Debt should be incurred with caution. Yet there are ways to take advantage of your available credit to enjoy a purchase, make an investment, or take care of an emergency. Here is a guide to finding out which form of borrowing will best suit your needs as well as some pointers on finding the lowest-cost loan available.
Let’s take a look at the various ways you can borrow money-and the negative and positive aspects of each.
HOME EQUITY LOANS
By using the equity in your home, you may qualify for a sizable amount of credit, available for use when and how you please at an interest rate that is relatively low. Furthermore, under the tax law-depending on your specific situation-you may be allowed to deduct the interest because the debt is secured by your home.
Related Guide: Please see the Financial Guide: HOME EQUITY LOANS: How To Shop For The One That’s Best For You.
HOME EQUITY LINES OF CREDIT
A home equity line of credit is a form of revolving credit in which your home serves as collateral. Because the home is likely to be a consumer’s largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills-not for day-to-day expenses. With a home equity line, you will be approved for a specific amount of credit- your credit limit-that is the maximum amount you can borrow at any one time while you have the plan.
Many lenders set the credit limit on a home equity line by taking a percentage (say, 75%) of the appraised value of the home and subtracting the balance owed on the existing mortgage.
Example: A home with a $60,000 mortgage debt is appraised at $200,000. The bank sets a 75% credit limit. Thus, the potential credit line is $90,000 (75% of $200,000 = $150,000 – $60,000).
In determining your actual credit line, the lender will also consider your ability to repay by looking at your income, debts, other financial obligations, and your credit history.
Home equity plans often set a fixed time during which you can borrow money, such as 10 years. When this period is up, the loan may allow you to renew the credit line. But, in a loan that does not allow renewals, you will not be able to borrow additional money once the time has expired. Some plans may call for payment in full of any outstanding balance, while others may permit you to repay over a fixed time.
Once approved for the home equity plan, you will usually be able to borrow up to your credit limit whenever you want. Typically, you will be able to draw on your line by using special checks. Under some plans, borrowers can use a credit card or other means to borrow money and make purchases using the line. However, there may be limitations on how you use the line. Some plans may require you to borrow a minimum amount each time you draw on the line-for example, $300-and to keep a minimum amount outstanding.
Some lenders also may require that you take an initial advance when you first set up the line.
TRADITIONAL SECOND MORTGAGE LOANS
If you are thinking about a home equity line of credit you might also want to consider a more traditional second mortgage loan. This type of loan provides you with a fixed amount of money repayable over a fixed period. Usually the payment schedule calls for equal payments that will pay off the entire loan within that time.
Tip: Consider a traditional second mortgage loan instead of a home equity line if, for example, you need a set amount for a specific purpose, such as an addition to your home.
In deciding which type of loan best suits your needs, consider the costs under the two alternatives. Look at the APR and other charges.
Caution: Do not simply compare the APR for a traditional mortgage loan with the APR for a home equity line-the APRs are figured differently. The APR for a traditional mortgage takes into account the interest rate charged plus points and other finance charges. The APR for a home equity line is based on the periodic interest rate alone. It does not include points or other charges.
Automobile loans are among the most common types of loans today. Your automobile serves as the security for the loan. These loans are available not only through banks but also through automobile dealers. However, the dealer itself does not provide the financing; it simply routes the loan to an affiliated finance company, such as the General Motors Acceptance Corporation (GMAC).
Planning Aid: Please see Auto Loan Rates for a reference on how to obtain an auto loan.
Borrowing against your securities can be a low-cost way to borrow money. No deduction is allowed for the interest unless the loan is used for investment or business purposes.
Caution: If your margin debt exceeds 50% of the value of your securities, you will be subject to a margin call, which means that you will have to come up with cash or sell securities. If the market is falling at the time, a margin call can cause a financial disaster. Therefore, we recommend against use of margin debt, unless the amount is kept way below 50%. We think 25% is a safe percentage.
CD AND PASSBOOK LOANS
Because the rate of interest you are earning on the CD or savings account is probably less than the interest that would be charged on the loan, it is usually a better idea to withdraw the money in the account (waiting until the term of the CD is up, to avoid penalties), than to borrow against it.
LOANS AGAINST 401(K) PLANS AND LIFE INSURANCE
One advantage of borrowing from a 401(k) plan or profit-sharing plan, assuming loans are permitted, is that the interest you pay goes back into your own pocket-right into your 401(k) or profit-sharing account. The amount of the loan is limited.
Loans against life insurance policies used to be available at fairly low rates. If you can get a rate of 5 or 6% on a loan against the cash value of your life insurance policy, it is generally a good deal. If the rate is any higher than this, such a loan is generally not a good idea.
CREDIT UNION LOANS
Credit union loans may be available at lower rates than those of banks.
BANKS AND SAVINGS AND LOANS
If you obtain an unsecured loan at a bank, the rate will be higher because there is no collateral. For this reason, unsecured bank loans are generally not attractive.
CREDIT CARD ADVANCES
These are almost always a bad idea, despite their convenience, because of the high rate you will pay.
If you are thinking of borrowing, your first step is to figure out how much it will cost you and whether you can afford it. Then shop for the credit terms that best meet your borrowing needs without posing undue financial risk. Look carefully at the credit agreement and examine the terms and conditions of the various possibilities, including the annual percentage rate (APR) and the costs you will pay to establish the plan.
The Truth in Lending Act requires lenders to disclose the important terms and costs of credit, including the APR, miscellaneous charges, the payment terms, and information about any variable-rate feature. In general, neither the lender nor anyone else may charge a fee until after you have received this information. Use these disclosures to compare the costs of loans. You usually get these disclosures when you receive an application form and you will get additional disclosures before the loan is made. If any term has changed before the loan is made (other than a variable-rate feature), the lender must usually return all fees if you decide not enter into the loan because of the changed term.
INTEREST RATE CHARGES AND LOAN FEATURES
Credit costs vary. By remembering two terms, you can compare credit prices from different sources. Under Truth in Lending, the creditor must tell you, in writing and before you sign any agreement, the finance charge and the annual percentage rate.
- The finance charge is the total dollar amount you pay to use credit. It includes interest costs, service charges and some credit-related insurance premiums. For example, a $10,000 loan may have a 10% interest rate and a service charge of $100; thus, the finance charge would total $1,100.
- The annual percentage rate (APR) is the percentage cost (or relative cost) of credit on a yearly basis. This is your key to comparing costs, regardless of the amount of credit or how long you have to repay it:
Example: You borrow $10,000 for one year at 10%. If you can keep the entire $10,000 for the whole year, and then pay back 11,000 at the end of the year, the APR is 10%. On the other hand, if you repay the $10,000, and the interest (a total of $11,000) in 12 equal monthly installments, you don’t really get to use $10,000 for the whole year. In fact, you get to use less and less of that $10,000 each month. In this case, the $1,000 charge for credit amounts to an APR of 18%.
All creditors–banks, stores, car dealers, credit card companies, finance companies-must state the cost of their credit in terms of the finance charge and the APR. Federal law does not set interest rates or other credit charges. But it does require their disclosure so that you can compare credit costs. The law says these two pieces of information must be shown to you before you sign a credit contract or use a credit card.
Interest rates may be either fixed or variable. A variable rate must be based on a publicly available index (such as the prime rate published in some major daily newspapers or a U.S. Treasury bill rate). Lenders then add a margin, i.e., a number of percentage points, to the index value to arrive at the interest rate you will pay. This interest rate will change, mirroring fluctuations in the index.
Tip: Because the cost of borrowing is tied directly to the index rate, ask what index and margin each lender uses, how often the index changes, and how high it has risen in the past.
Sometimes lenders advertise a temporarily discounted rate – a rate that is unusually low and often lasts only for an introductory period, such as six months.
Variable rate plans may have a ceiling (or cap) on how high your interest rate can climb over the life of the loan. Some variable-rate plans limit how much your payment may increase and how low your interest rate may fall if interest rates drop. Some lenders may permit you to convert a variable rate to a fixed interest rate during the life of the plan or to convert all or a portion of your line to a fixed-term installment loan.
With a variable rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a loan that calls for interest-only payments. At a 10% interest rate, your initial payments would be $83 monthly. If the rate should rise over time to 15%, your payments will increase to $125 per month. Even with payments that cover interest plus some portion of the principal, there could be a similar increase in your monthly payment, unless the agreement calls for keeping payments level throughout the plan.
Agreements generally will permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable-rate plans may not allow you to get additional funds during any period the interest rate reaches the cap.
REPAYING THE LOAN
Consider how you will pay back any money you might borrow. Some plans set minimum payments that cover a portion of the principal of the amount you borrow plus accrued interest. But, unlike the typical installment loan, the portion that goes toward principal may not be enough to repay the debt by the end of the term. Other plans may allow payments of interest alone during the life of the plan, which means that you pay nothing toward the principal. Thus, if you borrow $10,000, you will owe that entire sum when the loan ends.
Regardless of the minimum payment required, you can usually pay more than the minimum. Many lenders may give you a choice of payment options.
Whatever your payment arrangements during the life of the loan-whether you pay some, a little, or none of the principal amount of the loan-you may have to pay the entire balance owed when the loan ends, all at once. You must be prepared to make this “balloon” payment by refinancing it with the lender, by obtaining a loan from another lender, or by some other means. If you are unable to make the balloon payment, you could lose any security given for the loan (e.g., your home or car).
Even when you understand the terms a creditor is offering, it is easy to underestimate the difference in dollars that different terms can make. Suppose you are going to borrow $6,000. Compare the three credit arrangements below:
LENGTH OF LOAN
TOTAL FINANCE CHARGES
TOTAL OF PAYMENTS
|Creditor A||14%||3 years||$205.07||$1,382.52||$7,382.52|
|Creditor B||14%||4 years||$163.96||$1,870.08||$7,870.08|
|Creditor C||15%||4 years||$166.98||$2,015||$8,015.04|
How do these choices stack up? The answer depends partly on what you need.
- The lowest cost loan (total payments) is available from Lender A.
- If you were looking for the lowest monthly payments, that would be available from Lender B. This is because you are paying the loan off over a longer period of time. However, you would have to pay more in total costs. The loan from Lender B-also at a 14% APR but for four years-will add about $488 to your finance charge.
- If that four-year loan were available only from Lender C, the APR of 15% would add another $145 or so to your finance charges as compared with Lender B.
Other terms, such as the size of the down payment, will also make a difference. Be sure to look at all the terms before you make your choice.
Before signing for a home equity line of credit or other type of home equity loan, weigh carefully the costs of a home equity debt against the benefits. Remember, failure to repay the line could mean the loss of your home.
Many of the costs in setting up a home equity line of credit are similar to those you pay when you buy a home, such as:
- A fee for a property appraisal, which estimates the value of your home;
- An application fee, which may not be refundable if you are turned down for credit;
- Up-front charges, such as one or more points (one point equals one percent of the credit limit);
- Other closing costs, which include fees for attorneys, title search, mortgage preparation and filing, property and title insurance, as well as taxes; and
- Yearly membership or maintenance fees.
You also may be charged a transaction fee every time you draw on the credit line.
You could find yourself paying hundreds of dollars to establish the plan. If you were to draw only a small amount against your credit line, those charges and closing costs would substantially increase the cost of the funds borrowed. On the other hand, the lender’s risk is lower than for other forms of credit because your home serves as collateral. Thus, annual percentage rates for home equity lines are generally lower than rates for other types of credit. The interest you save could offset the initial costs of obtaining the line. In addition, some lenders may waive a portion or all of the closing costs.
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