If you’re like the vast majority of Americans, you’ll need to take out a loan at some point in your life. Taking out a loan is necessary for many of us to achieve our goals – get a degree, buy a home or car, or pay off medical bills. It can be challenging to know what type of loan is appropriate because there are so many out there.
Learning the types of loans that are available to consumers, their typical purposes, and standard terms can be beneficial to anyone.
Conventional loans are standard mortgage loans that are not insured by a government agency like the VA, Rural Housing Service (RHS), or Federal Housing Association (FHA).
Within conventional loans, you have conforming and non-conforming. Conforming conventional loans follow the Fannie Mae and Freddie Mac guidelines while non-conforming loans do not.
Lenders of conventional loans can also set their guidelines for these loans. This means they can allow a borrower to use other investments like stocks or bonds as security for that home mortgage.
Open- and Closed-Ended Loans
Open-ended loans mean that you can borrow funds over and over again. Lines of credit like credit cards are the most common form of open-ended loans. Credit cards and formal lines of credit both have credit limits or a maximum amount you can borrow at one time.
Depending on your needs at the time, you can borrow all or a partial amount of the credit. With each purchase you make on the line of credit, the amount you have left to borrow decreases, and with each payment, the amount you can borrow increases.
Credit cards can be a dangerous loop to fall into if you do not monitor your finances carefully. The average American household carries about $15,600 in credit card debt.
Closed-ended loans are lines of credit that are extended once and cannot be re-extended until the original line of credit is repaid. As you pay off your closed-ended loan, the balance goes down, but you do not get access to more credit. If you need more credit, you have to apply for another loan. The most common types of closed-ended loans are mortgages, student loans, and auto loans. All of these types of loans extend you the amount of money you applied for in a lump sum. After a specific time has passed, you must start repaying the loan with interest.
Secured Loans and Unsecured Loans
Secured loans involve the borrower putting up collateral for a loan. This is done in the event the borrower defaults on the loan so the lender may recoup his/her losses. At the time of default, the lender, typically a bank, may take possession of the collateral to cover its losses on the loan. Interest rates generally are lower for secured loans versus unsecured loans.
Before you get a secured loan, the item you want to put up as collateral might need to be appraised. An example of a secured loan is a title loan, a type of loan used for cars in which the car serves as the collateral. Finding locations of title loans near you is easy.
Unsecured loans, on the other hand, don’t require any collateral. These are typically more difficult to get and usually have higher interest rates. Lenders rely solely on your income and credit history to determine your risk. Unsecured loan lenders have many collection options including lawsuits and debt collectors.
Loans You Should Avoid
The types of loans we just discussed are all everyday financial tools. However, if you’re uneducated about the kinds of loans that are appropriate for each situation, you could fall prey to certain unsavory loans.
Loans like payday loans and advance-fee loans are predatory and take advantage of borrowers. Paydays loans use your next paycheck as a loan guarantee and are only given on a short-term basis. They have incredibly high APRs, making them difficult to pay off.
Advance-fee loans are merely scams. The “lender” trick you into sending a fee to obtain the loan amount. Once the fee has been sent, the “lender” usually disappears without sending the loan amount.
The more you know about types of loans and which situations they’re used for, the better you can plan your life financially. You can also avoid situations that can leave you in financial ruin.