Almost everyone needs to borrow money at some point. Maybe it's for a new home. Maybe it's for college tuition. Maybe it's to start a business.
Nowadays, professional financing options are many and varied. Below, we'll outline some of the more popular lending sources, 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 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 distribute that money in the form of mortgages and consumer loans at a higher rate. They make their profit 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.
Many find that doing business with their own 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. 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 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.
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.
Credit unions don't always offer the products you'll find at big banks.
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.
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 and lend money without the use of an official financial institution as an intermediary. While it removes the middleman from the process, it also involves more time, effort, and risk than using a brick-and-mortar lender.
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.
A borrower might receive the full amount he's 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.
Along with comparable accounts, such as a 403(b) or 457 plan, 401(k) plans allow employees to invest money on a tax-deferred basis. Their primary purpose is to provide for an individual's retirement. But they can be a last resort for financing.
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. Or rather, borrow it—since a permanent withdrawal incurs taxes and a 10% penalty if you're under 59.5 years old.
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.
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.
Bear in mind, though, that 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 to the plan until the loan balance is repaid. All of these things can have an adverse effect on your nest egg's growth.
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 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.
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 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.
The Bottom Line
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.