The choice of a loan product is extremely important if you want to achieve your financial goals. There are several different loan products on the market, each with its own set of features, benefits and costs. The key to choosing the right option is to understand what type of loan you qualify for and understand how the different loan terms affect your long-term strategy.
This post will give you an overview of the different types of loans and break down their distinctions based on borrower needs.
What is a loan?
A loan is a sort of credit instrument in which a sum of money is provided to another party in consideration for future repayment of the value or principal amount. In many circumstances, the lender increases the principal value by adding interest or finance fees, which the borrower must pay in addition to the principal sum.
Loans may be made for a predetermined, one-time sum or as an open-ended line of credit with a limit up to a certain amount. Loans are available in a variety of forms, including secured, unsecured, commercial, and personal loans.
How do loans work?
People that require money are typically applying for cash loans online, from banks, credit unions, or other organisations. The borrower could be asked for particular information, such as the loan's purpose, financial background, Social Security Number (SSN), and other things. A person's debt-to-income (DTI) ratio is taken into consideration by the lender when determining whether a loan can be repaid.
The lender decides whether to accept or reject the application based on the applicant's creditworthiness. If the loan application is rejected, the lender must state why. If the application is accepted, a contract outlining the terms of the arrangement is signed by both sides. The funds of the loan are given by the lender, and the borrower is then required to return the full amount, along with any additional fees like interest.
Before any money or property is exchanged or distributed, both parties must agree to the loan's conditions. In the loan paperwork, the lender specifies any collateral requirements. The majority of loans also have clauses regulating the maximum interest rate as well as other restrictions like the period of time until repayment is necessary.
11 types of loans you should know
Here are 11 types of loans you should know about and a brief description of each.
A personal loan is funds borrowed from a lender for nearly any purpose, such as paying off debt, financing a substantial purchase like a car, or paying for a wedding or a dream trip. Personal loans are available through internet applications, conventional banks, and credit unions, and you can get lump sum payments. Personal loans can be repaid over longer periods of time—typically between two and seven years.
You can choose between an unsecured personal loan or a secured personal loan when you are applying for a personal loan.
- Secured personal loans. These loans are backed by a property you own, such as your house. They also feature cheaper interest rates. However, your collateral can be confiscated if you are unable to pay your monthly fee.
- Unsecured personal loans. The most common loan type utilised by consumers is an unsecured personal loan. These are loans without any form of security. Unsecured personal loans might have higher interest rates since they pose a greater risk to lenders.
With a payday loan, a lender will issue high-interest credit depending on your income for a brief period of time. Usually, a portion of your next paycheck serves as its principal. High-interest rates are charged on payday loans for short-term, instant credit. Additionally, they are known as check advance loans or cash advance loans. These loans could be seen as predatory lending since they contain high-interest rates, don't take a borrower's capacity to pay back into the account, and include unstated terms that charge borrowers additional costs. Therefore, they may put customers in a debt trap. If you're thinking about getting a payday loan, you might want to start by considering safer personal loan alternatives.
An auto loan allows you to borrow the balance of the car's purchase price, less any down payment. When the borrower stops paying payments, the car is used as collateral and may be repossessed. Although longer loan durations are more common as car costs rise, auto loan lengths typically range from 36 to 72 months.
A student loan is borrowed money taken out to pay for college, either from the government or a private lender. The debt must be repaid in the future along with accruing interest. Typically, the funds can be spent on tuition, board, books, or other costs.
Private lenders for student loans often conduct credit checks and determine their own loan conditions, interest rates, and fees.
A house loan or mortgage is a credit line provided by a bank or other financial institution for purchasing, constructing, refinancing, or remodelling a residential property. In Australia, a house loan normally has a loan duration of 25 or 30 years, requires monthly payments, and has an interest charge. When you borrow money, a lender will charge you interest, which is expressed as a percentage of the loan amount.
Some of the most typical home loan kinds that you can come across are based on the interest rate type, repayment type, and loan purpose. The two primary types of mortgages are fixed-rate mortgages and adjustable-rate mortgages (ARMs).
An FHA loan is a mortgage that is guaranteed by the government and insured by the Federal Housing Administration. FHA home loans are particularly well-liked by first-time homeowners since they have lower minimum credit score requirements and down payments than many conventional loans. FHA loans are available with fixed interest rates and periods of 15 and 30 years. The agency's lenient screening requirements are intended to allow borrowers who would not be eligible for private mortgages to have a chance to buy a home.
Home equity loans
You can borrow up to a percentage of the equity in your house with a home equity loan or home equity line of credit (HELOC), which you can use for any reason. Instalment loans are those made using your home equity; you receive a lump amount and pay it back over time (often five to thirty years) in consistent monthly instalments. Revolving credit is what a HELOC is. Like with a credit card, you can use the credit line whenever you need during a "draw period" and only incur interest up to the end of the draw period. After that, you typically have 20 years to repay the debt. Home equity loans typically have fixed interest rates, whereas HELOCs typically have variable interest rates.
Debt Consolidation loans
A debt consolidation loan is a type of personal loan intended to be used to pay off high-interest debt, including credit card debt. If the interest rate on these loans is lower than the interest rate on your current debt, you might save money. Since there is only one lender to pay instead of multiple, consolidating debt also makes payments simpler. Your credit score might increase if you pay off credit card debt with a loan since it lowers your credit use ratio. Loans for debt consolidation might have a variety of repayment terms and fixed or variable interest rates.
Pawn shop loans
Another alternative for quick cash is a pawn shop loan. You will take a valuable item, such as jewellery or an electronic device, to a pawn shop and borrow money depending on the worth of the item.
The length of the loan and the interest rate might differ depending on the pawn shop. However, some states have intervened to control the sector. Additionally, despite the time frame for repayment varies by state, you typically won't receive your pawned item back until you have repaid the debt in full.
A credit-builder loan may not need a credit check and is intended to help people with bad credit or no credit history rebuild their credit. Usually, between $300 and $1,000, the lender deposits the loan amount into a savings account. Then, over a period of six to 24 months, you make predetermined monthly instalments. You receive the funds back after the loan is paid off (with interest, in some cases). Make sure the lender reports the loan to the three main credit agencies (Experian, TransUnion, and Equifax) before you apply for a credit-builder loan so that on-time payments can boost your credit.
Small Business loans
Small business loans are a sort of finance that different lenders offer to businesses for varied objectives. This kind of financing aids business owners in starting, running, and growing their enterprises. There are several online small business lenders to take into consideration, some of which may have simpler requirements and quicker applications. Getting a business loan for your firm doesn't necessarily need going into a bank and obtaining cash.
How to qualify for a loan?
Here are a few things you may do to increase your chances of getting approved for the money you need.
Lenders need to know if you can afford your payments easily. Your capacity to repay outstanding debt is likely to be best predicted by your income and job history. Considerations may include income kind, level, and stability.
The purpose of loans is not to leave you in long-term debt but to assist you in the short term. Make sure you just borrow the amount necessary to incur debt. We won't be able to accept your loan if your income is insufficient to cover the required repayments on the amount you're requesting for.
The debt-to-income ratio (DTI) is represented as a percentage and shows the percentage of a borrower's total monthly income that goes towards debt servicing. DTI helps lenders determine whether a potential borrower will be able to make payments on both new and existing debt. The optimal DTI is therefore less than 36%, while some lenders would accept a highly qualified candidate with a ratio of up to 50%.
Your lender will require collateral if you're requesting a secured personal loan. The collateral for loans for houses or cars is frequently connected to the loan's main objective. However, other valuable assets, such as cash accounts, investment accounts, real estate, and collectables like coins or precious metals serve as collateral for secured personal loans.
The lender has the right to take back the collateral to recover any unpaid loan balance if you are late on payments or default on your loan.
Credit score and credit history
One of the most crucial elements a lender takes into account when assessing a loan application is the applicant's credit score. The elements that determine a credit score include payment history, the amount of outstanding debt, and the length of credit history. Some lenders may lend to applicants with no credit history at all, but many lenders demand applicants to have a minimum score of roughly 600 to qualify.
Many lenders require that applicants pay loan origination fees to cover the expenses of processing applications, completing credit checks, and closing even if they are not a requirement for approval. Depending on variables including the loan amount and applicant's credit score, these costs often vary between 1% and 8% of the entire loan amount. Origination fees may be paid in cash by certain lenders at closing, financed by other lenders as a portion of the loan amount, or deducted from the overall loan amount paid at closing.
The Bottom Line
The bottom line is that you should establish your budget so you are aware of how much you can afford to pay back each month before you even consider borrowing money. Furthermore, having high credit might increase your chances of being approved for a loan with advantageous interest rates, regardless of the type you are looking for. Check your credit record and credit score to know where you stand before looking for loans.
Consider talking to a credit counsellor or reviewing your spending if you find yourself in financial problems frequently.
Marjorie Hajim is the SEO Manager for Friendly Finance. Friendly Finance is a leading loan matching service in Australia specialising in consumer finance. She loves growing businesses with a focus on their online presence and is passionate about organic growth and all things digital.