Borrowing money is a common and often necessary aspect of everyday living. Knowing the ins and outs of borrowing is crucial for making sound financial decisions.
Read more: How to use spending and savings buckets to pay off debt.
Understanding borrowing basics
To borrow money responsibly:
Know your credit score
Understand the terms
Make sure payments fit into your budget
Compare lenders before committing
Make payments on time
While personal loans offer quick funding and flexibility, they often have higher interest rates and fees, and could negatively impact your credit score.
Principal and interest rate
The principal is the total amount borrowed, while the interest rate is the percentage charged for borrowing that money. Your interest rate directly impacts the total cost, and can be either:
Fixed: Remains the same for the life of the loan
Variable: Fluctuates based on the underlying benchmark or index
Credit score and its impact
A higher credit score significantly increases your chances of loan approval and can influence the interest rate and loan terms. To improve your credit score, review your credit reports regularly, pay bills on time and keep older accounts open.
Types of loans
It’s important to know which type of loan best suits your needs.
Mortgage
If you’re in the market for a new home, you’ll likely have to take out a mortgage. How much you pay each month will be partly determined by your down payment. The more you’re able to save for a down payment, the better because it can result in lower monthly payments and interest rates. While searching for a lender, an Ally Bank Savings Account can help boost your savings before closing day arrives.
Personal loans
Whether you’re renovating, planning your wedding or consolidating debt, a personal loan can help cover the upfront costs. These can either be:
Secured: Requires collateral and can get you a lower rate or higher loan amount, but you risk losing your asset if you fail to repay the loan
Unsecured: Doesn’t require collateral and could have a higher interest rate, but you won’t risk losing an asset
While personal loans offer quick funding and flexibility, they often have higher interest rates and fees, and could negatively impact your credit score.
Student loans
Taking out a student loan to pursue college or higher education can help cover tuition, books and living costs. You can choose a federal loan through the U.S. government or a private loan through other lenders like banks or credit unions — or a mixture of both. Federal student loan interest rates are set by the government and typically lower than private loan rates, which are determined by individual lenders.
Auto loans
With an auto loan, you can make a down payment to lower the overall amount you need to finance. The larger your down payment, the lower your monthly payments could be. Make a down payment with cash, the value of a vehicle trade-in or both.
Managing credit cards and lines of credit
Both credit cards and lines of credit allow you to borrow up to a certain amount and only pay interest on what you borrow.
Credit cards
You can pay back the money you borrow in full or in installments with a credit card. If you don’t pay your balance in full, you’ll usually be charged interest. Credit card fees can include annual percentage rates, late fees and over-limit charges. To manage your credit card:
Create a budget
Pay your balance in full by the due date
Understand your terms
Lines of credit
While a loan is better for large, one-time expenses, a line of credit gives you access to funds that you can use as needed and is better for flexible purchases and emergencies.
Avoiding high-interest traps
If you borrow a significant amount of debt with an extremely high interest rate, you might find it difficult to pay off the principal amount of these types of loans:
Payday loans and cash advances
The high interest rates on payday loans (also called cash advances) coupled with short repayment terms, can easily trap borrowers in a cycle of debt. As an alternative, consider reaching out to family or friends, requesting an advance from your employer or taking out a small dollar loan from a credit union.
Common pitfalls in borrowing
To avoid common borrowing pitfalls, read the fine print, budget and take out only what you can realistically pay back.
Smart borrowing strategies
Borrowing money can be a step toward achieving your long-term goals, but remember: It should always be done with caution and a clear repayment plan.
Choosing the right lender
When comparing lenders, look for competitive rates and loan terms. Also consider their reputation, as this can affect your ability to get a loan, the terms of the loan and the overall trust between you and your lender.
Loan terms and repayment plans
Choose a loan term that fits your financial situation and set up manageable monthly payments.
Borrow with confidence
Knowledge about your options can empower you to make confident and informed borrowing decisions. When you need to borrow, do so with a strategic mindset and stay diligent in managing your finances to achieve your goals.
