Edited by Sandy Yong
Many different types of loans can meet your needs at various stages of your life. While taking out loans can help you reach certain financial goals, you must manage your debt responsibly. Common loans, such as mortgages and car loans, are helpful for big-ticket items. Understanding all the loan options available will help you make strategic decisions that fit your budget.
Your ability to borrow depends on your credit history. Using your credit score and credit report, potential lenders will assess your creditworthiness and ability to pay back the loan. If they determine you’re eligible, your credit history will influence the interest rate they offer and the amount you can borrow.
Loan Features
Different features of loans can be included in the loan terms. Make sure you understand the structure and requirements of your loans. Here’s an overview of the common features you’ll see when comparing different loan options:
Secured loans are backed by collateral, usually a tangible asset like a car, boat, or house. If you fail to make your loan payments, the lender can repossess the collateral. Banks are highly motivated to avoid this, so if you find yourself in this situation, you may be able to negotiate a repayment plan.
Unsecured loans do not require any collateral. Examples of unsecured loans include personal loans and student loans. In cases of non-payment, the lender can impose penalty fees, increase the interest rate, and report missed payments to credit bureaus, which will lower your credit score.
Fixed Interest Rate Loans have the same interest rate throughout the loan term. They’re predictable and protect borrowers if interest rates rise. Generally, many loans offer a fixed interest rate.
Variable Interest Loans feature an interest rate that can fluctuate because it’s typically tied to the U.S. Federal Reserve’s (Fed) interest rate. For example, an Adjustable Rate Mortgage (ARM) has a variable interest rate as it’s tied to the lender’s prime rate.
Fixed Payment Loans have the same payment amount each period for a specified period. Many loan types follow this structure, including mortgages, auto loans, and personal loans. It’s ideal for individuals who want consistency.
Variable Payment Loans have a payment amount that changes each period, based on the remaining principal and a variable interest rate. Usually, the variable rate is lower than the fixed rate, which could result in savings. Examples include a personal loan or a line of credit.
No-Interest Loans offer 0% interest throughout the entire loan period. Sometimes, car manufacturers provide this as an incentive to encourage purchases. During the pandemic, this was common as a way to boost sales during the economic downturn.
The Five Most Common Types of Loans
When you purchase a car, home, or go to school, or pay a medical bill, you’ll likely need to borrow money from a lender. These are the popular types of loans available to Americans.
- Auto and Vehicle Loans
Loans for cars, motorcycles, boats, and other personal vehicles are very common. They are designed for a specific purpose, with the vehicle used as collateral. The loans are straightforward, featuring fixed monthly payments and interest rates.
- Mortgages
Mortgages are used to purchase property, such as houses or buildings. They are more complex than other types of loans. They typically have fixed payments. Each month, your payment is divided between interest and principal. Every time you make a payment, the principal decreases, and you build more equity.
An Adjustable Rate Mortgage (ARM) usually features a fixed rate for a set period, then switches to a variable rate for the remainder of the loan term. These are accessible to borrowers with lower credit scores or short-term homeowners.
Refinancing means getting a new mortgage for the remaining principal at a lower interest rate. It reduces your monthly payments, but for it to make financial sense, the savings need to exceed the loan’s closing costs.
- Student Loans
Student loans are used to cover college and graduate school tuition. You can obtain loans from private banks or the federal government. There is debate in the U.S. about the debt burden students take on with these loans, considering the high cost of college. Some politicians are calling for the government to provide loan relief to students.
- Personal Loans
Personal loans can be used for nearly any purpose and are typically unsecured. You may use a personal loan for a home renovation, a medical bill, or to buy new furniture. They are simple loans, with the entire amount given upfront, and usually have fixed monthly payments.
- Lines of Credit
A line of credit is an approved amount you can borrow at any time, usually by writing a check or transferring money to another account. As you borrow money, your available credit decreases. An example is a Home Equity Line of Credit (HELOC), which is considered a second mortgage on your home.
Alternative Loans
Besides the most common loan types, there are lesser-known options for people with unique financial needs. Here are some other types of loans you should be aware of:
- Debt consolidation loans let you combine multiple loans and debts into a single loan with a lower interest rate. The advantages include making a single payment and paying less interest overall. Be sure to consider any extra fees when calculating the total financial costs and benefits.
- Peer-to-Peer (P2P) loans involve one consumer lending to another borrower. They are facilitated through online platforms and apps and don’t involve banks or financial institutions. For the lender, it’s considered an investment with the potential for higher returns. When you apply for a loan, you will still undergo a credit check, but it is often a “soft credit check” that doesn’t impact your credit score.
- Payday loans provide you with a loan before your paycheck. There’s no credit score check, but you must have an active savings or checking account, or a prepaid debit card. You’ll also need to show proof of your income. These loans are controversial because of the high interest rates they charge.
- Credit builder loans are meant for people with low or no credit. They typically require you to deposit funds equal to your loan amount. When you repay the loan, the deposit is returned to you. This type of loan can boost your credit score because it is reported on your credit report like any other loan.
FAQ
What is “APR” and why does it matter?
The Annual Percentage Rate (APR) is the total yearly cost of borrowing money, expressed as a percentage, which includes both the interest rate and additional fees. A higher APR means borrowing money will cost more.
Can I apply for multiple loans at once?
Yes, you can apply for several loans at the same time. However, having multiple hard credit checks in a short period can lower your credit score, so it’s best to spread out your loan applications over time.
What documents do I need to apply for a loan?
Most lenders require identification, credit history (usually checked on their end), proof of income (such as a pay stub), banking information, proof of assets (like a home or car), and sometimes tax statements.
Should I pay off my loans early if possible?
Paying off high-interest loans quickly is usually a good way to pay down debt faster and reduce interest costs over time. However, some loans have prepayment penalties (like a mortgage), so check your terms before proceeding. Also, if you have low-interest debt, you may want to focus on building an emergency fund or investing your cash.
How do loans affect my credit score?
Keeping high loan balances for long periods or missing payments can hurt your credit score. A lower credit score makes it harder to get approved for future loans and better interest rates. Therefore, it’s best to make payments on time and in full to increase your credit score.
What is refinancing?
Refinancing a loan means replacing an existing debt with a new one under different terms. People usually do this to get a lower interest rate, cut monthly payments, or access home equity. Keep in mind that refinancing often involves closing costs or prepayment penalties, so make sure the benefits outweigh the drawbacks.
Can I refinance a loan other than a mortgage?
Yes, you can refinance types of loans other than a mortgage. Many loans, like auto, student, and personal loans, can often be refinanced. However, it depends on the lender, your credit score, and your income. Also, there may be fees involved with refinancing.
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