If you are certain that you really need to borrow money (i.e., you have determined there is no better alternative), there are a number of types of credit from which you can choose. Perhaps, you have not given much consideration to some of them.
Have you thought about borrowing from yourself? For example, if you are permitted to borrow from your investment program at work, whatever interest that you pay will go into your own account. However, you will lose all of the earnings that you otherwise would have received if you had not borrowed from your company investment plan.
If you have a life insurance policy that has a cash value, you probably can borrow from the life insurance company, using the cash value of your policy as collateral. This may be one of your least expensive sources of borrowing, other than from yourself.
Home equity loans are generally an attractive source of borrowing. One of the major advantages of home equity loans is that, unlike most consumer loans, the interest that is paid can be claimed as an itemized deduction on the borrower’s income tax returns. Therefore, the aftertax interest rate for a home equity loan is usually less than the aftertax interest rates on most other types of consumer loans, but only if you itemize your deductions on your income tax return(s).
If you decide to obtain a home equity loan, be sure you do not get one that has a variable interest rate, rather than a fixed rate. This is especially true if there is no cap (i.e., maximum) on how much the interest rate can be raised either annually or over the life of the loan. If you have a variable interest rate home equity loan with no cap and there is a substantial rise in mortgage rates, the increase in the interest rate on your loan could create major financial problems for you – possibly even the loss of your house.
If you can obtain a loan from a credit union, this may be another relatively inexpensive source of borrowing.
Loans from banks, if secured by collateral such as a car, may also be a relatively inexpensive source of borrowing. Unsecured bank loans charge somewhat higher interest rates.
Credit from retailers, consumer finance companies, and credit cards usually carries somewhat higher interest rates than the previously mentioned sources, although there are times when special offers may result in temporarily very low, or even zero, rates. Usually, a retailer may give you a good deal on merchandise, but the retailer’s credit terms are not likely to be as favorable as you can get elsewhere. Conversely, if a retailer is willing to charge you a low interest rate, the price you pay for the merchandise itself will almost certainly be higher than it otherwise would be. This is especially true of automobile retailers. In this regard, consider the following excerpts from The Wall Street Journal (8-20-86):
[A lady in St. Louis] wanted the low [percentage rate] financing that her [automobile] dealer was offering, but she thought the price for the [car] was too high.
“I told the salesman to just forget it,” she recalls. “So he went in to see his boss and came back and said, ‘We can make a deal at [a] lower price if you finance the car yourself.’”
[The lady concluded], “The [percentage] isn’t a true [percentage]. They were going to make up losses from that low rate by charging more for the car.”
South Carolina’s consumer-affairs chief . . . [says], “The water-bed theory applies here: When you push down on one part, the other part will go up. And what goes up here is the price of the car.”
[He] also warns of added charges if dealer financing is chosen – dealer preparation, additional markup, ‘availability’ costs and the like.
Also, . . . dealers’ reduced-rate financing may be available only on certain slow-selling makes and models. . . .
Finally, car buyers who want dealer financing often find their choices limited to current dealer stock.
As for credit card usage, please see our article entitled “Credit Cards.”
There are at least two types of borrowing that should almost always be avoided: Loans by mail and income tax refund-anticipation loans. Both carry very high interest rates. Some loans by mail may charge annualized interest rates well in excess of 30%, and the rates on income tax refund-anticipation loans can be even higher. According to a study cited in The Wall Street Journal, the annualized interest rate for loans on an average income tax refund was an astounding 85%.
After you have incurred debt, the alternative costs of borrowing from each source should be reconsidered periodically to determine if it would be prudent to switch to a difference source of borrowing.
It is important to decide which of your debts should be paid off first. From a strictly financial standpoint, debts carrying the highest interest rates should be paid off before those having significantly lower interest rates. For example, it would be more prudent to pay off a credit card balance that carries an 18% interest rate than to pre-pay on a mortgage with a 5% interest rate, especially if you can take an income tax deduction for the interest on the mortgage. On the other hand, there may be a psychological reason (e.g., a greater sense of relief) why a person might choose to prepay on their mortgage, rather than apply extra money toward paying off a credit card balance.
If your preferred type of credit can be provided by more than one lending company, comparison shop periodically to determine if the lender that is providing your credit still has the best rates. Take into consideration not only the differences in the interest rates being offered, but also any fees that you would incur as a result of making a change.