Loans are part of how most of us live our lives. Loans help people get educated, buy a car, buy a home, pay for emergency medical bills and much more.
The list of reasons why people need loans is a long one. And, thankfully, there’s an equally long list of loans available for our diverse needs. If you’re just starting your financial journey, the sheer number of loan options can feel overwhelming.
So, which loan is right for your needs?
Use this guide to help understand the different types of loans and how they work. The more you know, the more confident you’ll feel when you’re deciding what loan or loans you should apply for to help you live your best (financial) life.
Here are the different types of loans:
Most lenders, like banks, credit unions and online lenders, offer personal loans. Personal loans can be used to pay for or finance just about anything – which is a plus.
Here’s the minus: Personal loans typically have higher interest rates than many other types of loans. And that’s because personal loans are usually unsecured loans. Unsecured loans don’t require the borrower to put up collateral (a valuable asset a lender can take if the borrower defaults on the loan). However, some personal loans are secured loans.
Personal loans usually have lower borrowing limits – up to a few thousand dollars. When you apply, you’ll typically need to provide the lender with your Social Security number and proof of income and assets.
Personal loan terms and interest rates vary by lender, and like most loans, your credit score will play a part in determining what they’ll be.
At the end of 2022, the average interest rate for an unsecured loan with a 36-month repayment term (3 years) was about 10% from a credit union.
FYI: Credit unions, which are nonprofit organizations, usually offer lower loan rates.
Personal loans are generally paid back over a loan term of 2 – 5 years.
Some popular ways to use a personal loan are to pay for a wedding or vacation, to consolidate debt, to fund small home improvement projects or to pay for unexpected medical expenses.
Buying a car can be expensive – especially now. Raise your hand if you, like many of us, don’t have tens of thousands of dollars parked in a savings account to buy a car. If that’s your dilemma, a possible solution is to finance your car purchase by taking out a car loan. Generally speaking, you can finance the purchase of a new or used vehicle.
Most dealerships, car companies and other lenders offer auto loans. It’s a good idea to shop around for a low rate and terms you like. Depending on your credit, you may be able to qualify for a 0% introductory rate and no down payment. BTW, if your credit score could use a tune-up, you’ve still got options. There are auto loans for borrowers with lower credit scores.
The average auto loan term lasts 36 – 72 months (3 – 7 years). In the first quarter of 2022, the average interest rate for a new car with a 48-month repayment term was around 4.5%.
Because the car acts as collateral for the loan, auto loans are considered secured loans. If a borrower defaults on their car loan, the car may be repossessed by the lender.
Many of us pursuing higher education do so with the help of a student loan (or two or three). The two main types of student loans are federal student loans and private student loans.
Federal student loans are backed by the U.S. Department of Education and are the most common borrowing option for students to cover their postsecondary education. Federal student loans typically don’t require a credit check.
Private student loans are offered by lenders, like banks and credit unions. They are often used to cover the gap between federal student loans and the remaining cost of tuition. Lenders will typically run a credit check on a potential borrower.
You use a mortgage loan, which is a secured loan, to buy a home. And, yes, the home you purchase is the collateral for the loan. Be sure to make your monthly mortgage payments on time and in full so you never have to worry about late payment fees or foreclosure.
A mortgage is commonly taken out to buy a primary residence, but you can also buy investment properties or vacation homes.
Applying for a mortgage is typically a main feature of the home buying process. Your loan amount is the difference between the home’s purchase price and your down payment. Like other installment loans, you pay back what you borrowed (plus interest) with monthly payments.
The typical mortgage term is 30 years. But you can get a mortgage with a 15-year term, a 10-year term or a shorter term.
Homes are usually the most expensive purchase a lot of us are going to make. And with so much money on the line, borrowers must undergo a comprehensive approval process. The loan’s interest rate will depend on a variety of factors, including the type of mortgage you’re applying for, your income, credit score and credit history, debt-to-income (DTI) ratio and the loan’s term.
There are two main types of mortgage loans: conventional mortgages and government-backed mortgages. A conventional mortgage loan (also known as a conforming loan) is the most common type of mortgage.
Government-backed mortgages are offered by government agencies like the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA). The government tries to encourage homeownership by providing these loan products and helping buyers with credit or savings issues become homeowners.
Home Equity Loans
Home equity loans let homeowners borrow a percentage of the equity they’ve built up in their homes (usually up to 80%). Equity is the difference between what you owe on your home and the property’s appraised value.
The two most common ways to tap into your home’s equity are with a home equity loan or a home equity line of credit (HELOC). Both loans are considered second mortgages.
What is a home equity loan?
Home equity loans are fixed-rate installment loans. You receive a lump sum and pay it back with interest every month for 5 – 30 years.
What is a HELOC?
A HELOC is revolving credit. It works like a credit card – you can borrow money up to your set credit limit, and you only pay interest on what you borrow. The interest rate on the HELOC can be variable or fixed.
The window when you can borrow from your line of credit is known as the draw period. The draw period usually lasts around 10 years. Once the draw period ends, the repayment period begins. And just like it sounds, you pay back the money you borrowed, including interest. The repayment period typically lasts around 20 years.
Credit Builder Loans
Credit builder loans are a type of personal loan. They help people with bad credit – or no credit – build or improve their credit history and credit score.
You can borrow up to $1,000 with credit builder loans. Your lender may not require a credit check and a low credit score may not disqualify you from approving for the loan.
But here’s one way your credit builder loan is different from your typical loan: You start making payments before you get the money.
The borrower pays the loan, including interest, every month for the loan’s term, which could be a few months or a few years. And the lender reports the borrower’s payments to the three major credit bureaus (Equifax®, Experian™ and TransUnion®). As long as the borrower pays on time and in full, their strong payment history will build or boost their credit score.
At the end of the loan’s term, the borrower receives the loan amount. In some cases, the borrower can also get back a portion of the interest they paid.
Debt Consolidation Loans
Debt consolidation loans are a type of personal loan, but the purpose of a debt consolidation loan is to pay down debt, not create new debt. High-interest debt is consolidated (read: combined) and transferred to a lower interest loan.
People with high-interest debt, like credit card debt, can use debt consolidation to lower their APR (a credit card’s interest rate) and their monthly payment.
The lender typically pays off your existing high-interest debts and gives you a single loan for the entire amount. The borrower pays back the loan plus interest every month with a single payment. The interest rates on debt consolidation loans can be fixed or variable.
Small Business Loans
A small business loan can help an entrepreneur (or aspiring entrepreneur) get up and running, expand or fund the purchase of new equipment. While you can use a personal loan for a small business, lenders offer small business loans to help business owners finance some of their business costs.
There are several types of small business loans, including lines of credit, equipment financing loans, working capital loans and accounts receivable financing. A business credit card can also be considered a type of business loan.
Except for lines of credit, most small business loans are fixed-rate installment loans and have a repayment period of up to 5 years.
Some small business loans are secured loans that require an asset – in this case, a business asset – to secure the loan. You can also apply for unsecured small business loans. For unsecured small business loans, lenders will evaluate the borrower’s creditworthiness to secure the loan and determine the interest rate.
Small Business Administration loans are a type of small business loan offered and backed by the government to encourage entrepreneurship.
A payday loan is another personal loan. Because payday loans typically have extremely high interest rates and fees, it’s best to steer clear of them.
A payday loan is a short-term loan borrowers must pay back in full by their next payday (hence the name). You can typically borrow up to $1,000.
Payday loans are mostly used for emergencies, but the short repayment period can make them difficult to pay back on time. And with high interest rates and late fees tacked on if you can’t repay the loan, you might find yourself trapped in a hard-to-break cycle of debt. Payday loans should be your last resort – but your best bet would be to avoid them.
Find the Loan That’s Right for You
There are a lot more loans out there and a lot more to learn about the loans we covered in our guide. But we can confidently tell you that you’ve got the fundamentals under your belt. Delve deeper into your loan of choice or start talking to a lender. The right loan is out there to finance the rest of your life.
The Short Version
- There are two main types of loans: secured loans and unsecured loans. A secured loan needs an asset as collateral. An unsecured loan requires no collateral
- Personal loans, auto loans, mortgages and student loans are common types of loans. Credit cards and lines of credit are also loans
- Installment loans (or term loans) give you a lump sum of cash you pay back with monthly payments. Revolving credit is an account you can borrow money from when you need
National Credit Union Administration. “Credit Union and Bank Rates 2022 Q3.” Retrieved April 2022 from https://www.ncua.gov/analysis/cuso-economic-data/credit-union-bank-rates/credit-union-and-bank-rates-2022-q3