Photo (cc) by kevin dooley
There are a couple of situations when borrowing money is appropriate. One, when it’s profitable: you earn more with the borrowed money than you pay in interest. Two, when your back’s against the wall, and you simply don’t have a choice.
Last week, we warned you about the dumbest ways to borrow money (hint: some payday loans charge nearly 400-percent interest rates if compounded annually). Today, we explore some smarter ways to borrow. In the video below, Money Talks News founder Stacy Johnson explains the benefits of zero-percent-interest credit cards, margin loans, and more. Check it out and then read on.
Next time you’re thinking about borrowing money, you may want to consider some of these methods. Since everyone’s financial needs and credit standings vary, look for the option that’s the best fit for you.
1. Zero-percent credit cards
Back in February, we mentioned that credit cards with zero-percent interest rates and no-fee balance transfers were making a comeback. Just this month, credit cards with zero rates are again making headlines. 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. After the card’s zero APR period expires, interest rates can be as high as 25 percent. So while the zero percent is by definition the lowest rate you can get, these credit cards are short-term solutions.
A second mortgage or home equity line of credit allows you to borrow longer-term, is potentially deductible, and offers rates as low as 4 percent.
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, like a major addition to your home or college tuition. A line of credit would be more appropriate when you won’t need all the money at once, or want to borrow some, pay it back, then borrow more.
In either case, be sure to read the fine print, focusing on rate and fees, and do lots of comparison shopping. And 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 about home equity lines of credit: “Buy a blouse, lose a house.”
3. Margin loans
Margin loans use securities like stocks and bonds as collateral. They allows you to put up only 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. Online brokerage firm Scottrade’s range, for example, is 5.25 percent for loans over $1 million to 7.75 percent for loans less than $1,000.
As long as you earn more than you pay in interest, a margin loan will be profitable. The big risk comes when margined securities drop in value, resulting in the infamous “margin call.” Should your stocks fall by a certain amount, the brokerage firm calls you for more money. Fail to cough it up immediately and they’ll liquidate enough shares to get it.
To better understand margin investing, check out this page of Sec.gov.
4. 401(k) loans
If you have a retirement plan, you 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.
Big caveat when it comes to these types of loans: If you quit your job or get laid off, you’ll have to repay it 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.
5. Borrowing from family or friends
Enlisting help from family or friends can be one of the worst ways to borrow money. In fact, we said so just last week in our list of The 7 Dumbest Ways to Borrow Money. However, this can also be a smart way to borrow – if the circumstances are right and proper precautions are taken.
For borrowers, this can be the safest kind of loan, since 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: just do a search for “promissory note.”
Perhaps more than any other type of loan, this type requires on-time payments and a complete understanding between the parties. Nobody likes seeing their friends or family spending on things like vacations or luxury items when they’re still owed money.
6. Peer-to-peer lending
In a recent post, we explained how peer-to-peer lending offers an opportunity as an investment. It might also be a good way to find lower-rate loans.
Borrowers can search for a lender on sites like 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’ve got a good credit score and need a small, short-term loan, peer-to-peer can beat the banks.
7. Credit unions
Credit unions offer flexible lending and lower rates than banks. As we explained in Credit Unions: Better for College Students – and Many Others, according to DataTrac, the average credit union rate on a car loan is 1.5 to 2 percentage points lower than at a bank, and home equity lines of credit average about half a percentage point lower.
Credit unions might also offer signature loans – an unsecured loan guaranteed only by your signature. Obviously, you’ll need membership and good credit, but this can be a good source of short-term cash.
Bottom line? There’s no one-fits-all solution when it comes to borrowing money, and the less you do it the better. But if you’re going to borrow, at least these options could result in lower costs and a faster payback.