Credit is a critical part of America’s economy, but many consumers struggle to understand how it works and its impact on their budgets. Learn more about the various types of loans available and the credit terms you should expect when you’re ready to borrow money.
Credit is a critical part of America’s economy, but many consumers struggle to understand how it works and its impact on their budgets. Learn more about the various types of loans available and the credit terms you should expect when you’re ready to borrow money.
Types of Consumer Credit & Loans
Loan contracts come in all kinds of forms and with varied terms, ranging from simple promissory notes between friends and family members to more complex loans like mortgage, auto, payday, and student loans.
Banks, credit unions and other people lend money for significant, but necessary items like a car, student loan or home. Other loans, like small business loans and those from the Department of Veterans Affairs, are only available to select groups of people.
Regardless of type, every loan – and its conditions for repayment – is governed by state and federal guidelines to protect consumers from unsavory practices like excessive interest rates. In addition, loan length and default terms should be clearly detailed to avoid confusion or potential legal action.
In case of default, terms of collection of the outstanding debt should clearly specify the costs involved in collecting upon the debt. This also applies to parties of promissory notes as well.
If you are in need of money for an essential item or to help make your life more manageable, it’s a good thing to familiarize yourself with the kinds of credit and loans that might be available to you and the sorts of terms you can expect.
Types of Credit: Open-End & Closed-End Credit Options
The two basic categories of consumer credit are open-end and closed-end credit. Open-end credit, better known as revolving credit, can be used repeatedly for purchases that will be paid back monthly, though paying the full amount due every month is not required. The most common form of revolving credit are credit cards, but home equity loans and home equity lines of credit (HELOC) also fall in this category.
Credit cards are used for daily expenses, such as food, clothing, transportation and small home repairs. Interest charges are applied when the monthly balance is not paid in full. The interest rates on credit cards average 15 percent, but can be as low as zero percent (temporary, introductory offers) and as high as 30 percent or more, depending on the consumer’s payment history and credit score. Loans for bad credit may be hard to find, but lower interest rates are available within nonprofit debt management programs, even for credit scores below 500.
Closed-end credit is used to finance a specific purpose for a specific period of time. They also are called installment loans because consumers are required to follow a regular payment schedule (usually monthly) that includes interest charges until the principal is paid off.
The interest rate for installment loans varies by lender and is tied closely to the consumer’s credit score. The lending institution can seize the consumer’s property as compensation if the consumer defaults on the loan.
Examples of closed-end credit include:
• Mortgages
• Car loans
• Appliance loans
• Payday loans
Types of Loans
Loan types vary because each loan has a specific intended use. They can vary by length of time, by how interest rates are calculated, by when payments are due and by a number of other variables.
Debt Consolidation Loans
A consolidation loan is meant to simplify your finances. Simply put, a consolidation loan pays off all or several of your outstanding debts, particularly credit card debt. It means fewer monthly payments and lowers interest rates. Consolidation loans are typically in the form of second mortgages or personal loans.
Student Loans
Student loans are offered to college students and their families to help cover the cost of higher education. There are two main types: federal student loans and private student loans. Federally funded loans are better, as they typically come with lower interest rates and more borrower-friendly repayment terms.
Mortgages
Mortgages are loans distributed by banks to allow consumers to buy homes they can’t pay for upfront. A mortgage is tied to your home, meaning you risk foreclosure if you fall behind on payments. Mortgages have among the lowest interest rates of all loans.
Auto Loans
Like mortgages, auto loans are tied to your property. They can help you afford a vehicle, but you risk losing the car if you miss payments. This type of loan may be distributed by a bank or by the car dealership directly but you should understand that while loans from the dealership may be more convenient, they often carry higher interest rates and ultimately cost more overall.
Personal Loans
Personal loans can be used for any personal expenses and don’t have a designated purpose. This makes them an attractive option for people with outstanding debts, such as credit card debt, who want to reduce their interest rates by transferring balances. Like other loans, personal loan terms depend on your credit history.
Loans for Veterans
The Department of Veterans Affairs (VA) has lending programs available to veterans and their families. With a VA-backed home loan, money does not come directly from the administration. Instead, the VA acts as a co-signer and effectively vouches for you, helping you earn higher loan amounts with lower interest rates.
Small Business Loans
Small business loans are granted to entrepreneurs and aspiring entrepreneurs to help them start or expand a business. The best source of small business loans is the U.S. Small Business Administration (SBA), which offers a variety of options depending on each business’s needs.
Payday Loans
Payday loans are short-term, high-interest loans designed to bridge the gap from one paycheck to the next, used predominantly by repeat borrowers living paycheck to paycheck. The government strongly discourages consumers from taking out payday loans because of their high costs and interest rates.
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 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.
Cash Advances
A cash advance is a short-term loan against your credit card. Instead of using the 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.
Home Equity Loans
If you have equity in your home – the house is worth more than you owe on it – you can use that equity to help pay for big projects. Home equity loans are good for renovating the house, consolidating credit card debt, 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 a source of collateral so interest rates are considerably lower than credit cards. The major difference between the two 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. Home equity loans and HELOCs are used for things like home renovations, credit card debt consolidation, major medical bills, education expenses, and retirement income supplements. They must be repaid in full if the home is sold.
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 clarification or adjustments.
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