The Different Types of Loans: A Primer
The other day a friend of mine asked me about different loan types, as she was on her way to the bank to consolidate some high-interest credit card debt. I was surprised at the seemingly elementary questions she was asking — she is an intelligent well-established gal who is pretty good with numbers (the credit card debt is another story).
It made me realize that maybe she is not alone. Although you may know what the various debt vehicles and loan types are, do you know all their inherent characteristics? If you’re not sure, here is a loan primer to refresh your knowledge.
Secured vs. Unsecured
All loans, no matter what they are, are either secured or unsecured.
These are secured (or borrowed) against an asset you own, such as your home, which is offered up as collateral. Ultimately if you default on the loan, the bank will get their money back by way of foreclosing your house (or otherwise seizing the collateral).
The interest rate should be very low (and often negotiable), hovering close to prime rate. The better your credit rating is, the more bargaining power you have with the terms, including loan amount and repayment period.
Payment terms are flexible, and can even be structured as “interest-only.”
If the loan is secured against the equity in your home, the application process usually involves a “drive by appraisal” of your home and some legal fees, that together amount to a few hundred (up to a thousand) dollars. As such, it’s usually best to apply for a higher loan qualification amount than you think you need (as long as you know yourself well enough not to get into more debt unnecessarily). This way if you wish to borrow more money later on, new appraisals and legal fees can be avoided.
Examples of secured loans:
- Car loans
- Boat (and other recreational vehicle) loans
- Home equity loans
- Home equity lines of credit
These are (as they sound) not secured against any assets. The bank can only utilize collectors (and freeze your accounts) if you default.
The loan amount granted is largely attributable to your credit history and income/assets/debts at the time of application. There is a considerably higher assumption of risk on the bank’s part with an unsecured loan. Thus, the interest rate is much higher.
Examples of Unsecured Loans:
- Personal loans
- Personal lines of credit
- Student loans
- Credit cards/department store cards
There are a few different ways the bank can lend you money.
Line of Credit
Similar to a credit card,you are given a maximum allowable balance, and each month you can borrow as much as you wish from the line of credit up to the maximum.
Monthly minimum payments vary from a percentage (e.g. 3%) of the outstanding balance (as for most unsecured lines of credit), to as little as interest only (as for some secured lines of credit).
You can pay as much as you wish above the minimum payment amount, whenever you wish.
Some lines of credit come with checks, or can be linked to your bank card for debit transactions.
Can be secured or unsecured.
Conventions loans include personal loans, home equity loans, car loans, etc.
The repayment terms and amortization is pre-determined and consistent. For example, a $5,000 loan payable over 3 years in equal payments at 8% interest.
You cannot add to this loan without applying for a new loan entirely.
You can usually pay off the loan faster than schedule without penalty.
Monthly minimum payments will often be higher than they would with a Line of Credit, due to the shorter amortization (period of time to pay it back).
Can be secured or unsecured.
Mortgages are always secured loans, with the collateral usually being real estate. They are for large amounts of money, and are payable over long periods of time.
Maximum amortizations (repayment periods) for a mortgage range from 25 to 30 years, depending on where you live.
You can borrow up to a certain percentage of the appraised value of the property, subject to some restrictions and insurance provisions.
Interest terms can be either fixed or variable. Fixed interest locks your rate in for a fixed period, typically five years. Variable interest rates will fluctuate with the prime rate, and have little to no lock-in period.
The penalty to break a fixed rate mortgage mid-term can be outrageous. So if the interest rates go down dramatically, you are stuck with the rate you have until the term (e.g. five years) is up. On the flip side, if the interest rates go up dramatically, your interest rate is protected for the duration of the term.
All the interest is paid up front. In the first few years of having a mortgage, almost all of your payments are comprised of interest, with only a few dollars reducing the principal. It is not until the later years of a mortgage that the reduction of your principal loan amount picks up momentum.
Althoughp you can’t always repay as much as you wish, you can usually make additional payments which directly reduce your principal loan amount.
Known in some circles as the antithesis of all things good and pure, credit cards tend to get a bad rap. Depending on how they are used and abused, they can admittedly be bad news.
You are allocated a maximum balance, with freedom to charge as much or little to it within the limit.
Standard credit cards are always unsecured, so the interest rate is high: usually 9-19% (with the average being closer to 18%)
The minimum payment is usually quite small — expressed sometimes as a percentage of the outstanding balance, but in some cases it is little more than just the interest.
Ifyou pay off the balance in full before the due date, you are not usually charged any interest (this depends on the credit card).
Each type of debt serves a specific purpose, although they can be interchanged depending on your situation. The most important thing in managing your debt is to be realistic about what you can handle. Underestimate the amount of money you have to pay towards your debt each month to be safe, in order to avoid getting in too deep.