Understanding different loan types

It's a fact of life—there'll come a time when there's something you want or need but don't have the money to pay for it. This could be that amazing home you saw or a fancy new car. Or, maybe you’ve got college tuition payments or you’re paying down a debt. Happily, there are different types of loans to cover a gazillion reasons for needing money (well, maybe not a gazillion, but lots).

So, what are these loans and what can you do with them? Let’s talk about the eight most common loan types that you might apply for on your own or with your other half. But, before understanding the types, it helps to know some of the background stuff, like how they work.

The six ways loans work

There are different types of institutions that will lend money to people just like you: banks, credit unions, and non-bank lenders, including online lenders. They’ve all got their own rules, but what they’ve got in common is how their loans work. Let’s look at the systems they've developed to reduce the risk of lending money while still making a profit.

• Secured loan:

  You put up an asset you own as collateral, which gives the lender something they can use to recoup the loan if you can’t pay it back.

• Unsecured loan:

  You won’t need to risk one of your assets as collateral, but you may pay higher interest rates. This means your repayments will be costlier because you're more of a risk (that's how the lender will see it).

• Installment loan:

  You might sometimes hear this called a term loan. It means you make regular fixed payments in installments, usually monthly and for a predetermined time period, until the loan is paid off.

• Revolving credit:

  You can borrow up to the credit limit the institution will offer. You’ll then either pay off the loan in full during the monthly cycle or let it roll into the next period (“revolve”) and just pay the interest. A home equity line of credit is an example of this type of loan using your home as collateral (gulp...). As you pay down the debt, the amount you can borrow goes back up.

• Fixed-rate:

  A fixed-rate loan is as simple as it sounds—the interest rate you pay is fixed and doesn’t change throughout the loan’s term.

• Variable rate:

  Interest rates can vary in line with the lender’s

  prime rate

  , which is a base rate they use to set their interest rates.

Understanding loan terms

A loan period is how long you’ve got to pay the money back. The terms you and the lender agree on will determine the interest rate and how much interest you’ll pay over the loan period. Your repayments will be the principal (that's the loan) and the interest (what the lender charges for lending the money).

Here’s a basic overview of short and long-term loans.

Some other things will affect your monthly payments too. If it's a mortgage loan, you’ll probably find homeowners insurance and taxes are included in each installment.

Eight different loan types

Now that we’ve had a look at some background info, let’s check out the eight most common types of loans.

1. Mortgage loan

A mortgage loan is used to pay for a home's purchase price minus the down payment. The property becomes the collateral, so you can expect the lender to want a real estate appraisal to confirm that the home is worth the purchase price. It also means the lender can take possession of it if you don’t keep up with the payments.

Mortgage loans are typically taken over longer periods because the amount you’re borrowing is much more than it would be for a smaller purchase. Standard mortgage terms are usually 15 or 30 years. Buying a home is a huge commitment, so you should keep in mind you'll be older and grayer before the loan's paid.

If you have a low-to-moderate income or you’re a veteran, you might qualify for an FHA-approved loan or a VA Home Loan.

2. Home equity line of credit (HELOC) and home equity loan (HELOAN)

A home equity line of credit (HELOC) is a line of credit you can take out to use for—well, just about anything you like. You’ll need to put your home up as collateral, so you’ll have to make sure you make the monthly repayments, or your home may be at risk.

Repayments are monthly and the line of credit can be anywhere between 5 and 30 years. One of the benefits of HELOC is if there’s a month you can’t pay the balance, you just pay the loan interest. It’s a bit like a credit card, only the line of credit is usually much higher.

A home equity loan (HELOAN) provides the borrower with a lump sum up front, for which they make fixed payments over the life of the loan (usually 20 years). You’ll usually find a standard HELOAN has a fixed interest rate, while a HELOC is variable.

3. Personal loan

Lenders can also offer either fixed or variable interest rates that'll last over months or years. Its flexibility makes it a good option if you're looking for short-to-moderate-term funding.

Personal loans can be a good option if you’ve got high-interest debt and you’re looking for a lower-interest way of paying it off.

4. Auto loan

Auto loans are a bit like mortgage loans, in that the thing you’re buying is also the collateral for the loan. In this case, it’s your new car the lender will repossess to get back its money if you don’t keep up with the repayments. Because you won’t be borrowing what you’d need for a house (unless you’re buying a Ferrari), loan periods are shorter—typically 36 to 72 months.

It’s so easy to desire the car and think about financing next, but you should really do it the other way around. It makes a lot of sense to check out the auto loan market before you go into a dealership and end up spending more than you planned. Salespersons will check lots of lenders to find you the best quote, but that doesn’t mean you should leave it up to them (they work on commission—remember?).

5. Student loans

A student loan covers tuition payments for college or graduate school, and, unlike other loans, is available from private lenders and the federal government. You probably already know most people prefer to apply for a federal student loan, and if you don’t know, you're totally excused. This stuff is confusing.

Here’s a breakdown of both options.

Federal student loans are funded by the U.S. Department of Education. Applying for the loan is as simple as filling out an online form known as Free Application for Federal Student Aid (FAFSA). As credit checks are rare, you might still be approved even if you have a poor credit rating or no credit history at all.

The people who take out a private student loan have usually exhausted their options with FAFSA. If you’re an undergrad, you’ll probably need a cosigner, as the bank/credit union/online lender will see you as a high risk. Expect to pay higher interest rates, but, if that’s what you’re prepared to do to get into college—respect.

6. Credit-builder loan

If you don’t have a credit file or you’ve got a poor credit rating, you’re unlikely to convince a financial institution to give you a loan. Step aside standard loans, and make way for the credit-builder loan, a great way to elevate your creditworthiness. It’s not a loan you apply for to buy something, but a way of proving you’re worthy of being approved for a standard loan.

The lender puts the amount it’s prepared to loan you into a savings account, which you’ll repay in installments over 6 to 12 months. A credit check isn’t always necessary, and when the loan is repaid, you’ll get the full amount back (sometimes with interest). The lender notifies major credit bureaus of your on-time payments, who should then update their records and elevate your credit score.

7. Debt consolidation loans

The clue’s in the name—a debt consolidation loan pays off one or more debts that have high-interest repayments. This type of loan's got some great benefits, such as:

• You can work with a single loan provider rather than the ones you’re paying high-interest payments to.

• Interest rates should be lower and over a longer period, which should ease your financial strain.

• If it’s to pay off credit cards, you might find your credit score gets a boost.

Lenders of debt consolidation loans usually offer a range of repayment terms, so you should find something that ticks your boxes. You’ll also find that fixed and variable interest rates are available.

Lots of lenders will allow you to be prequalified before you fill out an application. Because this involves a soft credit check that doesn’t affect your credit score, you’ll know in advance if you’re likely to be approved. It’s a good idea to avoid lenders that don’t do prequalification because a failed application will lower your credit score.

8. Payday loan

One word—avoid. They’re easy to get and hard to repay on time, which means borrowers renew them and have to pay even more administration fees and charges. Payday loan fees are often 400% or more of annual percentage rates (APRs), so just imagine how much money you’ll end up paying back.

A final word

Except for possibly federal student loans and credit-builder loans, your credit score will be crucial to you getting approved by a lender. So, pay close attention to the things that can raise or lower it—which include:

• Paying your bills on time

• Your current unpaid debt

• The number of loans you’ve got and how much you still have to repay

• If you’ve had a major debt issue, like bankruptcy or foreclosure

Getting a loan can be stressful, but if you go into it prepared, you're more likely to get the outcome you want. Good luck!