June 19, 2024

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Understanding the Different Types of Loans

3 min read

Purchasing a home, buying a car or completing your education often requires obtaining financing. There are many types of loans with different interest rates, loan terms and repayment requirements.

Loans can be revolving or closed-end, with open-ended lines of credit that can be spent and repaid (credit cards and HELOCs are examples) or fixed-limit loans that pay off in monthly installments over a set period (such as auto and student loans). Understand the different types of loans.

Mortgages

The type of mortgage loan you choose has an impact on your monthly payments and total costs both upfront and over time. Understanding the different types of home loans helps you prepare for conversations with lenders and narrow down options that fit your budget.

Conventional mortgages, or conforming mortgages, are the most common type of home loan. They meet limits set by the government that allow lenders to sell them to government-sponsored enterprises Fannie Mae and Freddie Mac, which make the loans available to more people. Conventional loans generally require a higher down payment than government-backed mortgages.

Other types of mortgages include adjustable-rate mortgages (ARMs), and graduated payment mortgages, which allow borrowers to qualify for larger mortgages by starting monthly payments at a lower rate. Many ARMs have interest-rate caps that limit how much the loan’s interest rate can increase over time. This can protect borrowers from rising rates that could significantly increase their mortgage payments.

Personal Loans

Personal loans are one-time lump sums of money you borrow from a bank or lender that you repay with set, fixed monthly payments over a specific loan term. They are typically unsecured, meaning you won’t need to put up collateral like a home or car to qualify. Some lenders offer secured personal loans, which can come with lower interest rates than unsecured personal loans since they’re considered less risky (though you run the risk of losing your assets if you fail to meet your repayment obligations).

You should carefully consider the pros and cons of taking out a personal loan before applying. Be sure to compare the rates, fees and terms from multiple lenders before making a final decision. And if you do choose to borrow, make sure the debt is going towards a worthwhile purpose and doesn’t end up just fueling your overspending behavior. That way, you can avoid slapping on tape to cover the leak and instead tackle your financial behavior head on.

Auto Loans

Most auto loans are secured, meaning the lender places a lien on the vehicle being purchased. This allows them to repossess the vehicle if you don’t make payments on time. Auto loan lengths vary from 24 to 84 months and are typically shorter than lease periods.

A portion of each monthly payment goes toward principal and the remaining amount is used to pay interest. This is called simple interest, as opposed to compounded interest used by credit cards.

Your credit score will be the biggest factor in determining your auto loan rate. To improve your score, you can consider adding a co-signer to your application or paying down debt in order to reduce your credit utilization (i.e., not using more than 30% of your available credit). Some lenders specialize in offering car loans to borrowers with less-than-perfect credit. These lenders often offer higher loan rates to offset the risk of lending money to borrowers with poor credit.

Student Loans

Taking out student loans to help pay for college can be a major commitment. Before you borrow, make sure you understand the terms and conditions. Federal student loans (also known as Direct Loans) offer a number of benefits, including lower interest rates and flexible repayment options like forbearance.

Federal student loans are categorized as either subsidized or unsubsidized. Subsidized loans are reserved for undergraduate students with financial need, and the government pays the interest while you’re in school. Unsubsidized loans are available to broader groups of undergraduate and graduate students, and interest accrues on these loans immediately.

Private student loans may also come with a variety of payment plans, forbearance and forgiveness options. To apply, prepare important documents, like personal and employment information, income verification and school details, and complete an application. It might take a few weeks for lenders to review applications. Once approved, your lender will notify you of the amount you’ll need to repay and when repayment begins.

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