Applying for a Loan: How to Get the Best Loan at the Lowest Cost

Types of loans

Home equity loans and lines of credit

Borrowing against the equity in your home usually comes with a relatively low interest rate, and depending on your situation, some or all of the interest may be tax deductible since the debt is secured by your home. A home equity line of credit works like revolving credit: the lender approves you for a maximum credit limit, often calculated as a percentage of your home's appraised value minus what you still owe on the mortgage. A home appraised at $200,000 with a $60,000 mortgage balance and a lender offering 75% of appraised value would produce a credit line of about $90,000 (75% of $200,000 is $150,000, minus the $60,000 owed). Your actual limit also depends on your income, existing debts, and credit history.

Home equity lines typically run for a set draw period, often around ten years, after which some plans allow renewal and others cut off further borrowing. If you know you need a fixed amount for a specific purpose, like a home addition, a traditional second mortgage with a fixed payment schedule may suit you better than a revolving line. When comparing the two, do not compare the APR figures directly: a traditional mortgage APR includes points and other finance charges, while a home equity line's APR reflects only the periodic interest rate.

Automobile loans

Auto loans are secured by the vehicle itself and are available both through banks and through dealers, who typically route the financing to an affiliated finance company rather than lending the money directly.

Investment loans

Borrowing against a securities portfolio, often called margin borrowing, can be a relatively low cost way to access cash, and the interest may be deductible if the loan is used for investment or business purposes. The risk is a margin call: if your margin debt grows to more than roughly 50% of your portfolio's value, you may be forced to add cash or sell securities, which can be painful if it happens during a market downturn. Keeping margin debt well below 50%, ideally closer to 25%, is a safer approach.

CD and passbook loans

Borrowing against a CD or savings account rarely makes sense, since the rate you would pay on the loan is almost always higher than the rate you are earning on the account. In most cases it is cheaper to simply withdraw the funds, waiting for the CD's term to end if needed to avoid an early withdrawal penalty.

Loans against retirement plans and life insurance

If your 401(k) or profit-sharing plan allows loans, one advantage is that the interest you pay goes back into your own account rather than to a lender, though the amount you can borrow is limited by plan rules. A loan against the cash value of a life insurance policy can also be reasonable if the rate is in the 5 to 6% range. Above that, it generally is not a good deal.

Credit union loans

Because credit unions are member owned, loan rates there are often lower than at a traditional bank.

Unsecured bank loans

Without collateral backing the loan, banks charge a higher rate to offset their risk, which makes unsecured loans one of the more expensive ways to borrow.

Credit card cash advances

Despite being convenient, cash advances carry high rates and fees and are almost always the most expensive way to borrow on this list.

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How to shop for a loan

Before borrowing, figure out what the loan will actually cost and whether you can comfortably afford the payments. The Truth in Lending Act requires every lender to disclose the annual percentage rate (APR) and other key terms before you sign, generally before any fee can be charged, which gives you a consistent way to compare offers.

Finance charge and APR

The finance charge is the total dollar cost of the credit, including interest and certain fees. The APR expresses that cost as a yearly percentage rate, which is the real key to comparing loans regardless of amount or term. Borrowing $10,000 for one year at 10% interest and repaying it in a single lump sum produces a 10% APR. Repaying that same $10,000 plus interest in 12 equal monthly installments instead effectively works out to an APR closer to 18%, because you have use of less and less of the original balance each month. Small differences in structure can change the real cost significantly, which is why the APR, not just the stated interest rate, is the number to compare.

Fixed and variable rates

A fixed rate stays the same for the life of the loan. A variable rate is tied to a published index, such as the prime rate, plus a margin set by the lender, and moves as the index moves. Ask what index and margin apply, how often the rate can change, and how high the index has moved historically. Many variable rate loans include a cap on how high the rate can climb over the life of the loan, and some allow converting to a fixed rate at some point during the term. Introductory rates that look unusually low for the first several months are also common and worth reading past.

How you repay matters

Some loans apply your payment to both interest and principal on a schedule that fully repays the balance by the end of the term. Others allow interest only payments, which means the full principal is still owed when the loan ends. If your agreement ends with a large lump sum due, known as a balloon payment, you need a plan for covering it, whether through refinancing, a new loan, or another source of funds. Falling short on a balloon payment risks losing whatever secured the loan, such as your home or car.

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Comparing loan offers

Even once you understand the terms, it is easy to underestimate how much a different rate or term actually costs. Consider three offers on the same $6,000 loan:

Lender A costs the least overall. Lender B has the lowest monthly payment but costs about $488 more in total finance charges than Lender A because the loan runs an extra year at the same rate. Lender C, at the same four year term but one point higher in APR, adds roughly another $145 on top of Lender B. Which offer makes sense depends on whether your priority is the lowest monthly payment or the lowest total cost, and other terms, like the size of a down payment, can shift the comparison further.

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A closer look at home equity loans

Before signing for a home equity line or loan, weigh the setup costs against the benefit. Because your home secures the debt, failing to repay it can put your home at risk.

Typical costs include an appraisal fee, an application fee that may not be refunded if you are turned down, upfront points (each point equals 1% of the credit limit), closing costs such as attorney, title search, and filing fees, and ongoing annual membership or maintenance fees. Some plans also charge a transaction fee every time you draw on the line. If you only plan to use a small portion of the credit line, these setup costs can meaningfully raise the effective cost of what you actually borrow. On the other hand, because your home lowers the lender's risk, home equity rates are generally lower than other forms of credit, and some lenders will waive part or all of the closing costs if you ask.

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