Understanding Different Types Of Loans

If you're looking to secure a loan to buy a car, spruce up your home or to fund your wedding, you'll want to know about your options. And while you know you'd like to tap into some form of financing, a big question mark might loom over your head on which one to choose.

To narrow in on your choices, you'll want to start by exploring what's out there. We'll walk you through the most common types of loans that can help you foot the bill for your goals, big or small.

Loan Categories: What They Are And How They Work

First, let's take a gander at the different categories the most common types of loans fall into. No matter the amount, terms and rates, a loan will be under one of four categories: secured and unsecured, open-ended or closed-ended. If you're looking for a mortgage, it'll be either nonconforming or conforming.

You'll want to do your research and make sure you have good credit. Generally, the stronger your credit and the lower your debt-to-income (DTI) ratio, the lower your interest rates. Here are the different main categories of loan options available:

Secured Loans

A secured loan is a loan that is backed by a valuable personal asset, otherwise known as collateral. Before you lock in a secured loan, you'll need to agree to offering such an asset in exchange for the funds. Common types of collateral include a car, home, jewelry or cash in a savings account. Mortgages and most car loans are secured.

When you offer collateral, you are promising to let the lender take control of your asset should you struggle with keeping up with payments. This offers a form of financial protection for the lender, and they can "seize" the collateral to use to pay back what remains on the loan.

Because you're offering a value asset, you're deemed a less risky borrower. In turn, secured loans tend to have less stringent financing criteria — you might be able to qualify with a lower credit score and higher DTI ratio than with other forms of financing. Plus, the interest rates might be lower.

Unsecured Loans

While a secured loan is backed by a valuable asset, an unsecured loan isn't backed by collateral. In other words, you won't need to offer your house, car, cash in savings or other asset that the lender can take to recover losses. Because this is more risky for the lender, you typically need a higher credit score and lower DTI ratio to lock in competitive interest rates.

As it goes, good and excellent credit scores make it easier to qualify for a loan. On the flip side, you'll have a harder time getting approved — and snagging a good interest rate — if you have a lower credit score.

Open-Ended Loans

Also known as revolving credit, open-ended loans are a form of financing where you're given a line of credit, which you can borrow from as you need. It just can't go over the preapproved amount, or credit limit. You pay it back as you can, and there's no fixed monthly amount. Plus, there's no set end date to repay the full amount owed. Common examples of open-ended loans are credit cards and home equity lines of credit (HELOCs).

Closed-Ended Loans

Closed-ended loans are also known as installment loans. Common types of closed-ended loans include mortgages, student loans, home equity loans, auto loans and personal loans. With a closed-ended loan, you receive a lump sum upfront.

There's a set term for the loan, which means there's a specific date the loan must be paid off. According to the repayment terms, you're required to make regular monthly repayments until the loan is paid off. Your monthly payments might include any fees and interest.

9 Common Types Of Loans

Now that we've gone over different major categories of loans, we'll get into the nitty-gritty of these common types of loans. Depending on your goal, you might consider one type of loan over another.

1. Personal Loans

A personal loan is a type of closed-ended or installment loan. A major advantage of a personal loan is that it's quite flexible in how the funds can be used. You might want to get a personal loan for the following reasons:

●      Refinancing or paying off credit card debt

●      Debt consolidation loans

●      Medical bills

●      Emergency expenses

●      Home improvements

●      Weddings and honeymoons

●      Vacations

●      Big-ticket purchases

●      Moving expenses

2. Mortgage Loans

A mortgage is a loan you take out to purchase or refinance a home. Once the application is approved, the lender will give you, the borrower, money to pay for or refinance an abode. It's a secured loan, which means you'll need to offer your home as collateral. Should you have trouble keeping up with your payments, the lender can seize your home to pay off the loan.

Mortgages are closed-ended loans, and the proceeds will go straight toward the purchase of the home. Your end of the bargain is to pay back the mortgage, usually in 15- or 30-year terms. Nearly all mortgages are fully amortized. In other words, they have a set payment schedule that makes sure the loan is paid off by the end of its term.

Types Of Mortgage Loans

Let's take a look at the most common types of mortgage loans:

●      Federal Housing Administration (FHA) loans: These are loans that are backed by the Federal Housing Administration. If you have a credit score of 580 or above, you can typically borrow up to 96.5% of your home's value.

●      Department of Veterans Affairs (VA) loans: These are designed specifically for veterans and offer more favorable loan terms. Some pluses include no down payment, interest rates tend to be lower and credit requirements tend to be more lenient.

●      USDA loans: USDA loans are backed by the USDA and are for low-income borrowers in rural areas.

●      Conventional loans: Conventional loans are loans that aren't backed by the government. They can be either conforming or nonconforming. Conforming loans go by the guidelines set by Freddie Mac and Fannie Mae.

●      Jumbo loans: Also known as a jumbo mortgage, a jumbo loan is a mortgage that is higher than limits set by the Federal Housing Finance Agency (FHFA). Because they don't adhere to these limits, they're considered non-conforming loans.

3. Auto Loans

Auto loans are secured installment loans that are backed by the car itself. As for the credit score needed to get an auto loan, you typically need at least a FICO^® score of 500. That being said, the lower your score, the harder it is to get approved for a car loan with attractive rates and terms.

Besides your credit score, lenders will also look at other financial criteria such as income and employment, loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, and payment-to-income (PTI) ratio.

4. Student Loans

Student loans are taken out to pay for higher education tuition and related expenses. Once you graduate, there's usually a grace period after you graduate, leave school or drop below half-time before you need to start making payments.

Student loans are a type of installment loan, so you'll usually have set monthly payments that include interest and any finance charges. You're required to pay off the loan before the end of its duration.

So how does repaying student loans work? There are different repayment plans for federal student loans. The two major categories are non-income-based plans, such as the standard repayment plan, graduated repayment plan, and extended repayment plan. Income-based repayment plans include the SAVE plan, PAYE repayment plan, income-contingent (ICR) plan, and income-based (IBR) repayment plan. 

Types Of Student Loans

Now, let's look at the different types of student loans:

●      Private loans: Private student loans are essentially non-federal student loans lenders offer to help pay for college and higher-education related expenses.

●      Subsidized loans: Subsidized loans are available for undergraduate students and are administered based on financial need.

●      Unsubsidized loans:  Unlike subsidized loans, unsubsidized loans don't require any demonstrated financial need. They're available for eligible undergraduate, graduate and professional students.

●      Parent PLUS loans: These are loans that parents can take out for their undergraduate kids who are dependents. Eligible graduate and professional students can also take out PLUS loans.

●      Direct Consolidation Loans: These are loans where you roll together several federal student loans into a single one. The purpose is to either lower your monthly payment or grant you eligibility for student loan forgiveness.

5. Business Loans

A business loan can help you kickstart your small business or expand an existing one. These loans can be used for a variety of business-related expenses, such as to purchase equipment or supplies, open a physical location or cover payroll costs. These are typically closed-ended loans. However, business lines of credit are open-ended loans.

Besides private small-business loans, you can also get a loan from the Small Business Administration (SBA) loan. These are partially backed by the SBA. In turn, it lessens the risk load from the private lender.

6. Payday Loans

Payday loans are for those who need cash right away. As short-term loans in small amounts that usually cap at $500, you need to pay back the loan amount by your next paycheck. While payday loans are a speedy way to get access to funds, beware of the exorbitantly high interest fees — we're talking an annual percentage rate of 400% or more for a 2-week loan.

7. Credit Builder Loans

Credit builder loans are loans that are designed for folks to build their credit. Instead of getting the proceeds from the loan upfront, the lender keeps your payments in a controlled account. Once you've finished paying off the loan, the funds are disbursed to you.

To help improve your credit, the lender will report your on-time payments to the credit bureaus. Common reasons people get credit builder loans are if they're credit invisible, have bad credit or want to save and improve their credit.

8. Debt Consolidation Loans

Debt consolidation is when you pay off several high-interest loans with a new loan, so you have one payment and ideally less to cover in interest. This not only streamlines your payments, but it can also save you in interest, lower your monthly payment or both. You may be able to use a personal loan or credit card with a low interest introductory offer to consolidate your debts.

9. Title Loans

A title loan usually has no — or few — credit requirements. Here's the catch: you'll need to secure the loan by offering your car as collateral. A title loan is typically a short-term loan with a repayment period of 15 – 30 days, although some might be longer. You can usually borrow anywhere from 25% – 50% of the car's value, so that range can be from $100 – $10,000.

A major drawback of title loans is their staggeringly high interest rates and fees, sometimes as high as 25% or more.