Loans are amounts of money a person borrows from a lender, usually a bank. As a borrower, you have to pay the lender interest on the money for a fixed period of time. You can choose to pay off the debt earlier but that might cost penalties.
In this article, I will be discussing the different types of loans you have access to. Depending on whether they are secured or not by collateral, we have two types – secured and unsecured loans. Let's start with them:
Secured Loans: How Does It Work?
These are loans that are secured by collateral or various assets. This means that the lender can impose a lien on the collateral in the event of missed payments or defaults. Usually, the item you purchase is used as collateral – your home or car or anything else.
These loans offer borrowers the best possible conditions on the market – lower interest rate and higher borrowing limits. In addition, the term of the loan can be much longer than what unsecured loans offer.
If you need a serious amount of money, only secured loans can deliver it. No bank will give a huge sum of money without assurance.
A serious drawback is a fact that should you fail to repay your loan, the lender will take the collateral. This is awful when we are talking about your home. So be careful and make sure that you make payments on time.
Examples of Secured Loans
- Mortgage: It's a loan that banks or building companies give an individual to buy a property. The collateral here is the real estate. There are many types of loans and the customer can choose between fixed-rate, ARMs mortgage or even a combination of them.
- Auto and car loans are a type of funding given to people when purchasing a car (both new or used). The collateral, in this case, is the car.
- Borrowers who want to purchase a recreational vehicle usually take out a recreational vehicle loan.
- Others would like to have a boat and can apply for a boat or RV loan.
- Home Equity Line of Credit (HELOC) is often referred to as a second mortgage. The borrower's property is once again, just like in the case of a mortgage, collateral.
Unsecured Loans: How Does It Work?
These are loans that have no “security,” which means that there is no collateral. Some of these loans include credit cards, personal loans, student loans, etc. If the borrower defaults on their debt, the lender doesn't have anything to compensate for the losses.
This uncertainty is what makes the conditions on these loans less attractive – they carry more risk. Often lenders may refuse borrowers an unsecured loan. But don't give up if you really need money to take out a secured one. Even though these loans are often called “signature” loans (because your signature is the only collateral they have), the bank will evaluate two main factors before they approve the loan.
1. Credit – Definitely the lender will assess your credit history. They will check if you have any previous or other debts also if you have missed payments and so on. Then they can have an idea of your credit score, which can also determine the interest rate on your loan.
2. Income – Are you sure you can really afford this loan? The lender will make sure! They would ask you a proof of income and will calculate the debt-to-income ratio which is crucial when deciding.
Examples of Unsecured Loans:
- Credit Cards are the most common unsecured loans. They grant their holders a line of credit, which they can use anytime they need.
- Personal Lines of Credit allows you ongoing funding, just like credit cards, when you need it.
- Personal (Signature) Loans are unsecured loans usually used for general purposes.
- Student Loans cover tuition fees and other expenses accumulated during the process of acquiring an academic degree.
- Home Improvement Loans are types of personal loans and people use them to cover expenses related to improving their home.
1. Open-Ended Loans
As their name suggests these loans are “open” and there is no specific date for repayment, which means that you can borrow money over and over again.
Do you have a credit card?
If the answer is yes, then you are a “proud” owner of an open-ended loan. Nevertheless, these types of loans have a limit – the maximum amount of money you can borrow at one time.
For example, you have a credit card with a $10,000 limit. This is the amount you can borrow as long as you have it. If you buy something, this amount will go down – let's say something that costs $500. Then you will be able to use only $9,500. As long as you pay off the balance, this credit limit will be restored.
Open-ended Loans give you the freedom to borrow again if you really need it. On the downside, keep in mind that there is no payoff date. This means that your interest rate will change and sometimes might increase. Automatically, this will result in higher monthly payments.
2. Closed-Ended Loans
These are loans that are fixed – the borrower cannot change the term of the loan nor the amount and number of the monthly payments. If you have a closed-ended loan, you cannot borrow the amount again. For instance, mortgages, personal loans, student loans are typical examples.
A word of caution:
As a serious drawback, we can consider the fact that you don't have any available credit to use in times of need. Instead, you have to take out a new loan or use refinancing. In addition, if you want to change the conditions of your current contract, the lender will impose fees and penalties which you have to pay. However, these types of loans are very suitable for specific purposes – buying a car, a house, etc.
3. Conventional Loans
A conventional loan is a type of mortgage, which is not insured by a government body such as the Federal Housing Administration (FHA), Rural Housing Service (RHS), or the Veterans Administration (VA). They can be usually two types – conforming and non-conforming. The former are mortgages that follow the requirements set by the Fannie Mae and Freddie Mac. The latter does not conform to the limits set by the two government agencies.
Most experts think that conventional loans offer great rates and are a very safe option. In addition, lenders usually spend less time approving a conventional loan than other types, for example, FHA backed loans. They require less information and the process is faster.
These loans require higher down payments – up to 20% of the loan value. In order to obtain these very good interest rates, you'll need a fantastic credit score.
The diversity of loans you can take advantage of is incredible. Before taking out one, make sure you know what you would like to achieve with it. Also, you have to know virtually everything part of your agreement.
Be particularly careful with several major things:
The first one is your monthly payments and what happens if you miss or delay one. Secondly, pay attention to the interest rate (fixed or variable) and the term of the loan. Last but not least, familiarize yourself with all the fees, charges, penalties. The more you know, the wiser choice you will make.