A Practical Guide to Credit and Loans
If you need cash, you need to choose the type of loan that best fits your situation. We break down your borrowing options and how to use them effectively.
As Americans face rising costs on just about everything, the amount of debt they're taking on is going up, too. Credit card balances recently reached a record $1.28 trillion. And according to credit-reporting company Experian, 38% of U.S. consumers now have a personal loan, with the number of these loans on credit reports reaching 67.5 million. Both of those figures represent the highest levels since Experian started collecting data in 2017.
For some, the strain of staying afloat is becoming more evident. The financial stress index from the National Foundation for Credit Counseling (NFCC), which reflects the financial ability of consumers to repay unsecured debts, recently hit its highest level since the NFCC began tracking it in 2018.
“I'm not surprised. I see a lot of people dealing with short-term financial pressure, and it's been going on for a while,” says Leah Hadley, a wealth adviser in Cleveland. A large, unexpected bill can leave households with no choice but to take on debt if they don't have a cash buffer to absorb the extra expense. (Or they may tap their retirement savings. Last year, about 6% of eligible participants in Vanguard 401(k) plans took a hardship withdrawal — an all-time high.) And while the unemployment rate was recently a relatively low 4.3%, the average time it takes job seekers to find work is the longest it has been since 2019. During an extended bout of unemployment, families may rely on credit or retirement savings to make ends meet.
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But economic challenges are only part of the picture. Even financially comfortable households are borrowing more frequently rather than paying cash, says Derik Farrar, head of everyday borrowing at U.S. Bank. Some are taking on loans strategically to fund, for example, a badly needed home renovation, while others are incurring debt to keep up with lifestyle inflation — say, upgrading to high-end cars or taking luxury vacations.
Another factor is how much easier it has become to borrow, and to borrow larger amounts, with the click of a button. Financial technology companies such as SoFi, Prosper and LendingClub, for example, let consumers take out personal loans online in as little as 24 hours, without ever speaking to a representative. Buy now, pay later (BNPL) plans from fintechs such as Affirm, Afterpay and Klarna have surged in popularity in recent years, allowing shoppers to delay payment on purchases big and small by signing up for a plan at online checkout. And major retailers, airlines and hotels tout their credit cards to customers, promising ample rewards on their spending — but with the potential to rack up high-rate debt, too.
While borrowing may be quicker and more convenient, the challenge of paying it back remains. Even a decent income isn't surefire protection against debt trouble. People seeking credit counseling now have an average household income of about $70,000, up from $40,000 before the COVID-19 pandemic, according to data from the NFCC.
Ideally, you'll have an emergency fund with at least three to six months' worth of living expenses, stored in a safe, easily accessible place, such as a bank savings account. But if you exhaust those funds — or haven't built them yet — you may have to look to other sources of cash in a pinch. Or, if you need extra money to finance a big project, such as a kitchen remodel, you may be looking to narrow down the best borrowing strategy.
If you decide to borrow, the key is understanding how the loan fits into your finances and how you'll repay it. This guide breaks down the main borrowing options and how to use them effectively.
Questions to ask before getting a loan
Before taking on a loan, step back and ask a few key questions. The answers can help you decide whether borrowing makes sense and, if so, determine how you'll repay the debt.
1. What are you borrowing for? Productive vs unproductive debt
Anytime you consider taking on debt, ask what you're getting in return and how long that benefit will last. For example, borrowing to renovate your home or launch a business can improve your finances over time, boosting your home's value or increasing your income and net worth.
Debt that covers short-term spending, such as shopping for designer clothes or going on a vacation, is less valuable and doesn't build wealth. Farrar frames the former as productive debt and the latter as unproductive, adding that unproductive debt should be minimized.
2. Can you reduce how much you need to borrow?
If you decide to get a loan, try to maximize how much of the expense you can cover yourself, limiting the amount you borrow. Even a small reduction in the loan balance can lower your monthly payments and make the loan easier to repay.
Start by reviewing your budget and identifying areas to cut back on discretionary spending, such as dining out or subscriptions. “People don't always realize how much they're spending until they actually sit down and look at their budget,” says Michael McAuliffe, president of Family Credit Management, a nonprofit debt-relief organization in Rockford, Illinois.
You can also look for ways to bring in additional income through part-time or gig work. This is especially important if you're borrowing to cover ongoing expenses. “In this situation, more loans are not the answer. People need to change their long-term habits,” says McAuliffe.
3. Can you afford to pay off the debt?
Make sure you can comfortably handle the monthly payments on any future loans. This is especially important with secured debt, which is backed by an asset; missing payments can put your home or retirement savings at risk. And keep in mind that being able to make the minimum payment doesn't necessarily mean the debt is affordable in the long run.
McAuliffe says that he has seen clients underestimate their total outstanding balances by tens of thousands of dollars. For that reason, it's important to look beyond the minimums and have a clear plan for paying down the balance. A debt-repayment calculator can help you estimate how long it will take based on your target monthly payments.
4. Are you getting the best terms?
Once you've decided to borrow, the next step is to make sure you do so on the best possible terms. A little preparation can lift your chances of approval and help you qualify for lower interest rates.
Start by checking your credit reports and making sure your accounts are in good standing. You can get your report from each of the big three credit-reporting companies (Equifax, Experian and TransUnion) weekly for free at AnnualCreditReport.com. Are there any mistakes dragging down your credit score, such as a credit card issuer reporting a missed payment that you made on time?
You'll also want to gather basic documentation, such as recent pay stubs, bank statements and tax returns, especially if you're applying with a new lender. “The more you borrow, the more you’ll need to verify,” says Farrar. Working with a bank or credit union where you’ve already developed a relationship can improve your chances of qualifying. However, check with a few other lenders to see whether any of them offer you a better rate. Some lenders also provide prequalification tools that let you estimate potential rates without undergoing a credit check.
Types of loan: Consider your options
When it comes to a loan, the right choice for you depends on how much you need, how quickly you can repay the debt and what assets you have available to borrow against. Here are some options to consider.
Zero-interest credit card offers
For short-term borrowing, a credit card with a 0% introductory interest rate on purchases can be one of the most cost-effective options. These offers typically allow you to carry a balance for 12 to 21 months without owing any interest. If you pay off the balance in full before that window closes, it’s essentially a free source of borrowing. A few of the top options include Chase Slate, U.S. Bank Shield Visa and Wells Fargo Reflect, which all offer new customers a 0% rate for 21 months.
The trade-off: If you’re still carrying a balance after the promotional period ends, interest starts up, usually at a high rate, flipping an initially attractive offer into one of the most expensive sources of borrowing. The average credit card rate is about 24%, according to LendingTree. No-interest credit card offers make sense for smaller purchases that you can pay off relatively quickly, such as car repairs or furniture.
“I don’t have a problem with 0% offers as long as you treat them as a short-term bridge,” says Hadley. “You need a plan to get rid of the debt before the deal expires.”
Home equity lending
If you own your home, you may be able to borrow against its value through a home equity loan or a home equity line of credit (HELOC). To qualify, you typically need to have equity — in other words, the difference between the value of your home and the outstanding balance on your mortgage — of at least 15% to 20%. You'll also need to provide proof of income and have a decent credit score, usually of at least 680.
Home equity loans, which provide you with a lump sum of cash up front, come with a fixed interest rate and a set schedule of monthly payments that do not change. Average home equity loan rates were recently about 8%, according to Bankrate, though your rate will depend on how much you borrow, the length of the loan term and your creditworthiness. A home equity loan can make sense for a large, one-time purchase or expense, such as a home renovation project.
A HELOC is a revolving credit line that offers more flexibility, allowing you to borrow at your convenience, repay and borrow again over time. “Even if you don't see a need right away, having a HELOC in place can give you access to cash in an emergency,” says Kenyon Sutton, a financial coach in Jacksonville, Florida. If you set up a HELOC and then lose your job, for example, you can still borrow against it. HELOCs recently had an average rate of 7%, according to Bankrate. But the rate is usually variable, meaning your monthly payment can go up and down based on market conditions.
Because your home secures these loans, they typically come with lower interest rates and open the door to larger borrowing amounts than unsecured loans. While unsecured personal loans tend to max out at $50,000, home equity lending could allow you to borrow in the six figures or higher, assuming you have the equity to back it up.
The trade-off is the level of risk. If you miss payments, you could eventually lose your home. These loans also charge up-front origination fees of around 0.5% to 1% of the borrowed amount. And you can't turn to home equity loans if you're in a hurry. They take time to launch because the lender has to evaluate your home's value.
Personal loans
With a personal loan, you get a lump sum of cash and pay back the loan on a set schedule, usually between one and five years. You can see the scheduled repayments and total cost of the debt when you apply.
On average, interest rates on personal loans (at about 12% for those with decent credit) are lower than standard credit card rates. But unlike some credit cards, personal loans don't come with an initial 0% period, so you owe interest immediately. With that in mind, personal loans often make sense for borrowing that will take a few years to pay off, such as home improvements or a new appliance. Borrowers also commonly use personal loans to pay off their high-rate credit cards, refinancing the debt at a lower interest rate. You need to show proof of income to qualify for a personal loan, so don't count on getting one to cover expenses if you lose your job.
Personal loans are widely available through both online lenders and traditional banks or credit unions. Online lenders tend to offer a faster application process and approval, with funds often available within a day or two. Banks and credit unions take longer to process loan applications, but they can offer lower interest rates. And you may have a better shot at qualifying by getting in-person assistance from a representative, especially at financial institutions where you have a long-term relationship.
“Online is faster, but there's no one to advocate for you. There's less flexibility on the borderline,” says Sutton.
Buy now, pay later plans
BNPL plans split purchases into smaller payments, typically charging no interest during this time. The standard BNPL plan lasts six weeks, though it can be stretched out to 24 months or longer for larger purchases. Used responsibly, BNPL can be a tool to spread out the cost of the occasional big-ticket purchase — say, to buy a new dishwasher after your old one breaks down. But BNPL's convenience too often leads borrowers to overuse it, spending more than they can afford on food delivery, clothes or other discretionary purchases.
“The problem isn't the first BNPL purchase, it's that they keep adding up,” says Farrar from U.S. Bank.
You also need to pay attention to the fine print. In some cases, “no interest” offers come with a catch. For example, if the balance isn't paid off in time, borrowers may owe substantial penalties or retroactive interest.
Money that you borrow from your 401(k) is out of the stock market until it's repaid, missing out on potential growth.
401(k) loans
If you have a workplace retirement plan, there's a good chance it allows you to borrow from your balance. Roughly 79% of 401(k) plans offer loans, according to research from John Hancock. If your plan is among them, your employer determines how much employees can borrow through the program rules, up to the IRS limit of 50% of your vested account balance (the amount you could keep after leaving the job) or $50,000, whichever is lower. You must repay the loan within five years.
Unlike many other types of borrowing, getting a loan through your 401(k) doesn't require a credit check. The interest rate depends on the plan, but typically, it's the prime rate plus one or two percentage points. Recently, that equaled 7.75% to 8.75%.
While those features might make a 401(k) loan sound like an appealing route to take if you need cash, there is a substantial downside: The money you borrow is also out of the stock market until it's repaid.
“People focus on the interest rate, but there's much more to the story,” says Hadley, the Cleveland wealth adviser. “You're missing out on any potential growth during that time.” Considering the S&P 500's average return over the past 30 years is about 10% per year, that's an additional opportunity cost of borrowing on top of interest.
There's also an added risk if your job situation changes. If you leave your employer, the loan typically needs to be repaid within a short time frame — about 90 days, depending on the plan. If it isn't, the remaining outstanding balance is treated as a withdrawal, triggering income taxes on the unpaid amount plus a 10% early-withdrawal penalty if you are younger than 59½.
Because of these risks, 401(k) loans are typically best used only if more-favorable options aren't available to you — say, because you can't qualify for other loans.
How to get on top of your debt
1. Start with a clear payoff plan
As you create a plan to whittle your debt, consider trying the “snowball” method, which involves ranking the debts by size. You make the monthly minimum payment on all of them, and any extra funds go toward the card or loan with the smallest balance. That way, you pay off one account as quickly as possible, banking a win that motivates you to continue to the second-lowest balance, and so on.
Alternatively, the “avalanche” method targets the loan with the highest interest rate first. After that, you tackle your other loans in descending order of the interest rate. This strategy saves you the most in monthly interest charges over time.
2. Consolidate cautiously
Debt consolidation involves combining multiple existing loans and credit card balances into one larger loan, with a single monthly payment and often a lower interest rate. You may, for example, use a personal loan or home equity loan to pay off multiple credit cards and other high-rate debts. But if you go this route, make sure to make changes in the spending habits that landed you in debt in the first place.
"People take out a consolidation loan, and then the credit cards are still available," says Michael McAuliffe, president of Family Credit Management.
"They don’t mean to, but they charge them back up," causing people to sink even further into debt.
3. Reach out to current creditors
Lenders may offer hardship programs, such as deferred payments or rate reductions for borrowers who have lost their jobs, face a sudden medical emergency or are dealing with other temporary setbacks.
4. Turn to credit counseling
If the situation becomes difficult to manage on your own, a nonprofit credit-counseling agency can help create a structured plan and negotiate with your creditors on your behalf to lower interest rates or get more time to pay off the debt. You make one monthly payment to the service, which uses the money to pay your creditors.
The agreement typically forces you to temporarily shut down most of your credit cards for future purchases, and enrolling in a debt-management plan can have a short-term negative impact on your ability to borrow in the future. You can find a local credit counselor through the NFCC or the Financial Counseling Association of America (FCAA).
This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to Kiplinger Personal Finance Magazine to help you make more money and keep more of the money you make.
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