Taking out a loan can be a significant financial decision, so it’s best to make it a smart one. Here are five essential things to know before you take out a loan.
1. Why you need the money (and if there’s a better option)
Knowing why you need to borrow money, to begin with, is the most critical factor you need to consider before taking out a loan. Borrowing money is a big financial step, and it can help you or hurt you—depending on how you manage it.
The most substantial loan you’ll ever take out is your home mortgage. If you can afford a sizable down payment and it’s a home that is within (or below) your means, it might mean taking out a loan is worth it.
But what about personal loans?
According to Finder, 47 percent of the consumers they surveyed took out a personal loan to cover bills or emergencies. Borrowing money to pay for things like medical bills, a flooded basement, or a dented car is never ideal, so we always recommend building up an emergency savings first.
That being said, about 69 percent of Americans don’t even have $1,000 saved for emergencies—so I understand why it may be a necessity (although this is a deeper-rooted issue to tackle). So, if you must borrow money for an emergency, make sure you follow the remaining four steps below.
The most considerable portion of the people surveyed by Finder showed that they were taking a personal loan to purchase a vehicle (31 percent). Many people default to looking at auto loans specifically (and many times through the dealer themselves). But, a personal loan can actually be a good solution if you do it right.
If the reason you need the money isn’t exactly an emergency, and you can wait it out a few months (or longer), do it. I strongly recommend you use a tool like You Need A Budget to help you break the total cost you need into smaller, monthly chunks. Then budget for this more significant expense. It’s a more financially-savvy move to save the cash for what you need.
2. How much you can afford to borrow (and pay back)
Now that you’ve determined why you need the money and that getting a loan is in your best financial interest, you’ll need to think about how much you can realistically afford (and pay back).
The word afford is tricky. Just because you can cover the monthly payment, doesn’t mean you can actually afford the loan. In fact, a recent Harvard study showed that nearly 40 million Americans are living in a home they cannot afford.
Cars are similar. A study by Bankrate showed that most families can’t afford the average new car anymore, while a AAA study showed that 64 million drivers would be incapable of coming up with just $500 or $600 for a car repair.
I don’t share these statistics with you to scare you away from taking out a loan—but I encourage you to reframe your thinking on the word afford.
The first step here is to ignore the APR of the loan for a moment. That’s usually the first thing the loan originator will try to sell to you. And rightfully so—it’s a standard way to compare loans quickly and easily.
But what’s even more critical than the APR is the total cost you’ll pay for the loan, sometimes referred to as the TAR (total amount repayable). This is the amount you borrow plus the interest you’ll end up paying over the life of the loan. A simple way to calculate this is by using a basic loan amortization calculator, like this one from Calculate Stuff.
The reason this is important is because an APR can trick you. I’ll give you an example. Say you want to borrow $10,000, and you have two options:
- Option A: $10,000 at 5.00 percent APR over five years (monthly payment: $188.71)
- Option B: $10,000 at 6.00 percent APR over three years (monthly payment: $304.22)
Which is the better financial decision? Option A gives you both a lower APR and lower monthly payment, but Option B is actually the better deal. Here’s how our output looks when using the amortization calculator:
As you can see Option A costs 11,322.74, while Option B only costs $10,951.88—a savings of $370.86. This amount may seem small, but as your loan amount increases and your term becomes longer, these types of gaps continue to widen.
So when you’re thinking about what you can afford, consider the monthly payment, but most importantly consider the total amount you’ll end up paying back.
3. Your credit score (and credit history)
Now that you know what you can really afford to borrow and pay back, it’s time to figure out what type of loan and rate you can qualify for. Enter the credit score.
Your credit score and credit history are the lifeblood of your financial well-being. Without credit—specifically, good credit—you can kiss low rates, low payments, and overall savings goodbye.
One thing I found particularly shocking was that 45 percent of college students don’t know their credit score. A college student is right at the beginning of their credit history in most cases, so I would think this would be the most crucial time to level-set and know where you stand. But it’s not just college students. MoneyTips found that 30 percent of the general population they surveyed don’t know their credit score either.
The point is, you need to know your credit score and your credit history. The good news is that it’s easy to accomplish this. For simplicity, we recommend using free tools like Credit Sesame and Credit Karma. But as a consumer, you’re entitled to get a free copy of your credit report from each of the three credit bureaus (Equifax, Experian, and TransUnion) every year.
We’ve even built a Credit Score Estimator tool so you can estimate what your score should be.
To give you a sense of what’s good and what isn’t take a look at our complete guide on how credit works here.
Before signing the papers on your shiny new loan, make sure you fully understand the terms of the loan. Know the annual percentage rate (APR) and the total cost you’ll pay for the loan (mentioned above), as well as all of the fees you will or could incur throughout the loan.
Here are some of the typical fees or hidden costs that aren’t always openly-discussed (or shown) when you get a loan:
- Loan origination (or loan processing) fee—This is common with mortgages, but it can also show up on personal loans, auto loans, or any other type of loan. This is when the loan provider charges you to process your application. Some lenders charge 1 percent of the loan’s value as an origination fee, for example. So the $10,000 loan we discussed above would cost you $100 just to open it. Outside of home loans, I would recommend you avoid all loans with origination or processing fees—or ask for them to be waived.
- Failed payment fee—A fee charged if you don’t have the money in your account to cover a payment you’ve made. Some lenders will charge you for this.
- Prepayment penalty—This is a fee that the loan processor will charge you if you pay the loan off early. This is actually quite common for many personal loans, and it’s a tactic lenders use to get the full amount of interest from you. Look to make sure your loan has no prepayment penalty.
- Late payment fee—Not only will this hurt your credit score, but most lenders will charge you a fee if you make your payment even a day late. Sometimes you can get this waived as a one-time courtesy, but don’t make it a habit.
You should also know how interest is calculated on the loan. When interest gets compounded, it builds on top of previously existing interest while you work on paying off the loan. It’s typically calculated on either a monthly or daily basis, so making additional or early payments can help reduce this cost.
Some loans have a pre-calculated interest—like student loans. This means that the interest is already part of your monthly payment, meaning you’ll pay the same amount in interest regardless of how much or how early you pay—so you may not be able to save as much money by paying the loan off early.
The goal here is to read through all of the loan documentation to make sure you understand what you’re getting into. A loan is a contractual obligation, and by breaking that contract, you’re hurting yourself financially.
5. All of your loan options, including where to get the loan
Depending on what kind of loan you need, you will have quite a few options at your disposal. The quickest and easiest way to get a personal loan is to go to the bank you already have a pre-existing relationship with. By sitting down with a person and going over a loan application, they can often approve you on the spot. Plus, your loan will be with the same bank, which makes managing the payment a little more comfortable.
But to really save money, I’d encourage you to shop around online. There are many places online that now offer great deals on personal loans. Two of my favorites right now are Fiona (formerly Even Financial) and LoansUnder36. You can use Fiona’s personal loan table, to find the best offers for your needs:
If you’ve ever used SoFi or Earnest to get low rates to refinance your student loans (excellent services by the way), Fiona is very similar. They have a simple form you fill out. It asks how much you need, what you need it for, what your credit score is, and your contact information. From there, Fiona will pull a list of offers for you from multiple lenders so you can choose the best offer for your situation. Fiona makes money by referring you to lenders, and the lenders compete for your business. This way, you get some of the best rates possible on a loan.
LoansUnder36 is a service that offers loans from $500 to $35,000. It’s like Fiona in that it presents you with a list of the best offers for you, based on your lender profile (credit score, income, etc.).
Getting a loan is a big step financially, and shouldn’t be taken lightly. Knowing the details of these five steps is critical. Once you make the decision to borrow money, make sure you’re going with the right lender and most flexible terms.
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