loan. If you’ve already built up equity in the home, you can also cash out the equity with the same loan. Essentially you’d be starting over paying off the house. This can be a good option if you can get a significantly lower interest rate or better borrowing terms on the new loan.
Regardless of your option, you should shop around for the best terms and be sure you’re using the money you borrow to increase the value of your home. Otherwise, you’re undermining your home’s value as a long-term investment.
Getting Consumer Loans
Consumer loans cost more, whether you’re using credit cards or taking out a fixed but unsecured convenience loan.
It’s best to avoid this kind of borrowing if possible, but if you do need a consumer loan to cover unexpected expenses or soothe a cash flow problem, try to find the best borrowing terms:
- Credit Cards: Traditional banks and credit unions often have a lower-interest option on credit cards, especially when compared with random offers you get in the mail. Credit card interest can approach 30 percent. If you have good credit, you can find a card with a much lower rate.
- Convenience Loans: These fixed-rate loans provide better terms in most cases. Since the loans have fixed amounts and payments, you’re less likely to get in over your head.
- Payday Lending and Title Loans: These lenders prey on consumers who either don’t understand the borrowing process. Stay away from these kinds of loans.
- Medical Borrowing: These loan programs can be helpful if you don’t have insurance and need an emergency dental procedure you can’t afford. Pay them off quickly, though, because you’ll usually face exorbitant terms after the promotional interest rate expires.
How to Get a Personal Loan
Buying a car isn’t the only reason you may need a personal loan. It could be when something unexpected occurs, for convenience, r for many other reasons. Other reasons could be home repair loans, student loans, medical bills, consolidating high interest debt, starting a business, or just getting by when times are tough.
A personal loan usually requires a credit application where the lender will look up your credit score, credit history, employment, or other factors.
Where to Get a Personal Loan
There are many places to get personal loans, but they aren’t all created equally. Before applying for a signature loan, be sure to investigate the company’s reputation, interest rates, fixed or variable interest rates, prepayment penalties, minimum loan payments, loan requirements, whether or not the lender requires collateral, or other factors that may affect the loan. The following are options for obtaining a personal loan.
Personal Loans from Peer to Peer Lending Networks
The premier peer-to-peer lending companies on the market are Lending Club and Prosper. P2P lending is where individuals apply for loans that are funded by a community of investors – people like you and I can purchase part of the loan, usually in $25-$50 increments. The borrower’s benefit is interest rates typically the lowest they can find for a similar loan. The only downfall is that good credit is a requirement.
Personal Loans from a Bank or Credit Union
The bank and credit unions are probably the first place most people will choose to visit. They are community lenders and the financial institutions most people are familiar with. Banks and credit unions will probably require more paperwork and time to approve a loan than a P2P lending company, and the interest rates may be higher. But you also have the added advantage of dealing with a person and company you deal with regularly.
Balance Transfer or Credit Card Cash Advance
There are two reasons why people would consider using a credit card for a large loan: to consolidate debt, or to make new purchases. Using a credit card to consolidate debt is a great idea if you can transfer your high credit cared balance to a 0% balance transfer card. Reducing a high interest credit card rate to a 0% rate can save you hundreds or thousands of dollars.
I don’t like the idea of using credit cards for cash advances or major purchases, but I understand that it may be unavoidable for some people. If you take out a cash advance from a credit card, be sure to investigate any fees, minimums or other possible expenses.
Another preferred option is to apply for a 0% APR credit card that offers 0% interest on purchases for an introductory period. Only use credit cards as a last resort if you have a plan to repay the loan in a short period.
What About Borrowing Money from Family or Friends?
I left family and friends near the end because there are many issues involved when it comes to borrowing money from people you know well. My suggestion is to do one of two things if you are borrowing money from a family member or friend, or loaning money to a family member/friend: put everything on paper into a legal document so there are no misunderstandings and both parties are aware of the legal consequences of the loan, or simply only lend money that you can afford to lose and be prepared to consider it a gift if the other party does not repay. Personal debt collection is not a fun task and can ruin relationships if you are not careful.
Bottom Line: Balance Your Current and Future Needs
Borrowing money has its place in a responsible financial life. A mortgage loan, in particular, can give you more power to create future financial stability.
With other kinds of loans, be sure to shop around for the best terms you can find and then get out of debt as quickly as possible.
Owing money to someone else limits your ability to save for the future, invest for retirement, and control your financial life.