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Understanding Different Loan Types

Select the option which best fits your financial situation

By Glenn Curtis

Updated June 19 2021

Reviewed by Thomas Brock

Borrowed money is a great option for a variety of motives, from financing a new business to buying your fiancee an engagement ring. With all the various types of loans available what’s the most suitable one for what reason? Here are the most commonly used kinds of loans and how they function.

The most important takeaways

Personal loans and credit cards are characterized by high interest rates but don’t require collateral.

Home equity loans are low-interest However, the home of the borrower serves as collateral.

Cash advances usually have high interest rates and transaction costs.

Personal Credit

Many banks, both online as well as on Main Street, offer personal loans, and the proceeds can be used for everything from purchasing a brand new 4K 3D smart television to paying bills. This is a costly way to obtain money because the loan is unsecured, which means the borrower does not provide collateral that could be taken away in the event of default, like the case of a auto loan or home mortgage. In general, a personal loan can be obtained from a few hundred dollars to thousands of dollars, with repayment periods of two or five years.

The borrower must provide income verification and proof of assets that are at least as large as the amount being borrowed. The application usually only a page or two in length, and the approval or denial is generally given within a couple of days.

The Best and Worst Rates

The average rate of interest for a 24-month commercial bank loan was 10.21% for the quarter ending in April of this year, as per the Federal Reserve.1 However, interest rates could be higher than three times the amount. For example, Avant’s APRs range between 9.95% to 35.99%.2 The highest rates can only be obtained by people with exceptional credit ratings and significant assets. The worst must be endured by people who have no other choice.

The personal loan is most likely the best method for those who need to borrow a relatively small amount of money, and know that they will repay the loan within several years. An online personal loan calculator can be an effective tool to determine what kind of interest rate is within your budget.

Bank Loan vs. Bank Guarantee

An institution’s loan cannot be the same as a bank guarantee. A bank may offer a guarantee in the form of a an assurance to a third-party in the name of one or more of its clients. If the customer is unable to meet the contractual obligation with this third-party, the third party may require repayment from the institution.

The guarantee is usually an arrangement between banks for their small-business customers. A corporation may accept an offer from a contractor for instance, but on the condition that the bank of the contractor provides a guarantee of payment in the case of default with the agreement.

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 it back in the next couple of years.

Credit Cards

When a person makes a payment using a credit card, it is effectively similar to taking out a personal loan. If the balance is paid in full within a few hours and no interest is charged. If any of the debt remains unpaid the interest will be charged each month until it is paid off.

The average credit card interest rate carried a 16.88% APR at the close in the 4th quarter the year, according to a the Federal Reserve–down slightly from the second quarter of 2019 rate of 17.14%, but nearly exactly where it was (16.86%) at the end in the 4th quarter 2018.3 Penalty rates, for those who fail to make one payment, could be increased further, for instance, to 31.49% on at least two HSBC Mastercards.4

Revolving Debt

The big distinction between a credit card as opposed to a private loan can be seen in the fact that the credit card is a revolving loan. The card has a set credit limit, and its owner can repeatedly borrow money up to that limit, and then repay it over time.

Credit cards are very convenient, and they need to be controlled to avoid overindulging. The research has proven that consumers are more willing to spend when they utilize money instead of plastic. The simple application form of one page makes it an even more convenient way to get an amount of $5,000 or $10,000 in credit.

Home-Equity Credit

Homeowners who own their own home can take out loans against the equity they have accrued in them. That is, they can take out loans as high as the amount they actually own. If the mortgage has been paid in half is completed, they are able to take out a loan equal to half the worth of the property or if the property has appreciated by 50%, they are able to take out the amount. In essence, the difference between the property’s worth and its fair market value as well as the remaining amount owed on the mortgage is the amount that can be borrowed.

Low Rates, Bigger Risks

One advantage of the home-equity loan has to do with the fact that the interest rate is far lower than for personal loan. Based on a survey conducted by ValuePenguin.com The average interest rate for a 15-year fixed rate home equity loan in the month of Feb. 5th, 2020 was 5.82 percent. Due to changes in the legislation of 2017 Tax Cuts and Jobs Act that enacted in 2017, interest on home equity loan can now be tax-deductible when the money borrowed will be utilized to “buy or build or substantially enhance the home of the taxpayer that is secured by the loan” as per the IRS.5

The main risk is that the house is an asset that is collateralized for the loan. The borrower may lose the house in case of not paying the loan. The money from a house equity loan can be used for any use, but they are often used to upgrade or increase the size of the house.

Anyone who is considering a home equity loan may be able to recall two lessons learned from the 2008-2009 financial crisis:

Home values could go down or up.

Employment is at risk in an economic downturn.

Home-Equity Lines of Credit (HELOCs)

The home equity line of credit (HELOC) works like credit cards but utilizes your home to secure. The maximum credit amount is given to the borrower. A HELOC may be used or repaid throughout the period the credit account is open, which typically 10 to 20 years.

Like a regular home-equity loan it is possible that the interest will be tax-deductible. However, unlike a traditional home equity loan however, the interest rate is not determined at the time the loan is granted. Since the borrower could be accessing the money anytime over a period of years and the rate of interest will be fluctuating. It may be pegged to an underlying index, like that of the prime rate.

Good or Bad News

A variable interest rate can be good and bad. In times of increasing rates, the interest charges on a balance that is not paid will rise. Someone who takes out a loan to construct a new kitchen and pays it off over a period of years, for instance, may end up paying more in interest than expected due to the fact that the prime rate increased.

There’s another potential downside. The credit lines that are available can be huge, and the introductory rates are very appealing. It’s easy for consumers to fall way over their head.

Credit Card Cash Advances

Credit cards typically have the cash advance feature. Effectively, anyone who has an account with a credit card can access a revolving line of cash available at any automatic ATM (ATM).

This is an extremely expensive way to borrow money. To take one example the interest rate for cash advances on the Fortiva credit card is 25.74 percent to 36%, depending on the credit score of your credit.6 Cash advances are also accompanied with a fee, typically equivalent to the range of 3%-5 percent of the amount you are requesting or a $10 minimum. Worse yet, the cash advance goes onto the credit card balance which is then able to accrue interest month after month until it’s paid off.

Other Sources

Cash advances can be obtained from other sources. Notably, tax-preparation companies may provide advances on an anticipated Internal Revenue Service (IRS) tax refund. However, unless there’s a dire emergency, there’s no reason to sacrifice a portion or all of the tax rebate to get the money quicker.

Small Business Loans

Small business loans are available through the majority of banks and through the Small Business Administration (SBA). These are generally sought by people setting up new businesses or expanding existing ones.

Such loans are granted only after the business owner has provided a formal business plan for review. The conditions of the loan typically contain the personal guarantee, meaning that the owner’s personal assets are used as collateral against default upon repayment. These loans usually extend for between five and 25 years. Interest rates are sometimes negotiable.

The small-business loan has proven to be a necessity for several, if certainly not all small businesses that are just beginning to emerge. However, the process of creating a business plan and getting approval for it can be challenging. The SBA provides a wide array of resources , both on the internet and in person to help get businesses launched.

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Personal Loan The Definition, Types and how to obtain one

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Understanding Different Loan Types

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Can personal loans be included in Bankruptcy?

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Can Personal Loans Be Transferred to a different person?

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Personal Interest Rates for Loans: How a Personal Loan Is Calculated

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How do I apply for a Personal Loan

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