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Personal Credit

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Small Business Loans

Personal Finance Lending

Understanding Different Loan Types

Choose the one which best fits your financial situation

By Glenn Curtis

Updated June 19, 2021

Reviewed by Thomas Brock

The money you borrow is a great option for a variety of reasons, from financing a new business to buying your partner an engagement rings. However, with the different kinds of loans available what is the best one, and for what reason? Below are the most common kinds of loans and how they function.

Important Takeaways

Individual loans as well as credit cards have the highest interest rates, however they do not require collateral.

Home-equity loans have low interest rates, but the borrower’s home serves as collateral.

Cash advances usually have high interest rates plus transaction charges.

Personal Lending

The majority of banks, both online and on Main Street, offer personal loans, and the proceeds can be used for everything from purchasing a brand new 4K 3D smart TV to paying bills. It’s a costly method to get money, because the loan is not secured, which means the borrower isn’t required to provide collateral that could be taken in the event in the event of default, similar to a auto loan or home mortgage. A typical personal loan is available from a few hundred dollars to thousands of dollars, with repayment terms of two or five years.

The borrower must provide income verification, as well as evidence of assets that are at least as large as the amount being borrowed. The application typically is only a few pages in length, and the approval or denial are usually granted within a few days.

Best and Worst Rates

The average interest rate for a 24-month commercial bank loan was 10.21% during the 4th quarter of 2019 as per the Federal Reserve.1 But interest rates can be higher than three times that amount: Avant’s APRs vary between 9.95 percent to 35.99%.2 The best rates are only available by those who have outstanding credit ratings and substantial assets. The most adversities must be endured by those who are left with no choice.

A personal loan is most likely the best method for those who have to borrow a relatively small amount of money, and know they can repay it within a couple of years. A personal loan calculator is an effective tool to determine what rate of interest is within your means.

Bank Loan vs. Bank Guarantee

The term “bank” refers to a loan does not mean the same as a bank guarantee. A bank may offer a guarantee in the form of a security to a third party for one of their customers. If the customer is unable to meet the contractual obligation to the third party, that party could request repayment from the institution.

The guarantee is typically an arrangement that banks make for their small-business clients. A business may be able to accept an offer from a contractor for instance, but on the condition that the bank of the contractor issues a guarantee of payment in the case of default on the contract.

A personal loan might be best for someone who needs to borrow a small amount of money and is confident of their capacity to pay back the loan within a couple of years.

Credit Cards

Each time a customer pays with a credit card, it is effectively similar to getting a small personal loan. If the amount is paid off in full in the first day, no interest is charged. If some of the debt is not paid it will be charged interest each month until it is completely paid off.

The average credit card interest rate was 16.88% APR at the close in the 4th quarter the year as per Federal Reserve. It was down slightly from the second quarter of 2019 rate of 17.14 percent, but almost exactly where it was (16.86%) at the close of the fourth quarter of 2018.3 Penalty rates for those who fail to make one payment, could get bumped even higher–for example, to 31.49 percent on at least two of HSBC’s Mastercards.4

Revolving Debt

The main difference between a credit card and a personal loan is the latter represents revolving debt. The card comes with a predetermined credit limit, and its owner is able to borrow money until the limit is reached and pay it back over the course of time.

Credit cards are very practical, but they also require discipline to stay away from overindulgence. The research has proven that consumers are more inclined to spend when they use money instead of plastic. The simple application form of one page is a more convenient way to get the $5,000 or $10,000 worth of credit.

Home-Equity Credit

Homeowners who own their own home can take out loans against the equity accrued in the properties. In other words, they are able to take out loans as high as the amount they have. If the mortgage is half is paid off, they can take out a loan equal to half the worth of the property, or if the house has increased in value to 50% or more, then they can borrow that amount. The difference between the home’s current worth and its fair market value as well as the balance due to the lender is what could be borrowed.

Lower Rates, Higher Risks

One benefit of a home equity loan is that the interest rate is far lower than for personal loan. Based on a survey conducted by ValuePenguin.com The median interest rate for a 15-year fixed-rate home equity loan at the time of February. 5, 2020, was 5.82 percent. Due to changes in the 2017 Tax Cuts and Jobs Act the interest rate on a home equity loan is now only tax deductible if the money will be utilized to “buy or construct, or substantially improve the home of the taxpayer that is secured by the loan” according to the IRS.5

The biggest potential downside is that the house is used as collateral to secure the loan. The borrower may lose the house in case of default on the loan. The money from the mortgage equity loan can be used for any use, but they are often used to renovate or extend the property.

If you are thinking about a home equity loan might keep in mind two lessons that the 2008-2009 financial crisis:

The value of homes can fall as well as up.

The job market is in danger due to an economic downturn.

Home-Equity Lines of Credit (HELOCs)

The home equity line of credit (HELOC) is similar to credit cards but utilizes your home to secure. A maximum amount of credit is given to the person who is borrowing. A HELOC is able to be used or repaid until the time that it is open, which typically between 10 and 20 years.

As with a typical home equity loan it is possible that the interest will be tax-deductible. However, unlike a normal home equity loan, the interest rate isn’t fixed at the time that the loan is granted. As the borrower may be using the funds at any point over a period of years and the rate of interest is usually fluctuating. It can be linked to an underlying index, for instance, an index that is the rate of prime.

Good or Bad News

A variable rate of interest could be good and bad. In times of increasing rates, the cost of interest on a balance that is not paid will rise. A homeowner who borrows money to install a new kitchen and then pays it back over the course of a few years, for instance, may get stuck paying much more in interest than they anticipated, just because the prime rate went up.

Another issue could be the cost. The credit lines are often very extensive and the initial rates very attractive. It is easy for people to fall way over their head.

Cash Advances on Credit Cards

Credit cards typically have the cash advance feature. Anyone with an account with a credit card can access a revolving line of cash accessible at any automatic teller machine (ATM).

This is an extremely expensive way to borrow money. For instance, the interest rate for cash advances with the Fortiva credit card ranges from 25.74 percent up to 36 percent, contingent on the credit score of your credit.6 Cash advances also come with a charge, which is typically in the range of the range of 3%-5% of the advance amount or a minimum of $10. The worst part is that the advance will be added to the credit card balance which is then able to accrue interest from month to month until it is completely paid off.

Other Sources

Cash advances are occasionally available from different sources. Tax preparation firms may offer advances against an expected Internal Revenue Service (IRS) tax refund. But, unless you’re in a dire emergency, there’s no reason to forfeit a part or all of the tax rebate to receive the money quicker.

Small Business Loans

Small business loans are available through the majority of banks as well as through the Small Business Administration (SBA). These are generally sought by people who want to start new businesses or expanding established ones.

Such loans are only granted after the business owner has presented an official business plan for review. The terms of the loan typically include the personal guarantee, meaning that the business owner’s personal assets serve as collateral in case of default upon repayment. Such loans usually are extended for a period of between five and 25 years. The interest rates can be negotiated.

The small business loan has proved indispensable for several, if certainly not all small businesses that are just beginning to emerge. But, preparing a business plan and getting it approved can be difficult. The SBA has a wealth of resources , both on the internet and in person to help start businesses.

KAS

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