If you want to buy a house or pursue a higher education, you’ll probably need a loan. There are a lot of different loan types though, and they can be confusing. Here are the big ones that you should know about (and you should read this economic glossary, too).
The basics of a loan
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A loan is money (or, sometimes, property or another material good) given by a lender to a borrower with the understanding that the borrower will pay it back with interest. Banks usually give out loans to individuals or organizations.
Here are some of the main types of loans, per Experian Financial:
- Personal loans are loans that can be used for basically anything the borrower wants, which makes them different from auto or educational loans. They can be used for emergencies, weddings, renovations, or any other major expense.
- Auto loans are designed to let you borrow the price of a car you plan to buy, but they don’t cover a down payment. The vehicle itself will serve as a collateral and can be repossessed in the event you don’t pay consistently.
- Student loans are used to pay for undergraduate or graduate-level education and can be given by the federal government or private lenders. You’ll usually want a federal one, since they offer deferment, income-based repayment options, and other benefits.
- Mortgage loans cover the purchase price of a home, but like auto loans, they don’t cover a down payment. Also like auto loans, they come with collateral: Your home can be foreclosed on if you don’t pay consistently. Some mortgages can be backed by government agencies like the Federal Housing Administration or Veterans Administration, depending on if the borrower qualifies.
- Home equity loans allow you to borrow up to a percentage of the equity in your home to use however you want.
- Credit-builder loans are supposed to help people with poor credit (or no credit) improve their borrowing history. The lender puts the loan amount in a saving account and the borrower makes fixed monthly payments for anywhere between six months and two years. When the loan is repaid, the borrower gets the money that was put away. In some cases, you even get it with interest.
- Debt consolidation loans are personal lines that will help you pay off high-interest debt, like credit card debt. They help you get all your debt into one place, so you’re only making one payment every time you pay toward it.
- Payday loans are generally bad news and should be avoided. You might get the money sooner than your regularly payday, but these loans are short-term and have incredibly high fees. They have to be repaid in full by the next time you get paid—or you’ll have to renew the loan, getting new fees and charges. Avoid them as much as possible.
Important loan-related terminology
The following words relate to the types of loans listed above:
- Unsecured loans do not require collateral, but typically have higher interest rates than secured ones, given they’re risker for the entity doing the lending. Auto and home loans are not unsecured, but many personal loans are. Secured loans are those that use some type of collateral.
- Installment loans (also called term loans) have to be repaid with fixed payments over a set period.
- Revolving credit allows you to borrow up to a certain amount. At the end of each billing cycle, you’ll either repay what you borrowed completely or carry it over into the next month’s balance by making only a minimum payment.
- Fixed rate loans have an interest rate that won’t change during the term of the loan, while variable rate loans have interest that can change.
Another phrase to know, per Forbes, is “annual percentage rate,” or APR. This refers to the total annual cost of taking out a loan, from interest rate to other finance charges. Lenders have to disclose the APR by law, so be sure to look for it when considering a loan.
Finally, you may need to take out a loan with someone else. For example, if you and your partner qualify for a mortgage loan together, you’ll be co-borrowers, or two people jointly responsible for paying a loan. Lenders look at both borrowers’ credit and income to qualify you, and you both end up owning the asset in question, such as a house or car. If you’re the only person who is getting the loan but you have bad credit or no credit, someone else with a better score can co-sign with you, meaning that they’ll be responsible for the loan repayments if you fail to make them, and their credit is also on the line.