You probably understand the concept of a loan. It’s money given when you don’t have enough and you to pay it back, with interest. But why do you need more money? It could be other people share that reason. If so, there is probably a type of loan for that need. If not, you can always apply to get a personal loan. Here’s a breakdown of five common types and why you might get one.
Here are some common terms before we continue. Most loans can be defined by two pairs of big categories:
Open-ended loan: A loan with no fixed end date is open-ended. Another name is revolving credit and the classic example is the credit card. You can borrow as much as you want, up to your credit limit, and pay back as much as you want each period, subject to a certain minimum. Many people pay back everything they borrow every month. Some keep a balance and pay it down over a few months, or a few years.
Close-ended loans: This loan has a predefined length and regular payments each period. All of the money borrowed is available at the beginning and interest is charged on it immediately. All your payments are scheduled, and the amounts fixed. Mortgages are a form of close-ended loans.
Secured loans: These loans have some kind of collateral guaranteeing your payment. The lender has a claim on something of value which they can take if you fail to pay. Mortgages fall into this category, the house itself acts as collateral.
Unsecured loans: When the borrower provides no collateral, the loan is unsecured. The lender depends on the creditworthiness, as shown by the borrower’s credit report and income. If it is likely the loan will be paid back, it will be approved. Most credit cards are unsecured, although secured cards are also available.
Loans basic characteristics are described by the combination of these pairs. Typical credit cards are open-ended, unsecured loans. Mortgages are close-ended, secured loans. But it does get more complex. Here’s some common types and some of those tricky details.
Close-ended, with a set payment schedule over some period of years, and secured with the house as collateral, mortgages have some of the very lowest interest rates of any loan. They are also may be insured by governmental agencies. “Conventional” loans are ones that are not insured by these agencies. Other agencies set out guidelines for conventional loans and “conforming” loans meet these guidelines, while “non-conforming” loans don’t.
Mortgages are used to purchase houses, or other buildings. The cost of a home is high enough that few people can afford to purchase one outright. A mortgage allows them to purchase a home and pay for it over a long period, such as 15 or 30 years. As the mortgage is paid off, the borrower earns equity in the home. Equity represents the difference between the value of the home and the amount owed. We’ll talk more about that next.
Home Equity Line of Credit
Also known as a HELOC, this is a secured, open-ended loan. The borrower uses the equity in their home as the collateral for the loan. Most lines of credit are open-ended, allowing the borrower to make small purchases over time and pay them back.
HELOCs are frequently used to finance remodeling projects, or purchase new utilities, washers, dryers, refrigerators, or even heating/cooling systems. Although this is common, it’s not the only use. Debt consolidation, medical expenses, or education expenses can be paid from a HELOC. Investing the money in upgrades or repairs to the house is common due to the close tie between the loan and the borrower’s equity.
A close-ended, secured loan similar to a mortgage. These are usually at a higher interest rate, shorter total length, and for a smaller amount than mortgages though.
Since they are used to purchase a vehicle rather than a building, it isn’t necessary to borrow as much money and so the payment schedule doesn’t have to be as long. Banks offer auto loans, as do other specialty lenders, usually through car dealerships. Compare rates between auto loans from your bank and the rates terms offered at the dealership. The dealership may not have the best deal available and going through your own lender could save you money.
A closed-ended, unsecured loan, usually with a long payment schedule due to the large amount borrowed. Lenders for student loans can be grouped into two big categories: federal student loans and private student loans. Federal programs to provide these loans usually offer lower interest rates than private lenders. There are also advantages in repayment options.
As the name implies, these loans are for students to pay higher education costs. The loan specifies what expenses may be paid for using these funds, limiting it to education-related items. As the cost of higher education increases, student loans are an option for many.
Yes, credit cards are loans. Unsecured usually, and open-ended. The borrower may take as much or as little money as they want, up to their credit limit, and pay it back quickly or slowly, although there is a minimum payment for a period defined. This flexibility comes at a high cost with some of the highest interest rates of any loan (outside of payday loans, which may be equivalent of thousands of percent interest).
You also have a great deal of flexibility on how you use the money you borrow. Paying travel expenses during business trips or vacations, purchasing consumer goods online, buying lunch, or fueling your car. Any of these can be done with a credit card. Using a loan dedicated to a specific purpose can save you money, but credit cards are hard to beat for flexibility.
These common loans represent only a fraction of the types of loans available. Before committing to a loan, be sure you understand how it works, what it’s for, and how you’ll repay it.