Getting a loan may sound like a simple process because it is. You go to a lender like a bank, apply for a loan, and you pay it back later. But getting a loan that works for you is a whole different story. Knowing when to get a loan and knowing which types of loans address your current situation best takes a lot of knowledge and a bit of experience – two things most people don’t have. This is why getting a loan is essentially calls for a thorough thinking process. You need to know many things, such as:
- Is taking out a loan the best option for you right now?
- What kinds of loans are available, and which one is best for your situation?
- What are the possible interest rates and how can you make things work for you?
There’s no one-size-fits-all in getting loans. Some types of loans will work for you, others won’t. Here, we’ll take a look at the entire thought process of taking out a loan and hopefully guide you to make the right decisions so that the loan you eventually decide to get doesn’t backfire and cause you to be buried in more debt.
Should You Be Getting a Loan?
A lot of financial advisers will tell you that you should save borrowing money as a last resort, and they do so for a good reason. A lot of people are easily tempted to just borrow money thinking that they’ll be able to deal with it later, when what usually happens is that they don’t. As a result, people get into a lot of money problems they could have easily avoided if they didn’t borrow the money they shouldn’t have to begin with. After all, the best way to get out of debt is to not owe people money in the first place.
So you need to ask yourself WHY exactly do you need the money because it will affect the answer to your main question: do you need to get a loan for this? Some of the easiest reasons that justify getting a loan are usually urgent, such as when there’s a medical emergency or you need to make immediate repairs for something. Other reasons are more indirect, like when you don’t have alternative sources of funding or when these alternatives, at the moment, are a lot less practical than just getting a loan.
Urgent Expenses: If you’re banking on getting a loan for the first reason, then you better make sure that the expense you’re loaning for is something you really need to pay for. Keep this in mind because it’s very easy to believe that we need something under normal circumstances when, in the context of a financial emergency, they’re not necessary at all. You’re going to want to strip down to basics, which usually involves three things:
- Every medical emergency is a real one. If you or a loved one gets sick and need costly medical attention, then you definitely need to get that loan. There are also other health related concerns like making sure you’ve got enough to eat, etc., and these are important too. Your health is important above all other things because without it, you can’t do much.
- Having a roof to live under is also a basic necessity. You need it to keep yourself safe and have someplace to rest. However, the gray areas are more apparent with home finances compared to health. For example, you need to discern between repairs that are absolutely necessary. If you’re renting an apartment, you might try to check if you can practically afford the rent you’re paying, in which case, moving out to a cheaper place could be better. Otherwise, borrowing money to get by with rent for the month can be a more practical choice.
- Work or livelihood. There are things that you need to sustain in order to be able to keep your job or business, which is your source of income. Maybe you need a financial buffer to your business capital so it doesn’t incur greater losses. Or perhaps you need to get your car repaired so that you can get to work on time every day. Anything that your job or business needs to survive is no doubt a non-negotiable expense.
Note that the above are just some of the bare essentials. Some things might be important enough for a loan as well, and you can add that to the list. But while a medical or car emergency might be no-brainers for getting loans, you might want to reconsider that family or group vacation you’ve been planning if you’re in a financial bind. Always remember that what you need now might not seem as important in a financial crisis.
As for the second reason, you’ll want to look at two factors, namely: (1) the availability of alternatives, and (2) whether they are better choices to a loan. With the credit industry becoming more and more diverse, you’ll definitely find some of these alternatives available to you:
- Borrowing from your retirement plan. Most qualified retirement plans allow their plan holders to borrow some money from the retirement assets and pay them back with interest that’s usually lower than some conventional lender.
- Borrowing from an insurance policy. This usually applies to whole life insurance policies with cash values. If the money you need is lower than the insurance policy’s surrender value, then you can apply to borrow money from the policy, to be paid back with typical interest rates (though they’re sometimes much lower compared to personal or payday loans). Just remember that you need to have a repayment plan because any money you borrow from the policy will reduce the value your beneficiaries will get from the policy.
- Credit card Advances. This one can be tricky. Sometimes their interest rates and fees are higher than the typical loans, but if your credit card is in good standing then they might be more convenient and more practical than your average loan.
- Payroll Advances. If you’re an employee and you need money, then you might want to check if you can borrow money from your employer. Of course, this will be charged off your future salary, but at least you’re sure you have a means of paying back that you badly need today.
- Government lenders. This varies greatly between states because they have different initiatives for giving financial aid to their constituents. Check out whether there are special government bodies within your locality that can give out loans. Because it’s more of a government service, the loans here tend to have lower interest rates and considerate terms.
- Church-backed loans. If you’re a member of a church or live in a church community, you might be able to get this. Some churches today assist their members by providing them with small loans.
- Peer-to-Peer lending/borrowing from friends or family. These are new age types of loans where individuals you may know might be willing to lend you some money within a formal or informal arrangement. Consider yourself lucky if you’ve got people who will lend you money not only because you’ll get really low interest rates (sometimes none at all), but because it means that you know people whom you can depend on when finances get tight.
- Bill forbearance. Some non-financial institutions like cable TV companies or utility providers will consider extending due dates on your bills. You can negotiate with these companies to let you pay them a bit later than usual, and then use the money saved for the more important expenses.
- Pawning or selling assets. When the money gets tight, you can let go of some valuable that you don’t really need any more for some money. If you have them pawned, you can get these valuable back once you pay the money you borrowed on time. If you’ve got potential buyers, you can also sell off some stuff you don’t need any more for some quick cash. You’d be surprised at how many things you own that you don’t need any more.
Keep in mind, however, that the alternatives mentioned above are not always better options to loans. What you need to do is to compare these choices with your loan options (to be discussed later). When doing so, consider the following factors:
- How much money will you be able to borrow and how much do you need?
- What are the interest rates and fees? Which one is more affordable?
- How long do the loan terms last? How do you pay the money back?
- What are the terms and conditions of the loan?
The guide questions above tackle very important aspects of a good loan: interest rates and loan costs, loan values, and payment terms and conditions. All these form part of a loan that works for you.
Picking the Loan that You Need
So you’ve decided that a loan is the best solution to your financial problem. But your thought process isn’t over yet. There are so many kinds of loans that you still need to choose which one works best for you. This requires some basic knowledge on the different kinds of loans and their features. Loans are categorized according to the following:
According to Collateral: Loans are either secured or unsecured. Secured loans are those that require a collateral or property that the lender can take and sell for value in case you are unable to pay the loan when it falls due. Naturally, those who offer collateral will be able to loan a value depending on what the collateral is worth and is more likely to get a higher value than from unsecured loans. This is because the security you provide for the loan makes the lender more confident to lend you more.
Unsecured loans have less risk to you, but they’re not ideal for those who have bad credit ratings because lenders won’t trust these kinds of borrowers without any additional security. Some unsecured loans also have a tendency to impose higher interest rates.
According to Term: Loans can vary as to the time before your payment is due and the frequency of payments.
- Loans by installment allow you to borrow money based on a pre-arranged schedule. The usual setup is that you will be paying your loan on a monthly basis, subject to change for a number of factors (but this doesn’t usually happen). This loan term will work well for you if you know that you’ll have money on a regular basis to slowly pay back the debt.
- A loan with a repayment term is similar to a loan by installment, except that they’re directed to a more specific transaction. You get these kinds of loans when you purchase a car that you can pay in a three year or 36-month period or something similar. Because the periods are longer, the amounts you pay monthly are smaller but the total amount you pay is larger because of the higher interest rates that come with the longer period. This is a good choice is you think you can’t accumulate the monthly payments unless they’re spread out on a larger period.
- Revolving loans are the kind where the balance you pay will always vary per month. As such, your payment will also vary, depending on the terms of the loan. A good example of this is a credit card loan, where you can either pay the amount you’ve loaned for that month in full or pay partially or have the balance “revolved” to the next monthly balance.
- Line of Credit is a kind of revolving loan, but your borrowing capacity is more limited. You can opt to borrow the entire amount at one time and pay it off quickly or borrow parts of it over certain periods. How you consume the credit will also affect your payment period. This is a good choice for those looking for a limited but flexible loan.
According to Purpose: This is where loans become more specific. You’ve probably heard of most of these loan types:
- Personal Loans. This is the most common type of loan. You can get a certain amount that you have to pay back over time with interest. But what makes this type of loan so popular is that you can use the money for any purpose you want. This type of loan doesn’t usually require security but if you have bad credit the lender might ask more guarantees on your ability to pay.
- Debt Consolidation Loans. Simply put, this is a type of loan that’s used to gather up all your other debts so that they can be paid off. You’re making a loan to pay off other loans. You can loan a specific amount and pay off all the debts or you can assign particular debts on which the money will be used to pay.
Other Specific Loans
All these other types of loans fit here because they’re essential just like any other loan, except that in contrast to personal loans where you can do whatever you need with the money, these loans already have specific transaction in mind. Here are some of the more common types:
- Student loans – used to help offset the cost of higher education and are usually paid off when the student graduates and starts working. These loans can be taken from the federal government or from private institutions
- Mortgages – you can use this if you want to purchase a home which you can’t pay for upfront. The house itself becomes the collateral for the loan.
- Auto loans – just like the mortgage loans, except that you’ll be using this to purchase a car, using it as collateral.
- Payday loans – as the name of the loan suggests, you take out a loan in anticipation of your next paycheck. This has high interest rates, but they’re useful for helping you get by until your next paycheck.
- Small business loans – need to expand your business? There are financial institutions especially intended to help out small scale businesses compete better.
Taking Out the Loan
So you’ve decided which type of loan you need. From here, taking out the loan is a simple process, especially if you’ve chosen to take out a simple personal loan. In most cases you’ll only need to fill out a form and present identification credentials. There might be additional requirements if:
- You’ll be assigning a collateral to the loan
- You have bad credit rating
- The lender has other special requirements
The requirements will vary from lender to lender, but only slightly. More often than not, they will try to make the process as simple for you as possible. You will usually get your loan on the same day or in a couple of days.
But as mentioned before, getting a loan and making the most of it are two very different things. Here are some things to help you make sure that the loan works out for you in the best way possible:
- Shop around. A loan is a financial service and many lenders compete for borrowers. Just like any other product, you’ll want to go through a wide selection of lenders before you settle for one. Try to focus on annual percentage rates or APRs, since that’s where these lenders will compete with one another.
- Read the Contract. Always be aware of every single term on the contract. It might sound like a tedious task, but you should never take the terms of the contract for granted. While you’re not expected to be an expert on all the terms, you should at least know the basics, such as:
- How much total you’re paying
- How much the interest rates are
- Important dates, such as when you’re supposed to pay
- Consider getting PPI. This stands for Payment Protection Insurance. It’s not very popular in the industry but it has proven to be useful in some cases. PPI protects you from your inability to pay due to sickness or unemployment. It’s “literally” insurance for your own debts.
- If you really need the money, most lenders will consider your personal circumstances and help make the loan work for you. You can go a long way with trying to ask if the interest rates can be brought down or to adjust the payment schedules to your favor.
- Borrow as much as you need. Some people have this tendency to only loan half of the actual amount that they need for whatever reason. Since you’re already taking out a loan on something important, you may as well loan the entire value. Higher loans usually result to lower interest rates, so you get more value for the money you borrow.
- Avoid taking multiple loans. This is in relation to the previous tip. Not only do multiple loans entail higher rates per loan, having multiple records of taking a loan with different lenders can look bad to lenders because they’ll see this as an indicator of increased risk. This might prompt them to impose higher rates or demand collateral.
- Put up the right collateral. Unlike home equity or car loans, there are loans where you get to choose what security you’re putting up against the loan. The rule of thumb is to avoid over securing your loan. Try to match the value of the security with the actual loan.
While it’s always better to avoid being in debt, we can’t avoid situations when we need to borrow money. The best thing you can do in this case is to loan smart. By going through the thought process and observing the practices mentioned above, you not only avoid the pitfalls of loans, but you make the loan work for you in the best way possible.