Money can solve a lot of problems, and sometimes it makes sense to borrow money for things that will improve your life over the long term. But money can also cause problems—especially if you owe a lot and your debt is spiraling out of control. So how can you borrow money wisely?
Make Sure It Makes Sense
The first step is to make sure that borrowing is actually the right choice. If you’ve heard of “good debt” and “bad debt” you’re familiar with the concept: good debt pays for things that provide long-term value and possibly even gain value over time. Bad debt pays for current consumption, assets that depreciate in value too fast like new cars, or risky assets, or investments that might lose their full value or not generate enough to cover the principal and the cost of debt.
Examples of good debt include:
- A college degree, since people with a degree will tend to earn more over their lifetimes (and they have more career choices)
- The purchase of an affordable home—if all goes well—since it can provide long-term financial benefits and control over your environment (you might even get to sell it at a profit someday)
Examples of bad debt include:
- Buying an expensive car, because it will lose value immediately, and continue to lose value over time (you might even owe more than the car is worth)
- Paying bills such as cable, phone bills, and entertainment expenses, since there’s no way you can keep borrowing to cover basic expenses—it’ll all come to an ugly end someday
Before you borrow, evaluate how long the debt will last and how much it will cost in total—adding principal and interest—compared to how long the benefits will last, and to what amounts they will rise or fall. If it’s not an investment in your future, look at other ways to fund the need.
Run Some Numbers
It’s important to pay the right price for anything you buy. For example, when shopping for a car, some salesmen try to shift the focus to your monthly payment instead of the purchase price–which can work out badly for you.
But your monthly payments and the terms of your loan are still important. Look at your income and expenses and figure out how much you can comfortably afford to pay for your new loan.
If the payments will be a burden, either pick something less expensive or make a larger down payment so that you’ve got more wiggle room if you fall on hard times.
To see how much you might need to pay on your debt, run some numbers. You can do all of the calculations yourself or use computers and online calculators to make the job easier:
- Use a calculator (see ours below) for fixed-rate loans (standard home, auto, and personal loans that you pay down over time)
- See how your credit card payments would look if you borrow with a credit card
Of course, you can almost always pay off your debts early by making additional payments.
Here’s the tricky part of running the numbers: you need to predict the future. You might want to borrow money again someday (if you’re buying a house now, you might want to get a car loan in five years)—and your monthly payments on today’s loan will hurt your ability to borrow tomorrow. Lenders want to see a reasonable debt to income ratio, and you simply might not be able to afford additional payments. If you use a calculator that tells you “how much house you can afford” (or similar), be conservative and don’t borrow the full amount available.
What’s more, you can’t predict if you (or your spouse, if you’re married) will lose your job. Borrowing at a level that’s “comfortable” protects you. For example, you might buy things that don’t require you to make sacrifices—because you’ll really need to make sacrifices if your income changes. If you buy a house that you can afford on your own income alone (or your partner’s), it’s not as disastrous if somebody gets laid off or quits.
Get the Right Loan
Match your loan to your needs. In some cases, that’s more or less automatic: if you’re buying a home you’ll probably only qualify for home loans (such as 15 or 30 year fixed rate mortgages). But it’s easy to find mismatches. For example, it’s risky to use a home equity line of credit to fund a business (but it could pay off—who knows?). If the business fails, as many do, you’re putting your home at risk of foreclosure if you don’t have a way to pay off the home loan.
It’s safer to use unsecured personal loans. If you don’t pledge any collateral, there’s nothing for lenders to take. Of course, if you default on a loan, your credit will suffer and you can eventually end up with legal troubles, but you won’t easily be forced out of your home (or have your car repossessed in the middle of the night).
Loans that you pay off monthly—also known as installment loans—are generally your best option. Loans that have to be repaid every week or at the end of the month are frequently very expensive loans, reserved for borrowers in desperate situations. Those loans are advertised at payday loan and money transfer shops, and will likely turn into very expensive mistakes.
How to Get Monthly Installment Loans
A decent loan has regular monthly payments that reduce your debt over time. Where can you find these loans? Look at small institutions (which are more likely to work with you if you have bad credit or you have not yet established credit) and look online:
- Local banks and credit unions—institutions with a community focus are your best bet
- Peer-to-peer lenders that allow individuals to fund your loan
- Other online non-bank lenders (which might fund your loan from a variety of sources)
Borrowing Money With Bad Credit
If you have bad credit, it’s harder to get approved. Any loans you get will have higher interest rates, which means you’ll effectively pay more for whatever you’re buying. How can you improve your chances of borrowing money with bad credit?
Build (Or Rebuild) Your Credit
If you borrow money and repay on time, your credit will improve. You might not be able to get approved for the loan you want today, but over time you can get your credit to a better place. See how to establish and improve your credit, and try small cash secured loan to get things started. Get to know your credit by checking your credit reports (for free) at least once per year, and learn how credit scores work so you understand what lenders are looking at.
If you have assets that you can borrow against, that’s always an option. But you need to realistically examine the risk–what happens if your asset (typically your car or your house) gets taken away because you can’t make payments. Will you have a place to live? Will you be able to get to work and earn an income? Will your family or anybody else suffer?
Help From Friends and Family
If professional lenders aren’t willing to approve your loan, you might be tempted to get some help from family or friends. While it may seem like they have plenty of extra money, it’s worth doing things on your own if possible. Their money might be earmarked for important goals like retirement or health care, and your friends and family might not be in the position to take a risk on lending money. Sure, you intend to repay, but life throws curveballs sometimes—what if you’re injured or killed in a car accident?
Borrowing money directly from your acquaintances can be awkward (although it helps to have a detailed conversation about expectations get everything in writing). Things might change in your relationship. If somebody is really willing and able to take the risk of helping you, consider using them as a cosigner for your loan.
A cosigner applies for the loan with you, and that person is also responsible for repaying the loan (if you can’t repay, whether you’ve run out of money, decided to spend the money elsewhere, or passed away, the cosigner will be on the hook for your debt). If you can find somebody with good credit and enough income to help you qualify.
To get a loan, you'll need to apply with lenders. It's a good idea to shop among several lenders. Costs and terms vary, and you can certainly save money by comparing offers (comparing three lenders is probably sufficient). Do all of your shopping within 30 days or less to minimize damage to your credit—if you keep applying for loans it can look like you're in financial trouble (and you'd be unable to repay).
Once you get approved, be sure to make your payments on time. Set up automatic electronic payments (unless you have a good reason not to) so that you don't miss payments.