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Borrowing basics: The ins and outs of loans, credit lines and more

May 8, 2020 • 9 min read

What we'll cover

  • How to borrow money

  • Different borrowing options 

  • Things to keep in mind when borrowing money

Big purchases often coincide with exciting milestones of life — moving into a new house, buying a car, getting into college — but they can also go hand-in-hand with something else: loans. Taking on debt can be intimidating, to say the least (and for some people, downright scary), but it doesn’t have to be. In fact, borrowing money can be a smart, strategic money move.

Before you head to the bank, the car dealership, or start channeling your inner Chip and Joanna Gaines, there are a few things you should know about borrowing money. Read on to learn more.

Borrowing basics

Understanding the fundamentals of borrowing before you consider taking out a loan or using credit is an important step in keeping up with your financial stability. Here are a few points to take note of:

Know your credit score. Your credit score has a huge impact on the loan you’ll be able to get, so it’s imperative to have an understanding of where yours falls on the scale.

A credit score above 700 is considered “good,” so if yours comes in below that, you might want to take some time to boost it. That’s because the higher your score, the lower your interest rate could be. Improving your score now could save you some serious greenbacks in the long run.

Don’t take on more than you can afford. It might seem like borrowing money is no big deal. But be mindful you could potentially be paying off a loan for a long time. (In the case of a mortgage, the repayment period could be 30 years.)

Crunch the numbers. Determine how much you can comfortably borrow and still afford to pay your bills. The 50/30/20 budget is generally considered a good guidepost and is a simple plan you can implement for yourself. No matter how tempting, do not borrow more than you can afford. Trust us: Your wallet and your peace of mind will thank you.

Do your homework. Just like you’d get a second opinion from a doctor, you shouldn’t go with the first loan you lay your eyes on. Weigh your options before submitting an application, so you wind up with the best terms for your situation.

Don’t make a late payment. Write your due date in your planner, set up a notification on your phone, leave a sticky note on your computer — whatever suits your fancy. Just make sure you do whatever it takes to avoid those costly late fees and the potential credit score damage that comes with overdue payments.

Mastering mortgages

Buying a home is likely the largest purchase a person will make. Not all mortgages are alike — in fact, there are numerous options to choose from — so it’s important to learn the basics before you become a house hunter.

Fixed rate vs. adjustable rate mortgages

A fixed rate mortgage has an interest rate shown as a percent that is guaranteed to stay the same for a fixed period of time.

An adjustable rate mortgage (ARM) has a fixed rate for the first five, seven, or 10 years (depending upon the length of your term) and a variable rate that may adjust every 12 months based on current market rates after that.

Which is better? It depends on your situation. You'll likely have a lower interest rate and APR (annual percentage rate) for the initial period of an adjustable rate loan than you would with a fixed rate loan. With a fixed loan, you might have a higher interest rate initially, but you’ll know exactly how much your monthly payments will cost years from now.

Conventional vs. non-conventional

A conventional loan is any mortgage that is not offered or secured by a government entity.

A non-conventional (sometimes called federal) loan is, as you might have guessed, offered or secured by the federal government. This means the agency insuring the loan will reimburse the lender for any losses if the borrower can’t meet the conditions of the loan (or in finance terms, “defaults” on the loan). They come in three forms:

FHA Loan: Insured by the Federal Housing Administration, an FHA loan is a prime lending opportunity for low- to moderate-income borrowers who may have difficulty saving up a large down payment. If you go this route, you may have to pay for the additional cost of a mortgage insurance premium, but in exchange, you have the flexibility to make a down payment as low as 3.5 percent.

VA Loan: This type of loan is only for veterans and their families. Insured by the Veterans Administration, borrowers who qualify for this loan might not be required to make a down payment.

USDA Loan: These loans , insured by the U.S. Department of Agriculture, are for rural borrowers with lower income.

Getting the best mortgage

Not sure how to select which mortgage is right for you? Keep these points in mind.

The data doesn’t lie. According to the Consumer Financial Protection Bureau, taking the time to compare mortgage rates from at least three lenders could save you more than $3,500 over the first five years of your loan. Start crunching the numbers with our affordability calculator .

Bigger might be better. Aiming for the smallest monthly mortgage payment possible? Take a look at a 30-year fixed rate mortgage. However, if you can afford the larger payments, you could spend less money in the long-term by going with a 15- or 20-year fixed loan. Use our mortgage payment calculator to help with the math.

Absorbing auto financing

At the most basic level, car financing functions similarly to home loans: You sign a contract, you make monthly payments for the term of the contract, and voilà! — the item is yours for the keeping.

But, while a new set of wheels is usually quite a bit cheaper than a house, your financing options differ as well:

Multiple financing options

At the most basic level, car financing functions similarly to home loans: You sign a contract, you make monthly payments for the term of the contract, and voilà! — the item is yours for the keeping.

Shorter terms

Auto financing typically has significantly shorter repayment periods than mortgages. Generally, you can get auto financing that ranges from 12 months to 96 months for a new car purchase. If you’re buying a used car, expect a shorter term, from 12 months to 72 months.

As noted above, it’s wise to shop around before committing to a car. Here’s what you should consider before getting auto financing:

Focus on the right stuff. When comparing car financing, one of the most important figures to focus on is the APR because it reflects the total cost of financing.

Keep it short and sweet. It’s no secret that a vehicle’s value depreciates the second you drive off the car lot, so shorter-term contracts may be your best option. They generally come with higher monthly payments, but you can pay them off faster and the total amount in interest you pay is usually less.

Don’t diss the down payment. To combat paying an excessive amount of interest, you may want to put as much money down as you can comfortably afford. Otherwise, you could find yourself in a situation where the cost of the car plus the total interest you’ll pay over the lifetime of the contract would exceed the original value of the car by quite a bit.

Conquering credit 

Using a credit card is probably something you already do in your day-to-day life. But it may not have occurred to you that using credit cards is a form of borrowing. It’s not called a credit card for nothing!

Credit cards allow you to make a purchase now and pay for it later. You can choose to pay your card balance in full each month or opt to pay a portion of it. If you choose the latter, be prepared to pay interest on your outstanding balance. Take note: Not all lenders charge the same interest rates and some can be steeper than others.

And not all credit cards are alike. Before you slide one into your wallet, get familiar with your options:

Standard credit cards: These cards can either be unsecured, which don’t require you to deposit cash before you make a purchase, or secured, which do. This type of card may not have perks associated with it, but it’s great for getting your credit established.

Cash back cards: These cards do exactly what they say they do: Give you money back when you use them to make purchases. The amount of cash back you receive varies from card to card but is usually between 1 and 4 percent and is sometimes capped at a predetermined amount per year.

0 percent intro APR cards: While the 0 percent APR is a limited time offer, this type of card allows you to carry a balance without being charged interest during an introductory time period (often around six months). Make sure you double check how long this period lasts — you don’t want to be surprised when that goose egg turns into a real number.

Travel rewards cards: If you’re a regular jet setter, this could be a good option for you. Making purchases with a travel rewards card will earn you miles on your next flight or points that will score you free hotel rooms.

Specialty cards: These cards offer perks specifically designed for their users, like students or businesspeople.

Now that you know the credit card basics, here comes the tough part: choosing one. There’s no one-size-fits-all card, so you’ll have to weigh the pros and cons of each to select the deal that benefits you the most

Studying student loans

It’s an understatement to say that college is expensive. Tuition to attend a public university has risen more than  213 percent  since 1988 and shows no sign of stopping its climb. Not surprisingly, taking out student loans to cover the costs is increasingly common.

To get an A+ in student loan management, keep these things in mind when you or your child is heading to the land of textbooks, lectures, and a whole lot of coffee.

Federal vs. private loans

Federal loans have fixed interest rates and could cost you less in the long run than a private loan would (more on their costs below). It’s a requirement that you’re enrolled in school at least half-time to qualify for a federal loan. You also don’t have to start paying off this loan until you graduate, decide to leave school, or reduce your course load such that you’re no longer considered a half-time student.

There are a few different types of federal loans up for grabs, all of which are distributed through the U.S. Department of Education:

Direct Subsidized Loans: These are for full-time undergrad students who “demonstrate financial need.”

Direct Unsubsidized Loans: Undergraduate, graduate, and professional students (for example, those attending medical or law school) can receive these loans without demonstrating a financial need.

Direct PLUS Loans: These provide financial support for things that financial aid may not cover for graduate students or parents of dependent undergraduate students.

Direct Consolidation Loans: Use this loan option to combine separate student loans into one from a single loan servicer.

Private loans are offered by banks and credit unions. They’re often recommended as borrowing option B if you don’t qualify for federal loans or other forms of student aid. They can also be a good option if your federal loan doesn’t cover the entire cost of attending school.

The downside of private loans is that they generally carry a higher price tag. That’s because they often have variable interest rates, potential fees associated with them, and no ability to consolidate or combine smaller loans into a single larger one that lowers your interest rate and monthly payment. (This is why they’re usually not borrowers’ first option.)

We’ve covered some of the basics when it comes to borrowing money, but you may need to take out a loan for any number of things. Whichever form of borrowing you need can be daunting to undertake. Once you have a firm understanding of how it works and all your options, you can feel confident that you have the information you need to borrow and succeed.

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