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 can even ruin your finances. Before you get a loan, get familiar with how loans work, how to borrow at the best rates, and how to avoid problems.
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. It’s easy to identify bad debt (expensive payday loans or a vacation funded entirely on a credit card), but good debt is more complicated.
We’ll describe the mechanics of loans below. Before you get into the nuts and bolts, it’s important to evaluate exactly why you’re borrowing.
This is usually an example of good debt: You’ll pay for degrees and skills that open doors for you professionally and provide income. This is mostly accurate, but everything is best in moderation. As student loan defaults reach all-time highs, it’s worth evaluating how much you pay against the potential payoff. Choose your field of study wisely and keep borrowing to a minimum.
A mortgage on a home is also seen as a good use of debt. Still, home loans were responsible for the mortgage crisis of 2008, and homeowners are always relieved to make their last mortgage payment. Home ownership allows you to take control of your environment and build equity, but home loans are large loans—so they’re especially risky.
Cars are convenient, if not necessary, in many areas. Most workers need to physically go somewhere to earn a living, and public transportation might not be an option where you live. 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. About half of new 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—is not sustainable and should be avoided.
Where to Get a Loan
You can probably borrow from several different sources, and it pays to shop around because interest rates and fees vary from lender to lender. Get quotes from three different lenders, and go with the offer that serves you best.
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.
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 improves your chances of getting approved when there are irregularities that are too complicated for automated programs to deal with.
Funds for online loans come from a variety of sources. 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 different criteria than those used by most banks and credit unions.
A mortgage broker arranges home loans and may be able to shop among numerous competitors. Ask your real estate agent for suggestions.
Hard Money Lenders
These lenders provide funding to investors and others who buy real estate—but who aren’t typical homeowners. They evaluate and approve loans based on the value of the property you purchase and your experience, and they are less concerned with income ratios and credit scores.
The U.S. 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.
Finance companies make loans for everything from mattresses to clothing and electronics. These lenders are often behind store credit cards and "no interest” offers.
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.
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.
They are called unsecured because there are no assets securing the loan: You do not need to pledge collateral as a guarantee for the lender.
- Credit cards are one of the most popular types of unsecured loans. With a credit card account, 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” offers are common.
- Signature loans are personal loans that are guaranteed only by your signature: You just agree to repay, and you don’t offer any collateral. If you fail to repay, all the lender can do is damage your credit and bring legal action against you (which might eventually lead to garnishing your wages and taking money out of bank accounts).
- Consolidation loans are meant to combine existing debts, typically with the goal of lowering your borrowing costs or your monthly payments. For example, if you have balances on several credit cards, a consolidation loan can free you from high-interest rates and simplify repayment.
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, and private lenders offer additional funding options.
These allow you to make monthly payments on automobiles, RVs, motorcycles, and other vehicles. Typical repayment terms are five years or less. But if you stop making the required payments on an auto loan, lenders can repossess the vehicle.
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.
- Home equity loans (second mortgages): You can borrow against the value of a home that you already own. Borrowers often get cash out for home improvements, education expenses, and other uses.
- Government loan programs: These often feature easier qualification with a smaller down payment or lower credit scores. Lenders have additional security because loans are backed by the U.S. government. FHA loans are among the most popular home loans available.
- Construction loans: These loans are meant to pay for the construction of a new home, including costs of land, building materials, and contractors.
The term "mortgage" is a combination of two words that come to us via Latin and French: "mort" ("dead") and "gage" ("pledge"). The "dead-pledge" is an arrangement that dies in either of two circumstances: the borrower pays off the debt and owns the property outright; or the borrower defaults and the lender claims the property.
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.
These are extremely small business loans. For lean outfits and small-scale entrepreneurs, these loans might be easier to qualify for—especially if you don’t have the credit, income, and experience that mainstream lenders are looking for.
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.
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.
You see them leave your bank account every month. Your monthly payment will depend on the amount you’ve borrowed, your interest rate, and other factors.
- Credit card loans (and other revolving loans) have a minimum payment that is 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 interest costs of the loan. 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 up-front for whatever you’re buying. 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 your loan balance, you’ll know what you’re getting into.
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, so lenders are always curious about your earnings. 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 monthly obligations under 31% of your income (or 43% if you include housing loans).
Other factors are also important. For example:
- 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 on your collateral are important. If you’re borrowing 100% of the purchase price, 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").
- A co-signer 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.
Costs and Risks of Loans
It’s easy to understand the benefits of a loan: You get money, and you can pay it back later. More importantly, you get whatever you want to buy, such as a house, a car, or a semester at school. To get the full picture, keep the drawbacks of borrowing in mind as you decide how much to borrow (or whether or not a loan makes sense 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. That extra cost is usually interest, and with some loans (like home and auto loans), those costs aren’t easy to see. Interest can be baked into your monthly payment invisibly, 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 (described above), you’ll find out exactly how much interest matters.
Your credit scores rely on a 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. However, 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.
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.