There are a couple of situations in which borrowing money is appropriate. One, when it’s profitable: You earn more with the borrowed money than you pay to borrow it. Two, when your back’s against the wall, and you simply don’t have a choice.
Here’s this week’s reader question:
My father loaned me $25,000 to buy a foreclosure home. I need to pay him back ASAP. What’s the best place to borrow from, and the best way to borrow? Thanks. — Brent
Before we get to Brent’s question, here’s a video that will help provide answers.
Now let’s discuss some specifics about the best ways to borrow.
The next time you’re thinking about borrowing money, consider one or a mix of these seven methods, most of which bypass banks.
1. Zero percent interest credit cards
Credit cards with a zero percent interest rate are one way to borrow without paying interest, at least for a designated period of time. You can find examples in the credit card section of our Solutions Center. These cards offer “teaser rate” incentives with grace periods from six to 18 months.
These promotions are typically for purchases or balance transfers only, not cash advances, so they probably won’t work for Brent. In addition, after the card’s zero APR period expires, interest rates can be as high as 25 percent. So while zero is by definition the lowest rate you can get, these credit cards are short-term solutions.
What could be a good option for Brent is a mortgage, second mortgage or home equity line of credit. These allow you to borrow longer-term, the interest is potentially deductible and, in the case of a first mortgage, may carry rates as low as 4 percent.
If Brent already has a mortgage on his foreclosure property, he could look into a second mortgage. As the name implies, a second mortgage resembles a first: You borrow a fixed amount, often at a fixed rate, and have a level monthly payment until it’s paid off.
A home equity line of credit acts more like a credit card. You’re approved for a certain amount and draw on it as needed. Like a credit card, the interest rate is generally variable, and your payment is based on the amount outstanding.
Second mortgages are generally the way to go when you have a large lump-sum expense, such as a major addition to your home, college tuition or, as in Brent’s case, you need a lump sum of cash.
A line of credit would be more appropriate when you won’t need all of the money at once, or want to borrow some, pay it back, and then borrow more.
Before taking out any kind of mortgage loan, be sure to read the fine print, focusing on rate and fees, and do lots of comparison shopping.
One major caveat when you’re borrowing against your home: Don’t ever use this type of loan to support a lifestyle you can’t afford. There’s a popular warning among those in the credit counseling business when it comes to using a home as a source for cash: “Buy a blouse, lose a house.” In other words, when you borrow with a mortgage, you’re risking the roof over your head. Don’t do it lightly.
3. Margin loans
Margin loans use securities such as stocks and bonds as collateral. They allow you to put up half the purchase price when you buy stocks, or borrow up to half of your stock’s value whenever you’d like. Retirement accounts, however, aren’t eligible.
Rates vary by company and the size of the loan. As I write this, online brokerage firm ETrade, for example, says it charges 9 percent on a $25,000 loan. To get that loan, Brent would need to provide at least $50,000 of eligible securities as collateral.
The big risk with margin loans occurs when margined securities drop in value, resulting in the infamous “margin call.” Should your margined securities fall by a certain amount, the brokerage firm calls you for more money. Fail to cough it up immediately, and they’ll liquidate enough of your investments to get it.
To better understand margin investing, check out this page of SEC.gov. And to find the best online brokerages, check this page of our Solutions Center.
4. 401(k) loans
If Brent has a retirement plan through his job, he might be able to borrow from it. Employers are allowed to restrict lending criteria or not offer loans at all. Limits vary, but you can generally borrow up to half of your account balance, with a maximum of $50,000.
Rates can be low, and the best part is that you’re paying interest to yourself, essentially taking money out of one pocket and putting it in the other.The big caveat when it comes to these types of loans is this: If you quit your job or get laid off, you’ll have to repay the loan in full, usually within 60 days. If you can’t, you’ll owe income taxes on the entire amount, as well as a 10 percent penalty.
For more on this option, see “Ask Stacy: Should I Borrow From My Retirement Account to Pay Debts?”
5. Borrowing from family or friends
What Brent has already done — hitting up family and friends — can be one of the worst ways to borrow money. However, it can also be smart if the circumstances are right and proper precautions are taken.
For borrowers, this can be the safest kind of loan because you don’t have to worry about hidden fees or surging interest rates. On the other hand, you want to be confident that borrowing doesn’t put a strain on your relationship. To keep your relationship intact, make it as official as possible.
To make sure everyone’s on the same page, draft a legal document specifying rates, terms and due date. You can find the necessary forms cheap or free at any number of legal websites by searching for “promissory note.”
Like any other type of loan, this type requires on-time payments and a complete understanding between the parties. Nobody likes to see their friends or family spending on things like vacations or luxury items when they’re still owed money.
6. Peer-to-peer and other direct lenders
Also known as marketplace lending, peer-to-peer lending means bypassing banks and their tight purse strings by getting a loan through online platforms that either dole out money themselves or from multiple individual personal lenders. This might be a good way for Brent to find a lower-rate loan without jumping through banking hoops.
Borrowers can search for a lender on such sites as Lending Club or Prosper. The rate of interest you’ll pay will depend on your credit: If your credit score is very low, you may not be able to borrow this way at all. But if you have a good credit score and need a short- to medium-term loan, peer-to-peer can beat the banks.
MTN writer Maryalene LaPonsie in an earlier post described some of the big names in the industry today:
Prosper: Arguably the originator of for-profit peer-to-peer lending in the U.S., Prosper offers loans from $2,000 to $35,000. Rates vary widely based on your creditworthiness. The initial application asks for your address, income, credit score, loan amount and not much else.
Lending Club: Another of the early peer-to-peer lending sites, Lending Club also lends in amounts up to $35,000. Rates vary widely based on your creditworthiness. Its application process is remarkably similar to Prosper, with only basic information needed to get a rate quote.
Kabbage: [This lender] is specifically for small businesses and offers lines of credit of up to $100,000. Repayments are made on a six-month term, with fees ranging from 1 percent to 13.5 percent as of this writing.
Upstart: Targeting millennials who may not have the creditworthiness of more established borrowers, Upstart has a more involved application process. While still short, the application asks for information such as where you went to school, when you graduated and what you studied. “We built a model that … looks at your employability,” says Upstart CEO Dave Girouard. Loans from $1,000 to $50,000 are offered, with interest rates based on credit quality.
7. Credit unions
Credit unions typically offer flexible lending and lower rates than banks. As we explained in “9 Reasons to Love Credit Unions (and Not Big Banks),” credit unions typically pay higher interest on savings and charge less on loans. Many offer mortgage loans, and they’re a great source of car loans as well.
Credit unions might also offer signature loans, an unsecured loan guaranteed only by your signature. Obviously, you’ll need a membership and good credit, but this can be a good source of short-term cash.
What should Brent do?
It’s impossible to know the best option for Brent without additional information. We don’t know his cash flow, whether he has good credit, a 401(k) or securities he can borrow against. But one thing we do know: The better his credit, the more options he has. He may also be able to combine multiple sources to come up with the required money.
Bottom line? There’s no one-size-fits-all solution when it comes to borrowing money, and the less you borrow, the better. But if you’re going to borrow, at least these options could result in lower costs and a faster payback.
Got a question you’d like answered?
You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here. The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.
I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. If you’ve got some time to kill, you can learn more about me here.
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