It’s easy to get a loan unless you need it
“Norman Ralph Augustine”
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Credit is easy to compare badly. Borrowers often concentrate on the interest rate, monthly payment or amount a lender is prepared to advance, yet none of those figures tells the whole story. The real cost of borrowing depends on the interest rate, fees, repayment period, collateral requirements and what happens if the debt cannot be repaid as planned.
Shopping around matters because lenders do not price every borrower or every loan in the same way. A bank, credit union, specialist lender and car dealer may all be willing to finance the same purchase, but the resulting cost can differ considerably. Even two borrowers applying for the same amount can receive different terms because lenders assess their credit history, income, existing debts, collateral and other risk factors differently.
This makes borrowing similar to many other financial transactions: the first quoted price should not automatically be treated as the market price. A borrower with stable income, a strong credit record and several competing offers may have room to negotiate. Sometimes the lender will reduce a rate, waive a fee or match another offer. Sometimes it will not. There is little reason to avoid asking.
The more useful question is not simply, “Can I obtain this loan?” It is, “Is this the cheapest sensible way to finance what I am trying to buy?” An auto loan arranged through a dealership might be convenient, but financing from a bank or credit union could cost less. A credit card may be convenient for a purchase that will be repaid within the interest free period, but expensive for a balance that will remain outstanding for several years.
Comparing the annual percentage rate, or APR, can help. In the United States, the Consumer Financial Protection Bureau explains that APR includes the interest rate and certain additional loan fees. It therefore gives a broader indication of borrowing cost than the nominal interest rate alone. APR is still not a substitute for reading the agreement, particularly where rates can change or fees depend on how the account is used.
Before applying for a major loan, it can make sense to examine the information lenders are likely to examine themselves. Credit reports contain information about borrowing and repayment history, while credit scoring systems use data from those reports to estimate credit risk. A stronger credit profile can improve access to credit and may reduce the rate a lender is prepared to charge.
In the United States, consumers can obtain reports from the three nationwide credit reporting companies through AnnualCreditReport.com. Checking a report before applying for a mortgage, auto loan or other substantial debt provides time to identify incorrect information rather than discovering it after a lender has made a decision.
Errors should be disputed rather than ignored. The CFPB provides guidance on disputing inaccurate credit report information, including contacting the credit reporting company and supplying documents that support the dispute.
Building credit does not require a large salary or ownership of property. What matters is how credit accounts are managed. Paying obligations on time, avoiding persistently high card balances and applying for new credit with some restraint can all matter. The CFPB’s guidance on credit scores places particular emphasis on payment history, credit usage, length of credit history and avoiding unnecessary applications.
A student working part time can therefore establish a stronger credit record than somebody earning considerably more but repeatedly missing payments. Income and credit history are related to lending decisions in different ways. Income helps determine whether a borrower appears able to service a debt, while the credit record provides evidence of how previous obligations have been handled.
Loans can be grouped in several ways. One of the most useful distinctions is between secured and unsecured borrowing. Another is the difference between installment credit, where a defined amount is repaid according to a schedule, and revolving credit, where the borrower can repeatedly draw against an available credit limit.
A secured loan is backed by collateral. The borrower pledges an asset that gives the lender additional protection if repayments stop. Mortgages and many auto loans are familiar examples. The property secures the mortgage, while the vehicle normally secures the auto loan.
Collateral reduces part of the lender’s risk because there is an asset that can potentially be taken and sold after default, subject to the law and the loan agreement. That can make secured borrowing cheaper than unsecured borrowing for the same borrower. The tradeoff is straightforward: the borrower has placed an asset at risk.
The quality of the collateral also matters. A lender is unlikely to value an asset according to what its owner hopes it is worth. Liquidity, volatility, condition, legal ownership and the ease with which the asset could be sold can all affect lending terms. A house, car and investment portfolio therefore create quite different collateral risks even though all three can support secured borrowing.
A pawn loan is a basic version of the same principle. An item is left with the lender as security. If the loan is not repaid according to the agreement, the lender can sell the item. Large secured loans use more paperwork and more complicated legal agreements, but the economic principle remains similar.
An unsecured loan does not give the lender a named asset as collateral. Personal loans, many bank loans and ordinary credit card balances can fall into this category. Because the lender has less direct protection, the borrower’s creditworthiness becomes more important.
Unsecured does not mean consequence free. A borrower who stops paying can face late charges, damaged credit, debt collection and potentially legal action. The distinction simply means that a particular asset was not pledged to secure the original debt.
Rates on unsecured borrowing are commonly higher than rates on comparable secured debt because the lender is accepting more credit risk. That does not mean converting unsecured debt into secured debt is always an improvement. Using home equity to refinance expensive credit card balances may lower the rate, but it also turns debt that was not secured against the house into debt that is. The CFPB warns that using home equity to consolidate card debt can put the home at risk if the new loan cannot be repaid.
A mortgage is a loan secured by real estate. The property acts as collateral, and failure to meet the obligations of the mortgage can eventually lead to foreclosure. Because mortgages normally involve large sums and long repayment periods, small differences in rates and fees can translate into substantial differences in total cost.
Borrowers should compare more than the monthly payment. A longer term can reduce the amount due each month while increasing the period over which interest is charged. Two mortgage offers with similar monthly payments can therefore have very different economics.
The difference between interest rate and APR is particularly useful with mortgages. The CFPB notes that mortgage APR reflects the interest rate together with certain points, fees and other charges. Borrowers should still examine individual closing costs, loan features and any penalties rather than relying on one percentage figure.
Fixed rate mortgages give the borrower more certainty about the interest rate over the fixed period. Adjustable rate mortgages expose the borrower to changes according to the formula defined in the loan agreement. A lower initial payment can be attractive, but investors will recognize the underlying problem immediately: reducing today’s financing cost by accepting more interest rate risk does not eliminate the risk, it relocates it.
A home equity line of credit is revolving credit secured against a home. Rather than receiving the entire approved amount immediately, the borrower can generally draw funds from the credit line during an agreed period and pay interest on the amount used.
HELOCs commonly use variable rates. According to the CFPB’s explanation of home equity lines of credit, payments may therefore change as the rate changes, although some products allow part of a balance to be converted to a fixed rate.
The attraction is easy to see. A homeowner with substantial equity may obtain credit at a lower rate than would be available through an unsecured personal loan or credit card. The danger is equally easy to identify. The borrowing is secured by the house. Using a HELOC to finance discretionary spending, highly speculative investments or recurring living expenses places a major asset behind expenditure that may produce little or no lasting value.
Investors should be particularly cautious about using home equity as trading capital. A leveraged investment already contains market risk. Funding that position with debt secured against a residence adds financing risk and collateral risk. FINRA has specifically warned investors about the risks of borrowing against home equity to invest. A bad trade is unpleasant. A bad trade attached to a loan secured by the family home is a rather more expensive version of the same lesson.
Credit cards provide revolving credit. The cardholder receives a credit limit and can make purchases or, depending on the card, obtain cash advances and other forms of credit. Repayments restore part of the available limit, allowing the credit to be used repeatedly.
This flexibility is useful, but it can obscure the cost of carrying debt. A purchase does not become inexpensive because the required minimum payment is small. Paying only a small portion of the outstanding balance extends the repayment period and allows interest to accumulate for longer.
Credit card interest is normally expressed as an APR. The CFPB describes the card interest rate as the price paid for borrowing money. The actual cost to a cardholder depends on how the account is used, including whether balances are paid in full, whether a grace period applies and whether transactions such as cash advances are subject to different rates or fees.
Rewards can complicate the comparison. Cashback, airline miles, hotel points, insurance and other benefits can have real value, especially for someone who would make the purchases anyway and pays the statement balance in full. They become much less impressive when expensive interest is being charged on a persistent balance. Earning 2 percent cashback while paying interest at a rate many times higher is not financial engineering. It is expensive borrowing with a small rebate attached.
A secured credit card requires a cash deposit that serves as security for the account. It is often used by people who have little credit history or who are rebuilding credit after previous problems. The deposit reduces the issuer’s risk but does not turn card spending into prepaid spending. The cardholder still receives bills and remains responsible for paying them according to the agreement.
The CFPB notes that secured cards can help establish a credit record, although fees and interest rates should be checked carefully. It is also worth confirming that the issuer reports account activity to the major credit reporting companies. A card intended to build credit is much less useful for that purpose if its payment history is not reported.
For somebody starting with a thin credit file, a secured card can provide a relatively controlled way to establish a repayment history. The useful part is not carrying a balance or paying interest. It is demonstrating that an available credit line can be used and repaid reliably.
The term “investment loan” is used for more than one type of borrowing. It can describe money borrowed for the purpose of making an investment, or it can refer to borrowing secured by an investment portfolio. Those are not the same transaction. Here, investment backed borrowing refers to a loan or line of credit where securities are pledged as collateral.
A securities backed line of credit can give an investor access to cash without immediately selling investments. That can be useful where selling would disrupt a long term portfolio, create tax consequences or force the investor to dispose of assets at an inconvenient time. Because the lender has collateral, the borrowing rate may also be more attractive than unsecured credit available to the same borrower.
The central risk is that investment portfolios do not have fixed collateral values. Stocks, funds and bonds can fall in price. If pledged securities decline enough, the lender may require the borrower to provide more collateral or repay part of the outstanding balance. The SEC’s Investor.gov warning on securities backed lines of credit emphasizes that the securities supporting such borrowing can be volatile.
FINRA also describes the risks attached to securities backed lines of credit, including the possibility that a lender may sell pledged securities if collateral requirements are not met. The exact rights of the lender depend on the agreement, which makes the fine print rather less decorative than it first appears.
Consider an investor who owns a $500,000 portfolio and borrows $150,000 against it. At the outset the loan may appear conservative because the debt is only 30 percent of the portfolio value. A 40 percent market decline, however, reduces the portfolio to $300,000 while the debt remains. The effective loan to collateral ratio has risen sharply without the investor borrowing another dollar.
If the lender then requires additional collateral or repayment, the investor can encounter the same problem seen with leveraged trading accounts: liquidity is demanded precisely when asset prices are weak. Selling securities after a substantial decline may crystallize losses that the investor originally intended to ride out. The loan has changed the portfolio’s time horizon.
This is why the interest rate alone is a poor measure of an investment backed loan. The rate may indeed be lower than an unsecured personal loan, yet the borrower is accepting another source of risk. Portfolio volatility now affects not just mark to market wealth but also access to financing.
The intended use of the money deserves equal scrutiny. Borrowing against a diversified portfolio to meet a temporary liquidity requirement is different from using the proceeds to buy more volatile assets. In the latter case, the investor has introduced leverage on both sides of the transaction. Existing investments secure the loan while the borrowed funds are placed into another risky asset.
Using such borrowing for leveraged forex, options or cryptocurrency speculation increases the problem further because losses on the new position can occur at the same time as declines in the original collateral. Correlations that appeared modest during normal markets have an irritating habit of becoming less helpful during periods of stress. Investors considering leveraged trading can read more about the mechanics and risks of forex trading at DayTrading.com.
Investment backed credit should therefore be judged as leverage, even if it is marketed primarily as convenient access to liquidity. The borrower has converted an unleveraged portfolio into collateral supporting a liability. That can be perfectly manageable under conservative conditions, but the risk analysis needs to include falling asset prices, higher borrowing costs, collateral calls and the possibility of forced sales.
A payday loan is short term borrowing that is normally intended to be repaid from the borrower’s next income payment or within a similarly short period. Loan amounts are generally small compared with mortgages or conventional personal loans, but the cost relative to the amount borrowed can be extremely high.
The CFPB gives the example of a two week payday loan charging $15 for each $100 borrowed, which corresponds to an APR of almost 400 percent. Laws governing payday lending differ by jurisdiction, and some US states prohibit or heavily restrict the product.
Payday lenders have traditionally served borrowers who may have difficulty qualifying for conventional bank credit. Approval standards vary between lenders and jurisdictions, so it is inaccurate to assume that payday lending universally involves either a traditional credit score check or no assessment at all. A lender may use information about income, bank accounts, previous borrowing or specialist consumer reporting databases when making a decision.
The main economic problem is the short repayment period combined with a high fee relative to the principal. A borrower who cannot repay the balance without immediately needing another loan can become trapped in repeated borrowing costs. A $15 fee looks modest in isolation. Repeated against every $100 of short term principal, it is not.
No form of credit is automatically appropriate simply because the borrower qualifies for it. A mortgage can be a sensible way to finance a home because the asset is expensive and long lived. A revolving credit line can be useful when the amount and timing of borrowing are uncertain. A credit card can be efficient for transactions that are repaid promptly. The same products become considerably less attractive when their structure does not match the reason for borrowing.
Term matters as much as rate. Financing a short lived purchase over many years may produce an attractive monthly payment while leaving the borrower paying for something long after its economic value has disappeared. Extending repayment is not the same as reducing cost.
Lenders and dealers often discuss credit in terms of monthly payments because monthly affordability is easy to understand. It is also incomplete. A loan can be made to look cheaper each month by increasing the repayment period. The borrower gets a smaller bill but makes more of them.
Auto financing provides a good example. The CFPB recommends comparing the APR, interest rate, loan term and total amount financed when examining auto loan offers. Those figures make it easier to distinguish a genuinely cheaper loan from one that has simply stretched repayment across more months.
Fees deserve the same treatment. Origination fees, annual charges, late fees, closing costs and other expenses can change the economics materially. Some charges are unavoidable, others depend on borrower behavior and some may be negotiable. They should all be understood before the agreement is signed.
Debt is often described primarily as a way to obtain money now and repay it later. For investors, a more useful description is that borrowing changes the distribution of financial outcomes. It can allow an asset to be purchased sooner, preserve liquidity or increase investment exposure, but it also creates a fixed or semi fixed obligation that remains when asset prices, income or economic conditions move against the borrower.
This distinction is most obvious with leverage. If an investor borrows $50,000 and adds it to $100,000 of personal capital, a 20 percent rise in the purchased assets produces a larger return on the investor’s initial equity than an unleveraged position would have produced. A 20 percent decline works through the same arithmetic in the opposite direction, while interest on the debt still has to be paid.
Consumer credit works on a less dramatic scale but follows the same principle. Borrowing commits part of future cash flow. The greater the fixed obligations, the less flexibility remains if income declines or expenses rise. A loan that appears affordable under normal conditions may become uncomfortable during unemployment, illness or a period of higher living costs.
The sensible approach is to compare borrowing according to cost, term, collateral and purpose. Check your credit information before making large applications, obtain competing quotes where practical and look beyond the advertised monthly payment. If collateral is involved, consider what can be lost as well as what can be borrowed.
For investors, this becomes even more important when a portfolio is used to secure credit. A low rate does not make leverage harmless, and access to borrowing does not make borrowed money investment capital that can safely be lost. The relevant question is whether the expected benefit of the borrowing justifies both its financial cost and the additional risk imposed on the borrower’s balance sheet.
Credit can improve liquidity, spread the cost of large purchases and allow capital to be used more efficiently. It can also magnify losses, place valuable assets at risk and turn a temporary cash shortfall into a long term obligation. The difference usually lies less in the name of the loan than in its price, structure and how the borrower uses it.
“Norman Ralph Augustine”
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