Understanding Different Loan Types

The borrowed money can be used for many purposes, from financing a new business to buying an engagement ring for your bride. But with all the different types of loans available, which one is the best – and for what purpose? Below are the most common types of loans and how they work.

Top Takeaways

  • Personal loans and credit cards have high interest rates, but do not require collateral.
  • Real estate loans have low interest rates, but the borrower’s home serves as collateral.
  • Cash advances generally have very high interest rates plus transaction fees.

Personal loans

Most banks, online and on Main Street, offer personal loans, and the proceeds can be used for just about anything, from buying a new 3D 3D 4K smart TV to paying bills. This is an expensive way to get money, because the loan is unsure, which means that the borrower does not offer collateral that can be seized in the event of default, such as on a car loan or residential mortgage. Typically, a personal loan can be obtained for a few hundred to a few thousand dollars, with repayment periods of two to five years.

Borrowers need some form of income verification and proof of assets that are worth at least the amount borrowed. Typically, the application is only one or two pages long and approval or denial is usually issued within a few days.

Best and worst rates

The average interest rate for a 24-month commercial bank loan was 10.21% in the fourth quarter of 2019, according to the Federal Reserve.What others are sayingSee moreBut interest rates can be more than three times higher: Avant’s APRs range from 9.95% to 35.99%.What others are sayingSee moreO best rates it can only be obtained by people with exceptional credit ratings and substantial assets. The worst must be borne by people who have no other choice. A personal loan is probably the best way to go for those who need to borrow a relatively small amount of money and are confident that they will be able to repay it within a few years.

Bank loan vs. Bank guarantee

A bank loan is not the same as a bank guarantee. A bank may issue a guarantee in accordance with deposit to third parties on behalf of one of your customers. If the customer fails to fulfill the relevant contractual obligation with the third party, that party may demand payment from the bank.

The guarantee is usually an agreement for a bank’s small business customers. A company can accept a contractor’s offer, for example, on condition that the contractor’s bank issues a payment guarantee in case the contractor fails to fulfill the contract.

A personal loan may be the best for someone who needs to borrow a relatively small amount of money and is sure of their ability to repay it within a few years.

Credit cards

Every time a consumer pays with a credit card, he or she is taking out a personal loan. If the balance is paid in full immediately, no interest will be charged. If part of the debt remains unpaid, interest will be charged each month until it is paid.

The average credit card interest rate showed an APR of 16.88% at the end of the fourth quarter of 2019, according to the Federal Reserve – slightly below the rate for the second quarter of 2019 of 17.14%, but almost exactly where it was (16.86%) at the end of the fourth quarter of 2018.What others are sayingSee moreThe fine rates, for consumers who miss a single payment, may increase even more – for example, to 31.49% on at least two of HSBC’s Mastercards.What others are sayingSee moreWhat others are sayingSee more

Revolving debt

The big difference between a credit card and a personal loan is that the card represents a revolving debt. The card has a defined credit limit and its owner can borrow money repeatedly up to the limit and repay it over time.

Credit cards are extremely convenient and require self-discipline to avoid overeating. Studies have shown that consumers are more willing to spend when they use plastic instead of money. A short one-page application process makes it even more convenient to get $ 5,000 or $ 10,000 in credit.

Equity loans

People who own their own homes can borrow against equity they built on them. That is, they can borrow up to the amount they actually have. If half the mortgage is paid, they can borrow half the value of the home or, if the home has increased by 50%, they can borrow that amount. In short, the difference between the current current of the house fair market value and the amount still owed on the mortgage is the amount that can be borrowed.

Low rates, big risks

An advantage of the equity loan is that the interest rate charged is much lower than for a personal loan. According to a survey conducted by ValuePenguin.com, the average interest rate for a 15-year fixed rate loan on February 5, 2020 was 5.82%. As a result of changes in Law of cuts and taxes of 2017, interest on an equity loan is now deductible only if the borrowed money is used to “buy, build or substantially improve the home of the taxpayer who guarantees the loan” by the IRS.What others are sayingSee moreWhat others are sayingSee more

The biggest potential downside is that the home is the collateral for the loan. The borrower may lose the home in the event of a loan default. The proceeds of an equity loan can be used for any purpose, but are generally used to update or expand the home.

A consumer considering a home loan may have two lessons in mind for the 2008-2009 financial crisis:

  • House values ​​can decrease as much as they increase.
  • Jobs are threatened by an economic crisis.

Equity credit lines (HELOCs)

The home equity credit line (HELOC) works like a credit card, but uses the home as collateral. A maximum amount of credit is extended to the borrower. A HELOC can be used, refunded and reused as long as the account remains open, which is typically 10 to 20 years old.

Like a regular stock loan, interest may be tax deductible. But, unlike a regular stock loan, the interest rate is not set at the time the loan is approved. Since the borrower can access the money at any time over a period of years, the interest rate is typically variable. It may be linked to an underlying index, such as the the best rate.

Good news or bad news

A variable interest rate can be good news or bad news. During a period of rising rates, interest on an outstanding balance increases. A homeowner who lends money to install a new kitchen and pays for a period of years, for example, may be stuck paying far more interest than expected, just because the basic interest rate has gone up.

There is another potential downside. The available credit lines can be very large and the introductory rates very attractive. It is easy for consumers to understand what they think.

Cash advances on credit card

Credit cards usually include a cash advance feature. In fact, anyone with a credit card has a revolving line of cash available at any ATM.

This is an extremely expensive way to borrow money. For example, the interest rate on a Fortiva credit card cash advance varies from 25.74% to 36%, depending on your credit.What others are sayingSee moreCash advances also come with a fee, usually equal to 3% to 5% of the advance amount or a minimum of $ 10. Worse, the cash advance goes to your credit card balance, accruing interest from one month to another until paid.

Other sources

Cash advances are occasionally available from other sources. Notably, tax preparation companies can offer advances against an expected tax refund from the IRS. However, unless there is a terrible emergency, there is no reason to give up part of your tax refund just to get the money a little faster.

Small Business Loans

Small business loans are available from most banks and the Small Business Administration (SBA). These people are usually sought after by people who establish new businesses or expand established ones.

Such loans are granted only after the business owner has filed a formal statement. business plan for review. The terms of the loan usually include a personal guarantee, which means that the business owner’s personal assets serve as a guarantee against default on repayment. These loans are generally granted for periods of five to 25 years. Sometimes, interest rates are negotiable.

Small business lending has proven to be indispensable for many, if not most, start-ups. However, creating a business plan and getting it approved can be arduous. The SBA has a wealth of resources online and locally to help launch businesses.

Paula Fonseca