How Loans Work and How to Borrow Wisely
There's a lot to learn about borrowing, and most of it is here
Borrowing money makes a lot of things possible. For example, if you can’t afford to pay cash for a house, a home loan allows you to buy a home and start building equity. But borrowing can be expensive, and it's important to keep an eye on your loan balances so they don't get out of hand. Before you get a loan, take the time to familiarize yourself with how loans work, how to borrow at the best rates, and how to avoid problems with debt.
How to Borrow Wisely
Loans make the most sense when you make an investment in your future or buy something that you truly need and can’t buy with cash. Some people think in terms of “good debt” and "bad debt," while others see all debt as bad. Everyone's situation is different, and only you know when it makes sense to get a loan and when it doesn't.
In general, it's best to avoid loans that have unreasonable terms and interest rates. Payday loans fall into this category. Some unsecured personal loans, auto loans, and even home loans can fall into this category as well. Look closely at the terms of any loans you're considering. It's also helpful to evaluate your reasons for borrowing money to see if they align with your long-term financial goals.
Here are a few common reasons borrowers take out loans.
- Paying for educational expenses: Government student loans have relatively low interest rates and flexibility with payments. These loans help pay for a degree that can open doors for you professionally. If you're considering student loans, it’s worth comparing how much you plan to borrow with your earning potential.
- Buying a home: A mortgage on a home is often seen as a good use of debt. Still, homeowners are always relieved to make their last mortgage payment. Homeownership allows you to take control of your environment and build equity, but home loans are large loans, so they’re especially risky. As with any loan, it's critical to look carefully at the terms.
- Buying a vehicle: Cars are convenient, if not necessary, in many areas. Unfortunately, it’s easy to overspend on an automobile, and used vehicles often get overlooked as inexpensive options.
- Starting and growing a business: Entrepreneurship can be rewarding, but it’s risky. Many businesses fail within the first few years, but well-researched ventures with a healthy injection of “sweat equity” can be successful.
- There’s a risk and reward trade-off in business, and borrowing money is often part of the deal, but you don’t always need to borrow large amounts.
Loans for Other Uses
Whether or not it makes sense to borrow is something you’ll need to evaluate carefully. In general, borrowing to fund your current expenses—like your housing payment, food, and utility bills—isn't sustainable and should be avoided if possible.
Types of Loans
You can borrow money for a variety of uses. Some loans are designed (and only available) for a particular purpose, while other loans can be used for just about anything.
These are called unsecured because no assets are securing the loan. In other words, if you aren't able to pay the loan, there's nothing that the lender can take back and sell to pay off your loan balance. Because they're riskier to the lender, these loans typically have higher interest rates and are more difficult to get than secured loans. Here are the most common types of unsecured loans:
- Credit cards: Although you might not think of them as a loan, credit cards are actually one of the most popular types of unsecured loans. With a credit card, you get a line of credit that you spend against, and you can repay and borrow repeatedly. Credit cards can be expensive (with high interest rates and annual fees), but short-term “teaser” rates are common.
- Personal loans: These loans are sometimes called signature loans because they are guaranteed only by your signature. You just agree to repay, and you don’t offer any collateral. If you fail to repay, the lender can report your lack of payments to the credit bureaus, which damages your credit, and bring legal action against you (which might eventually lead to garnishing your wages and taking money out of bank accounts).
- Student loans: These loans are generally only available to individuals enrolled in certain education programs, and they can be used for tuition, fees, books and materials, living expenses, and more. The U.S. government provides student loans with borrower-friendly features. Depending on your circumstances, you may be able to balance loans with other types of financial aid that don't need to be repaid. Private lenders also offer student loans, but they may not have the flexibility of federal student loans.
Auto loans are secured loans. If you stop making the required payments on an auto loan, lenders can repossess the vehicle. These loans allow you to make monthly payments on automobiles, RVs, motorcycles, and other vehicles. Typical repayment terms are five years or less.
Mortgages are designed for the large sums needed to buy a home. Standard loans last 15 to 30 years, resulting in relatively low monthly payments. Home loans are typically secured by a lien against the property you’re borrowing for, and lenders can foreclose on that property if you stop making payments.
Most lenders require that business owners personally guarantee loans unless the business has significant assets or a long history of profitability. The U.S. Small Business Administration (SBA) also guarantees loans to encourage banks to lend.
How Loans Work
Loans may seem simple: You borrow money and pay it back later. But you need to understand the mechanics of loans to make smart borrowing decisions. Here's what to look at when you're considering whether to get a loan.
Interest is the price you pay for borrowing money. You might pay additional fees, but the majority of the cost should be interest charges on your loan balance. Lower interest rates are better than high rates, and the annual percentage rate (APR) is one of the best ways to understand your borrowing costs, as it accounts for the interest rate and any fees associated with the loan.
Your monthly payment will depend on the amount you’ve borrowed, your interest rate, and other factors. It will also vary depending on whether you have a revolving loan or an installment loan.
- Revolving loans: Credit cards and other revolving loans have a minimum payment that's calculated based on your account balance and your lender’s requirements. But it’s risky to only pay the minimum because it will take years to eliminate your debt and you’ll pay a significant amount in interest.
- Installment loans: Most auto, home, and student loans get paid down over time with a fixed monthly payment. You can calculate that payment if you know a few details about your loan. A portion of every monthly payment goes towards your loan balance, and another part covers the loan's interest costs. Over time, more and more of each monthly payment is applied to your loan balance.
Usually expressed in months or years, loan length determines how much you’ll pay each month and how much total interest you'll pay. Longer-term loans come with smaller payments, but you’ll pay more interest over the life of that loan. Even if you have a long-term loan, you can pay it off early and save on interest costs.
With many loans, you have to pay some amount upfront. Down payments are standard with home and auto purchases, and they reduce the amount of money you need to borrow. As a result, a down payment can reduce the amount of interest you’ll pay and the size of your monthly payment.
Once you understand how interest is charged and payments are applied to a loan balance, you can make an informed decision about whether to move forward.
How to Get Approved
When you apply for a loan, lenders will evaluate several factors. To ease the process, evaluate those same items yourself before you apply and take steps to improve anything that needs attention.
Credit History and Score
Your credit tells the story of your borrowing history. Lenders look into your past to try to predict whether or not you’ll pay off new loans you’re applying for. To do so, they review information in your credit reports, which you can also see yourself for free. Computers can automate the process by creating a credit score, which is just a numeric score based on the information found in your credit reports. High scores are better than low scores, and a good score makes it more likely that you’ll get approved and get a good rate.
If you have bad credit or you’ve never had the opportunity to establish a credit history, you can build up your credit by borrowing and repaying loans on time.
Ability to Repay
You need income to repay a loan. Most lenders calculate a debt-to-income ratio to see how much of your monthly income goes towards debt repayment. If a large portion of your monthly income gets eaten up by loan payments, they’re less likely to approve your loan. In general, it’s best to keep your total monthly obligations under 43% of your income.
Other factors are also important. For example:
- Collateral: Collateral can help you get approved. To use collateral, you pledge something that the lender can take and sell to satisfy your unpaid debt (assuming you stop making the required payments). As a result, the lender takes less risk and might be more willing to approve your loan.
- Loan-to-value ratios: Lenders also consider the amount you're borrowing compared to the value of your collateral. If you’re borrowing 100% of the purchase price of a home, lenders take more risk—they’ll have to sell the item for top dollar to get their money back. If you make a down payment of 20% or more, the loan is much safer for lenders (partly because you have more "skin in the game").
- Co-signers: Co-signers can improve your application. If you don’t have sufficient credit or income to qualify on your own, you can ask somebody to apply for the loan with you. That person (who should have good credit and enough income to help) promises to repay the loan if you fail to do so. That’s a huge—and risky—favor, so both borrowers and co-signers need to think carefully before moving forward.
Where to Get a Loan
You can borrow from several different sources, and it pays to shop around because interest rates and fees vary from lender to lender. Get quotes from at least three different lenders, and go with the offer that serves you best. You may want to check out:
- Banks: The local bank often comes to mind first, and they might be a great option, but other types of lenders are definitely worth a look. Banks include big household names and community banks with a local focus.
- Credit unions: These are similar to banks, but they are owned by customers instead of investors. The products and services are often virtually the same, and rates are and fees are often better at credit unions (but not always). Credit unions also tend to be smaller than banks, so it may be easier to get a loan officer to personally review your loan application. A personal approach may improve your chances of getting approved.
- Online lenders: You'll find a variety of lenders online. Individuals with extra cash might provide money through peer-to-peer lenders, and non-bank lenders (like large investment funds) also supply funding for loans. These lenders are often competitive, and they might approve your loan based on criteria other than those used by most banks and credit unions.
- Finance companies: Finance companies make loans for everything from mattresses to clothing and electronics. These lenders are often behind store credit cards and "no interest” promotional offers.
- Auto dealers: You don't need to visit a bank for a car loan as many dealers allow you to borrow and buy at the same place. Dealers typically partner with banks, credit unions, or other lenders. Some dealers, especially those selling inexpensive used cars, handle their own financing.
- Mortgage brokers: A mortgage broker arranges home loans and may be able to shop among numerous competitors. Ask your real estate agent for suggestions.
- The federal government: The federal government funds some student loans, and those loan programs might not require credit scores or income to get approved. Private loans are also available from banks and others, but you’ll need to qualify with private lenders.
Costs and Risks of Loans
It’s easy to understand the benefits of a loan. You get the money you need to buy something, and you can pay it over time. To get the full picture, keep the drawbacks of borrowing in mind as you decide how much to borrow (or whether to borrow money at all).
It’s probably no surprise that you’ll need to repay the loan, but it’s challenging to understand what repayment will look like, especially if payments won’t start for several years (as with some student loans). It’s tempting to assume you’ll figure it out when the time comes. It’s never fun to make loan payments, especially when they take up a large part of your monthly income. Even if you borrow wisely with affordable payments, things can change. A job cut or a change in family expenses can leave you regretting the day you got a loan.
When you repay a loan, you repay everything you borrowed—and you pay extra. Interest can be baked into your monthly payment, or it can be a line item on your credit card bill. Either way, interest raises the cost of everything you buy on credit. If you calculate how your loans work, you’ll find out exactly how much interest matters.
Impact on Your Credit
Your credit scores rely on your borrowing history, but there can be too much of a good thing. If you use loans conservatively, you can (and probably will) still have excellent credit scores. If you borrow too much, your credit will eventually suffer. Plus, you increase the risk of defaulting on loans, which will really drag down your scores.
Lack of Flexibility
Money buys options, and getting a loan might open doors for you. At the same time, once you borrow, you’re stuck with a loan that needs to be paid off. Those payments can trap you in a situation or lifestyle that you’d rather get out of, but change isn’t an option until you pay off the debt. For example, if you want to move to a new city or stop working so you can devote time to family or a business, it’s easier when you’re debt-free.
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Consumer Financial Protection Bureau. "What Is the Difference Between a Mortgage Interest Rate and an APR?" Accessed May 10, 2020.
Experian. "Understanding Revolving Credit." Accessed May 10, 2020.
Consumer Financial Protection Bureau. "What Is the Difference Between a Credit Report and a Credit Score?" Accessed May 10, 2020.
Consumer Financial Protection Bureau. "What Is a Debt-to-Income Ratio? Why Is the Debt-to-Income Ratio Important?" Accessed May 10, 2020.
Federal Trade Commission. "Co-Signing a Loan." Accessed May 10, 2020.
MyCreditUnion.gov. "What Is a Credit Union?" Accessed May 10, 2020.