The Best Way To Borrow

By Glenn Curtis AAA

From time to time everyone needs to borrow money, whether to start a new business, erect a new backyard deck, or buy a new car. But what's the best source of financing? Here we'll outline some of the more popular sources of funds as well as review the pros and cons associated with each.

Credit Unions
A credit union is considered to be a cooperative institution controlled by its members, or the people that use its services. Credit unions usually tend to include members of a particular group, organization, or community to which one must belong in order to borrow. (For more insight, read Choose To Beat The Bank.)

Credit unions may be nonprofit enterprises. When this is the case it means that they can usually lend money at more favorable rates than banks. In addition, certain fees (such as lending application fees) may be cheaper. Plus customers typically don't get nickel-and-dimed with transaction fees like they do at banks.

On the other hand, credit unions typically don't send checks that have been drafted back to the checks' owners. They also don't typically offer ATMs, or only have a limited number of ATMs in the area in which they operate. And, in some cases, credit unions may be uninsured or carry limited insurance, which can cause problems in the unlikely situation that the credit union folds. In addition, some credit unions only offer plain vanilla loans and do not provide the variation of loan products that some of the bigger banks do. (For related reading, see Are Your Bank Deposits Insured?)

Banks
Banks offer a variety of mortgage products, personal loans, construction loans and other loan products depending upon their customers' needs. By definition, they take in money (deposits) and then loan out that money in the form of mortgages and consumer loans at a higher rate. They make their money by capturing this spread.

Banks are a traditional source of funds for those purchasing a house or car, or those that are looking to refinance an existing loan at a more favorable rate. (For more on borrowing, see Different Needs, Different Loans.)

Many find that doing business with their own a bank is easy. After all, they already have a relationship and an account there. In addition, personnel are usually on hand at the local branch to answer questions and/or help with paperwork. ATM machines are typically available for the quick withdrawal of funds. A notary public may also be available to help the customer document certain business or personal transactions. Also, checks are usually returned to the account owner and/or a copy of such checks is provided or available.

The downside to getting financing from a bank is that bank fees can be hefty. In fact, some banks are notorious for charging check fees, ATM transaction charges, maintenance fees, loan application fees, minimum balance fees and a number of other charges. In addition, banks are usually privately owned or owned by shareholders. As such, they are beholden to those individuals and not necessarily to the individual customer. Finally, banks may resell your loan to another bank or financing company and this may mean that fees and/or procedures may change - often with little notice. (For more insight, read The Ins And Outs Of Bank Fees.)

401(k) Plans
401(k) plans allow employees to set aside money for retirement and for those funds to grow on a tax-deferred basis. To be clear, their primary purpose is to provide for an individual's retirement and are generally a last resort for borrowing. (To learn more, read Borrowing From Your Plan.)

The money that you've contributed into the plan is technically yours, so there are no underwriting or application fees if you want to withdraw it. You can use the money for virtually anything you want from buying a home, to building a new backyard deck.

Unfortunately, the negatives of withdrawing funds from one's 401(k) vastly outweigh the positives. For starters, the person withdrawing the funds must pay taxes on the money. In addition, there is usually a 10% penalty for withdrawing the funds before reaching age 59.5 (although there are some exceptions, such as disability). In addition, if you remove money from your retirement plan, you lose out on the tax-deferred funds that would have compounded with interest had they not been withdrawn. Obviously, all of these things can have an adverse effect on your retirement plans. (To learn more about borrowing from your 401(k), see Eight Reasons To Never Borrow From Your 401(k))

Credit Cards
If used responsibly, credit cards are a great source of loans, but can cause undue hardship to those who are not aware of the costs. They are not considered to be sources of longer term financing, however, they can be a good source of funds for those who need money quickly and intend to repay the borrowed amount in short order.

If an individual needs to borrow a small amount of money for a short period of time, a credit card (or a cash advance on a credit card) may not be a bad idea. After all, there are no application fees (assuming you already have a card). For those who pay off their entire balance at the end of every month, credit cards can be a source of 0% financing. (For more insight, check out Understanding Credit Card Interest.)

On the flip side, if a balance is carried over, credit cards can carry exorbitant interest rate charges (increasingly in excess of 20% annually). Credit card companies will usually only lend or extend a small amount of money or credit to the individual. In other words, credit card companies typically don't make mortgages, which can be a disadvantage for those that need longer term financing or for those that wish to make an exceptionally large purchase (such as a car). Borrowing too much money through credit cards creates could reduce your chances of getting loans or additional credit from other lending institutions. (For more insight, read How Credit Cards Affect Your Credit Rating.)

Margin Accounts
Margin accounts allow a brokerage customer to borrow money. The funds/equity in the brokerage account is often used as collateral for this loan. The primary purpose of a margin account is to allow an individual to purchase additional securities at a favorable rate. (To learn more about margin accounts and margin trading, see Margin Trading and What is a margin account?)

The interest rates charged in 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 somewhat easy to come by.

Margin accounts are primarily used to purchase securities, and are not typically a source of funding for longer-term financing. That said, an individual with enough equity can use margin loans to purchase everything from a car to a home. However, should the value of the securities in the account decline, the brokerage firm may require the individual to put up additional collateral on short notice or risk the stock being sold out from under them. Finally, in a market downturn those that have extended themselves on margin tend to experience more severe losses because of the interest charges that accrue as well as the possibility that they may have to meet a margin call.

The Government
The U.S. government or entities sponsored/chartered by the government can be a terrific source of funds. For example, Fannie Mae is a quasi-public agency that has worked to increase the availability and affordability of home ownership over the years.

The government or the sponsored entity typically allows borrowers to repay borrowings over an extended period of time. In addition, interest rates charged are often favorable compared to alternative sources of funding.

On the other hand, the paperwork to obtain a loan from a quasi-public agency can be daunting. In addition, not everyone qualifies for government loans. There can be restrictive income and/or asset requirements. For example, with regard to certain Freddie Mac mortgage offerings, an individual's income must be equal to or less than the area median income.

Financing Companies
Financing companies, such as GE Commercial Finance, routinely make loans to those looking to purchase any number of items. While some lenders make longer term loans, many, if not most, finance companies that specialize in providing funds for smaller purchases such as a car or a major appliance.

Finance companies usually offer competitive rates, and the overall fees can be low when compared to banks and other lending institutions. In addition, the approval process is usually completed fairly quickly.

However, financing companies may not provide the same level of customer service or offer additional services, such as ATMs. They also tend to have a limited array of loans.

Bottom Line
Whether you are looking to finance your children's education, a new home, or your fiancés engagement ring, it pays to analyze the pros and the cons of each potential source of capital available to you.

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