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What is financing?
Financing is the process of receiving funds from a lender to help make a purchase and then paying those funds back over time. For example, someone may want to finance big-ticket items like furniture, a renovation project, a new car, or a new home. With financing, the individual doesn't pay the full purchase amount upfront themself. Instead, they borrow the funds from a bank or lender and pay back the lender over time, usually with interest.
It's important to understand financing basics before applying to use a form of financing. Learn about some of the different types of financing available, how the financing process may work, and the potential associated risks.
Different types of financing
There are various types of financing available. Each comes with its own potential benefits, risks, and terms that may fit different financial needs.
Common types of financing include:
- Credit cards. Credit cards allow cardholders to access funds up to a certain credit limit and pay back the balance used at the end of each month or payment period. Any unpaid balance may incur interest depending on the terms of the credit account.
- Buy now, pay later. Also known as BNPL, this form of financing can be used to make an immediate purchase and pay it off in installments over time. Many retailers offer buy now, pay later options at checkout through BNPL providers. Some buy now, pay later plans include interest, while others may offer interest-free payment options for certain purchases. For example, PayPal Pay Later offers Pay in 41, which gives qualified shoppers the ability to split eligible purchases into 4 interest-free, bi-weekly payments and Pay Monthly2, which gives qualified shoppers the ability to split eligible purchases into 6, 12, or 24-month payment plans.
- Loans. Loans are a lump sum of money given by a lender that is then paid back in installments over a set period with interest. A mortgage, for example, is a home loan that many homebuyers use to pay off their property over 15 or 30 years.
- Lines of credit. A line of credit is similar to a credit card, but it can be used to borrow cash and doesn't have to be connected to a card. Lines of credit normally have credit limits and replenish once the used funds plus interest are repaid.
How does financing work?
The financing process may look different depending on the lender and form of financing being used. However, here’s a general breakdown of what individuals can expect:
- Someone wants to access funds to make a purchase or cover an expense.
- They apply for financing from a lender, such as a bank or other financial institution. Information applicants need to provide may vary depending on the lender and form of financing.
- The lender assesses the applicant based on a variety of criteria, such as credit history, income, what the financing will be used for, and more. Criteria may vary depending on the lender.
- The lender sets terms, such as the amount of money offered, the period for repaying that money, and added interest and fees.
- The borrower accepts the terms.
- The lender provides access to the funds, either as a lump sum or line of credit.
- The borrower repays the funds plus any interest, often in installments over the set repayment period.
Someone may use financing so they can pay for a purchase over time instead of all at once. Say someone is leaving for a trip but suddenly needs a new water heater for their home. They may opt for a financing option to cover the purchase of the heater. This way, they can pay in installments instead of spending the money they had set aside for their trip.
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Potential risks of financing
Financing terms may be varied and complex. Before applying for any type of financing, it's best to understand the potential risks. Here are some factors to consider:
- Interest rates. Financing options typically include interest, which is normally calculated as a percentage of the amount borrowed. Interest rates can be fixed, meaning they stay the same over the course of the borrowing period, or variable, where they change over time. High interest rates can lead to higher repayment costs. If borrowers are unable to make their payments on time and in full, they risk late or missed payment fees, growing debt, and potential negative impacts to credit score.
- Fees. Along with interest, financing options may come with additional fees, such as application fees, origination fees, annual account fees, processing fees, and late payment fees.
- Conditions. Lenders may set certain conditions when financing. If borrowers don't understand these conditions upfront, it may result in them paying more money than anticipated or hurting their credit. For example, some forms of financing may require collateral for approval. If the borrowed amount isn't repaid on time, the buyer could risk losing that collateral. On the other hand, some may come with prepayment penalties or charges for paying off a loan early, while financing options like credit cards can include introductory offers like no interest payments, which expire after a certain period.