Americans in 2017 have $3.7 trillion in consumer credit outstanding, according to the Federal Reserve. That figure does not include the roughly $14 trillion in mortgage-related borrowing. Clearly consumers can find many places to borrow money, with each type of borrowing having pros and cons. It’s good to understand how credit options work to make the best choice when you need to borrow money.
Credit Card Purchase
With a debit card, you’re withdrawing money from your own funds, but with a credit card you are effectively borrowing from the provider for a short period. If you pay the money back in full by the due date, you generally will not pay interest. However, if you pay less than the full amount, you will pay interest on the continuing balance. While interest rates vary from about 10% to over 20% for those with bad credit ratings, the average credit card APR is around 16%.
PROS: The grace period of the credit card, the time required for repayment, may be as much as 21 days. Some credit cards offer rewards or small rebates for purchases if the balance is consistently paid in full. New purchases up to your credit limit do not require new loan applications, so money is available instantly.
CONS: Late payments and missed payments may result in higher interest and fees. Unpaid balances continue to accrue high interest charges. Cards may have annual fees.
SOURCES: Banks, other financial services, retail organizations, service organizations, numerous branded entities.
Credit Card Advance
This is similar to a credit card purchase, with three additional negatives: a transaction fee is charged, interest charges begin from the instant the advance is provided and the interest rate is generally higher than for purchases.
Mortgage, Home Equity Loan and Home Equity Line of Credit (HELOC)
When you buy a house, you pay a down payment, often 20% or more, and borrow the remainder of the home price as a mortgage. Repayment is amortized as equal monthly payments spread over the length of the loan, typically 10 to 30 years. After you have built equity in your home, home equity loans (or second mortgages) and HELOCs let you use part of the value of your home as an asset to borrow back the money from your home equity to use for other expenses.
PROS: Other than paying cash in full, a mortgage is probably the best way to become a home owner. Interest rates for loans secured by a home are typically the lowest of all borrowing options. These are among the few loans with potentially tax-deductible interest (consult a tax advisor to learn more). Home equity lending can be used for many purposes, such as home improvement, debt consolidation and major expenses like weddings or education.
CONS: Because of the size and complexity of these loans, the approval process may take longer than other loans, possibly months. The house is used as collateral for all these loans, so if the borrower cannot make all payments on time, the home is at risk for foreclosure. These loans typically have longer terms than other options,.. Refinancing, home equity loans and HELOCs may extend the length of repayment and actually increase the total interest paid over the length of the loan.
SOURCES: Banks, other financial services, FHA, VA.
A personal loan is not secured by collateral, such as a home or a car, and can be used to consolidate debt or provide funds for a major expense or unexpected need. Approval is based on credit score and expected repayment capabilities based on ongoing income.
PROS: Creates a fixed monthly payment, which may be helpful for budgeting. Rates can be lower than credit cards. Consolidation and reducing credit utilization across multiple cards can improve financial stability. Can be used for many purposes. Faster application timelines than mortgages.
CONS: Rates are generally higher than mortgages. Rates also generally increase as credit rating decreases with APRs that can go from single digits to above 20% or even 30% depending on your situation. Approval may be more difficult than secured loans.
SOURCES: Banks, other financial services.
Strictly for a new or used vehicle purchase.
PROS: Rates are generally lower than personal loans because the car is used as collateral. Dealers typically provide instant decisions during the car purchase transaction.
CONS: As the loan is secured, your car can be repossessed if you do not make all payments on time.
SOURCES: Banks, other financial services through car dealers
Strictly for education-related expenses, often with a term of 10 to 25 years.
PROS: Historically interest rates have been lower than credit card and personal loans. Federal loans often have lower rates than private providers. Some loans have a six-month grace period after leaving college before the start of repayment.
CONS: Starting adult life with a big debt burden can be troublesome.
SOURCES: Banks, other financial institutions, federal government.
This is the generic name for a short-term, high-interest loan that nominally provides emergency funds from one payday to the next. In effect, the borrower writes a check for the borrowed amount plus a fee and the total is repaid or removed from his checking account after a short, fixed term. Extending the loan incurs an additional fee.
PROS: Generally no credit checks are needed. Access to cash is fairly quick. For unbanked individuals, this may be one of the few borrowing options available.
CONS: Payday loans have among the highest interest rates, sometimes as much as triple digit annual percentage rate (APR), especially if they are extended multiple times. Scams are prevalent in this business.
SOURCES: Online and brick-and-mortar providers.
This is a secured loan. You are borrowing from your personal funds in your retirement 401k or other instruments (but not IRAs).
PROS: Interest rates are often lower than credit cards, personal and other loans.
CONS: While the loan remains outstanding, you may not be able to make pretax contributions, thus incurring higher taxes. If you do not repay your loan, you may be subject to a penalty of 10% for early withdrawal. The intent of this account is saving for retirement, so borrowing against it is counter to that intent.
SOURCES: Financial service where your retirement funds are held.