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Sooner or later, you’re going to want to make a big-ticket purchase like a new home, car, college, etc. But you probably won’t have enough cash on hand to buy it outright or the time it would take to save up that much money. Because of this, you’ll need to get a loan.
For many people, getting a loan is literally the only way to achieve today’s standard of living. I remember getting married and then needing a new car followed by a house almost immediately after.
It wasn’t long before I realized that pretty much no one can afford these types of things without the help of financing.
Even though they’re intended to be helpful, loans can also be dangerous under the wrong conditions. Too many loans or ones that are too big or have high interest rates can quickly have you drowning in debt.
This was a scenario I saw happen right in front of me during the 2008 housing crisis. A lot of my neighbors either borrowed too much money or agreed to terms that were not in their favor.
It ultimately resulted in many of them foreclosing on their loans and walking away from their houses altogether.
In this post, we’ll introduce you to the various types of loans that exist and what you need to know about them. We’ll also talk about the process of getting a loan and some steps you can take to avoid them when possible.
Secured vs Unsecured Loans
The first thing to know about loans is that they can generally be grouped into one of two categories: secured and unsecured loans. Here are the differences between the two:
Secured Loans: Secured loans are backed by what’s known as collateral. In the simplest of terms, this means that if you fail to pay back the lender, then they will seize the property you took the loan out against.
For example, if you buy a car but fail to make the loan payments, the bank will eventually come after you and repossess your car.
Unsecured Loans: Unsecured loans are not backed by any collateral. However, you are still legally obligated to pay them back.
For instance, you could think of a credit card as an unsecured loan because, unlike a car loan, the credit card issuer is effectively letting you borrow the money short-term to make your purchases.
If you fail to make your payments, you won’t lose the items you purchased, but you will still owe the issuer the principal plus interest and penalties.
What are the Different Types of Loans I Can Get?
If you were to go online and start shopping around for loans, something that you’d notice right away is that there are several different kinds to choose from.
Many financial institutions offer loans that target certain purposes and carry specific terms. Here are some of the most popular ones:
- Mortgage – This is a loan that’s used to buy a house. Mortgages are secured loans because the lender can take your property if you fail to make your payments. Most conventional mortgages have a 30-year term and low interest rates (since they are tied to the rates set by the Federal Reserve).
- Home Equity – If you need to make an expensive home repair, renovation, or some other large purchase, then you have the option to borrow against the equity that you’ve built up against your home. However, your home will serve as the collateral, so you have to be careful about why you’re borrowing the money. For example, if you plan to start a new business with your home equity loan and the business fails, then you’d risk also losing your house.
- Auto Loan – This type of loan is for buying a new or used vehicle. Auto loans are secured loans where the vehicle you purchase is also the collateral. The term is generally 5 to 7 years.
- Student Loan – Student loans are unsecured loans used to pay for college tuition, books, fees, room and board, and other living expenses. These loans usually come from the federal government or private institutions and typically have a payback term of 10 years (but can be refinanced for longer).
- Personal Loan – Personal loans are unsecured and can be used for virtually any purpose: debt consolidation, medical bills, weddings, etc. The payback period is typically 1 to 5 years, and the interest rates can vary from 6 to 36%.
- Cash Advance – Aside from being able to buy things, most credit cards also offer their holders the option to borrow against their available balance by withdrawing it as cash. Hence, this type of short-term loan is called a cash advance. However, because their average interest rate is 21.2%, you should avoid them whenever possible. By contrast, you could just make a withdraw from your savings account at an ATM for free or for a $5 service charge.
- Payday Loan – If you need the money from your paycheck one or two weeks early, then you can take out what’s called a payday loan. When you do eventually get paid, you’ll owe the lender your paycheck plus a ridiculous amount of interest – sometimes as high as 600%! Avoid these types of loans like the plague.
- 401k Loan – Though it’s not a great option, most 401k retirement plans will allow their participants to borrow money if needed. Loans cannot exceed $50,000 or 50% of the account balance (whichever is less) and must be paid back within 5 years. Though you can technically use the money for any reason, many 401k loans are often utilized as a down payment for a home.
What Type of Loan is Right for You?
When I was in my young 20s, it seemed like nearly everyone I knew financed the things they owned with the help of loans.
But as I grew older and became savvier with money, I realized that this may not always be the best strategy for making big purchases.
In fact, for some people, it can be a slippery slope that gets them into mountains of debt and possibly even bankruptcy.
Here’s when you should and shouldn’t get a loan:
When Should You Get a Loan?
1. When you can't pay outright with cash. Let’s be real … there are just some times when it's simply not practical to buy something with cash. How many people do you know who have $250,000 lying around ready to spend on their next house? For large-scale purchases like these, sometimes financing is your only viable option.
2. When there is a clear path for repayment. Taking on debt is not the end of the world. If you’ve got a secure job, do your homework ahead of time, and find that the monthly payments for the loan are well within your budget, then it's perfectly acceptable to borrow money if you need to.
3. When the loan terms are in your favor. When the interest rate or payback term is reasonable, then why not spread out your payments? I’ve known many people who gladly take out auto loans as opposed to buying the vehicle with cash. This is because they can instead invest their money and get a higher rate of return than the interest rate they’ll end up paying on the loan.
When Shouldn't You Get a Loan?
1. When the thing you want to purchase may lose all value. One of the most absolutely foolish reasons to get a loan is because you want to invest in something questionable. For instance, you may speculate that a certain stock will go up in value based on a rumor or tip. But then when the opposite happens, you’d lose all of your money and still be on the hook to pay back the loan plus interest. Bad move.
2. When you have no chance of successful repayment. Part of the reason for the 2008 housing crash was because banks started giving loans to people who had no means to pay them back. Even if you get approved for a loan, it's up to you to make sure that it fits within your budget and won’t cause you financial stress.
3. When the loan terms are unfavorable or even predatory. Another reason for the 2008 housing crisis was that many of the loans that were pushed onto consumers had adjustable interest rates. In the case of my neighbors, many of their mortgage payments doubled overnight and led to them losing their homes. In the case of payday loans, these lenders are completely taking advantage of the borrowers by charging them obscene interest rates. Again, you have to understand what it is that you may be signing up for.
How to Get a Loan
If you’ve given it some thought and decided that you’d like to pursue getting a loan, then here’s what you need to know about the process:
Find Out Your Credit Score
I’ve always been amazed by what a difference your credit score can have on your ability to qualify for a loan and what kind of interest rate you’ll receive. Whereas I might get an offer in seconds (since my score is 800+), I’ve had plenty of friends who were either rejected or were offered loans with less than favorable APRs.
If you don’t already know your credit score, check with your credit card company. Many of them now print it or show it somewhere within their app.
Alternatively, Credit Karma is another service where you can find out your most recent credit score for free.
If something seems off about your credit score, then you may want to download a free copy of your report. Look it over for any errors or possible cases of fraud.
Determine How Much You Can Afford
Like I mentioned earlier, a big part of the 2008 housing crisis was the fact that many people were being offered loans that were way out of their financial capability.
Why would banks do this? Because quite frankly they didn’t care. The banks knew the risk but were greedy for profits and approved people for more than they could handle anyways. And now the rest is history.
The only way to combat this is to set a limit for yourself. Know your budget and what you’re prepared to handle. Whatever you do, don’t let anyone convince you into going over the amount you’re comfortable with.
I’ve applied for mortgages and other loans where the officer tried to encourage me to take out more than I needed.
They’ll say things like “Oh, come on! Don’t you want a little extra to go on a nice vacation or spruce up the house?” And every time, I politely decline and proceed ahead with the amount I know I’m good to work with.
Save Up a Down Payment
Although not every loan requires one, some will expect that you’re going to put forth a down payment.
This is especially true for an auto loan or mortgage. In fact, if you put down less than 20% on your mortgage, then you’ll be forced to buy a special kind of insurance called PMI to protect the lender in case you default.
As part of your homework, know in advance if you’ll need a down payment and how much it will be. Start planning as far in advance as possible so that you’ll have it ready when needed.
Get Your Documents in Order
In addition to a down payment, most lenders are also going to ask you for various documents such as your:
- ID and Social Security number
- Recent paycheck stubs
- W2s and past income tax returns
- Financial statements
These types of documents are not only needed to verify your identity, but they are also required to prove that you have the financial means to make your payments.
Be sure you know where these documents are and have copies (or digital copies) that you can share with the lender.
Choose a Reputable Lender
Don’t just go online and apply for a loan with the first lender you find. That’s a good way for someone to either steal all your information or potentially defraud you of the title to your home or car.
One time I got a letter from “Big Jim’s Mortgage Depot” offering to refinance my mortgage. That one was a hard “no thank you” …
Fortunately, you don’t have to look too far to find reputable and well-known companies. Usually, a good place to start is with your local bank, credit union, or a referral from a trusted friend.
You can also go online to find respectable lenders. Major financial sites like Bankrate and Nerdwallet have curated lists of companies that include terms, stats, and reviews.
That way, you can investigate them as much as you want and make sure that they’re legit before moving forward.
I’d recommend asking for soft offers from at least 3 different vendors. A soft offer is when the lender doesn’t pull your credit history (which means it won’t affect your credit score).
Generally, they can give you a good ballpark rate or estimated payment amount based on the information you supply them.
Once you’ve found the best offer, call up the loan officer and proceed with a full application. This will entail doing a hard credit check where the lender will need to pull your credit history.
Once they do this, it will affect your credit score, but not by very much and can usually be recovered within a few months.
You’ll also likely have to submit details about your finances along with some of the documents we mentioned earlier. Again, this is just to ensure that you’re not a credit risk and will have the ability to repay the loan.
For every loan I’ve ever applied to, this process is relatively quick. In fact, my last auto loan took about 15 minutes to get approved from start to finish.
Again, it helps to have all of your information and documents prepared and ready ahead of time.
How to Avoid Needing a Loan Altogether
Loans can help buy some of the major things we need. But they can also become downright dangerous if you start to use them too frequently and get too far over your head into debt.
Here are a few tips for buying the things you want without having to apply for a loan:
The most tried and true of all savings strategies is to plan in advance and put a few bucks aside with every paycheck.
I’ve been doing this with my children’s college by putting $100 per month in a 529 plan since they were born. Over time, that money has grown to tens of thousands of dollars and will definitely reduce (or possibly eliminate) the need for student loans someday.
Budget Your Money
The danger of not having a budget is that your money will slip through your fingers like water. When you budget, you assign a purpose for every dollar you spend. That means you can decide ahead of time what goals it should go towards and how much you can afford.
When I needed a new car this year, I worked a payment of $300 into my budget for the year. Then, when it was time to actually buy a new car, there was no surprise and no financial heartache because I was already prepared to take on this new expense.
Have an Emergency Fund Ready
Sometimes we take out loans for sudden and unexpected reasons. The only way to alleviate this to have an emergency fund set aside for such situations. Target having 3 to 6 months’ worth of living expenses in a separate savings account that can be accessed at a moment’s notice if needed.
Prepare a Contingency Plan
One of my favorite personal strategies for handling emergencies (and avoiding loans) is to have what I call my “contingency plan” prepared.
A contingency plan is basically a list of expenses and financial goals that I could temporarily shut off if there was ever a true emergency. More than once, I’ve had to refer to this list to cover some unexpected expenses like a home repair that was more than I was anticipating.
Build Up Your Retirement Savings
I’m not at all a fan of dipping into your retirement savings when you need money. But if worse came to worse, it is a possibility that you may have to consider.
Forbes reported that nearly 30% of all Americans had to dip into their retirement plans during 2020 due to the COVID-19 pandemic.
Even if your retirement savings is an option of last resort, it’s still a good idea to have a sizeable nest egg in your pocket just in case you need to use some of it.
The Bottom Line
If you need money, then there are many different types of loans you can apply for. However, some will be better suited for certain situations (like a mortgage or student loans) while others should be avoided at all costs (like cash advances or payday loans).
Before applying for a loan, you'll need to consider why you need it, how much you can afford to pay and understand what the terms will be.
Be sure to also check your credit score, have a down payment ready to go, get your financial documents in order, and consider multiple offers from reputable lenders.
Although loans are helpful, there's no need to use them every time and get yourself into more debt than is necessary.
If you're willing to plan ahead, budget your money, and be prepared with an emergency fund, contingency plan, and retirement savings, then you might be able to avoid needing a loan altogether.
As they often say, a little bit of planning can go a long way.
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