Borrowing money can fund a new home, pay for college tuition or help start a new business. Financing options range from traditional financial institutions, such as banks, credit unions, and financing companies, to peer-to-peer lending (P2P) or a loan from a 401(k) plan.
Key Takeaways
- Borrowing money can fund a new home, pay for college tuition or help start a new business.
- Traditional lenders include banks, credit unions, and financing companies.
- Peer-to-peer (P2P) lending is also known as social lending or crowdlending.
- Borrowers should know the terms and the interest rate and fees of the loan.
Banks
Banks are a traditional source of funds for individuals looking to borrow to fund a new home or college tuition.
Banks offer a variety of ways to borrow money, including mortgage products, personal loans, auto loans, and construction loans. They also offer opportunities to refinance an existing loan at a more favorable rate.
Although banks may pay little interest on deposited funds they take in, they charge a higher interest rate on the funds they disperse as loans. This spread is essentially how banks earn money.
Consumers often have a relationship and an account with a bank, and personnel are usually on hand at the local branch to answer questions and help with paperwork.
However, banks tend to have high costs associated with loan applications or servicing fees. Banks may also resell loans to other banks or financing companies, and this may mean that fees, interest rates, and procedures may change, often with little notice.
Borrowing From a Bank
Pros
Banks are well-established sources of consumer loans.
Consumers often have a relationship with a bank, making it somewhat easier to apply.
Cons
Banks may resell your loan to another institution.
Fees can be high for loan applications or servicing.
Credit Unions
A credit union is a cooperative institution controlled by its members, those who are part of a particular group, organization,or community. Credit unions offer many of the same services as banks but may limit services to members only.
They are typically nonprofit enterprises, which enables them to lend money at more favorable rates or on more generous terms than commercial financial institutions, and certain fees or lending application fees may be cheaper or even nonexistent.
Credit union membership was once limited to people who shared a "common bond" and were employees of the same company or members of a particular community, labor union, or other association.
Borrowing From a Credit Union
Pros
Credit unions are nonprofit institutions and may charge less than a regular bank.
Fees and interest rates may also be more favorable.
Cons
Credit unions may offer fewer loan products than a larger institution might offer.
Credit unions may have membership requirements in order to apply.
Peer-to-Peer Lending (P2P)
Peer-to-peer (P2P) lending, also known as social lending or crowdlending, is a method of financing that enables individuals to borrow from and lend money to each other directly.
With peer-to-peer lending, borrowers receive financing from individual investors who are willing to lend their own money for an agreed interest rate, perhaps via a peer-to-peer online platform. On these sites, investors can assess borrowers to determine whether or not to extend a loan.
A borrower may receive the full amount or only a portion of a loan, and it may be funded by one or more investors in the peer lending marketplace.
For lenders, the loans generate income in the form of interest. P2P loans represent an alternative source of financing, especially for borrowers who are unable to get approval from traditional sources.
Peer-to-Peer Lending
Pros
Borrowers might be able to get a P2P loan even if they do not qualify for other sources of credit.
Loan interest may be lower than traditional lenders.
Cons
P2P lending sites may have complex fee structures that borrowers need to read carefully.
Borrowers may end up owing money to multiple lenders rather than a single creditor.
401(k) Plans
Most 401(k) plans and comparable workplace-based retirement accounts, such as a 403(b) or457 plan, allow employees to take a 401(k) loan.
Most 401(k)s allow loans up to 50% of the fundsvested in the account, to a limit of $50,000, and for up to five years. Because the funds are not withdrawn, only borrowed, the loan is tax-free, and payments include both principal and interest.
Unlike a traditional loan, the interest doesn't go to the bank or another commercial lender, it is repaid to the borrower. If payments are not made as required or stopped completely, the IRS may consider the borrower in default, and the loan will be reclassified as a distribution with taxes and penalties due on it. A permanent withdrawal from a 401(k) incurs taxes and a 10% penalty if under 59.5 years old.
Borrowing From a 401(k) Plan
Pros
No application or underwriting fees.
Interest goes back to the borrower's account, effectively making it a loan to themselves.
Cons
There may be tax implications for borrowing against your 401(k)
This will also reduce the amount of money you have when you retire.
Credit Cards
Using a credit card is just like borrowing money. The credit card company pays the merchant, essentially advancing a loan. When a credit card is used to withdraw cash. It's called a cash advance.
A cash advance on a credit card incurs no application fees and for those who pay off their entire balance at the end of every month, credit cards can be a source of loans at a 0% interest rate.
However, if a balance is carried over, credit cards can carry exorbitant interest rate charges, often over 20% annually. Also, credit card companies will usually only lend or extend a relatively small amount of money or credit to the individual, so large purchases cannot be financed this way.
Borrowing Through Credit Cards
Pros
No application fees.
No interest, provided you can pay off your advances every month.
Cons
Extremely high interest rates if a balance is allowed to compound.
May reduce your credit score of you borrow too much.
Margin Accounts
Margin accounts allow a brokerage customer to borrow money to invest in securities. The funds or equity in the brokerage accountare often used as collateral for this loan.
The interest rates charged by margin accounts are usually better than or consistent with other sources of funding. In addition, if a margin account is already maintained and the customer has an ample amount of equity in the account, a loan is easy to initiate.
Margin accounts are primarily used to make investments and are not a source of funding for longer-term financing. An individual with enough equity can use margin loans to purchase everything from a car to a new home, but if the value of the securities in the account decline, the brokerage firm may require the individual to add additional collateral on short notice or risk the sale of the investments.
Borrowing Through Margin Accounts
Pros
Better interest rates than other sources.
Cons
Borrower may have to provide additional collateral if the price declines.
Losses may be higher in the event of a downturn.
Public Agencies
The U.S. government or entities sponsored or chartered by the government can be a source of funds. Fannie Mae is a quasi-public agency that has worked to increase the availability and affordability of homeownership over the years.
The government or the sponsored entity allows borrowers to repay loans over an extended period. In addition, interest rates charged are usually favorable compared to private sources of funding.
The paperwork to obtain a loan from this type of agency can be daunting, and not everyone qualifies for government loans, which often require restrictive income levels and asset requirements.
Borrowing From the Government
Pros
Better interest rates than private lenders.
Cons
Borrower may have to meet certain income requirements.
Applications may also be more complicated than a traditional loan application.
Finance Companies
Finance companies are private companies dedicated to lending money. They usually provide loans to purchase big-ticket goods or services, such as a car, major appliances, or furniture.
Most financing companies specialize in short-term loans and are often associated with particular carmakers, like Toyota or General Motors, who provide auto loans or auto leases.
Financing companies usually offer competitive rates depending on a borrower's credit score and financial history. The approval process is usually completed fairly quickly and often completed at the retailer.
Finance companies are not subject to federal oversight and are licensed and regulated by the state in which they operate.
Borrowing From a Finance Company
Pros
Interest rates are usually competitive.
Fees may be lower than traditional lenders.
Cons
Lower level of customer service.
Less regulated than banks and other lenders.
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Tips on Borrowing Money
Before borrowing money, it's important to note the following:
- Understand the interest rate that each lender charges as higher interest rates mean paying more for the money that is borrowed.
- Know the loan repayment terms, the length of time to repay the loan, and any other specific rules of repayment.
- Fees may be charged in addition to the interest rate and may include origination fees, application fees, or late fees.
- Know if the loan is secured or unsecured. If collateral secures the loan, such as a home, it can be forfeited to the lender or face foreclosure if there is a default on payments.
What Borrowing Methods Are Best to Avoid?
A payday loan is a short-term loan that’s meant to be repaid with your next paycheck. However, these loans are extremely costly, up to $15 for every $100 borrowed, which amounts to an APR of 391% for a two-week loan.
High-interest installment loans are repaid over a few weeks to months and have interest rates above 36%, the maximum rate that most consumer advocates consider affordable.
What Are Common Types of Borrowing?
Most loans are either secured (i.e., backed by an asset) or unsecured (i.e., without collateral). Common types of loans include mortgage loans, personal loans, student loans, credit card advances, and retail financing loans.
What Are the Advantages of Borrowing Money?
Borrowing money allows consumers to obtain large ticket items like a home or a car. Borrowing can also be a way to establish a credit history or improve a credit score. Handling debt responsibly can make it easier to borrow money in the future.
What Is Considered a Good Credit Score?
Credit scores range from 300 to 850 and are a rating that measures an individual's likelihood to repay a debt. A higher credit score means that a borrower is lower risk to a lender and more likely to make on-time payments.A credit score of 700 or above is generally considered good and 800 or above is considered excellent.
The Bottom Line
Banks, credit unions, and finance companies are traditional institutions that offer loans. Government agencies, credit cards, and investment accounts can serve as sources for borrowed funds as well. When considering a loan, it is important to know the terms of the loan and the interest rate and fees for borrowing.
