Depending on what you are going through in life – whether that involves funding a new business or buying an engagement ring for your fiancée – you may seek out a loan to help make the necessary payments. But often people get flustered because of the various types of loans at their disposal. We’ll go over the types of loans, what they’re best for and how they function.
What is a loan?
A loan is a set amount of money that you borrow and pay back over time, whether it’s through a bank, credit union, or even a family member. In most cases, the lender will add interest charges to the principal value of your loan.
Installment credit vs revolving credit (loans vs lines of credit)
Installment credit is a type of credit where you receive a set amount of money, typically delivered in a single lump sum, that you pay back over a set period. You determine the amount you borrow when you apply for the loan. The payments for the loan are generally fixed, meaning the payment remains the same for the life of the loan, barring changes in things like variable interest rates. Once the funds from the loan are used, you must get a new loan if you need to borrow more.
By contrast, revolving credit provides an open credit line that you can borrow against as needed. Credit cards are the most common form of revolving credit. You are given a set limit of how much you can charge to the credit line. The payments change based on how much you owe. A higher balance means higher payments. In the case of credit cards, you can use the account indefinitely, meaning you can use it as long as you make the payments and keep it open and active.
|Mortgages, student loans, auto loans, and personal loans
|Credit cards and personal lines of credit, home equity lines of credit (HELOCs)
|Rates are fixed when the loan is established and there are variable-rate loans.
|Interest is only owed on the amount drawn.
|Fixed number of payments made over a set period; in many cases, payments also stay fixed
|Payments vary based on the balance owed
|Effect on credit score
|Can increase credit scores through an improved mix of credit, payment history, as well as credit age
|Has a larger effect on credit score because it affects the key scoring factor of credit utilization
Secured vs unsecured loans
Loans can be secured or unsecured, which comes down to whether you have to put up collateral to get the loan.
- A secured loan requires an asset that can be used as collateral by the lender in case you fail to pay them back. However, secured loans typically offer lower interest rates because the lender has protection in case you default.
- An unsecured loan does not require any collateral. However, interest rates can be higher since lenders rely on your creditworthiness to determine whether you qualify. Since there’s more risk for the lender, the cost of borrowing (interest) is higher.
Types of loans
There are various types of loans you can use, depending on your situation and financial needs. Finding the right loan and getting the best terms and rates helps you manage your loans or pay off the debt they generate.
A mortgage is a loan you use to purchase a home. They are always secured loans that use the home you purchase as collateral. They are different types of mortgages available, so whether you are a first-time homebuyer or military Veteran, you have options for borrowing. Failing to pay your mortgage could land you in hot water, as you would end up facing foreclosure.
If you already own a home, you can borrow against the equity you have built up in it. Home equity is the value of the home minus the remaining balance on the primary (first) mortgage. You can borrow up to a certain percentage of the equity you have available. A home equity loan is a second mortgage product, which means essentially having two mortgages on a property when you use a home equity loan.
Auto loans are another type of secured loan that you can use to buy a vehicle. The vehicle you purchase acts as collateral for the loan. Auto loans typically have terms between three to seven years, giving you time to pay off the value of the vehicle. Auto loans are available through banks, credit unions, online lenders, and even car dealerships.
Student loans are used to pay for qualified education expenses. There are two types of student loans: federal and private loans. However, most student loans in the U.S. are federal loans that are backed by the Department of Education. Generally, federal student loans offer more borrower protections and repayment options than private loans.
Personal loans can be used for a variety of purposes, from redecorating your apartment or funding a vacation to jump-starting an investment strategy or college savings fund. That’s right, in the right circumstances, you can borrow to invest and come out on top. Personal loans are often preferable to credit cards for expensive purchases or a big project because they offer lower rates. Of course, you need good credit for that to be true.
Debt consolidation loans are personal loans with a specific purpose. Consolidation loans allow you to roll multiple unsecured debts into a single monthly payment. You use the funds from the loan to pay off those debts. If you have high-interest rates, a debt consolidation loan can help you save money because you can reduce interest charges and focus on repaying the principal.
Credit builder loans are small loans that are taken out to, as the name states, help you build credit. You don’t need good credit to qualify for them unlike regular loans because they are aimed at helping people with no credit or bad credit. However, they work differently than typical loans. Instead of receiving the money upfront, you make fixed monthly payments and get the funds from your loan back at the end of your loan term. So, they can help you save while building credit.
Medical expenses quickly add up and usually they take you by surprise. That’s where medical loans come into play. Medical loans are another type of personal loan with a purpose. If you cannot pay your medical bills or if you require living expenses while you recover, you can turn to medical loans. With good credit, you can get a low interest rate.
Small business loans are aimed at helping small businesses – defined as any business with up to 300 employees – fund their operations. Lenders provide small businesses with the funds they need to financially boost their business or startup. However, be aware that small business loans have more qualification requirements than personal loans do.
Types of loans to avoid
There are a few other types of loans that are best avoided because they are typically not beneficial to borrowers. They have high interest rates, unrealistic repayment terms, and potentially devastating impacts on your finances. These include:
- Payday loans, which you get a loan at a very high interest rate that must be repaid by your next paycheck. When you don’t pay the loan off in full, you can face financing charges up to $30 for every $100 borrowed.
- Title loans, where you put up the title of your car for cash. If you don’t repay the loan, they take your car.
- Short-term installment loans, which are basically just another name for a payday loan. Any loan that gets repaid in a few weeks and requires no credit check should be avoided.
Applying for a loan
For some people, it can be stressful finding the right loan, let alone applying for one. If you don’t know where to begin, it can be overwhelming. But it doesn’t have to be. We’ve broken down the steps you can take to ease your way into the loan application process.
Step 1: Check your credit and budget
Before you even begin looking at loans, start by checking your credit score. Your credit history can affect how quickly you are approved for a loan, as well as the interest rate on the loan. Lenders will also take your debt-to-income ratio into consideration when considering you for a loan. This helps lenders figure out whether you’ll be able to make the payments on the loan.
If you have time, take steps to build credit before you apply, including:
- Reviewing your credit report
- Repairing your credit if you find mistakes in your report
- Paying down credit card debt
It’s also a good idea to check your finances and budget to make sure you can afford the loan payments. You can use a loan calculator to see what the estimated payments will be on the amount you want to borrow with an estimated interest rate.
Step 2: Compare loans
Never settle for the first loan that falls in your lap. Just because you get a piece of mail offering you a loan or see an ad on your bank’s website, it doesn’t make it a great deal for you. Instead, shop around for loans that suit your needs.
Make sure to only ask for quotes from lenders and don’t apply for the loan fully. In many cases, multiple loan applications can hurt your credit score because each lender you apply with will run a credit check. However, since these are quotes and not based on your credit, keep in mind that these are potential offers with tentative terms and rates.
Make sure to check the following places as you look for loans:
- Your own bank or credit union
- Local banks and credit unions
- Online loan comparison sites that allow to get multiple quotes at once
Step 3: Apply for the loan you want
Once you finish your comparison shopping, choose the offer that provides the best rates and terms. Contact that lender to complete your loan application. This means you will get a hard inquiry on your credit report, which may affect your scores. But there’s no need to worry about long-term damage.
Step 4: Go through underwriting
If you’ve applied for a credit card, you might expect approval immediately after you apply. But with most (not all) loans, there is another part to the process, known as underwriting. This is where a loan officer or underwriting agent reviews your application and your finances to make sure you qualify for the loan.
They will ask you for documents to verify your income and employment, typically including:
- 2-3 months of recent pay stubs
- 2 years of W2 tax forms
You may need to provide other documentation as well if you are self-employed or in certain other situations. The underwriter will check your documentation, and make sure you qualify for the loan.
The bigger and more complex the loan is, the longer underwriting takes. For a personal loan, it can take a few days. For a loan like a mortgage or home equity loan, it can take a few weeks. Be prompt when responding to requests from your loan officer to keep the processing time to a minimum.
Credit builder loans do not require this step. Neither do payday loans, but more on those soon.
Step 5: Get approved
Once the loan underwriter confirms you qualify for the loan, you will be approved. The loan officer will send you a Truth in Lending Act (TILA) disclosure that summarizes the terms and rates on the loan. Review this document carefully to make sure the terms match your expectations of what you were getting.
Once you affirm those terms, the loan officer will provide the loan agreement for you to sign. This can usually be handled online using DocuSign. Once everything is signed, the funds from the loan are “disbursed,” which basically means the lender sends the money wherever it needs to go.
- For a personal loan, the funds will usually be directly deposited into your account
- With federal student loans, the funds are disbursed through the Department of Education to your school
- For a debt consolidation loan, the funds may be disbursed directly to your creditors
The exception to this is with a mortgage. When you complete the mortgage process, you go through closing. This is an in-person meeting with the mortgage title company and the home’s seller where you sign all the paperwork to transfer the title of the home and then you get your keys.
Getting preapproved for loans
Secured loans like mortgages and auto loans have an extra optional step you can take after your check your credit and budget in Step 1 above. You get preapproved for a loan with a lender. This essentially tells you how big of a home or car you can afford to buy. A preapproval letter shows sellers that you’re a serious buyer and that you can afford to purchase the home or car you’re looking to buy.
When you get preapproved, you get a letter that you can take when you go shopping for a home or vehicle. You are not required to use the lender that you got preapproval with to get your final loan. So, you usually go to your own bank or credit union to get preapproved. Once you find the vehicle or home you want, then you can choose to go with the lender that gave you preapproval or a different lender.
When you refinance a loan, you are basically taking out another loan with either a lower rate or better terms to replace your existing loan. In most cases, you refinance to get a lower interest rate. In this case, refinancing can lower your monthly payments, save you money on interest charges over the life of your loan, and help you pay off a debt sooner.
If you are trying to refinance student loans, you, unfortunately, cannot refinance federal student loans through a federal relief program to get a lower interest rate. You would have to convert all your federal student loan debt to private debt. If you have job stability, this can be beneficial. However, if you have any trouble with your loan, you may not have access to deferral or forbearance.
Auto loans also have refinancing options. Most commonly, borrowers seek out lower interest rate auto loans. If your credit has improved since you originally received your loan, you may be eligible for lower interest rates. Otherwise, you can extend the term of your loan to help reduce monthly payments. But be warned that you would be paying more in interest over time by doing so.
Mortgage refinancing is a little more complex than other types of refinancing because you have more options and more reasons to refinance. You can:
- Switch from an adjustable-rate mortgage (ARM) to a fixed-rate
- Shorten the term from 30 years to 15 to shorten the term, paying off the home and building equity faster
- Move from an FHA loan, which requires mortgage insurance, to a traditional loan that doesn’t
- Cash-out equity in the home using cash-out refinancing.
When you refinance your mortgage, you will need to go through closing again, which means more closing costs. And whether you’re talking about a mortgage or any other type of loan, make sure to assess the cost of refinancing before you proceed. Fees and closing costs may be high enough to negate any cost savings you get from lowering the interest rate.
Abuses in lending
Predatory lending occurs when lenders try to impose abusive loan terms to a borrower. These types of loans come with very high fees and sky-high interest rates all to benefit the lender. Predatory lenders use misleading promises and manipulative tactics to get a borrower to sign off on a loan that is setting them up for failure.
For example, loan sharks are prime examples of predatory lenders. A loan shark is someone who loans money at ridiculously high interest rates and may even use threatening tactics to collect their debts. But beware of predatory lenders in sheep’s clothing. Sometimes the people you think you can trust end up trying to get one over you, such as banks, mortgage brokers, attorneys, and even real estate agents.
Defaulting on a loan
Defaulting on a loan occurs when a borrower fails to make payments within a certain period. When a loan goes into default, it can be sold off to a debt collection agency. The collection agency will contact the borrower to receive the unpaid amount. Defaulting has an immense impact on your credit score and can lead to the seizing of your personal property for secured loans.
That’s why it’s important to maintain a healthy relationship with your lender. Contact your lender or loan provider, explain your situation and discuss options like deferment or forbearance, payment plans, or restructuring your loan terms.
What happens if you don’t make your payments?
If you have secured loans, like mortgages or auto loans, defaulting will most likely result in a reclaiming of assets. The bank will seize your personal property as collateral for failing to make payments on your loan.
For unsecured loans, there are varying consequences depending on the type of loan and your lender. In some extreme cases, a debt collection agency may go so far as to garnish your wages, levy funds in your bank account, or intercept your tax refund. For most loans, the lender must sue you in civil court to take these types of actions. For student loans, these things can happen without a court order.
There are a few ways you can avoid defaulting on a loan. Let’s go over some steps you can take:
- Contact your lender: If you are having trouble making payments, you can be proactive and call your lender. You can try and work out an arrangement to work out a solution as a demonstration of good faith as a borrower.
- Document everything: If you manage to work out an agreement with your lender, make sure to keep a record of all the documents. Scan them so you can have digital copies as well. And try to get any agreements in writing.
- Make use of student loan relief options: Because federal student loans enter default once you have missed 270 days of payments, you have time to explore relief options. Explore and find out if deferment, forbearance, income-based repayments, or other repayment options can help solve your struggles.
- Modify your mortgage: Instead of defaulting on your home loan, you can seek out ways to lower your monthly payments through loan modification.
- Speak to a credit counselor: And if you simply are finding it overwhelming finding a solution, you can reach out to a credit counselor for help. Ideally, you want to reach out to a non-profit credit counseling company to get a free evaluation.
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Debt collection occurs when a collection agency reaches out to a borrower to collect debts that are past due. If you have fallen behind on payments or if you have an older outstanding debt that has yet to be paid off, you will have most likely heard from a collection agency. And if you haven’t been contacted, don’t get too excited because that call or letter might come sooner than you expect.
When they can, debt collectors will use your personal banking information, such as savings and investments accounts, to determine whether you have money to repay them.
Repossession occurs when a borrower has defaulted on payments on a secured loan. It leads to the taking back of the property used as collateral on the loan.
A lender will either repossess the property as collateral or they will pay a third-party service to do so on their behalf. Often repossessions occur without warning. In some cases, your car may even be remotely shut off until you clear things up. But let’s say you have defaulted on car payments, for example, a collection agency would either send a driver or a tow truck to collect the vehicle.
In the case of your home, repossession is foreclosure. The bank takes back the home due to nonpayment.
Loan rehabilitation is available for federal student loans and is a one-time opportunity for a borrower to bring their loan out of default. Rehabilitation will help by removing the default from your credit history and eliminating additional collections costs. However, any late payments leading up to the default will remain. And you will have to make nine payments within a 10-month period for your loan to no longer be in default.
Some mortgage lenders will also offer loan rehabilitation plans to help homeowners avoid foreclosure.
Should I consider using a payday loan?
Payday loans are a bad idea because of the extremely high interest rates and fees associated with them. They often lead to borrowers getting stuck in vicious debt cycles. And more often than not, payday lenders are predatory. So, before you take out a payday loan, find out exactly why you may be better off seeking a different loan.
What will happen if I use my loan for a different purpose than initially intended?
If you happen to use your loan for a different purpose than your loan agreement states, then you would be at risk of getting in serious trouble with your lender. If they find out, you would likely be considered in breach of contract. From there, a lender may take legal action to hold you liable for the original loan amount, plus legal costs and fees. And if you are unable to pay them back, they may go so far as to liquidate your assets to recoup the funds.
Why is interest higher for short-term loans?
The reason for higher interest on short-term loans is because there are increased administration costs in setting up the loan. And that means you will also be making higher monthly payments.
Will student loans be forgiven?
In 2021, the government passed legislation that makes all student loan forgiveness tax-free through 2025. And if you have received forgiveness through the Public Service Loan Forgiveness (PSLF), then the forgiven amount is also considered tax-free regardless of when it was forgiven. However, there is currently nothing stated as to whether or not student loans will entirely be forgiven.
How can you reduce your total loan cost?
There are actually a few ways you can try to lower your loan cost. You can opt for a shorter loan term. What most people don’t realize is that the culprit in your loan is actually the amount of interest you pay over the term of your loan. Longer loan terms may lower your monthly payments, but shorter loan terms reduce your overall interest which helps lessen the payment burden.
Another option is to seek out a balance transfer. If your current loan’s terms have high interest rates, you can transfer the remaining principal to another bank or lender with lower interest rates. Additionally, a smart method of lowering total loan costs is to make increased monthly payments if and when possible.