Borrowing

The Basics of Borrowing Money

As common as the act of borrowing money may have become, there are still very few sources that explain what happens when an individual applies for a loan. Banks and other private lenders explain certain details regarding the process but tend to only focus on the obligations of the borrower, not on how the system itself works. The same can be said when talking about online lending platforms, however, these often offer smartphone apps that guide the borrower through the entire process and also explain each step.

This having been said, as far as traditional lenders are concerned, the act of borrowing money and the loans are mostly the same. Here is what you need to know:

You Have a Credit Score and It Matters

All official financial decisions and information of an individual are stored in his credit file. The collected data can then be used by lenders to calculate a credit rating for that individual. This score is extremely important and plays a part in establishing whether or not he will be allowed to borrow money from banks and other private lenders. In many ways, this credit score gives lenders information regarding how an individual manages his personal finances and how he pays his debt.

Furthermore, the credit score is also used to establish the exact interest rate that an individual will get as part of his loan agreement, as well as whether or not the loan will be secured or unsecured.

There Are Two Main Types of Debt

From a functional point of view, there are two main types of debt: secured and unsecured. As the name implies, secured forms of debt need additional insurance for the lender. This means that for an individual to take out a secured loan, he will have to offer his personal property as collateral. In most cases, the preferred form of collateral is the borrower’s home, but some lenders will also accept other types of high-valued property.

Secured forms of debt have larger value limits, which means that individuals can borrow more money, and come with lower interest rates. The low cost of the debt can usually be explained by the fact that secured loans are safer than unsecured ones.

young angry and worried man working with laptop at home looking at bills and paying bills in home finance concept

The Credit Score Is Built Up Over Time

For the most part, it is impossible to increase your credit score in a short time. This is a because most of the data that goes into calculating it comes from long-term financial affairs such as how fast an individual repays his debt, how many times he uses his credit card over 12 months, how much of the credit that is available to him he is using at any given time, etc.

However, making poor financial decisions can have a sudden negative impact on your credit score. For example, missing a loan repayment, taking out a payday loan right after submitting an application for a large personal loan, or maxing out a credit card.

Not Being Able to Repay a Loan Is Not Always Dangerous

Most individuals tend to avoid secured loans because they are afraid of what could happen if they don’t manage to repay the money on time, however, banks are usually very understanding in extreme scenarios.

Banks will always prefer to get their money back rather than take possession of the borrower’s property. As a result, the lender will first sit down and negotiate with the borrower to find a mutually agreeable way to repay the loan. The bank will take possession of the collateral only as a last resort and only if the borrower does not cooperate.

Is It Better to Borrow from Banks or Other Lenders?

Banks have traditionally been the go-to lender every time an individual needed to borrow money. They are heavily regulated by the government and are required to offer complete transparency when it comes to the financing products and services that they provide the consumer with. In other words, banks can always be trusted to be fair, or at least to make the loan agreements as clear as possible.

Most banks have been around for many years, enabling them to build a reputation that lets potential borrowers know that they have nothing to worry about. In terms of financing, they are considered traditional lenders, in the sense that all banks have a similar functional structure and most loan agreements will be largely the same between them.

This having been said, banks are not the only lenders on the market and some of these can offer unique types of deals or advantages. So, who is it better to get a loan from, banks or other types of lenders? This largely depends on the borrower’s needs and financial situation.

Types of Lenders

Before moving onward, we must determine what types of credit providers there are.

  • Banks – These need no introduction. They are financial institutions that offer various forms of financing to individuals and organizations alike;
  • Credit Unions – Credit unions are financial institutions that usually revolve around communities. They offer several types of loans, however, unlike banks, the profit that they make is invested into the community. These unions tend to offer lower interest rates than banks, however, their services are locked behind memberships. Only those who are part of the community can access the products of the credit union;
  • Payday Loan Companies – These companies operate both online and offline and usually have standard interest rates that they attach to their microloans, such as £20 for a £200 loan that has a duration of one month. Despite their high interest rates, payday loan companies are popular because they have lower requirements in terms of what credit rating the borrowers have;
  • P2P Platforms – Only found online, the services of P2P platforms offer a great alternative to banks. The platforms only put borrowers and lenders in contact with each other and ensure that all parties involved follow the terms and conditions that they have agreed to. Anyone can become a lender by creating a user account and specifying that you want to give out loans. P2P platforms rarely perform credit score checks, making them great for individuals that would get a poor credit rating at the bank;

Banks Offer More Stability

Each of the four types of lenders above is useful in their own right, however, banks remain the safest. This is mainly because they are directly regulated by the government and offer complete transparency when it comes to the terms and conditions of a loan.

Furthermore, the interest rates that they offer are less likely to fluctuate as the national economic situation changes. It is also important to mention that they are the safest place to get a secured loan from. Even if a borrower is unable to return the money on time, the bank will first work with him to find a mutually-agreeable solution, before moving to take possession of the collateral.

Other Lenders May Have Lower Requirements

The other lenders presented above tend to have considerably higher interest rates and some do not offer complete transparency concerning the loan agreement. However, unlike banks, most of these companies and services do not perform credit score checks or have lower credit rating standards. These low requirements make them a better choice for individuals with poor credit scores or who have had a bad relationship with the bank.