Borrowing is often a fact of adult life. Almost everyone needs to take out a loan at some point. Maybe it's for a new home. Maybe it's for college tuition. Maybe it's to start a business.
Whatever the reason you have to borrow money, professional financing options are many and varied nowadays. They range from traditional financial institutions, like banks, credit unions, and financing companies, to Internet Age creations, like peer-to-peer lending (P2P); from public agencies to your own personal 401(k) plan. Below, we'll outline some of the more popular lending sources, explaining how they work and reviewing the pros and cons associated with each.
- A variety of financing options exist for consumers.
- General-purpose lenders include banks, credit unions, and financing companies.
- Peer-to-peer (P2P) lending is a digital option for putting together lenders and borrowers.
- Credit cards can work for short-term loans, margin accounts for buying securities.
- A 401(k) plan can be a last-resort source of financing.
Banks are a traditional source of funds for individuals looking to borrow. By definition, that's what they do: They take in money (deposits) and then distribute that money in the form of financing products, like mortgages and consumer loans.
Although banks may pay a little interest on deposited funds they take in, they charge a higher interest rate on the funds they give out, as loans. This spread is essentially how they make their profit.
Banks offer a variety of ways to borrow money: mortgage products, personal loans, auto loans, construction loans, and other financing products. They also offer opportunities for those looking to refinance an existing loan at a more favorable rate.
Pros and Cons of Borrowing From a Bank
Many people find that doing business with their own 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 help with paperwork. 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 the high cost of their loan application or servicing fees. 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, interest rates, and procedures may change—often with little notice.
A credit union is a cooperative institution controlled by its members—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.
Pros and Cons of Borrowing From a Credit Union
Credit unions offer many of the same services as banks. But they are typically nonprofit enterprises, which helps enable them to lend money at more favorable rates or on more generous terms than commercial financial institutions. In addition, certain fees (such as transaction or lending application fees) may be cheaper or even nonexistent.
Originally, credit union membership was limited to people who shared a "common bond": They were employees of the same company or members of a particular community, labor union, or another association. In the 2000s, though, many credit unions have loosened restrictions, opening up membership and their products to the general public.
On the downside, some credit unions only offer plain vanilla loans or do not provide the variety of loan products that some of the bigger banks do. And of course, you have to join a credit union and open an account with it before you can borrow money from it—though often, you can do so with a very nominal amount.
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, without an institutional intermediary, like a bank or broker. While it removes the middleman from the process, it also involves more time, effort, and risk than going through an official financial institution.
With peer-to-peer lending, borrowers receive financing from individual investors who are willing to lend their own money for an agreed interest rate. The two link up via a peer-to-peer online platform. Borrowers display their profiles on these sites, where investors can assess them to determine whether they would want to risk extending a loan to that person.
Pros and Cons of Borrowing Through Peer-to-Peer Lending
A borrower might receive the full amount they're asking for or only a portion of it. 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. It's quite typical for a loan to have multiple sources, with monthly repayments being made to each of the individual sources.
For lenders, the loans generate income in the form of interest, which can often exceed the rates that can be earned through other vehicles, such as savings accounts and CDs. In addition, the monthly interest payments a lender receives may even earn a higher return than a stock market investment. For borrowers, P2P loans represent an alternative source of financing—especially useful if they are unable to get approval from standard financial intermediaries. They often receive a more favorable interest rate or terms on the loan than from conventional sources too.
Still, any consumer considering using a peer-to-peer lending site should check the fees on transactions. Like banks, the sites may charge loan origination fees, late fees, and bounced-payment fees.
If you need a loan, why not borrow money from yourself? Most 401(k) plans—along with comparable workplace-based retirement accounts, such as a 403(b) or 457 plan, allow employees to withdraw funds in the shape of a 401(k) loan.
A permanent withdrawal from a 401(k) incurs taxes and a 10% penalty if you're under 59.5 years old. But you avoid that with a 401(k) loan since you're technically taking out the funds temporarily.
Most 401(k)s allow you to borrow up to 50% of the funds vested 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. You then repay the loan gradually, including both the principal and interest.
Pros and Cons of Borrowing From a 401(k) Plan
The interest rate on 401(k) loans tends to be relatively low, perhaps one or two points above the prime rate, which is less than many consumers would pay for a personal loan. Also, unlike a traditional loan, the interest doesn't go to the bank or another commercial lender—it goes to you. Since the interest is returned to your account, some argue, the cost of borrowing from your 401(k) fund is essentially a payment back to yourself for the use of the money.
And, since the money that you've contributed to the plan is technically yours, there are no underwriting or application fees associated with the loan, either.
Bear in mind, though, just because you're your own lender doesn't mean you can be sloppy or lazy with repayments. If you don't pay on schedule, and the IRS finds out, you could be considered in default and your loan classified as a distribution (with taxes and penalties due on it).
Another important, long-term consideration: If you remove money from your retirement plan, you lose out on the funds compounding with tax-free interest. Also, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. All of these things can have an adverse effect on your nest egg's growth.
So, borrowing money from your 401(k) is usually seen as a last resort. Certainly, it's not a loan to be undertaken lightly.
Anytime you use a credit card, you are in a sense borrowing money: The credit card company pays the merchant for you—advancing you the money, so to speak—and then you repay the card issuer when your card statement comes. But a credit card can also be used not just to purchase a good or service, but for actual funds. It's called a cash advance.
Pros and Cons of Borrowing Through Credit Cards
If an individual needs to borrow a small amount of money for a short period, 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 loans at a 0% interest rate.
On the flip side, if a balance is carried over, credit cards can carry exorbitant interest rate charges (often in excess of 20% annually). Also, credit card companies will usually only lend or extend a relatively small amount of money or credit to the individual. That 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).
Finally, borrowing too much money through credit cards could reduce your chances of getting loans or additional credit from other lending institutions.
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.
Pros and Cons of Borrowing Through Margin Accounts
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 somewhat easy to come by.
Margin accounts are primarily used to make investments 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 investments 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 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 homeownership over the years.
The Pros and Cons of Borrowing Through Public Agencies
The government or the sponsored entity allows borrowers to repay borrowings over an extended period. In addition, interest rates charged are usually favorable compared to private 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, aka finance companies, are outfits dedicated to lending money. Unlike banks or credit unions, finance companies do not accept deposits or provide other financial services or products (safe-deposit boxes, credit, cards, etc.). They just routinely make loans to individuals or businesses needing funds. In the case of consumers, they usually provide loans to purchase big-ticket goods or services, such as a car, major appliances, or furniture. Some specialize in medical or healthcare costs.
While some lenders make longer-term loans, most financing companies specialize in short-term loans. Often they are connected to a manufacturer or larger company, serving as their financing arm, so to speak. Some of the best-known finance companies are associated with particular carmakers, like Toyota or General Motors, and make auto loans or auto leases.
Pros and Cons of Borrowing Through Financing Companies
Financing companies usually offer competitive rates—though a lot depends on your credit score and financial history—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. Plus, there's the convenience factor, when the finance company is connected to the retailer or manufacturer whose products you're buying.
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.
It's also important to note that finance companies are licensed and regulated by the state in which they operate. They are not subject to federal oversight and rules, the way banks and credit unions are. In short, they are less regulated and have more liberty in adjusting their rates and altering their terms.
What Is Borrowing in Finance?
Borrowing means to take money from a source, with a formal agreement that the funds will be repaid by a certain date and, usually, in stated regular installments. Most borrowed funds incur interest, meaning that the borrower pays an additional amount—a percentage of the sum they are borrowing—as compensation to the lender for extending the funds.
What Are the Types of Borrowing?
Borrowing exists in many forms and can be classified in different ways. Most loans are either secured, meaning they're backed by an asset, which is forfeit to the lender if the borrower defaults; or unsecured, meaning they have no collateral.
Common types of borrowing include:
- Personal loans
- Credit card advances
- Title loans
- Payday loans
- Bank overdrafts
What Are the Advantages of Borrowing Money?
The biggest advantage of borrowing money is, of course, the opportunity it gives you to obtain something you can't afford to buy outright. It skips the time and the need for saving up. Often people borrow to buy things they could never purchase on their home, such as a six-figure home.
Borrowing can often be a more efficient use of your money, too. Even if you could afford to buy something outright, it might not make sense to tie up all your funds in it. Borrowing allows you to spread funds around in different ways or in a variety of investments—a practice called leveraging, in finance.
Borrowing can also be a way to establish a credit history or improve your credit score, if you handle the debt responsibly, paying your loans back fully and making payments on time.
What Is the Cheapest Way to Borrow Money?
There's no one single cheapest way to borrow money—a variety of factors can influence what interest rate you'll pay—some based on the lender/type of loan, others on your situation. But some of the better borrowing-money methods include:
- Personal loans: Especially if you have a high credit score (700 or above). Obtained via banks and credit unions.
- Home equity loans/lines of credit: With these, you put up your home as collateral; you can borrow up to a certain amount, based on the value of the home. The home equity loan means borrowing a fixed sum at a fixed rate, similar to a mortgage; the line of credit gives you access to funds, up to a certain amount, like a credit card. Interest may be tax-deductible.
- Credit cards: If you see one offering a 0% APR (or a very low one), grab it; it can be a way to buy something and pay it off gradually, paying effectively no interest. Bear in mind these are often introductory rates, for specific periods—so be sure to pay the balance in full within the 18 months, or whatever the period is. If you want money in hand, double-check that the deal applies to cash advances.
What Is the Best Place to Borrow Money From?
If you can't go to a relative or a friend to borrow money, the best places to borrow money include:
- An FDIC-insured bank: It's a source of a lot of different financing, from personal loans to home equity loans. First stop should be any place you already have an account or loan; existing customers often qualify for special "relationship" rates or deals.
- A credit union: Again, extra points if you already bank there.
- Online lenders/banks: Digital institutions pass on the amount they save in overhead to you in the form of lower interest rates. They often have streamlined approval processes, too. Just be sure to do due diligence about the lender.
- Your own 401(k) plan: A 401(k) loan involves borrowing money from your retirement plan account. Since it's a loan, not a withdrawal, you won't be charged taxes or penalties on the money. You pay a low rate of interest, and you pay it back into the account—to yourself, in other words.
The Bottom Line
There are a variety of ways to borrow money. Banks, credit unions, and finance companies are all traditional institutions that offer loans. Government or government-sanctioned agencies and authorities provide financing as well—usually to specific groups (veterans, Native Americans, etc.) or for specific ends (buying a home).
Credit cards and investment accounts can serve as sources for borrowed funds as well.
Finally, you can borrow directly from yourself, temporarily withdrawing the funds in your 401(k) account, or from other individuals, connecting through a peer-to-peer lending platform.
However, not all forms of borrowing are created equal. 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.