Published July 31, 2012
Borrowing money is always a last resort, but for anyone who's been in a pinch between paychecks, sometimes it's a necessary evil. But who or where you choose to borrow from can take your predicament from a temporary dollar dilemma to a long-term financial nightmare.
We consulted financial experts to help decipher which borrowing options are most likely to set you on a course toward financial disaster. Here are their borrowing breakdowns, from least risky to last resort...
1. Credit card purchase. Putting your unexpected expense directly on your credit card is a wiser option than a cash advance. And, it can actually work to your advantage if you can pay the balance when the bill arrives, says Beverly Harzog, an independent credit card expert and consumer advocate. "If you can pay it off and you have a rewards card (or cash back or airline miles), you can get rewards on that purchase as well."
That being said, Harzog is quick to point out that any credit card purchase can be a slippery slope since you can end up carrying the debt for a long period of time if you're not diligent about paying it off quickly.
The verdict: good borrow... if you pay off the purchase right away.
2. Pawnshop loan. Believe it or not, a pawnshop loan is one of the better options to consider, says Mary Hunt, author of "7 Money Rules for Life," and founder of Debt-Proof Living. "A lot of people think of them as back alley, but that's really not how they work anymore," she says. In fact, thanks to shows like "Pawn Stars," they've become more mainstream than ever.
The way it works is you bring in an item as collateral for the cash they give you. The pawnshop must keep your item for an agreed upon amount of time (for instance, 90 days). If you come back and pay back the loan before the term is up, you get your item back. If you don't, your item is sold
The perks: "It's clean. There are usually no credit checks. And you have the option to not pay it back legally," says Hunt. In terms of risk, the only thing to consider is how much sentimental value the item has, just in case you're unable to pay for its safe return.
The verdict: good borrow... if you're not using your family heirlooms or wedding rings as collateral.
3. Borrow from a relative. If you're lucky enough to have a well-off relative who's happy to help you out of a jam, good for you. But even so, when asking for a loan, sit down together and put the terms in writing, says Hunt. "Have a plan in mind before you plan to borrow and offer some collateral for that loan. It will put you in a much better light if you say, 'I want you to hold my iPhone until I pay you back,'" she says.
Other terms you need to agree upon include the payment schedule, how much interest you'll pay (Hunt says 5% is a fair amount) and what happens if you miss payments.
There are even online services like LoanBack.com and LawDepot.com that allow you to customize a family loan contract for a small fee. The extra effort may help avoid a family feud over a few hundred bucks.
The verdict: good borrow... if you treat your family loan like a business transaction.
4. Peer-to-peer lending. Fairly new to the lending arena is peer-to-peer lending. Sort of like the eBay of small loans, a group of lenders pool available funds and then decide which borrowers they'd like to work with. The SEC is involved, so it's regulated, but it can be a less strenuous qualifying process than a traditional bank loan.
"Lending clubs turn down a high majority of borrowers, so it's not a slam dunk. If you have excellent credit and aren't in debt up to your eyeballs, though, you can get a good interest rate," says Harzog.
The verdict: good borrow... if you have good credit and some time to spare until you qualify.
5. Credit card cash advance. Most credit card companies offer customers the option to get cash via an ATM or bank withdrawal (sometimes it comes in the form of a check), but that convenience comes with a price. "First of all, you'll be charged an initial fee of 3% to 5%," explains Hunt. "And that cash amount immediately starts incurring interest." In other words, you don't have any grace period at all. Perhaps the worst part, however, is that a cash advance is subject to a much higher interest rate than you'd have on a regular credit card purchase. "It can be 10% to 15% higher," says Hunt.
The verdict: bad borrow
6. Bank advance direct deposit loan. An advance on your direct-deposited salary is basically a bank-sanctioned payday loan. You may feel like it's a legitimate option because your bank is offering cash upfront for the promise of repayment when you receive your paycheck, but the problem is the temporary patch can potentially lead to bigger debts down the line, says Mitchell D. Weiss, a professor of finance at the University of Hartford and author of, "Life Happens: A Practical Guide to Personal Finance from College to Career." "You intend for it to be a one shot deal, but people who can least afford it get caught in this debt trap," says Weiss.
"You're sacrificing the future stream of payments for cash upfront today," explains Weiss. The problem is you won't get all of next week's paycheck, and then what do you do for an encore if you come up short again?
The verdict: bad borrow
7. Payday loan. Similar to a bank direct deposit advance, the way a payday loan usually works is you write a postdated check for the amount you are borrowing with a fee and interest tacked on, and the establishment gives you the cash on the spot. Another alternative is to allow the payday lender to electronically transfer the amount from your bank account to theirs come payday. In other words, you're granting them access to your bank account, which is always a shady prospect.
"It is like the ultimate snowball that turns into a huge avalanche. Borrow $100 to start, and it will turn into thousands," Hunt says. The reason? "They make it sound so easy." Payday loan providers are often reassuring, says Hunt, telling you not to worry if you need to roll your loan over for another pay period or until you're back on your feet. Of course, that means the fees will keep adding on, too. "They take full advantage of people who don't understand the system," she says.
The verdict: bad borrow
The key to wise borrowing -- no matter which route you take -- is to first try to avoid it and if you can't, have a well-thought out plan in place for paying back what you owe. Try going with the option that will cost you the least in the long run, and when it's behind you, start socking away some money toward an emergency fund so you won't have to go borrow in the future.