Common Types Of Loans: A Beginner's Guide
Lauren Nowacki6-minute read
December 15, 2021
Whether you’re planning on buying a home, getting a new car or furthering your education, you may have some questions about what type of loans you’ll need to pay for it. It can be intimidating trying to find the right financing in a sea of various lending options. We’ve narrowed down the most common types of loans that cover a broad spectrum of financing options you may encounter while trying to reach one of many life goals.
Different Types Of Loan Categories
First, let’s take a look at the different categories common loans fall into. When you get a loan, it will be either secured or unsecured, open-ended or closed-ended and, if you’re getting a mortgage, nonconforming or conforming.
Secured And Unsecured Loans
When it comes to any loan, it will be either secured or unsecured.
Secured loans require you to offer up a personal asset, such as a home or a vehicle, to obtain the loan. If you default on your payment, the lender may repossess that asset. The loan amount and interest rates depend on the value of the offered asset, along with your credit score and income. Interest rates are generally lower because the collateral offers a lower risk to the lender. The most common types of secured loans are auto loans and mortgages. You’ll typically borrow the appraised value of the home or car minus any down payment you make on it. If you default on your loan, the car or home can be taken away.
Unsecured loans are personal loans not backed by any collateral. However, that doesn’t mean nothing happens if you default on the loan. If you stop making payments on an unsecured loan, the lender can charge you fees, hand you over to collections or take you to court.
Since you aren’t offering any collateral, the interest rate and loan amount for unsecured loans are determined by your credit score and income. It’s important to remember that unsecured loans typically have a higher interest rate than secured loans because there’s more risk involved. One example of this type of loan is a credit card. Credit cards have an average interest rate of about 20%, compared to the average auto loan interest rate of about 5% – depending on your credit.
While the act of collecting on defaulted loans differs by whether it’s secured or unsecured, there is one major consequence that happens if you default on either type of loan: harm to your credit. Not only will defaulting on a secured or unsecured loan negatively impact your credit score; it will also stay on your credit report for up to 7 years. This can make it difficult to open new lines of credit or purchase a home in the future.
Open-Ended And Closed-Ended Loans
A loan can also be open-ended or closed-ended. Here are the differences between the two.
Open-ended loans feature a fixed-limit line of credit that can be borrowed from again and again. Your available credit decreases as you spend and increase with every repayment you make. Two common examples of open-ended loans are credit cards and home equity lines of credit (HELOCs).
Closed-ended loans are one-time loans that cannot be borrowed from again. The loan amount is fixed and repaid over an agreed-upon amount of time. As you pay down the loan, you cannot take more money out. If you need to borrow more money, you must repeat the application and approval process for the loan. A few examples of closed-ended loans include mortgages, student loans and auto loans.
Nonconventional And Conventional Loans
Nonconventional and conventional loans are two different mortgage loans. The category the loan falls into has to do with how it’s insured and what guidelines the lender follows.
Nonconventional loans, or government loans, are backed by the government. That means the government insures these loans, which typically have more lenient qualifications, like lower credit score and smaller down payment requirements. This can make them a more obtainable financing option for someone who may not meet the guidelines of other loans. Examples of nonconventional loans are the FHA loan, USDA loan and VA loan.
Conventional loans are backed by private lenders, such as a bank, a credit union or a mortgage lender, and not by any government entity. These loans have stricter qualification requirements because, without government insurance, the lender is the one at risk of losing money if the borrower defaults. These loans usually require a stronger credit score and a larger down payment.
Conforming And Nonconforming Loans
Conventional loans fall under two categories: conforming or nonconforming.
Conforming loans follow (or conform to) guidelines set by Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgage loans. The Federal Housing Finance Agency (FHFA) oversees Freddie Mac and Fannie Mae and sets funding criteria, including a maximum loan amount these entities can purchase. The loan limit for 2022 is $647,200 for most markets. Along with the amount someone intends to borrow, loan qualifications for conforming loans depend upon the borrower’s debt-to-income ratio, as well as loan-to-value, and their credit history.
Nonconforming loans do not follow guidelines for Fannie or Freddie, and thus do not qualify under those entities. These are loans that are above the loan limits set by the FHFA and are often referred to as “jumbo” loans. If you require a loan amount that exceeds the conforming loan limit, you’ll need to get a nonconforming loan. Since these loans are riskier for lenders, they may be harder to obtain.
8 Common Types Of Loans
We mentioned several types of loans that fall into the categories above. Let’s take a closer look at these common loans you may get throughout your life to better understand how they work and why you may consider using them.
1. Home And Mortgage Loans
You get a home or mortgage loan to purchase a house or real estate property. The amount you borrow on a mortgage is based on the appraised value of the home and the amount of money you pay as a down payment.
These types of loans are secured and closed-ended loans and can be conventional or nonconventional. The house will be put up as collateral and you will make monthly mortgage payments for a specified amount of time (typically 15 or 30 years) until the loan is paid off.
2. Auto Loans
Auto loans are taken out to purchase a new vehicle, while typically putting that vehicle up as collateral for the lender. That makes them secured loans, typically, as well as closed-ended.
Like a mortgage, the amount you borrow will depend on the value of the collateral – the car you are purchasing with the loan – minus the down payment, if you are required to make one. You’ll make monthly payments to the loan for a specified amount of time until it’s paid off.
3. Student Loans
You take out student loans to cover costs of higher education, which may include tuition, room and board, other living expenses and classroom expenses including textbooks and lab fees. These loans are typically unsecured and closed-ended. You will not need to put up collateral for this type of loan.
Student loans can also break down into one of two other categories: subsidized or unsubsidized. Subsidized loans are based on your financial need. You must demonstrate a financial need to qualify and the amount you borrow will not exceed the amount you need. Unsubsidized loans are for any student, regardless of financial need. The amount you borrow is based on the cost to attend the school and what other financial aid you’re receiving.
4. Business Loans
Business loans are used to set up a new business or expand upon an established one. These types of loans can be open-ended or closed-ended and are usually secured loans, as it is commonly required to offer up an asset as collateral. Such assets you can use as collateral include equipment, buildings, inventory or accounts receivable.
While some businesses choose a one-time loan, others choose a line of credit from which they can borrow continuously as long as there is credit available.
5. Payday Loans
Payday loans are short-term loans that are due upon receipt of your next paycheck. They’re often used when someone is in a bind and needs cash fast since there are very few requirements and no credit checks to qualify.
However, these types of loans are notorious for high lending fees and annual percentage rates (APR) and can be difficult to pay off for lower-income individuals. This is why they’re often referred to as predatory loans.
The government and many finance experts discourage the use of payday loans, and some states ban the practice entirely. Avoid payday loans if you can and consider any alternatives if possible.
6. Personal Loans
A personal loan is a type of installment loan that offers much more flexibility for borrowers. Compared to student loans or mortgages, personal loans allow borrowers to use their financing however they see fit. You could use a personal loan to consolidate high-interest credit card debt or fund your next home project.
Some personal loan providers offer a fast funding turnaround once you’ve been approved, and with average terms ranging from 2 to 5 years, you’ll likely have a good amount of time to handle repayment. Expect personal loan interest rates to be higher than student loans and mortgages, but lower than credit cards.
7. Borrowing From Family And Friends
Often considered an “informal” personal loan, borrowing from your personal network is one quick method for securing funds fast and with little to no administrative fees. Though it can be a way to borrow relatively inexpensively, both the borrower and lender should consider the implications of mixing finances and personal relationships.
On one hand, a personal, individual lender will likely have much lower standards than a traditional lender, which could make this kind of arrangement a good option for those who do not qualify for more conventional loan types. Your friend or family member will also have full control over the interest rate they charge you, which could mean much lower rates.
On the other hand, these types of loans rarely have the same legal standings as more official loan arrangements. Without the right legal documentation in place, you could have little to no control over abrupt increases in the interest rate, term or other repayment conditions. Receiving funding from a close connection can also complicate or damage the personal relationship you have with that person.
Consider your options or speak with a legal professional before you seal the deal.
8. Cash Advances
A credit card cash advance is a short-term loan for borrowers who need fast access to funds. Cash advances work by using your credit card to “purchase” cash, similar to making other purchases on plastic. However, unlike a regular purchase, you’ll likely have a much lower limit on the amount you can take out with a cash advance.
Because there is no application process, cash advance loans provide a fast, simple way for borrowers to resolve their immediate financial needs. However, the convenience of a cash advance comes at the expense of higher interest rates, no grace period and additional processing fees with certain banks.
The Bottom Line: Know What Types Of Loans There Are Before You Borrow
Loans can fall into a number of different categories that help determine their terms, like how you qualify, how much you borrow, your interest rate and the consequences of failing to make the required payments. Loans can serve a number of different purposes. Some serve specific uses like buying a home, starting a business or getting a college degree.
When determining which loan is right for you, make sure you understand what type of loan you’re dealing with, its terms and what’s expected of you. When it comes to being a responsible borrower and securing a successful financial future, it’s important to stay informed about the state of your finances.
Follow more of our personal finance tips for helping staying up to date on financial matters.
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