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Are you coming up short financially and thinking about borrowing money? If so, you’re definitely not alone. Household debt hit $13 trillion as of the end of 2017’s third quarter, and credit card debt alone exceeded $1 trillion.
Reaching for a credit card is simple (if you already have one in your wallet), but it’s not always the best way to handle a budgetary shortfall. In fact, there are lots of options if you need to borrow money, some of which are much better than others.
The best and worst ways to borrow money
Four factors you’ll want to consider are: the initial cost of borrowing; convenience and timeliness; the interest on the loan; and the risks you’re taking on. Options to compare include:
- Credit cards: If you have a credit card, borrowing is fairly effortless. That convenience comes at a price, however, as you’ll pay an average interest rate of 15.59%, according to CreditCards.com. If you’re going to carry a balance for a long time, those high interest makes credit cards a less-than-ideal option. On the other hand, credit cards are unsecured debt — there’s no collateral, so your assets aren’t seriously at risk in case of nonpayment. One caveat: Opening a balance transfer card with 0% interest can work as part of a debt repayment plan. You’ll pay a small fee — usually around 3% — to transfer other, higher-interest debt to the new card, and pay no interest on it for around a year, giving you time to pay it down.
- Personal loans: Banks, credit unions, and other financial institutions make personal loans available with either no fees or relatively low application or origination fees. Interest rates are lower than credit cards at around 10.3% to 12.5% for those with excellent credit, but higher than other options such as home equity loans. Some personal loans offer fixed rates, but others are variable, so there’s a chance your interest — and your payments — could increase. Because personal loans are unsecured, the risk to your home and assets is low in case of nonpayment. Repayment terms vary by loan, but you can often stretch out repayment for years.
- Home equity loans: Home equity loans allow you borrow a lump sum against the value of your house. Interest rates are relatively low — around 5.31% this month — but the initial costs can be high. Home equity loans also require you to actually have equity in your home, and the risk level is high because if you default, the lender could foreclose on your home.
- Home equity lines of credit (HELOC): Home equity lines of credit also involve borrowing against your home’s equity, but you don’t take a lump sum. Instead, you’re approved for a line of credit to use as needed, and will be required to repay the entire amount you borrow at the end of a designated period. There are often fees and closing costs, and while interest rates on whatever debt you incur are around 5.29% as of this month,, HELOCS often have variable rates, so the rate you pay could end up higher. Because your house is collateral, the risk level is also high.
- 401(k) loans: Borrowing from your 401(k) may seem like a great solution to your cash flow issues since you pay the interest to yourself. But there’s a huge risk. If you leave your job, you either have to pay the entire loan back right away, or take a huge tax penalty. In fact, tax penalties hit if you don’t pay the loan back on time for any reason. Moreover, you’re jeopardizing your retirement security and losing tax benefits, because you’ll repay your loan with after-tax funds, but that money is treated the same way as your tax-deferred contributions when you withdraw it in retirement.
- Cash advances: Credit cards lenders will also loan you cash to pay for things you can’t charge. The interest rates on those cash advances are usually exorbitant, with median rates of 24.24%, according to CreditCards.com. This option should be considered one of your last resorts, something to consider only when you’ve exhausted nearly all other avenues for borrowing.
- Car title loans: These are short-term loans that — as the name suggests — use your car as collateral. The amount you can borrow is based on the vehicle’s value, and the lender will take your car if you don’t repay them in a timely manner, so the risk is high. Interest rates and fees are often exorbitant — the FTC warns that you can expect a triple-digit APR — and you may be required to pay for costly add-ons like a roadside assistance plan. Despite their high costs, people turn to car title loans if they have no credit cards and cannot get approved for conventional loans.
- Payday loans: These are secured by personal checks or bank accounts. The borrower writes a post-dated check or provides their bank account information to the lender in exchange for a short-term loan. The check is for the amount of the loan, plus a fee. The lender gives you money immediately and agrees not to cash the check until your next payday, when you will, in theory, have the cash to cover it. The annual percentage rates (APR) on such loans can be more than 300%, so they’re a terrible option used most often by people with no other access to credit.
Whenever you borrow money, no matter what approach you take, you pay for the privilege. Sometimes, borrowing is unavoidable, especially if you experience an emergency or need to make a big purchase.
Still, if you can break the cycle and stop borrowing for anything other than assets that go up in value — like a home — you’ll put yourself in a far better financial position. Try some techniques to cut spending, such as creating (and living on) a budget, or switching to cash instead of cards for routine purchases. If you get your expenses and outlays below your income, you can build up a a savings cushion that you can tap instead of borrowing.