Types of Loans : The Basics

Types of Loans : The Basics

It’s important to understand the basics associated with the many types of loans, as this will help you make an informed decision if the time comes to borrow money.

There are three specific details to consider when categorizing and comparing loans :

  • Secured vs. unsecured loans
  • Open-ended vs. closed-ended loans
  • Fixed rate vs. variable rate loans

Let’s get started!

Secured vs. Unsecured Loans

Secured Loans

With a secured loan, you guarantee payment through collateral, such as your home or a car.

In the event that you default on the loan, the lender has the legal right to repossess the property.

Primary Benefit and Drawback:

With collateral, you can typically obtain a lower interest rate
If you default on the loan the lender can take your collateral

Unsecured Loans

This is the exact opposite of a secured loan, as the lender does not require any collateral.

Your interest rate is dependent primarily on your credit history, credit score, and income.

Personal loans are among the most common types of unsecured loan. With this, you borrow money at a predetermined interest rate for a predetermined period of time, all without the requirement of putting up any collateral.

Primary Benefit and Drawback:

Faster application process since there is no collateral
Higher interest rate since the lender doesn’t have collateral to protect itself

Open-ended vs. Closed-ended Loans

Open-ended Loans

With an open-ended loan you gain access to revolving credit, with the ability to use this credit as needed.

As you borrow more money the amount you can access goes down. However, as you pay back the money you’ve borrowed, you can reuse the credit line once again.

Credit cards and lines of credit are two of the best examples of open-ended loans.

Primary Benefit and Drawback:

  • Access to the money you need when you need it (without the requirement to use the funds)
  • Variable interest rates often come into play, which can change how much you owe in the future

Closed-ended Loans

Also known as installment loans, these include things such as: mortgage, student loans, and car loans.

You borrow a specific amount of money and have a predetermined amount of time to pay it back.

With a closed-ended loan, once the money is paid back you don’t owe anything else. If you again want to borrow money, you’ll have to start at the beginning.

Primary Benefit and Drawback:

  • A clear idea of how much money you’ll pay and when your loan will be paid off
  • Depending on the type of loan there could be an origination fee

Fixed Rate vs. Variable Rate Loans

Fixed Rate Loans

A fixed rate loan has a defined interest rate throughout the duration of the payback period. It does not have the potential to change, regardless of what happens with the market.

Primary Benefit and Drawback:

  • Comfort in knowing that your rate will never change
  • Inability to gain access to low introductory variable rates

Variable Rate Loans

Unlike a fixed rate loan, a variable interest rate has the potential to change in the future.

For example, you may start out with a five percent interest rate, just for it to change to seven percent after the first year.

Primary Benefit and Drawback:

  • The opportunity to benefit from a low introductory rate
  • Your rate can increase in the future, thus changing your monthly payment

Final Thoughts

With this information, you’ll find it easier to secure the right loan for your particular situation. As you get closer to making a final decision, don’t let any of these details slip through the cracks. They’re all important to your financial future.