Borrowing Money

An Introduction

There are various sources from which you can borrow money, including banks, payday lenders, online platforms, and, of course, friends and family. It’s important to carefully consider your options and understand the terms of any loan before making a commitment. To help you make the best decision for your financial situation, here is a comprehensive overview of the process of borrowing money and the factors to consider.

Disclaimer: The purpose of this guide is to provide information only, and it is not intended to serve as financial or legal advice. While we strive to ensure that all information presented here is accurate at the time of publication, we cannot guarantee its accuracy or completeness. ‍‍

Topics We’ll Cover

1. Overview of household debt in the United States
2. How much Americans borrow from Friends & Family
3. Five options for borrowing money quickly
4. Advantages and disadvantages of borrowing from family and friends
5. Considerations to keep in mind before borrowing money
6. Essential financial terms to understand
7. Explanation of how interest is calculated
8. Commonly asked questions about borrowing money

Overview of household debt in the United States

Here are some high level insights into how much debt American households are carrying. As of the third quarter of 2022, total household debt in the US increased by $351 billion, or 2.2%, to reach $16.51 trillion in total according to the latest report from the Federal Reserve Bank of New York’s Center for Microeconomic Data. This marks a $2.36 trillion increase from the end of 2019, before the start of the pandemic recession.

Mortgage balances, the largest component of household debt, rose by $282 billion to reach $11.67 trillion at the end of September, a 15% year-over-year increase. And credit card balances also saw a significant increase, rising by $38 billion or 15% year-over-year, the largest increase in over 20 years. Auto loan balances increased by $22 billion, while student loan balances slightly decreased to stand at $1.57 trillion. Non-housing balances overall grew by $66 billion.

Mortgage originations, including refinances, reached $633 billion in the third quarter, a $126 billion decline from the previous quarter but returning to pre-pandemic levels. The volume of newly originated auto loans was $185 billion, slightly lower than the previous quarter but still elevated compared to average levels from 2018-2019. Credit card account limits increased by $82 billion to stand at $4.3 trillion.

The rate of debt transitioning into delinquency increased for nearly all types of debt, following two years of historically low transition rates. The delinquency transition rate for credit cards and auto loans increased by about half a percentage point, similar to the increase seen in the second quarter.

How much Americans borrow from Friends & Family

In addition to formal lending sources like banks and credit card companies, borrowing from friends and family members is a common financial strategy for many Americans. In fact, according to a 2023 report by the Federal Reserve, nearly 20% of adults in the U.S. have borrowed money from someone in their close network at some point. This kind of borrowing often takes the form of informal loans, where the terms are not legally structured but instead based on trust and mutual understanding.

The amounts borrowed vary significantly, ranging from small sums to cover daily expenses to more substantial amounts for down payments, business investments, or debt consolidation. On average, individuals borrow about $3,500 from friends or family, although this figure can be higher in certain regions with higher costs of living. While family and friends may offer lower or no interest rates compared to traditional lenders, borrowing in this way also carries its own unique risks, including the potential for personal relationship strain.

Five Options for Borrowing Money Quickly

When immediate funds are needed, borrowers have several options to consider. Here are five popular avenues:

Personal Loans from Banks or Credit Unions
Traditional banks and credit unions offer personal loans with varying terms, often ranging from $1,000 to $50,000. These loans typically require a credit check and may take a few days to process, but they often come with competitive interest rates.

Credit Cards
For those with existing credit lines, credit cards can provide quick access to funds. However, interest rates can be high, so this option is best for short-term borrowing or emergencies.

Online Lenders and Peer-to-Peer (P2P) Platforms
Online lenders and P2P platforms like Prosper or LendingClub offer quick access to funds and often have lower requirements for approval. These loans may be ideal for people with limited access to traditional banking.

Cash Advances
A cash advance from a credit card allows users to withdraw cash, though fees and high interest rates are typically involved. This is a quick, convenient option but should be approached with caution.

Borrowing from Friends or Family
This option may be interest-free or carry low interest, depending on the arrangement. However, borrowing from personal connections should be considered carefully, as repayment issues can affect personal relationships.

Advantages
and Disadvantages of Borrowing from Family and Friends

Advantages:

Lower or No Interest Rates:

Borrowing from family and friends often means benefiting from lower or no interest rates, making it a highly affordable financing option. Unlike traditional lenders, who charge significant interest to offset risks and generate profit, family and friends typically have a personal stake in your success and may be willing to lend at a much lower rate or even interest-free. This minimizes the financial burden and enables you to allocate more funds toward business growth and essential expenses, rather than high interest payments. Additionally, these terms can be more flexible, allowing for adjustments to repayment schedules if unexpected challenges arise.

Flexible Terms:

IInformal loans from family and friends often come with flexible repayment terms that are tailored to suit your financial situation. Unlike traditional lenders, who may have rigid payment schedules and penalties for early repayment, family and friends are generally more open to adjusting terms as needed. This flexibility can provide significant relief during periods of cash flow challenges, allowing you to make payments based on what’s feasible for your business at the time. Additionally, the absence of strict deadlines or penalties for early payments means you have the freedom to repay the loan faster if circumstances allow, reducing debt more quickly and improving financial stability.

Access for Individuals with Poor Credit:

For individuals with limited or poor credit histories, obtaining a loan from traditional lenders can be difficult due to strict credit requirements. Friends and family, however, may be more willing to offer financial support based on trust and personal relationships rather than credit scores. This makes family and friend loans an accessible option for those who may otherwise face rejection or high-interest rates from banks. By providing this support, friends and family enable borrowers to achieve their financial or business goals, potentially helping them rebuild credit over time and improving their long-term financial prospects.

Disadvantages:

Risk to Personal Relationships:

Borrowing from family and friends comes with the inherent risk of straining personal relationships if repayment is delayed or fails altogether. Unlike transactions with traditional lenders, loans from loved ones are often based on trust and emotional investment, which can make any repayment issues feel personal. Failure to meet the agreed terms can lead to feelings of disappointment, frustration, or resentment on both sides, potentially causing lasting damage to relationships. It’s crucial to approach these arrangements with transparency, clear communication, and a formalized repayment plan to minimize misunderstandings and help preserve the personal bonds involved.

Lack of Formal Structure:

Loans from family and friends often lack the formal structure that traditional lending agreements provide, which can lead to misunderstandings about terms, repayment expectations, or even loan amounts. Without a clear, written agreement, assumptions about interest, repayment schedules, or flexibility in payments may differ between parties, increasing the potential for confusion and conflict. Establishing a formal agreement, even if informal in nature, helps to clarify these details, set mutual expectations, and prevent disagreements that could otherwise arise from ambiguous or unwritten terms.

Limited Loan Amounts:

One drawback of borrowing from family and friends is the typically limited loan amount compared to what financial institutions can offer. Unlike banks or credit unions, which have extensive resources and can fund larger, structured loans, family and friends may only be able to contribute smaller sums based on their personal finances. This may make it challenging to fully cover high startup or expansion costs, potentially requiring borrowers to seek additional funding sources to bridge the gap. As a result, while loans from loved ones can provide initial support, they may be best suited for smaller, short-term financial needs rather than large-scale projects.

Considerations
to Keep in Mind Before Borrowing Money

Before taking on debt, it’s crucial to consider the following:

Ability to Repay:

Before borrowing, it’s essential to carefully assess your financial situation and determine if you can realistically meet the repayment terms. This includes evaluating your income, expenses, and any existing debt to ensure that you’ll be able to make timely payments. Not only does timely repayment protect your credit score and financial stability, but it also helps maintain trust with family and friends if they are the lenders. Failure to repay as agreed can lead to credit damage and strain relationships, making it crucial to borrow only what you can confidently afford to pay back on schedule.

Interest Rates and Terms:

Before committing to a loan, it’s important to fully understand the cost of borrowing, including any interest rates, fees, or hidden charges. Even small differences in interest rates or additional fees can add up over time, significantly affecting the total repayment amount. Familiarize yourself with the terms and conditions, including the repayment period, frequency of payments, and any potential penalties for late or missed payments. Having a clear picture of these details enables you to make informed decisions and ensures you are prepared to meet the financial obligations associated with the loan.

Impact on Personal Relationships:

When borrowing from a friend or family member, it’s essential to consider the potential impact on your relationship. Financial agreements can be sensitive, and misunderstandings around repayment terms can lead to tension or even long-term strain if expectations are not met. To avoid conflicts, ensure that both parties have a clear understanding of the repayment terms, including amounts, timelines, and any flexibility that may be expected. Setting up a written agreement and maintaining open, honest communication throughout the repayment process can help protect and preserve the personal relationship, ensuring that both parties feel respected and valued.

Alternative Options:

Before deciding to take on a loan, consider all available financing options to determine the best path forward. Review your savings and assess whether you can fund your needs independently or partially, which may reduce or eliminate the need for borrowing altogether. Additionally, explore other potential resources, such as grants, lower-interest credit products, or community-based funding programs, which might better suit your needs or carry fewer risks. By evaluating all alternatives first, you can make a well-informed choice that aligns with both your financial situation and long-term goals, potentially minimizing debt and preserving flexibility.

Legal Protections:

When borrowing or lending significant amounts of money, it’s wise to consider drafting a formal loan agreement to protect the interests of both parties involved. A well-structured agreement outlines the loan amount, interest rates, repayment terms, and any penalties for late payments, ensuring that expectations are clear from the outset. This legal documentation can help mitigate misunderstandings and disputes, providing a framework for resolution should issues arise. Additionally, having a formal agreement lends a sense of professionalism to the transaction, reinforcing the commitment of both parties and preserving the personal relationship. Consulting with a legal professional can further enhance the agreement’s effectiveness, ensuring that it complies with applicable laws and adequately addresses the specific needs of both the borrower and the lender.

Essential
Financial Terms to Understand

Understanding key financial terms can help borrowers make informed decisions. Here are a few:

APR (Annual Percentage Rate):

The Annual Percentage Rate (APR) is a critical financial term that represents the annual cost of borrowing money, expressed as a percentage of the loan balance. Unlike the nominal interest rate, which reflects only the cost of interest on the principal amount, the APR provides a more comprehensive view of the total cost of the loan by incorporating not only the interest rate but also any additional fees or costs associated with the loan. This includes origination fees, closing costs, and other charges that may apply. Understanding the APR is essential for comparing different loan options, as it allows borrowers to see the true cost of borrowing over a year and make informed decisions. A lower APR indicates a more affordable loan, while a higher APR can significantly increase the total amount repaid over time. Thus, when considering a loan, it’s vital to evaluate the APR alongside other factors to ensure you are choosing the most cost-effective financing option.

Principal:

The principal is the original amount of money borrowed in a loan before any interest or additional fees are applied. This figure is critical because it serves as the foundation for calculating interest, which is then added to determine the total amount owed over the life of the loan. Understanding the principal amount helps borrowers grasp how much they are truly financing and allows for better financial planning regarding repayment. As borrowers make payments, a portion of each payment goes toward reducing the principal, while another portion covers interest. Knowing how the principal decreases over time is essential for understanding the amortization schedule of a loan, which outlines how payments are allocated between interest and principal throughout the repayment period. A lower principal amount typically results in lower overall interest costs, making it a key factor in the affordability of any loan.

Term:

The term of a loan refers to the duration a borrower has to repay the loan in full, including both the principal and interest. This period can vary from a few months for short-term loans to several years for long-term loans like mortgages. Understanding the loan term is crucial, as it affects the monthly payment amount and the total interest paid; longer terms usually result in smaller monthly payments but higher overall interest costs, while shorter terms have higher payments but can save on interest. Choosing the right term should align with the borrower’s financial situation, repayment capability, and overall goals.

Collateral:

Collateral refers to an asset that a borrower pledges as security for a loan, providing the lender with assurance that they will recover their money in case the borrower defaults on the loan. Common forms of collateral include real estate, vehicles, or savings accounts, which the lender can seize and sell to recoup losses if necessary. Understanding collateral is important for borrowers, as it can influence the loan terms, including interest rates and the amount borrowed; loans secured with collateral typically have lower interest rates due to the reduced risk for the lender. However, using collateral also involves the risk of losing the asset if the borrower fails to meet repayment obligations, making it essential for borrowers to consider their ability to repay the loan before pledging any valuable assets.

Credit Score:

A credit score is a numerical rating that reflects a borrower’s creditworthiness, indicating the likelihood of timely repayment based on their credit history. Typically ranging from 300 to 850, this score is influenced by various factors, including payment history, credit utilization, length of credit history, types of credit accounts, and recent credit inquiries. Lenders use credit scores to assess risk when evaluating loan applications; a higher credit score generally leads to better loan terms, such as lower interest rates and higher borrowing limits. Understanding your credit score is essential for managing your financial health, as it can significantly impact your ability to secure loans and the cost of borrowing. Regularly monitoring your credit score can help you identify areas for improvement and make informed financial decisions.

Explanation
of How Interest is Calculated

Interest is the cost of borrowing money, typically calculated as a percentage of the principal. There are two common types of interest:

Simple Interest:

Simple interest is a method of calculating interest that is based solely on the principal amount of a loan, without compounding. This means that the interest remains consistent over the life of the loan, making it straightforward to calculate and understand. For example, if you take out a $5,000 loan with a 5% simple interest rate for one year, the interest accrued would be $250, calculated as 5% of the $5,000 principal. Simple interest is commonly used in short-term loans, car loans, and certain personal loans, providing borrowers with predictability in terms of repayment amounts. Understanding how simple interest works can help borrowers make more informed financial decisions and better compare different loan offers.

Compound Interest:

Compound interest is a method of calculating interest that is applied not only to the principal amount of a loan but also to any accumulated interest from previous periods. This means that interest can “compound” over time, leading to an exponential increase in the total amount owed. For instance, if you have a loan with a principal of $5,000 at an interest rate of 5%, the interest for the first year would be calculated on the principal alone. However, in the second year, the interest would be calculated on the new total, which includes the principal plus the first year’s interest. While compound interest can be advantageous for investments—where it allows earnings to grow rapidly—it can also significantly increase borrowing costs, making it crucial for borrowers to understand how it works. By recognizing the implications of compound interest, individuals can make informed decisions about loans and investments, weighing the benefits against the potential costs.

Most credit cards and many loans utilize compound interest, which can dramatically increase the total amount owed if balances are not paid off promptly. Unlike simple interest, which is calculated solely on the principal, compound interest accrues on both the principal and any unpaid interest from previous periods. This means that if a borrower carries a balance on their credit card or does not make timely payments on a loan, the amount owed can grow quickly due to the compounding effect. For example, a credit card with a high-interest rate can lead to substantial debt if the balance is not paid in full each month. Understanding how compound interest works is essential for borrowers, as it emphasizes the importance of making timely payments to avoid escalating debt and to minimize the overall cost of borrowing. By staying aware of the implications of compound interest, individuals can better manage their finances and make more strategic decisions about credit usage.

Commonly
Asked Questions about Borrowing Money

Q: What credit score is required to qualify for a personal loan?
A: Credit score requirements for personal loans can vary significantly among lenders, depending on their individual policies and the specific type of loan being offered. Generally, most lenders prefer borrowers to have a credit score of 600 or above, which is considered the threshold for fair credit. Borrowers with scores in this range may still qualify for a personal loan, but they may face higher interest rates compared to those with better credit scores. Typically, higher credit scores—such as those above 700—are associated with lower interest rates and more favorable loan terms, as they indicate a stronger history of responsible credit management and a lower risk of default. It’s essential for potential borrowers to check their credit scores before applying and to shop around among different lenders, as some may have more lenient requirements or offer better terms for individuals with lower credit scores. Additionally, improving one’s credit score prior to applying can enhance the chances of securing a loan with favorable conditions.

Q: Can I borrow with a low income?
A: Yes, it is possible to borrow with a low income, although potential borrowers may face some challenges. Lenders typically assess an applicant’s ability to repay the loan based on their income, credit history, and overall financial situation. Consequently, if your income is low, you might qualify for smaller loan amounts and potentially higher interest rates, as lenders may perceive a greater risk associated with lending to individuals with limited income. However, there are options available for those in this situation.

Credit unions and community banks often have more flexible lending criteria compared to traditional banks and may be more willing to work with borrowers with lower incomes. Additionally, online lenders may offer specialized products designed for individuals with less conventional financial backgrounds, including those with lower income levels. It’s also beneficial to consider securing a co-signer, as this can improve your chances of approval and potentially lead to better terms. Before applying, it’s wise to assess your budget and determine how much you can afford to borrow and repay, ensuring that taking on a loan is a feasible option for your financial circumstances.

Q: Should I pay off high-interest debt first?
A: Generally, yes, it is advisable to prioritize paying off high-interest debt first. This strategy can lead to significant savings over time by reducing the total amount paid in interest, which can accumulate rapidly with high-interest rates, such as those associated with credit cards or certain personal loans. By focusing on these debts, you effectively decrease the financial burden and free up more of your income for other expenses or savings in the long run.

Paying off high-interest debt first also has the added benefit of improving your overall financial health and credit score, as it lowers your credit utilization ratio—the amount of credit you’re using compared to your total credit limit. This can make it easier to manage other debts and potentially qualify for better interest rates in the future.

While it’s important to stay current on all your debts to avoid late fees and damage to your credit score, developing a targeted repayment plan that emphasizes high-interest debt can help you regain control of your finances. It may also be beneficial to explore debt consolidation options or negotiate lower interest rates with creditors to make your repayment journey more manageable. Ultimately, a proactive approach to handling high-interest debt can pave the way for greater financial stability and peace of mind.

Q: Is it better to get a loan or use a credit card?
A: Whether it’s better to get a loan or use a credit card largely depends on the specific financial situation, including the amount needed and the intended repayment period. Personal loans typically offer lower interest rates compared to credit cards, especially for larger sums of money. This makes them a more cost-effective option for significant expenses, such as home renovations, medical bills, or major purchases, as they allow borrowers to pay off the debt over a structured repayment period, often ranging from one to five years.

On the other hand, credit cards can be more convenient for smaller, short-term needs. They provide instant access to funds without the need for a formal application process, making them ideal for emergencies or everyday expenses. Many credit cards also offer rewards programs or cash back on purchases, which can add extra value if the balance is paid off promptly to avoid high interest.

Ultimately, the choice between a loan and a credit card should be guided by the amount of money needed, the duration of the borrowing period, and the ability to repay the debt. Borrowers should also consider their financial habits; if they are disciplined enough to pay off a credit card balance each month, it may be a viable option. However, if they anticipate carrying a balance or require a larger sum, a personal loan may be the more prudent choice to minimize interest costs and maintain better financial health.

Q: How can I avoid falling into debt traps?
A: To avoid falling into debt traps, it’s essential to make informed decisions about borrowing and managing your finances. Begin by carefully assessing your financial situation before taking on any debt. This includes understanding your income, expenses, and overall financial goals. Always prioritize avoiding high-interest loans, such as payday loans or certain credit card advances, as these can quickly lead to a cycle of debt due to their exorbitant interest rates and fees. Instead, consider alternatives, such as personal loans from credit unions or banks, which typically offer lower rates and better terms.

Additionally, developing a comprehensive budget can help you manage your spending and savings effectively. This practice allows you to plan for emergencies, such as unexpected medical expenses or job loss, so you’re less likely to rely on loans during tough times. Establishing an emergency fund, even if it starts small, can provide a financial cushion that reduces the need for borrowing when faced with unforeseen circumstances.

Seeking financial advice from professionals or reputable resources can also be invaluable. They can provide guidance on debt management strategies, budgeting techniques, and ways to improve your credit score. Educating yourself about financial literacy is key to making smart choices and avoiding pitfalls that can lead to excessive debt. By combining careful planning, informed decision-making, and proactive financial management, you can significantly reduce the risk of falling into debt traps.