Taking out a loan can change your life. The funds can give you the means to make large purchases you’d otherwise have to spend years saving up for. However, you can’t just walk into a bank and ask for “a loan.” First you have to figure out exactly what type of loan you need.
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How do different types of loans work?
Before you can understand the many types of loans that exist, you need to understand the ways that loans can differ from each other.
As you probably know, loans differ in terms of their purpose (e.g., you take out an auto loan for a car, a mortgage for a house, etc). However, loans don’t just differ in terms of what you can buy with them. Loans are also categorized in the following ways:
- Secured loans vs. unsecured loans: Secured loans are backed by an asset that your lender can take if you stop repaying your loan. Common examples are car loans and mortgages (where your lender can seize your car or your house). Unsecured loans aren’t backed by any collateral.
- Fixed-rate vs. variable-rate loans: As the name implies, a fixed-rate loan has a fixed interest rate that cannot fluctuate during the loan term. With variable-rate loans, the interest rate changes according to market conditions.
When applying for any type of loan, make sure that you pay attention to these factors so that you understand your obligations as a borrower and the financial implications of the loan.
Common types of consumer loans
Here are some of the most common types of loans that banks and other institutions offer to consumers (as opposed to businesses).
Unsecured personal loans
Personal loans are used for general purchases, and they’re usually unsecured. They’re one of the most popular types of loans because they’re incredibly versatile.
These loans can have either fixed or variable interest rates, depending on the terms of your loan agreement. You typically need a good credit score to qualify because they’re not backed by any collateral.
You may need to provide proof of income when applying for an unsecured personal loan, as well as concrete proof that you own assets that are worth at least the amount you want to borrow.
Personal loans can be used for just about anything, so they’re a great option for funding small (or big) life expenses that you can’t pay for by cash or credit card. Here are just a few examples:
- Moving or relocation costs
- Home renovations
- Medical bills
- Big life celebrations, like weddings
Debt consolidation loans
Debt consolidation loans are actually a type of personal loan, but they’re used specifically for paying off multiple (often high-interest) debts.
Using a loan to consolidate your debts is an effective way of getting out of credit card debt. This is because loans generally have lower interest rates than credit cards, meaning that transferring the debt to a loan slows down the accumulation of interest.
Debt consolidation loans are also helpful if you want to streamline your finances. Once you receive the money from the bank and pay off your outstanding debts, you only need to focus on making payments to one lender.
Secured personal loans
Similar to unsecured personal loans, secured personal loans can be used for just about any purchase. However, they’re backed by an asset or funds that your lender can take if you go into default. Generally, the bigger the loan you apply for, the more collateral you need to offer.
The good news is that secured personal loans typically have lower interest rates since they’re lower-risk for lenders. This makes them a more affordable option if you’re sure you can keep on top of your payments.
The exact loan terms you’ll be offered depends on several factors, including your credit rating and what you can offer up as collateral.
Student loans are exactly what they sound like—installment loans that help you pay for higher education. Ultimately, they fall into two categories:
- Federal student loans: These are loans backed by the US government, and they don’t require a credit check. They typically come with better terms and benefits than private loans, including deferment, forbearance, forgiveness and income-based repayment options. 1
- Private student loans: These are loans issued by private lenders. They almost always require a credit check, and they don’t have many of the benefits of federal loans.
Many people don’t have the spare cash needed to buy a car. Luckily, auto loans and auto financing are widely available from financial institutions, online lenders, and car dealerships.
Auto loans are always secured, with the car you’re buying serving as the collateral for the loan. This means that if you end up not being able to make your auto loan payments, your car will be repossessed.
Interest rates and terms for car loans can vary widely, so it’s a good idea to compare quotes from different lenders to ensure you get the best deal. Getting prequalified first is also a smart move because it’ll give you an idea of what cars you can afford and give you some negotiation power when you’re actually ready to make an offer.
When most people buy a home, they need a mortgage or home loan. This is the biggest purchase most people will ever make. Mortgages usually take decades to pay off, but they’re an important financial tool if you plan to invest in property.
As a secured loan, a mortgage loan uses the property you’re buying as collateral. Mortgages can have fixed or adjustable interest rates. It’s very important that you don’t miss any mortgage payments, otherwise you risk facing foreclosure and losing your home.
Mortgages typically fall into five categories. The table below shows the credit score required to buy a house with each type of mortgage:
Types of Mortgages
|Mortgage Type||Description||Credit Score Required|
|Conventional mortgage||Offered by private lenders for amounts within the “conforming loan limit” set by the Federal Housing Finance Agency||620|
|FHA loan||Backed by the federal government and designed to be more accessible to first-time homebuyers||580 with a 3.5% down payment
500 with a 10% down payment
|VA loan||Backed by the US Department of Veterans Affairs and exclusively available to current or former members of the US Military or National Guard and their spouses||No set minimum, but generally 580–620|
|USDA loan||Insured by the United States Department of Agriculture and designed for people looking to buy a home in a rural area||No set minimum, but 640 is required for streamlined application processing|
|Jumbo loan||Offered by private mortgage lenders to consumers who want to purchase a high-cost home beyond the conforming loan limit||700 to 740 (depending on the loan amount)|
Home equity loans and lines of credit
A home equity loan is a secured loan that you take out using the equity you have in your home as collateral (i.e., the percentage of your mortgage you’ve actually paid off). People often take out home equity loans to pay for renovations or additions that will increase the value of their home.
Home equity lines of credit (HELOCs) are similar to home equity loans, but they’re a type of revolving credit. You can withdraw and repay funds from this line of credit for a specific amount of time (often 10 years).
After a HELOC draw period ends, the repayment period begins, and it usually lasts for 20 years. 2 Borrowing against the equity in your home is a risky move, and you could end up losing all of your investment in your property if you’re not careful. Make sure to carefully weigh up all the pros and cons before getting one of these loans.
Credit-builder loans are more of a credit-building tool than an actual loan. You won’t actually get any money upfront, so it’s not a good option if you want quick cash—instead, you’ll get the loan funds after you’ve made all your payments.
Just about anyone can get a credit-builder loan, and it’ll build up your payment history the same way any other loan would, as long as your lender reports your payments to the credit bureaus (Equifax, Experian, and TransUnion). You can generally get them from banks or credit unions.
If you have a bad credit score, an insufficient credit history, or no credit score at all, then a credit-builder loan is a great solution for building up your credit without having to meet high credit score requirements.
How are business loans different from consumer loans?
In contrast to consumer loans, business loans are specifically designed for use on business purchases. You can use them to turn a business idea into reality or help your already-existing business prosper and grow.
Business loans are generally installment loans with fixed repayment schedules, just like personal loans. However, they have different requirements than ordinary (consumer) loans.
When you apply for a consumer loan, your lender will generally consider your credit score, credit history, and income, but to get a business loan, you’ll also have to present them with a formal business plan to show that you’ll be able to use the loan to successfully grow your business.
How to get a small business loan
If you’re interested in getting a business loan, you can start by exploring the loan options offered by the Small Business Administration. You can then search for an SBA-approved lender that’ll give you the funds you need. Small business loans can be secured (e.g., by your own personal assets) or unsecured, depending on the lender and your circumstances. 3
Loans to avoid: high-risk loans for quick cash
By now, you’ve probably noticed there are a lot of different types of loans out there. While all the loans above can be helpful, there are a handful of loans you should avoid taking out, as they can (and usually will) do more harm than good.
Payday loans are short-term, high-interest loans that you typically need to repay within 2 weeks or by your next payday. You’ll usually need to put up some form of collateral, such as a post-dated check or access to your bank account. Needless to say, both of these options are incredibly risky.
The interest rates on payday loans tend to be extortionate, often reaching 400% or higher. 4 For reference, personal loans with a 2-year loan term had an average interest rate of only 8.73% in May 2022. 5
Payday loans are notorious for being financial traps used by predatory lenders. In fact, for this reason, they’re actually banned in some states, including New York. 4 Even if you desperately need some quick cash, you should avoid this option.
Pawn shop loans
Pawn shops don’t have a very good reputation, and for good reason. Borrowers almost never get the good end of the deal when pawning their personal (and often sentimental) items for a quick buck.
Pawn shop loans are secured, with the item you’re pawning serving as collateral. If you can’t pay back your loan in time, the pawn shop dealer reserves the right to sell the item you gave them.
Much like a private lender, a pawn shop lender can set their rates and fees as high as they please. They may also charge storage fees, insurance, and loan term renewal fees. This means you may not be able to tell how much you’ll owe until you’ve committed to the transaction.
Pawn shops don’t require credit checks, which makes them especially appealing to borrowers with poor credit, but their accessibility comes at a steep price. On the bright side, however, some states have begun to regulate the industry.
The most common type of title loan is a car title loan, which is a secured loan that uses your car as collateral. However, you can also have title loans for recreational vehicles (RVs), motorcycles, and other vehicles. The lender gives you cash, and in exchange, they hold onto ownership rights of your vehicle until you pay off the loan and interest in full.
To get approved for a car title loan, you’ll need to already own the car or have documented equity in the vehicle. This means that if the car legally belongs to your mom or partner, for example, you can’t use it to take out a title loan.
Car title loans typically allow you to borrow up to 25%–50% of the car’s value. 7 They usually come with very short terms (e.g., 15–30 days) and allow you quick and easy cash access.
However, don’t let the superficial convenience of a car title loan fool you into thinking you’re getting a good deal. They often come with incredibly high interest rates (up to 300%). If you’re thinking about getting a car title loan, be sure to read (and reread) the fine print first.
Credit card cash advances
If you need some quick cash, you may be able to get a credit card cash advance, which is a short-term loan that you take out against the available credit on a credit card account. You can get access to the funds by simply using your credit card to withdraw money from an ATM.
Except in an emergency, getting a credit card cash advance usually isn’t a good financial decision. The money you borrow accrues interest every month until it’s entirely paid off. Some banks also charge additional fees for cash advances. 8
What type of loan should you choose?
There’s no one perfect loan for every situation. Your budget, financial needs, and credit score are all important factors to consider when deciding what type of loan to get.
Once you decide what kind of loan to go with, your creditworthiness (e.g., your credit score and debt-to-income ratio) will determine the terms you can get approved for. You’ll also still need to sift through the terms and fees attached to each loan offer.
The bottom line is that you should always do your research before committing to a loan type and lender. If you play your cards right, you’ll end up building credit while getting access to the financial support needed to live the life you desire.