The idea of borrowing money can be overwhelming. That said, the average college student relies on student loans, credit, and other lending resources. But how do different types of borrowing compare? And which one is right for you? Here’s everything you need to know about borrowing money and how to make the most of it.
Why People Borrow Money
There are tons of reasons why people borrow money. Some of those reasons are better than others, but here are the most common.
Car loans are one of the most common types of loans. Apply for pre-approval at your bank or credit union before shopping around to give yourself more buying power and prevent various dealerships from running your credit. Remember, running your credit lowers your score, albeit marginally. But if multiple dealerships run your credit, those little hits add up. Reserve new credit checks for cars you’re sure you want to buy after the test drive.
Few people have the upfront cash to buy a home. Getting the best interest rate on a home loan involves a combination of market value, down payment, credit history, and other factors. That said, it’s never too soon to start saving for your first house.
College tuition costs more and more every year. And considering that college loans can take a lifetime to pay back, finding the right loan for your budget is crucial.
Medical expenses vary, but even breaking a bone can put people into debt. However, having insurance or medical savings can help mitigate the bill.
A lot of people use credit cards and lines of credit for emergencies like flat tires, unforeseen expenses, etc. If you have trouble keeping your hands off your credit card, then a line of credit is likely the better option.
Should You Save or Borrow?
Before you borrow, consider if saving is a viable, cost-effective option. For example, let’s say you live in a major city with great public transportation. One day, your car breaks down, and it’ll cost $500.00 to fix. You can either put the $500 on your credit card and get your car back the same day. Or you can leave it in the shop for a week until your paycheck comes in. In this case, it’s better to wait.
However, using that same example, let’s say you need your car to get to and from work and that your next paycheck is going towards rent. In that case, it’s better to use your credit card to ensure you continue having money via your job.
While this example is a bit of a broad stroke, it helps show how savings vs. borrowing is a complex topic. Here are a few things to consider,
What Are the Costs of Waiting?
For example, let’s say your car is making a weird sound. You won’t be able to get the problem fixed for a month, and the sound is getting worse. In this case, it’d be better to repair the car since the sound not only makes the car unsafe but also will lead to more complicated issues that you’ll also need to pay for. By fixing the car now, you’re saving yourself money later.
Is It Essential?
For the most part, save borrowing for the essentials. School, car, food, internet, etc., are essential. If you have your eye on a new video game, jacket, or other non-essentials, then it’s better to save for it.
Is it Worth Paying Interest On?
If you don’t pay your balance in full for the previous month, your credit card charges you interest. That amount varies but let’s say you buy something on credit for $300 and take a few months to pay it off. In total, you end up paying close to $400. Was the item worth that amount? Asking yourself that question before paying may be the pause you need to make a different choice.
How Borrowing Money Can Be Transformed into a Good Financial Habit
Despite the overwhelming nature of getting your first credit product, borrowing money can benefit your life in various ways. With the proper practices and a little restraint, you can set yourself up for lifelong financial growth. Here’s how.
The biggest benefit to borrowing is improving your credit score. High credit helps secure low-interest loans for cars, cars, homes, and more. Getting the lowest possible payments helps prevent stress and gives you more room in your budget. Because life has curve balls, having a lower payment helps should you ever find yourself making less money than when you initially took on debt.
On a smaller, more niche scale, having good credit is a requirement of certain finance jobs.
Most small businesses need loans during their early years to stay afloat. That means there could come a time when your credit history is the only thing standing between you and your dreams of owning a small business. That said, a stable business will operate more on revenue than credit.
Helps Create a More Stable Environment
Many years down the line, you may want kids and a spouse. And even if you plan to fly solo for a lifetime, having a stable address does wonders for your mental health and equity. Many people have to bounce from apartment to apartment and rely on multiple incomes to keep a roof over their heads. There’s no judgment. The economy is what the economy is. But you can avoid that by practicing good money habits as soon as possible. You’ll be able to afford apartments in nicer areas and, in the long run, better homes. That way, the home you buy will earn value over time instead of losing it. Feel free to raise a family or travel knowing your home base is waiting for you.
The Downsides of Borrowing Money
It’d be irresponsible of us to only talk about the pros of borrowing money. So here are a few of the biggest downsides to credit products.
Debt is the number one downside to borrowing. That said, only the wealthiest among us make it through life, never having to borrow a dime. Something can be said about the frugal among us as well. But the average person needs credit cards, car loans, etc., to live a modest life. Just remember only to borrow what you need. Lenders may approve you for thousands more than you requested. You don’t have to take the total amount. Additionally, make it a priority to pay high-interest loans back first. Everything above your minimum payment goes directly to the principal balance.
Not all lenders are created equally. Shopping between prime rate lenders will get you a variety of interest rates. For example, the average person’s interest rate for a car loan can fall between 4%-10%. 10% is incredibly high in most scenarios. But these ranges are normal. Shady lenders or sub-prime lenders charge astronomical interest rates under the guise of helping people with bad credit. It’s not uncommon to hear of car loan rates as high as 30% (which, to be clear, is entirely unacceptable and you should never agree to.)
Shady lenders exist in all forms of borrowing. If a loan sounds too good to be true, then it likely is. Do your due diligence to prevent signing up for a subprime loan.
This particular downside is more about the person than the lender. Many people borrow far more than they should and spend more than they borrow. If you have a high credit card balance and the charges are mostly made up of impulse purchases that you don’t immediately pay off, you may be overindulging, also known as mismanaging finances.
To prevent this, download a budget app, speak with your local advisor, and take steps to better your finances.
Types of Borrowing
Here are the most common types of credit products and their average interest rates at the time of this article. Also be sure to read our article on loans 101 for college students, which I briefly cover in the first few sections below.
The average student loan has an interest rate as high as 7.5%. But with the right cosigner, transcript, and credit, you can get one much lower than that. Start working on acquiring student loans as soon as possible. And put as much of your own money toward tuition as you can. It’ll save you money in the long run.
Personal loan interest rates can go as high as 15%. Personal loans are typically used to pay for large unexpected expenses. For example, car repairs, emergencies, home repairs, etc. Personal loans are rarely the best option but can come through in a pinch if a person has no prior credit products such as lines of credit or credit cards. The better alternative to a personal loan is a line of credit.
In my personal opinion, car loans are one of the biggest opportunities to save money. Most people purchase a current-year car for upwards of 18k despite only making about 35k per year. It’s worth noting that even new cars have mechanical issues. It’s better to research the most reliable vehicles in your area and shop for one with low miles and manageable fixes. For example, a car in perfect condition except for a tear in the driver seat and a bad stereo and approx 90k miles is typically a cheaper, equally long-lasting investment compared to its current year version. Shop smart when it comes to cars. And if you don’t know what makes one vehicle better than another – do research.
Home loans may seem increasingly out of reach in today’s economy, but the market changes. The average home loan can go as high as 8% and as low as 3%. Getting the best rate involves credit history, open credit products, and downpayment. The general rule of thumb for home purchases is to have 20% cash for the downpayment. That said, there are many state-based factors in buying a home. Do your research before shopping.
Check out our basic guide to mortgages for college students to learn more!
Home Equity Lines of Credit are lines of credit with limits and interest rates based on the value of your home. A HELOC offers most homeowners the best emergency option regarding repairs, expansions, and general expenses. A HELOC can also come in card format.
Credit cards have one of the most varied interest rates in all of lending. Individuals with credit in the 800 range can expect rates as low as 3-4%, but those with bad credit will see rates as high as 30%. Most people have rates between 10-19%. Credit cards are unique because, unlike other monthly bills, the money you pay on them is still accessible. So if your budget allows an extra $50 to go to your credit card, then, by all means, pay it. You can always charge it to the card if you need it later.
Retirement accounts allow you to borrow off of your own equity. You can’t access the full value of your account until you come of age, but you can borrow a set percentage against it at a lavishly low-interest rate. Borrowing against retirement accounts should be done sparingly, as you’d hate to have multiple loans on the account once you reach senior age.
Peer-to-peer, more commonly stylized as P2P, is a lending format in which people lend money to each other and borrow against a shared pool. For example, if ten people put forward $100, the group has $1,000 to lend to themselves. This base concept is what a lot of credit unions were initially.
P2P lending can be tricky if not done through an approved organization. For example, message requests on social media about turning X amount of money into X amount should never be taken seriously. Due your research into an organization before trusting it as a lender.
Golden Rules of Borrowing
- The Golden Rules of Borrowing change depending on who you ask. But after years of working in personal finance, here are the best rules to live by.
- Never borrow more than you need and pay more than the minimum.
- Read the terms and conditions.
- Never borrow from a place of desperation.
- Being able to finance something doesn’t mean you can afford it.
- It’s better to save and spend than to borrow.
- Keep an eye on your credit score and the average interest rates for your range.
Common Borrowing Terms and Definitions
Here’s a quick glossary of common lending terms.
- Annual Percentage Rate: APR is the magic number that decides how much you pay in interest charges every month. The higher the APR, the higher your monthly payment.
- Term: Term refers to the length of the loan. For example, a 24-month term allows for up to two years worth of payments.
- Debt-to-Income: Also known as DTI, Debt-to-income refers to how much money you make each month vs. how much money you spend on bills. It’s almost as important as your actual credit score.
- Minimum Payment: The smallest amount you can pay to satisfy the loan and not be considered late.
Books and Resources to Learn More About Borrowing Money
Here are a few resources to consider before borrowing. Check out all the books in our personal finance library for college students for more subjects!
The Total Money Makeover Workbook
Dave Ramsey, the famed financial advisor, wrote a book that covers everything from spending to saving for retirement. Because Ramsey has been an expert in his field for decades, this book is chock full of in-depth tools and more. At just shy of 260 pages, it’s a slightly longer read, but it’s irreplaceable for those that have the time to read it.
The Successful Lender’s Field Guide
The Successful Lender’s Field Guide goes into depth about the math, history, and purpose of lending. It’s a great way to get the bank’s perspective on loans and an understanding of credit that most consumers simply don’t possess. It also covers advanced financial resources like stocks and business development. Check it out!
Another great resource to stay up to date on the prime rate (the number that decides how much interest you pay.) The prime rate changes periodically, and fedprimerate.com – a government website – helps you accurately track it. Be sure to check it out!
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