Consumers commonly take on loans to finance home purchases, education, debt consolidation and general living expenses. For the growing small business, loans are available for working capital, equipment, real estate, expansion, and inventory purposes, debt problems get worse instead of better

In short, there’s a wide variety of options available on the loan market, so it’s important to research what type of debt obligation will work for you. In this article, you can find a breakdown of each loan type and how it will affect your finances.

• What are the Different Types of Loans?
• Small Business Loan Uses
• 401(k) Loans
• Top 4 Reasons to Borrow From Your 401(k)
• HELOC Loan
• Bridge Loans
• Construction Loans
• Is it Harder to Qualify for a Construction Loan?
• What are the 4 Types of Loans?
• What is the most Expensive Loan?

What are the Different Types of Loans?

Consumer Loan Types

The most common consumer loans come in the form of installment loans. These types of loans are dispensed by a lender in one lump sum, and then paid back over time in what are usually monthly payments. The most popular consumer installment loan products are mortgages, student loans, auto loans and personal loans.

Read Also: FHA Loan Foreclosure Waiting Period

In general, lenders use consumer’s credit score and debt-to-income ratio to determine the interest rate and loan amount for which they are qualified.

Installment loans can come as either secured or unsecured. Secured loans are backed by collateral, meaning that the lender can seize the borrower’s collateralized asset if the loan isn’t paid back. Unsecured loans are not secured by collateral, and lenders have a more difficult time recouping their losses for these loans if a borrower defaults. In general, larger loans and specific purchase loans like mortgages and auto loans are secured.

Mortgages

Mortgages are used by consumers to finance home purchases. Because most homes cost much more than the average person makes in a year, mortgages are designed to make homebuying accessible by spreading out the cost over many years. The most common home loan is the 30 year fixed-rate mortgage.

This loan is repaid in fixed monthly installments over the course of 30 years in a process called amortization. Mortgages with term lengths of 15 or 20 years are also offered but are far less common—as their monthly payment is much higher than the 30-year variety.

Mortgage programs also differ depending on which agency sponsors them. There are three main types of mortgages: conventional mortgages, which are backed by Fannie Mae and Freddie Mac; FHA loans, which are designed for low income or credit poor individuals and are backed by the Federal Housing Administration; and VA loans, which are for veterans and are backed by the Department of Veterans Affairs.

FHA loans are good for people who want to make a lower down payment, while conventional mortgages are more affordable for those who make a down payment over 20%.

Student Loans

Most student loan borrowers opt to take out federal student loans, which have fixed interest rates and don’t have to be repaid until a few months after graduation. The two main types of federal student loans are subsidized loans and unsubsidized loans. The subsidized version is meant for students with the highest financial need, as the government makes interest payments on the loan while the student is still in school.

Federal unsubsidized loans are available for the average student borrower regardless of financial situation. Undergraduate students who are still dependent on their parents are allowed to borrow up to $31,000 total over the course of their career, with a limit of $23,000 in unsubsidized loans. Federal loans have the same interest rate for all borrowers.

Due to the caps on federal loans, some students choose to take out loans with private companies. Private loans often offer interest rates that are slightly lower than for federal loans, though rates are dependent on each individual’s financial situation.

Student loans from private lenders can also be borrowed with a variable interest rate, meaning that interest payment goes up or down depending on the current interest rate of the market. Limits on private loans vary from lender to lender.

Personal Loans

Personal loans are the most versatile loan type on the consumer lending market. While mortgages, car loans and student loans must be used for a specific purpose, personal loans can be borrowed for debt consolidation, day-to-day living expenses, vacations or credit building, among other things.

The terms of personal loans vary as widely as their uses, though term lengths are generally under 10 years and the maximum amount is usually capped at $100,000.

A common use of a personal loan is to consolidate existing credit card debt. Credit card interest can quickly accumulate when the balance isn’t paid off, so personal loans are often a more affordable way to pay down debt. Depending on the lender, personal loans can either be secured or unsecured. Loans not secured by collateral have higher interest rates, as they’re riskier for lenders to make. It can often be difficult to get a loan if you have a poor credit history, but if you shop around specifically for the best personal loans for bad credit, there are options available designed for this very purpose. 

Auto Loans

Auto loans can be used to purchase either new or used vehicles. The term of an auto loan typically ranges from 24 months to 60 months, though longer loans with 72 or 84 months are becoming increasingly common. Most lenders limit the term lengths to 48 or 60 months for older car purchases, as used cars are riskier to finance.

This is because car value generally declines over time, unlike home value. Accordingly, if the car being financed is also used as collateral, lenders need to make sure that it will be worth enough to cover their losses if the borrower defaults.

Because of the rapid depreciation of car value, shorter loan terms and larger down payments are most advisable for auto loans. For an older used car, it’s quite easy for borrowers to find themselves “upside-down”—meaning that they owe more on their loan than their car is currently worth.

To avoid this situation, it’s important to not take out money with too long of a repayment schedule and to evaluate how quickly your car will depreciate. The consequences of defaulting on a car loan can be severe, as many loan servicers will require that the loan is repaid even after default and asset forfeiture.

Debt Consolidation Loans

A consolidation loan is meant to simplify your finances by combining multiple bills for credit cards, into a single debt, repaid with one monthly payment. This means fewer payments each month and lower interest rates.

Consolidation loans are typically in the form of personal loans.

Home Equity Loans

If you have equity in your home – the house is worth more than you owe on it – you can borrow against that equity to help pay for big projects. Home equity loans are good for renovating the house, consolidating credit card debt, major medical bills, paying off student loans and many other worthwhile projects.

Home equity loans and home equity lines of credit (HELOCs) use the borrower’s home as collateral so interest rates are considerably lower than what you pay on credit cards. The major difference between home equity and HELOCs is that a home equity loan has a fixed interest rate and regular monthly payments are expected, while a HELOC has variable rates and offers a flexible payment schedule.

• Common loan terms: 5-10 years for home equity loans; 15-30 years for HELOCs
• APR interest range: 5%-9% at end of 2020
• Credit score requirements: 680
• Collateral requirements: the home serves as the collateral.

Balloon Mortgage Loans

A balloon mortgage loan is one in which the borrower has very low or no monthly payments for a short-time period but then is required to pay off the balance in a lump sum. This is an extremely high-risk loan. It could be structured so that the borrower pays no interest or makes no payments for a short time period, but at the end of that time period, must make a “balloon payment” that covers the accumulated amount of principal and interest.

The only reason to consider this would be if you intend to own a home for a very short time period and expect to sell it quickly, or you hope to refinance the loan before the balloon period expires.

Loans for Veterans (VA Loans)

The Department of Veterans Affairs (VA) has lending programs available to veterans and their families. With this loan, the money comes from a bank, not the VA. The VA guarantees the loan and effectively acts as a co-signer, helping you earn higher loan amounts with lower interest rates.

Cash Advances

A cash advance is a short-term loan against your credit card. Instead of using a credit card to make a purchase or pay for a service, you bring it to a bank or ATM and receive cash to be used for whatever purpose you need. Cash advances also are available by writing a check to payday lenders.

Payday Loans

Payday loans are short-term, high-interest loans designed to bridge the gap from one paycheck to the next. These loans are used predominantly by repeat borrowers living paycheck to paycheck. The repayment period – and 399% APR interest that goes with them – makes consumers ripe for loan scams. The government strongly discourages consumers from taking out payday loans because of excessive costs and interest rates.

Pawn Shop Loans

This is a high-interest loan similar to secured loans, but with far more risk. The borrower offers some sort of property (jewelry, coin collection, electronics, etc.) as collateral for a loan. The pawn shop owner provides the loan and sets the terms for repayment. If the borrower repays the loan on time, the property is returned. If the loan is not repaid on time, the pawn shop owner can sell the item to recover the unpaid amount.

Borrowing from Retirement & Life Insurance

Those with retirement funds or life insurance plans may be eligible to borrow from their accounts. This option has the benefit that you are borrowing from yourself, making repayment much easier and less stressful. However, in some cases, failing to repay such a loan can result in severe tax consequences.

Borrowing from Friends and Family

Borrowing money from friends and relatives is an informal type of personal loan. This isn’t always a good option, as it may strain a relationship. To protect both parties, it’s a good idea to sign a basic promissory note.

Small Business Loan Uses

Businesses use loans for many of the same reasons as consumers—to cover gaps in short-term financing, to pay for daily expenses and to purchase the property.

Most small business loans can be used for general business expenses, but there are also specific business debt products like the commercial real estate loan, which is similar to the consumer’s mortgage, and the business line of credit, which is like a credit card. There are more complex financing products like invoice factoring and merchant cash advances for businesses with particular needs.

Small business loans can be a helpful tool for owners looking to expand their inventory, buy new office space or otherwise scale or finance their business. The loan amounts for small businesses can range from a few thousand to over a million dollars. If you’re considering taking on debt to finance your business, you should compare lenders and loan types to see whose loan program best fits your specific needs.

Most online lenders require that business owners have a minimum credit score around 500 to 600 and have been in business for a certain period of time, usually a year or two, in order to be eligible. Traditional banks like to see that borrowers have minimum credit scores of 680 or higher. The standards for being considered a small business vary by industry, though businesses with less than 500 employees usually fall into the small business category.

401(k) Loans

Technically, 401(k) loans are not true loans, because they do not involve either a lender or an evaluation of your credit history. They are more accurately described as the ability to access a portion of your own retirement plan money—usually up to $50,000 or 50% of the assets, whichever is less—on a tax-free basis. You then must repay the money you have accessed under rules designed to restore your 401(k) plan to approximately its original state as if the transaction had not occurred.

Another confusing concept in these transactions is the term interest. Any interest charged on the outstanding loan balance is repaid by the participant into the participant’s own 401(k) account, so technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss.

As such, the cost of a 401(k) loan on your retirement savings progress can be minimal, neutral, or even positive. But in most cases, it will be less than the cost of paying real interest on a bank or consumer loan.

Top 4 Reasons to Borrow From Your 401(k)

The top four reasons to look to your 401(k) for serious short-term cash needs are:

1. Speed and Convenience

In most 401(k) plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit score.

Many 401(k)s allow loan requests to be made with a few clicks on a website, and you can have funds in your hand in a few days, with total privacy. One innovation now being adopted by some plans is a debit card, through which multiple loans can be made instantly in small amounts.

2. Repayment Flexibility 

Although regulations specify a five-year amortizing repayment schedule, for most 401(k) loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions—using after-tax dollars, though, not the pre-tax ones funding your plan.

Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.

3. Cost Advantage 

There is no cost (other than perhaps a modest loan origination or administration fee) to tap your own 401(k) money for short-term liquidity needs. Here’s how it usually works:

You specify the investment account(s) from which you want to borrow money, and those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for a short period. And if the market is down, you are selling these investments more cheaply than at other times. The upside is that you also avoid any further investment losses on this money.

The cost advantage of a 401(k) loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed. Here is a simple formula:

Cost Advantage= ​Cost of Consumer Loan Interest −Lost Investment Earnings​

Let’s say you could take out a bank personal loan or take a cash advance from a credit card at an 8% interest rate. Your 401(k) portfolio is generating a 5% return. Your cost advantage for borrowing from the 401(k) plan would be 3% (8 – 5 = 3).

Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. Keep in mind that this calculation ignores any tax impact, which can increase the plan loan’s advantage because consumer loan interest is repaid with after-tax dollars.

4. Retirement Savings Can Benefit 

As you make loan repayments to your 401(k) account, they usually are allocated back into your portfolio’s investments. You will repay the account a bit more than you borrowed from it, and the difference is called “interest.”

The loan produces no (that is to say, neutral) impact on your retirement if any lost investment earnings match the “interest” paid in—i.e., earnings opportunities are offset dollar-for-dollar by interest payments. If the interest paid exceeds any lost investment earnings, taking a 401(k) loan can actually increase your retirement savings progress.

HELOC Loan

Home equity lines of credit are a bit different. They are a revolving source of funds, much like a credit card, that you can access as you choose. Most banks offer a number of different ways to access those funds, whether it’s through an online transfer, writing a check, or using a credit card connected to your account.

Unlike home equity loans, they tend to have few, if any, closing costs, and they usually feature variable interest rates—though some lenders offer fixed rates for a certain number of years.

There are pros and cons to the flexibility that credit lines offer. You can borrow against your credit line at any time, but untapped funds do not charge interest. In that way, it’s a nice emergency source of funds (as long as your bank doesn’t require any minimum withdrawals).

Especially now—if you’ve lost your job because of the Coronavirus, need cash, and have equity in your home—taking out a HELOC may be a good option. Many banks are still offering them, though Wells Fargo and JPMorgan Chase were two frontrunners, announcing application freezes for new HELOCs in May 2020. (The freezes don’t affect those who already have HELOCs.

Most home equity credit lines have two phases. First, a draw period, often 10 years, during which you can access your available credit as you choose. Typically, HELOC contracts only require small, interest-only payments during the draw period, though you may have the option to pay extra and have it go toward the principal. 

After the draw period ends, you can sometimes ask for an extension. Otherwise, the loan enters the repayment phase. From here on out, you can no longer access additional funds and you make regular principal-plus-interest payments until the balance disappears. 

Most lenders have a 20-year repayment period after a 10-year draw period. During the repayment period, you must repay all the money you’ve borrowed, plus interest at a contracted rate. Some lenders may offer borrowers different types of repayment options for the repayment period.

HELOCs have many attributes that make them different than a standard credit line and also offer advantages. However, the interest-only payments in the draw period mean payments in the repayment period can almost double.

For example, payments on an $80,000 HELOC with a 7% annual percentage rate would cost around $470 a month during the first 10 years when only interest payments are required. That jumps to around $720 a month when the repayment period kicks in.

The jump in payments at the onset of the new repayment period can result in payment shock for many unprepared HELOC borrowers. If the sums are large enough, it can even cause those with financial hardships to default. And if you default on the payments, you could lose your home.

Bridge Loans

A bridge loan is a short-term loan used until a person or company secures permanent financing or removes an existing obligation. It allows the user to meet current obligations by providing immediate cash flow. Bridge loans are short-term, up to one year, have relatively high-interest rates, and are usually backed by some form of collateral, such as real estate or inventory.

These types of loans are also called bridge financing or a bridging loan.

How a Bridge Loan Works

Also known as interim financing, gap financing, or swing loans, bridge loans bridge the gap during times when financing is needed but not yet available. Both corporations and individuals use bridge loans and lenders can customize these loans for many different situations.

Bridge loans can help homeowners purchase a new home while they wait for their current home to sell. Borrowers use the equity in their current home for the down payment on the purchase of a new home. This happens while they wait for their current home to sell. This gives the homeowner some extra time and, therefore, some peace of mind while they wait.

These loans normally come at a higher interest rate than other credit facilities such as a home equity line of credit (HELOC). And people who still haven’t paid off their mortgage end up having to make two payments—one for the bridge loan and for the mortgage until the old home is sold.

Example of a Bridge Loan

When Olayan America Corporation wanted to purchase the Sony Building in 2016, it took out a bridge loan from ING Capital. The short-term loan was approved very quickly, allowing Olayan to seal the deal on the Sony Building with dispatch. The loan helped to cover part of the cost of purchasing the building until Olayan America secured more-permanent, long-term funding.

Construction Loans

A construction loan (also known as a “self-build loan”) is a short-term loan used to finance the building of a home or another real estate project. The builder or home buyer takes out a construction loan to cover the costs of the project before obtaining long-term funding. Because they are considered relatively risky, construction loans usually have higher interest rates than traditional mortgage loans.

Construction loans are usually taken out by builders or a homebuyer custom-building their own home. They are short-term loans, usually for a period of only one year. After the construction of the house is complete, the borrower can either refinance the construction loan into a permanent mortgage or obtain a new loan to pay off the construction loan (sometimes called the “end loan”).

The borrower might only be required to make interest payments on a construction loan while the project is still underway. Some construction loans may require the balance to be paid off entirely by the time the project is complete.

If a construction loan is taken out by a borrower who wants to build a home, the lender might pay the funds directly to the contractor rather than to the borrower. The payments may come in installments as the project completes new stages of development. Construction loans can be taken out to finance rehabilitation and restoration projects as well as to build new homes.

Example of a Construction Loan

Jane Doe decides that she can build her new house for a total of $500,000 and secures a one-year construction loan from her local bank for that amount. They agree on a drawdown schedule for the loan.

In the first month, only $50,000 is required to cover costs, so Jane takes only that amount—and pays interest only on that amount—saving money. Jane continues to take funds as they are needed, guided by the drawdown schedule.

She pays interest only on the total that she has drawn down rather than paying interest on the whole $500,000 for the entire term of the loan. At the end of the year, she refinances with her local bank the total amount of funds she has used into a mortgage for her dream home.

Is it Harder to Qualify for a Construction Loan?

It’s harder to get approved for a construction loan than for a typical purchase mortgage, Moralez and Thomas say. That’s because the bank is taking extra risk during the building phase, since there isn’t an asset to secure the mortgage.

Typical down payments are around 20%. Federal Housing Administration, Veterans Affairs and U.S. Department of Agriculture mortgage programs back construction loans and can allow some credit leniency, sometimes along with lower down payments.

“If you can put 20% down and you have a 720 credit score or better, you know you’re pretty much going to qualify for everybody’s program,” Thomas says.

What are the 4 Types of Loans?

There are 4 main types of personal loans available, each of which has their own pros and cons.

1. Unsecured Personal Loans

Unsecured personal loans are offered without any collateral. Lenders approve unsecured personal loans based on your credit score. A good credit score will make it easier to get approved. Because there is no collateral involved, these loans are riskier for lenders. They offset this high risk by imposing higher interest rates on unsecured loans.

Pro: You don’t have to put up your home or car as collateral.

Con: You pay a slightly higher rate of interest on the loan.

2. Secured Personal Loans

Secured personal loans are backed by collateral. Lenders offer unsecured personal loans against your vehicle, personal savings, or any other valuable asset. If you default on your loan, the lender can seize whatever asset you’ve put up as collateral.  Because the risk is lower, you will a lower interest rate on these loans.

Pros: Potentially lower rate of interest. Depending on the value of the collateral, you may also get approved for a larger loan.

Cons: You could lose your collateral if you do not repay the loan on time.

3. Fixed-Rate Loans

With fixed-rate loans, your interest rate and monthly payments stay the same throughout the life of the loan.

Pros: Consistent monthly payments make it easier to make and stick to a monthly budget. Also, rising interest rates won’t affect you.

Cons: You won’t benefit in the rare event that interest rates fall.

4. Variable-Rate Loans

With variable-rate loans, the interest rate can rise or fall depending on prevailing market conditions. However, there is usually a cap on how much the rate can change over a specified period of time. These loans usually have a lower APR as compared to fixed-rate loans. Variable-rate loans

Pros: Lower APR as compared to fixed-rate loans. You may benefit if overall market interest rates drop.

Cons: The interest rates and monthly payments fluctuate frequently, making it difficult to set a budget. You may pay a higher rate if market interest rates rise.

The key is to find a loan that works for you. Understanding the features of the different types of personal loans and the pros and cons of each can help you choose one that’s right for you.

What is the most Expensive Loan?

Payday loans, auto title loans, and credit card cash advances are three of the costliest ways to borrow cash. Here’s why.

1. Payday loans

Payday loans are popular among individuals with poor credit because they give you cash quickly and they don’t usually require a credit check. The problem is that the interest rates are astronomically high — in some cases, more than 500%. Plus, the loan terms are only for a couple of weeks, so you don’t have much time before you need to pay back an amount that’s much more than you originally borrowed.

To put this in perspective, consider a $250 loan with a 400% interest rate and a one-month repayment term. At the end of that month, you’d owe $333.33. If you didn’t have a spare $250 in the first place, it’s unlikely that you’ll be able to afford to pay the original $250 plus $83.33 in interest one month later. That’s why many people end up taking out new loans to cover the old ones and the cycle continues and the interest grows exponentially.

2. Auto title loans

Auto title loans are similar to payday loans in that they have short loan terms and don’t require a credit check. Basically, you surrender your car’s title to the loan provider in exchange for a certain amount of money, usually up to 25% or 50% of the car’s value. You must have equity in the car in order to do an auto title loan and some companies require that you own the car outright. 

These loans can have interest rates of 300% or more, so you end up in a similar situation to people who’ve taken out payday loans. If you cannot pay back what you borrow, your lender may offer to roll over your remaining balance into a new auto title loan, or they can legally repossess your vehicle. 

3. Credit card cash advances

Credit card cash advances are when you withdraw cash using your credit card. Cash advances often accrue interest at a higher APR than regular purchases — and even regular purchase APRs can sometimes be in excess of 30%. Cash advances usually have a fee associated with them, often a percentage of the amount that you’re requesting. You can find all of this information out by reading your cardholder agreement.

Read Also: Cost to Refinance Home Loan

While this is a much better deal than payday loans, it can still lead to debt you carry around for months or years. Those who take out multiple cash advances or charge a lot to their credit cards might see their debt problems get worse instead of better over time.

Conclusion

Whenever you decide to borrow money – whether it is to pay the bills or buy a luxury item – make sure you understand the agreement fully. Know what type of loan you’re receiving and whether it is tied to any of your belongings.

Also, familiarize yourself with your repayment terms: what your monthly obligation will be, how long you have to repay the loan and the consequences of missing a payment. If any part of the agreement is unclear to you, don’t hesitate to ask for clarifications or adjustments.