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How to Finance a Purchase

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Few Americans can get through life without financing something. Whether it's a home, vehicle, or large project, financing can make it easier to get things done.

Keep reading to find out more about financing.

What is financing?

Financing is when a financial institution -- like a bank, credit union, or online lender -- lends you money to cover an expense. For example, when you need money for a car, a lender provides financing in the form of a loan. Financing is how most Americans pay for major purchases, such as:

Types of financing

The best type of financing for you depends, in part, on what you plan to do with the money. Below, we'll cover the main types of financing -- and what you need to know about each.

Note: If you've lost income due to the coronavirus pandemic, you may qualify for a coronavirus hardship loan. Read our guide to coronavirus hardship loans for more details.

Personal loans

Important characteristics of personal loans include:

  • Can pay for just about anything
  • Range of amounts, from $1,000 to $100,000
  • Interest rates are usually lower than credit card interest rates

The credit score needed for a personal loan varies. If your credit score is less-than-perfect, check out our expert-recommended lenders for below-average credit:

TIP

If you can, boost your credit score before applying

If your credit score is low, you may be charged a higher personal loan interest rate. It's worthwhile to take some time to boost your credit score before applying for a personal loan.

Some personal loans are "secured," while others are "unsecured." Here's the difference:

A secured loan is backed by collateral. Say you take out a loan for a boat. The lender considers the boat "collateral," an item of value they can repossess if you fail to make your payments. All secured loans are backed by collateral, like bank accounts, vehicles, or jewelry.

An unsecured loan is backed only by your signature. If you miss payments, your credit score will take a hit -- but other than suing you for the money, the lender does not have many options (they can't take your possessions). That is why it's harder to qualify for an unsecured loan, and the interest rate on an unsecured loan is almost always higher.

If your credit score is low, you might have a better chance of getting approved for a personal loan by applying for a secured loan. Even if you can get a personal loan without putting up collateral, you might get a lower interest rate with a secured loan.

You can use the calculator below to calculate the monthly payment on a personal loan.

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Debt consolidation loan

Debt consolidation allows you to take out a single lower-interest loan to pay off higher-interest debts. You apply for a low-interest loan, use the funds to pay off your high-interest debt, and then focus on repaying the loan. This strategy can save you a significant amount of money in interest charges.

Imagine you have three credit cards. You owe $5,000 on each card, and you pay 17% interest. Here's how much money you could save with a debt consolidation loan:

Item Credit cards Debt consolidation loan
Interest rate 17% 7.99%
Monthly payment $450 $380
Time to pay off 46 months 46 months
Amount paid in interest charges $5,445 $2,464

As you can see, in this scenario, a debt consolidation loan could save you a jaw-dropping $2,981. If you're considering a debt consolidation loan, take a look at our experts' list of best debt consolidation loans.

Personal line of credit

This type of financing makes sense for borrowers with a good credit score (700 or above). Like a credit card, this is unsecured financing. The lender sets a total amount that can be borrowed, and you can take funds out as needed, up to that total. Once you have repaid it, that amount is again available to you.

Home equity loans

Homeowners with enough equity in their homes have a financing option not available to other borrowers -- a home equity loan. It works like this: Say you owe $100,000 on your home, but it's worth $200,000. That means you have $100,000 in equity. Most lenders will lend up to 85% of the equity, in this case, $85,000. As with other financing types, you make payments each month for a set number of months.

How financing works

When you finance a purchase, you borrow money and pay it back with interest. Usually, you repay it in monthly installments. Before the lender gives you the money, you sign a contract outlining how much you are borrowing, the interest rate, how much your monthly payments will be, and when the loan will be paid in full.

If you're considering whether to finance a purchase, it's time to do some homework.

These simple steps will help you save money when you get a personal loan:

  1. Make sure you have found the best deal on the item you want to finance. Let's say you are shopping for a new car and are attached to a particular model. Before you decide to finance the car, shop around at other dealers to ensure that you've landed the best price. The same applies to home renovations, RVs, or anything else you want to finance.
  2. Check your credit score. The better your credit score, the lower the interest rate you will qualify for when you finance a purchase, and the better the repayment terms.
  3. Compare the best personal loan lenders. Look for lenders who offer loans with low fees, low interest rates, and a variety of repayment terms.
  4. Shop for the best interest rate. As long as you are smart about it, there is no reason to worry about the impact rate shopping will have on your credit score. Here's how: The credit bureaus expect you to rate shop. A cluster of applications that occur for the same purpose within a short period -- generally two weeks to 45 days -- is treated as a single credit inquiry. To be on the safe side, do all your rate shopping within a two-week period.

When is financing a good idea?

Financing is helpful when you need something but do not have the cash available to pay for it. For example, if you are in an emergency room with a broken arm and must cover your co-pay before treatment, you can apply for a medical loan. If someone you love passes away and you need funds to cover the funeral, or someone is ill and you need to travel to see them, financing is a good idea.

Financing is a responsible option when you need (rather than want) what you are financing and you have the income to repay the loan. It is a good idea when your credit score is strong enough to land one of the best personal loans available.

When is financing a bad idea?

Financing is a bad idea when you want something but do not have the money to pay for it.

Let's say you move into an apartment with bright blue carpeting. You decide your sofa clashes with the flooring and head out furniture shopping. The smart move is to save enough cash for a new sofa, or better yet, save for a sofa cover that matches the carpeting.

As useful as financing is in many situations, it is not without risks, including:

  • Making your budget so tight that you might miss monthly payments and harm your credit score
  • Sleepless nights fueled by worry about debt
  • Buyer's remorse when you realize what you wanted was not worth the anxiety

There is a lot of talk about the value of "balance," and with good reason. When it comes to your money, balance is all about building an emergency fund with enough to cover three to six months' worth of bills, paying cash whenever possible, keeping debt to a minimum, and taking advantage of financing options when it benefits your bottom line.

Is financing a purchase right for me?

Financing a purchase not only allows you to buy the things you need now and pay for them over time, it can also help you build strong credit and add to the quality of your life.

As with every important financial decision, it is essential to weigh your options. Ask yourself if what you want to finance is something you need, if you can easily afford the monthly payments, if your job is secure, and if you have money put away for a rainy day.

Also, consider whether the purchase you want to finance will add to your bottom line. For example, installing wood floors in your home can increase its value from 3% to 5%. Let's say you have a home currently worth $250,000 and spend $15,000 to install wood floors. If the property's value immediately rises by an amount between $7,500 and $12,500, you made a wise investment.

Only you can decide for sure whether financing a purchase is the right move. But you have already taken the first step by learning more about the process.

Still have questions?

Here are some other questions we've answered:

The Ascent's best personal loans

Looking for a personal loan but don’t know where to start? Our favorites offer quick approval and rock-bottom interest rates. Check out our list to find the best loan for you.

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