Loan Basics 101
There are many types of loans. Know the difference before you borrow.
Just about everyone has some form of loan. Since few people have the means to pay for a house or car outright, borrowing helps them buy these items.
Loans come from many places – banks, credit unions, merchants (store credit cards), and even family and friends. No matter where loans come from, they all have to be repaid and they all charge interest. The more you know about the different types of loans and how they work, the better choices you can make when using credit. Here’s a brief overview of some of the more popular consumer loans.
- Open-ended loan. These loans have flexible balances up to a specified limit. Credit cards are common types of open-ended loans. When you make a purchase, your available credit decreases. When you make a payment, your available credit increases. Interest is charged on the unpaid balance.
- Closed-ended loans. These loans are for a fixed amount to be paid back in specific installments. This option includes mortgage and auto loans.
- Secured loans. Secured loans use a specific asset as collateral. If you don’t make payments, the lender can take possession of the asset. An example is a home mortgage.
- Unsecured loans. These loans don’t have an asset for collateral and rely solely on your credit history and income to qualify. As a result, they’re harder to get and have higher interest rates.
- Single-payment loans. Single-payment loans are also known as balloon loans, bridge loans or interim loans and are typically used for short-term lending. Single-payment loans are repaid in one lump sum, including interest, at the end of the specified term – for example, at the end of one year.
- Installment loans. Installment loans are repaid at regular intervals and each payment includes principal and interest. With each payment, more goes toward the principal and less toward interest. Examples are home and auto loans.
- Fixed-rate loans. Fixed-rate loans charge the same interest rate for the duration of the loan.
- Variable or adjustable rate loans. The interest on a variable-rate loan can be adjusted during the life of the loan to reflect market changes.
- Convertible loans. Convertible loans can change their interest-rate structure. A convertible loan may start off having a variable interest rate and then switch to a fixed interest rate.
- Payday loans. These are short-term loans using your next paycheck as a guarantee. Payday loans have notoriously high annual percentage rates and can be difficult to pay off.
- Home equity loans / Home equity lines of credit (HELOC). These loans use the equity in your house to secure the loan. One of the most attractive benefits of home equity and HELOC loans is that the interest payments may be tax deductible. However, if you default, you could lose your home.
- Student loans. Student loans typically have federally subsidized interest rates and are used solely to pay for higher education. Repayment can often be deferred until six months after a student graduates or discontinues full-time enrollment.
Before you take out any type of loan, whether issued by a financial institution or merchant, make sure you understand its features, rules, policies, repayment plan and potential tax implications. If you’re unsure how a loan works, speak to an accountant or financial advisor.