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What Is a Loan? Learn About Types of Loans

| Money Rates Columnist
min read

group-of-diverse-young-peopleWhat is a loan? It seems like a simple question. You need money, you ask someone to lend it to you, and you pay it back. But there are many types of loans. What type of borrowing is best for you? Here are the important options to consider.

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Attributes of a Loan

All loans have certain things in common. To get the best rates and terms these are the big questions to consider.

  • What is the loan amount?
  • Is the loan secured or unsecured?
  • How much is the interest rate? What is the annual percentage rate (APR)?
  • How is the interest rate calculated? Fixed or adjustable? Simple interest or based on a formula such as the rule-of-78s?
  • Is the financing a business loan or personal?
  • What are the fees and charges associated with the loan, if any?
  • How long is the loan term?
  • Is there a balloon payment at the end of the term?
  • Can you prepay the loan in whole or in part without penalty?
  • When are loan payments due? Is there a grace period?
  • Is there a fee for late payments? How much?

Open-ended vs closed-ended

Loans come in two basic flavors, open-ended and closed-ended.

Most mortgages, car loans, and personal loans are examples of "closed-end" financing. A closed-end loan is a form of financing which generally has a fixed interest rate, a set term, and consistent monthly payment. The debt and all related interest are paid off at the end of the loan term.

A credit card can be seen as an "installment" loan. Credit cards are essentially lines of credit from which you can borrow up to your credit limit. You pay at least a minimum monthly amount, but you also have the option of bringing the loan balance down to zero without penalty.

Secured vs unsecured

Loans are either in the form of secured or unsecured financing. A "secured" loan is financing backed by the borrowers promise to repay and they claim on the borrower's property if the loan is not repaid. Mortgages and auto financing are examples of secured loans.

An unsecured loan is a form of financing personally guaranteed by the borrower. Realistically, this means that the lender makes the loan after looking at the applicant's credit standing, income, and debts. If the borrower does not repay an unsecured loan, the lender will likely have to either take the borrower to court or write off the debt. Because unsecured loans are riskier than secured loans, they typically require a higher rate of interest. Credit cards and personal loans are examples of unsecured financing.

Business vs personal

It might seem as though one $10,000 loan and another $10,000 loan are both alike. That may not be the case. For example, one might be a business loan and the other might be personal financing. The difference is that personal loan borrowers benefit from an array of consumer protections while business borrowers have very few safeguards. The logic is that a business borrower is supposed to be a "sophisticated" individual who has the ability to defend his or her own financial interests.

Types of Loans

Loans come in many different formats, each with its own particular purpose and format. The most common examples include the following types of financing.

Credit cards

Credit cards are a form of revolving credit. You can use a credit card in lieu of cash to buy items in even for cash advances. The lender charges an interest rate as well as an assortment of fees and charges. Both interest and fees can often be avoided by paying down balances to zero each month and by shopping for the best available cards.

Personal loans

Personal loans are available from banks, credit unions, friends and family. This is a form of unsecured financing in which you borrow a specific lump sum and repay the debt over time, usually at a fixed rate of interest. As an example, if you borrow $7,500 at 10% interest over five years the monthly payment will be $159.35.

Personal lines of credit

Personal lines of credit are not so much alone as the right to borrow. You might have a checking account with overdraft protection. Overdraft protection is really a personal line of credit. You may not ever use it, but it's something most consumers should have to avoid overdraft charges and returned check fees.

Student loans

Student loans are an entirely common way to finance college and technical educations. According to the Federal Reserve Bank of New York, student debt amounted to $1.51 trillion at the end of 2019. Many borrowers have great difficulty repaying student debt because the amount they owe is so large, expected incomes do not emerge after training, and sometimes the borrowers fail to complete the education they financed. To the extent possible students should seek to find scholarships, grants, and paid internships to hold down student loan balances.

Payday loans and check advances

Payday loans and check advances are widely associated with their small size - typically about $400 - and enormously high rates of interest. A 2013 study by the Consumer Financial Protection Bureau found that the typical payday loan was $392 while the median interest rate was 332%. Rather than payday financing and check advances, it's better to set aside money - even $10 a week - to build-up reserves and avoid such loans.

Auto financing

Auto financing is a loan secured by a vehicle. Usually the loan's purpose id to purchase the vehicle serving as collateral. While some auto financing is based on simple interest, a large percentage of auto loans compute interest using the rule-of-78s, a formula which pushes interest costs to the front of the loan and makes prepayment less attractive. Importantly, auto financing - which totaled $1.3 trillion at the end of 2019 - is less regulated than other forms of consumer lending. In 2010 Congress created a "carve out" so that auto lending could not be regulated by the Consumer Financial Protection Bureau. As an alternative to auto loans borrowers might want to consider a personal loan or the use of real estate equity.

Mortgages

Mortgages are financing secured by real estate. The marketplace is enormous but even with generally rising home prices the mortgage market is actually smaller than in recent years. Figures from the Federal Reserve show that American homes secured mortgages worth $9.95 trillion at the end of 2019. That's a lot of money but actually less real estate debt than the country owed in 2008.

Most real estate debt today is in the form of fixed-rate, 30-year mortgage financing. The long-term historic norm for mortgage interest is 8%, a rate twice as much as the interest levels seen in early 2020. Such low rates allow many people to bid for residential real estate, one reason we have seen rising home values in most areas of the country.

Home equity loans and HELOCs

As home values have risen owners have often had an interest in converting their growing real estate equity into cash. There several ways of doing this including the replacement of a current mortgage with cash-out refinancing, a second mortgage, or a home equity line-of-credit (HELOC). Which loan option is best depends on the amount of equity available to the homeowner as well as the individual's financial profile and preferences.

Business loans

In addition to consumer financing, there are also loans for businesses. Such loans include money to buy inventory, mortgages for commercial structures, financing to purchase entire businesses, and similar types of debt financing. Unlike consumer loans, business financing has few borrower protections.

401(k) loans

With fewer corporations offering defined pension benefits many individuals now have 401(k) accounts. The balances in such accounts can be substantial, often six figures and sometimes more. In many cases it is possible to borrow from such accounts, often the lesser of half the value of the money in the account but not more than $50,000. Interest is charged on such loans and curiously the interest paid actually goes to the borrower. This happens because it is the borrower's money which is being used in the first place. Program details vary, for more information speak with your pension administrator.

How to Choose the Right Loan

Most come in all shapes and sizes and there is no one which is right for every occasion. For instance, home equity might be the cheapest way to finance your business, But if you're financing a restaurant with a 70% chance of going under, do you want to put your home at risk? Similarly, 401(k) loans are easy to qualify for because you borrow from yourself. But if you leave your job for any reason they can become horrendously expensive.

Before selecting a loan option, borrowers must always consider their needs and financial abilities as well as the loan's specific purpose. Next, they should compare loans from several competing providers and select the best offer available.

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