Learning about how to borrow money the smart way can be overwhelming! There is so much information online, and much of it is complicated, hard to read, and difficult to understand.
Borrowing money smartly can really have a positive impact on your long-term financial future so let’s discuss, in simple terms, how to borrow money, why people borrow money, and then help you decide if borrowing money is right for your financial situation or spending habits!
How Borrowing Money Works
First of all, what does it mean to borrow money?
When you borrow money from a lender, you agree to pay back the principal amount of money that you borrowed PLUS interest on that amount. Lenders will look at a few things before determining if they will loan you money and what interest rate they want to charge you.
Lenders will look at the following:
- Your credit history. Have you ever taken out a loan before? Did you make those payments on time? Did you pay your payments in full?
- Length of credit history. Borrowers that have taken out many loans over the course of many years and that have made consistent, on-time payments are more likely to get a lower interest rate than borrowers that have no loans or haven’t made consistent payments.
- Current income. Lenders want to make sure you make enough money to pay your living expenses AND pay them back the money they are loaning you.
- Debt-to-income ratio. How much debt do you have already compared to your income? When was the last time you took out a loan, and how often do you take out loans? Too many loan applications in a short period of time could flag lenders into thinking you have financial issues.
The Different Types of Borrowing Money
How do you borrow money and how do you start the process of borrowing? Here are 5 ways to borrow money with the pros and cons of each:
- Banks. If you have a bank account with a bank already, you may want to consider applying to them for a credit card or loan. Banks will lend you money for major purchases such as a mortgage, vehicle, student loan, or personal loan. Do some research on the bank before applying for a loan because one major con is that some banks will resell loans to other institutions without telling the borrower.
- Credit Union. Credit unions offer many of the same services as banks, but you must be a member to use them. Because they are usually nonprofit organizations, the interest rate is usually lower than a bank.
- Peer-to-peer lending. This cuts out the institutions and allows individuals to borrow or lend money to each other directly.
- 401k or retirement account loans. This allows you to take a loan against your retirement savings and is usually tax-free because the funds are being borrowed against and not withdrawn from your retirement account early. Even though it’s YOUR retirement account, you don’t set the terms of the loan. The terms are set by the institution.
- Credit card. Credit cards can be used to make purchases or for cash advances. There are no fees to apply for a credit card, and if you pay it off monthly without carrying over a balance into the following month, you pay zero interest.
Why Do People Borrow Money?
People will usually borrow money for major purchases that they don’t have enough savings to cover. Examples include: buying a home, taking a vacation, purchasing a vehicle, making home repairs, covering an unexpected emergency, paying for a wedding, going to college or university.
Others borrow money if they want to consolidate debt they already have. Consolidation loans are used to add as much debt as possible to either have a lower interest rate, have fewer bills to keep track of, or have a lower monthly payment.
This type of loan allows you to clean up a bit of a financial mess if you have one and start to wipe the slate clean. It’s beneficial not to take out more loans or debts after the consolidation until we can manage our money well. Instead, learn how to manage debt and control your impulses to spend money unless absolutely necessary.
Should You Save or Borrow Money?
In the financial community, there are two camps on this topic. The first camp believes that all debt is bad and to pay cash for everything. The second camp believes that borrowing money is a great financial move because you’re spending someone else’s money at a low interest rate and can keep your money in your own pocket or invest it at a higher return rate.
The answer is simple….
How disciplined can you be with money and spending?
If you can control your spending impulses and are disciplined in your approach to money, it will make more financial sense to borrow money for major purchases and save or invest your own money. In the event of an emergency, you have money on hand to cover an unexpected expense rather than needing to stress about it OR you can invest long-term funds for higher rates of return.
If you aren’t as disciplined with money, you should focus on saving money for major purchases and borrowing as little as possible to prevent getting into a financial bind.
How Borrowing Money Can Actually Be a Good Financial Habit
Borrowing money and making on-time payments over time will boost your credit score and give you a longer credit history. To build my credit, I took out small loans with low interest rates and paid them off early.
I would borrow $1,000 from my bank and ask for a $100/month payment, then make six months of payments and pay it off early. This method boosted my credit score very quickly!
Rotating through microloans like that can build and maintain a strong credit history.
Downsides of Borrowing Money
Borrowing too much money, having too much outstanding debt, or borrowing too often will all impact your credit score and long-term credit history. Every time you borrow money will be recorded on your credit history and is called a check on your credit.
Too many checks on your credit could result in you getting denied by lenders for future loans.
If we take out too many loans or the payments become unmanageable, we could have trouble making on time payments. Late payments will impact our credit scores, and if you aren’t able to make payments for too long, the lender may take action against you. Depending on what type of debt you owe, you could have to file for bankruptcy or lose your home or vehicle.
If you don’t have a long credit history or the best credit score, a lender may want to charge you a very high interest rate until your credit improves. This will impact the monthly payment and how much you end up paying back to the lender over the course of the loan.
Golden Rules of Borrowing Money
- Keep a budget. Keep track of your income and your monthly expenses. Understand how much money is being paid out for your debts. If your income or expenses change, make sure your budget reflects those changes.
- Shop around for the best interest rate. I always check with my own credit union first, but I have no loyalty to them. If I find a better interest rate at another institution or better lending terms, I will absolutely use that lender.
- Know and understand the lending terms. How long do you have to pay the loan back? What type of loan is it? What is the interest rate? How much will the monthly payments be? Be sure to understand how much you have to pay, when you have to pay, and how much you have to pay.
- Be mindful of the interest rate. Some loans will have astronomical interest rates that can be higher than the monthly payment on the principal of the loan, which means that not much of the money you pay every month is going toward paying off the loan. If you take out more loans with high interest rates, this turns into a vicious cycle that can be very hard to get out of.
- Check your credit report before applying for the loan. Knowing your credit score will help you understand your options. If you have incorrect information on your credit report, you have an opportunity to dispute it with the credit bureaus. A low credit score or lack of credit history could impact the interest rate that you’re offered, and a higher credit score or longer credit history will, also, impact the interest rate that you’re offered. Either way, don’t let a lender take advantage of you.
How to Have Conversations with Parents About Borrowing Money
As parents, we have made our fair share of mistakes. Some of us are embarrassed by those mistakes where others want to share our lessons learned, so the next generation doesn’t make the same mistakes we did.
Start by asking high-level questions about how to open an account or take out your first loan. Eventually, move into asking questions about how they manage their loans or what they use loans for in your family. Having conversations with loved ones that are making good life choices will help us all learn valuable lessons, so definitely have conversations as often as possible.
Borrowing Definitions
- Loan – money borrowed from a lender with a promise to pay it back with interest
- Borrow – to take money from a lender for a specific amount of time where a borrower promises to pay the money back with interest
- Principal – the borrowed amount of money before interest is paid
- Interest – money paid on top of the borrowed amount. This is the cost of borrowing money
- Debt-to-income ratio – this is how much money you owe versus how much money you earn. This ratio is used to assess a borrower’s creditworthiness so a lender can determine whether or not to loan money or what interest rate to charge
- Term – these are the terms and conditions of borrowing money and include how long you have to pay the money back, interest rate, penalty rate, and special conditions
- Credit report – this is a detailed breakdown of a borrower’s credit history
- Credit bureau – a data collection agency that puts together information from creditors and compiles reports on each borrower
Books and Resources to Learn More About Borrowing
Rich Dad, Poor Dad for Teens – This book offers two very different perspectives on money from two successful men that were mentors to the author. Learn the difference between borrowing money and saving money with how each impacts your life.
I Want More Pizza: Real World Money Skills For High School, College, And Beyond – This book covers a range of personal finance topics like debt, savings, investing, goal setting, and so much more! It’s actually included in some high school curriculums across the country to learn about money management.
How to Money: Your Ultimate Visual Guide to the Basics of Finance– A visual guide that walks teens through personal finance basics of how to manage money, make money, spend money, and manage your debts.
Why Didn’t They Teach Me This in School?: 99 Personal Money Management Principles to Live By – Written by a father of 5, this book was written to pass on his knowledge and life lessons in 8 easy-to-follow steps with 99 principles that fit into each step. This isn’t written in textbook format and won’t put you to sleep, but it is a quick read that’s easy to digest.
Broke Millennial: Stop Scraping By and Get Your Financial Life Together (Broke Millennial Series) – You’re not a millennial, so this book won’t apply to you, right? Wrong. This book uses humor to explain complex financial topics in a way anyone can understand, even novices, in personal finance.
