How to pick a loan that best works for your budget

Loans are a tool that, when used wisely, can help with cash flow or increasing wealth.

A loan is something that is borrowed, often a sum of money that is paid back with interest. However, if not managed properly, it can cause long-term financial problems.

So, how do you put your loan to work for you so that it benefits you the way you intended? The key to making smart decisions is to understand the different types of loans so that you can choose what will better meet your objectives.

There are many types of loans, with ranging terms and interest rates. Loans secured by collateral, such as a mortgage or auto loan, will have much lower rates and better terms than unsecured loans. The common factor with all loans is your credit score. Because of this, it is to your advantage financially to manage your credit well.

Buyers with high credit scores have more options when financing due to their history of being a responsible borrower and making their payments on time. Let’s take a look at loan options.

Mortgage

A mortgage is a loan you take out on a piece of land or real estate because you don’t have enough cash, or don’t want to use your cash to buy the investment.

A mortgage works by using the property you are purchasing as collateral for the loan. As the home buyer, you contribute a down payment, and the lender pays the difference between your down payment and the total sale price of the home.

Buying a home is a large purchase and can be a sign of financial stability. Being able to maintain a mortgage payment shows lenders and creditors that you are fiscally responsible. Borrowers with a credit score above 720 are more likely to find a bank that will offer a mortgage that provides favorable terms.

Home equity loans

Home equity loans and home equity lines of credit are often referred to as a second mortgage, both types of loans are secured by a lien behind your primary mortgage. If you default on your payment and the lender forecloses, the primary mortgage is paid back first. The second lien holder is then paid back if proceeds are available from the sale of your home.

Home equity loans are lump-sum loans, with the interest rate, fixed payment, and length of the loan established upfront. In general, home equity interest rates are often lower than that for other types of loans, because they’re secured by the home itself.

Another way to borrow from your equity is with a home equity line of credit (HELOC). A HELOC is a line of credit that you can borrow from as needed—up to your credit limit—over a 10-year draw period. The minimum payment can change monthly due to the interest rate being variable.

HELOCs allow you to make monthly interest-only payments on the amount you have borrowed. You can pay off the loan or carry a balance during the 10-year draw period. If at the end of the period, you have a balance remaining, it will convert usually into a 20-term loan, with a fixed monthly payment.

Reverse mortgage

A reverse mortgage is a loan that allows eligible homeowners ages 62 or older to borrow money against the equity in their home. Reverse mortgages can provide much-needed cash for older people who are cash-poor but have considerable equity in their home.

The homeowner can choose to receive the proceeds in a lump sum, a fixed monthly payment, or a line of credit. Unlike a regular mortgage—a reverse mortgage doesn’t require the homeowner to make any loan payments during their lifetime. Instead, the loan becomes due when the borrower dies, moves out permanently, or sells their home. After the home is sold, the remaining proceeds beyond what the lender is owed go to the homeowner or their estate.

Auto, RV and boat loans

An auto loan is a type of loan that allows you to borrow money from a lender and use that money to purchase a car. The loan will then be repaid in fixed monthly installments over a set period.

A boat loan is a type of financing for the purchase of a boat or related expenses. Boat loans generally have a fixed monthly payment. The loans can be secured or unsecured and have repayment terms of two to 20 years.

Recreational loans financing is available for used and new vehicles. The typical length of a loan is on average 10 to 15 years, but some lenders will extend the term to 20 years for loans greater than $50,000.

Personal loans

Personal loans are commonly used for vacations, weddings, debt consolidation, or emergencies. There are two types of loans: secured and unsecured. Secured loans are backed by collateral, such as a vehicle or savings account. Unsecured loans do not require collateral and tend to be more expensive than a secured loan.

Banks and credit unions offer personal loans and make the process quick. For example, Wells Fargo Bank offers loans from $3,000 to $100,000 with usually a same-day credit decision and with no origination fee or prepayment penalty. Their rates, depending on credit history, range from 7.49% to 24.99%, and terms range from 12 to 84 months.

Credit cards

Credit cards are common forms of credit in the world, allowing users to purchase goods and services now and pay later. Credit cards allow the user to build a continuing balance of debt up to the card’s limit. If the debt is paid off, monthly interest is not charged. If it isn’t the debt will incur interest. In today’s environment, it is common for a lender to charge an annual interest rate as high as 30 percent.

Family loans

Reaching out to a family member for a loan, especially a parent, may be easier than qualifying for a traditional loan from a bank or lender. If you’re lending to or borrowing money from a family member, it is a good idea to formalize the loan with a signed note. Gifts of money to family members without the formality of a note have the potential to cause a family rift if the loan is not paid back as promised.

To avoid problems with the IRS, the loan should be formally structured, with an interest rate at market, and if necessary, collection attempts that are documented. If the loan does not meet these criteria, the IRS may consider it a gift, which could be subject to gift tax.

Payday or pawnshop loans

Payday, title, and pawnshop loans can be considered predatory. Predatory lending practices include failure to disclose information about interest rates or repayment times, disclosing false information, risk-based pricing, and inflated charges and fees. They are short-term loans with high interest rates. These types of loans target individuals who have limited or no other options due to poor credit scores and the desperate need for cash.

Student loans

Student loans are to pay for tuition, fees, and living expenses at accredited institutions. There are two types of student loans: federal and private. Federal loans are obtained by filling out the Free Application for Federal Student Aid (FAFSA) on the studentaide.gov website. Federal loans come with more protections and benefits but charge rates slightly higher than private student loans. If your credit score is high, you may qualify for a lower interest rate with a private loan.

Why loans can be emotional

After you accept the terms and conditions of your new debt obligation, it is normal to have an array of thoughts and emotions. You may second-guess the transaction because you now owe a hefty sum of money on the new mortgage you acquired to purchase a home. Or you may feel excited because you purchased your dream sports car. In some cases, you may even feel denial or anxiety because you used your credit card for a purchase that you know you cannot afford.

Remember, just because you qualify for a loan doesn’t mean that you can afford it. Prior to committing to additional debt, pencil out your budget to thoroughly understand your monthly cash flow. If you cannot afford the new loan payment, hold off and save, applying additional cash down when you can afford the purchase.

Lastly, set your emotions aside while evaluating your new debt obligation. Make your decision to acquire new debt based on your ability to repay the loan.  Loans are tools that, when managed well, can be beneficial to your finances, making your dreams obtainable. Use them wisely.

Teri Parker CFP® is a vice president for the Riverside office of CAPTRUST Financial Advisors and has practiced in the field of financial planning and investment management since 2000. Contact her at Teri.parker@captrust.com.