Types of Loans
Loans. Debts. One leads to the other, yet you want to get one without the other. Sorry Charlie, you are out of luck. But since you need the first, you better know what types of loans are out there and get the right one so that you don't end up with more of the latter than necessary.
Generally, as a borrower you will go to some sort of financial institution, bet it a bank, credit union, payday loan business, etc., and request a loan for a certain amount. They will ask you what you are going to use the money for. The loan should be tailored to fit the need. It will also be tailored to fit your credit worthiness. As a result, the amount of money you get may be different than what you were hoping for. The interest rate you pay back may also be different than what you were hoping for.
But you really need the loan so you are willing to take what you can get. Congratulations, you just borrowed yourself some a debt. And with that debt, you probably signed away some permission stating that the lending institution can claim the rights to your most prized possessions. Sound unlikely? Well, think again. With certain loans it is very likely. And because of that, your interest in continuing on with this article should have jumped a few levels. Well, happy reading. When you get done, you will be able to apply for the correct loan for your needs and know what to expect in return.
There are many types of loans that you can get. We will focus on personal loans, also called consumer loans. But to understand them all, you need to understand the two categories that they fall under: secured loans and unsecured loans.
A secured loan is a loan that is given to the borrower with a contract of repayment and the pledge of an asset as collateral. What does this mean? Well, let's look at the most common type of secured loans as an example: a mortgage loan.
Mortgage loans are perfect examples of a secure loan. A mortgage loan is generally for a lot of money. The payback terms usually cover many years. And the house you are buying with that mortgage loan is what the bank uses for collateral. Collateral is a guarantee. You generally won't have the money to guarantee the repayment of the mortgage loan (that is why you got the loan in the first place). So the house becomes collateral. This means that the bank in essence owns the house while you are paying back the mortgage loan. If you stop paying, the bank takes possession of the house and you have to move out. The bank secures their loan with a valuable asset that is yours.
Home Equity loans are loans given to you based on the value of your house. If your house is valued at more than what you owe, you have equity. But this type of loan is another secured loan, so guess what the collateral on a home equity loan is…yep, your house. So if you already have a mortgage loan, and you get a home equity loan, you now have two debts using your house as collateral. You better not default on either one or you will be in a world of financial hurt.
Auto loans are another common type of secured loan. Auto loans aren't generally for as much money as a mortgage so you won't have to pay back as much either. However, you will still need collateral and generally the car you purchase becomes the collateral for the auto loan. You default on it, your car is repossessed (quite an embarrassment in the neighborhood to have that repossessed).
The other commonly used secure loan is referred to as Home Improvement Loan. This is sometimes referred to as a Home Equity Loan, but the financial institution you work with may actually refer to the two differently. The difference between the two types of loans is that Home Improvement Loans aren't granted based on the equity you have in the house. In fact, where equity loans are limited by the amount of equity you may have acquired, improvement loans allow you to borrow up to the total value of your house. The thin that the improvement loan has in common with the equity loan is the collateral. Once again your house if up for grabs by the bank if you default on this type of loan.
Now that you know what a secured loan is, it should be easy to figure out what an unsecured loan is. However, just to make it completely clear, an unsecured loan does not have any of your assets tied to it as a guarantee to pay back.
So what becomes the motivation to pay it back? First of all, there are usually higher interest rates attached to unsecured loans. If you don't pay them back, you will end up owing a lot more than you borrowed because of interest charges. But if that isn't enough of an incentive, how about having collection agencies come after you? I know…you can ignore them by not answering your phone or door. If that isn't enough of an incentive there is always legal action…they could put a lien on assets you have or try to get your wages garnished. And if you are in Queens, New York, you might meet a guy named Guido who would like to show you a pair of brass knuckles and cement shoes as encouragement to repay the loan. Okay, so that last line is a joke but it is important to repay your loans because of the other reasons listed.
So what types of loans qualify as unsecured loans? The most common unsecured loan is a credit card. There are also personal loans, bank overdrafts (loans backed by checking accounts), lines of credit, and corporate bonds. Some of these are revolving loans (such as credit cards), meaning that you will have a limit of what you can spend, but that limit remains as you pay down the balance. So if you have a $5,000 limit, and you spend it all, once you start paying the balance down you have money made available again to you. Take the limit, subtract what you owe, and that is what you have available. And it continues to be that way.
Other types of loans are fixed. With these loans you get a sum of money, spend it how you may, pay it back, and you are done with the transaction. Simple, right? Of course there will be payment terms that say how many months you will be paying back the loan and how much you will pay each month. You will also be told how much money you will be paying in interest to receive the loan. But it isn't a bad thing. In fact, the interest charges may just be enough of a motivation to get your loan paid off.
Education loans fall under the unsecured, fixed loan category. However, they are a little bit different. First of all, they are underwritten by the government. You may go to a bank to request the student loan, but the government is in essence providing the funds. Because of this, they will allow you leniency on paying it back. The leniency comes in the form of deferral of payment until you have been out of school for six months.
The government understands that student loans are taken because someone wants to learn a new trade/career and doesn't have the money to pay for school themselves. The government realizes that if you have to borrow the money to go to school, you probably won't have the money to pay back the loan while you are still a student. Because of this, you won't have to start paying back until you are done. And the interest rate is going to be favorable too.
Debt consolidation loans are also termed as unsecured loans. These can be great because you will only have one creditor to work with and hopefully you will be consolidating to a lower interest rate. But there are some cautions as outlined in the "Managing Debt" article. The benefits are great, but beware of the risks.
There are other unsecured loans that are becoming more and more popular: payday loans. These are also referred to as high risk personal loans, bad credit personal loans, or guaranteed personal loans. Why are they known under these names? First of all, someone that needs to get a quick loan to help them get by until payday is probably not managing their money wisely enough to get by…or at least wisely enough to qualify for a personal loan from a bank. If they are in this situation, they probably don't have the greatest credit score either.
Payday loans usually aren't granted by banks and credit unions. Instead you go to a business that is set up specifically for that type of loan. Because of the nature of these businesses the loans they give out are considered high risk. Think about it, someone with poor credit, can't manage their money enough to get from paycheck to paycheck, and no collateral to back the loan. So why do these companies exist? Unfortunately, there is a demand for it. People need to get money to pay for expenses. Payday loan businesses have found a way to make money by lending it to these individuals. How does it work?
First of all, you need to remember that the loans are generally for quick needs to get by until the next payday. Hopefully that is only a few days away. But regardless of the time frame, these types of loans are usually small. It could be anywhere from $50 to as much as $2,000. The lender won't do a credit check on you, but they will verify that you are employed and have a checking account. They verify these two things because if you don't have a job, you probably won't pay back the loan and if you don't have a checking account, they won't be able to secure payment. You see, many of these types of lenders don't actually have all the cash on hand but instead will do a direct deposit of the loan into your checking account. It also means that they can do an automatic withdrawal of the funds you borrowed once your payday has arrived.
One caution about using the payday loan businesses…they can be expensive. Interest rates and fees could put you behind financially when the next payday comes and they withdraw the money that you owe. If this puts you behind, you may need to visit them again before the next payday. Then the cycle continues. Before you know it, you could be finding yourself in a pretty big financial predicament. It is recommended to only use payday loan businesses as a last resort. They are convenient, but convenience could come with a price.
Take Your Pick
Now that you have learned about the different types of loans that are available to you, you can make your selection and choose the one that works best for you. There are other types of loans available that are not covered in this article. They are less common loans and not always available at the institution where you do your banking. For this reason it is important to take what you have learned here and add to that knowledge by researching the financial institutions in your area to see what loans are available for you to choose from.
As you look at your choices, make sure to evaluate your financial situation. Don't go for a loan that will cause financial stress. Don't ask for more than you need. Don't be naïve. These education articles are here for a reason: to help you be a more financially responsible consumer. As you learn what will help you in making decisions, it is in your best interest to make sure that you are putting to use the knowledge that you gain from these articles and any other research that you do. And now that you know what loans are available, you just need to learn how to get one. And that is taught in the "Getting a Loan" article. Happy reading!
Disclaimer: Information found within this page are for informational purpose and does not represent bank practice or services offered at its entirety.