From time to time, everyone may need 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 Union Lending
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. (See also: Choose to Beat the Bank.)
Credit unions are typically nonprofit enterprises, which helps enable them to 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.
Peer-To-Peer Lending (P2P)
Peer-to-peer (P2P) lending -- also known as social lending or crowdlending -- is a method of debt financing that enables individuals to borrow and lend money without the use of an official financial institution as an intermediary. Peer-to-peer lending removes the middleman from the process, but it also involves more time, effort and risk than the general brick-and-mortar lending scenarios.
With peer-to-peer lending, borrowers take loans from individual investors who are willing to lend their own money for an agreed interest rate. The profile of a borrower is usually displayed on a peer-to-peer online platform where investors can assess these profiles to determine whether they would want to risk lending money to a borrower. A borrower might receive the full loan amount or only a portion of what he asked for from an investor. In the case of the latter, the remaining portion of the loan may be funded by one or more investors in the peer lending marketplace. In peer-to-peer lending, a loan may have multiple sources and monthly repayment has to be made to each of the individual sources.
P2P platforms connect borrowers to investors with attractive interest rates. For lenders, the loans generate income in the form of interest which can often exceed the interest amount that can be earned through savings vehicles, such as savings accounts and CDs. In addition, an investor is able to earn a higher return on his investment than he can get from the stock market through the interest payments he receives monthly from the borrower. On the other hand, P2P loans give borrowers access to financing that they may not have gotten approval for from standard financial intermediaries. Furthermore, a borrower gets a more favorable interest rate on her loan than one she would otherwise have gotten from a bank.
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. (See also: 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 is usually on hand at the local branch to answer questions and 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, copies of checks the customer has written are made available electronically.
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 procedures may change—often with little notice. (See also: The Ins and Outs of Bank Fees.)
Borrowing From 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 a last resort for borrowing. (See also: Borrowing From Your Plan.)
The money that you've contributed to 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 adding a new swimming pool.
Unfortunately, the negatives of withdrawing funds from one's 401(k) vastly outweigh the positives. For starters, if withdrawing funds, as opposed to borrowing against your holdings, you must pay taxes on the money. In addition, there is usually a 10% penalty for withdrawing the funds before reaching age 59½ (although there are some exceptions, such as disability).
Also, 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. All of these things can have an adverse effect on your retirement plans. (See also: Eight Reasons To Never Borrow From Your 401(k))
However, if you borrow against your 401(k), most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
Credit Card Borrowing
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, 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. (See also: Understanding Credit Card Interest.)
On the flip side, if a balance is carried over, credit cards can carry exorbitant interest rate charges (often 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 new car). Borrowing too much money through credit cards could reduce your chances of getting loans or additional credit from other lending institutions. (See also: How Credit Cards Affect Your Credit Rating.)
Using 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. (See also: 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 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.
U.S. Government Lending
The U.S. government or entities sponsored or 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 allows borrowers to repay borrowings over an extended period. In addition, interest rates charged are 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. Also, not everyone qualifies for government loans. There can be restrictive income and 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's median income.
Financing companies, routinely make loans to those looking to purchase any number of items. While some lenders make longer-term loans, most, finance companies specialize in providing funds for smaller purchases such as a car or 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.
Whether you are looking to finance your children's education, a new home or an engagement ring, it pays to analyze the pros and cons of each potential source of capital available to you.