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Understanding Different Loan Types

Choose the one that best suits your financial situation

By Glenn Curtis

Updated June 19, 2021

Review by Thomas Brock

Borrowed money can be used for many purposes, from funding an entrepreneur’s new venture to buying your spouse an engagement wedding ring. But with all of the different types of loans out there, which is best–and for what use? Below are the most common kinds of loans and how they function.

Key Takeaways

The personal loans as well as credit cards are characterized by 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 rates of interest and transaction fees.

Personal Credit

The majority of banks, both online as well as in Main Street, offer personal loans, and the proceeds can be used for everything from buying a brand-new 4K 3D smart TV to paying off bills. This is an expensive way to get money, because the loan is not secured. This means that the borrower doesn’t provide collateral that could be taken away in the event in the event of default, similar to a car loan or mortgage on a home. A typical personal loan is available from a few hundred dollars to thousands of dollars, with repayment periods of two up to 5 years.

The borrower must provide income verification as well as proof of assets equal to or greater as the amount being borrowed. The application typically is only a few pages in length. The decision to approve or deny the application is usually granted within a few days.

The Best and Worst Rates

The median interest rate for a commercial bank’s 24-month loan was 10.21 percent during the 4th quarter of 2019 as per the Federal Reserve.1 But , the rates can be three times or more that amount: Avant’s APRs vary from 9.95% to 35.99%.2 The most favorable rates are only available by those who have outstanding credit ratings and significant assets. The worst rates 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 are certain that they will repay the loan within several years. A personal loan calculator is a useful tool for determining the interest rate that is within your budget.

Bank Loan vs. Bank Guarantee

An institution’s loan cannot be the same as a bank guarantee. A bank could issue a guarantee as security to a third party for one of their customers. If the customer is unable to perform the required contract with that third party the third party may require an amount from the bank.

The guarantee is typically an arrangement between banks for their small-business customers. A company may agree to a contractor’s bid for instance, under the requirement that the contractor’s bank offers a payment guarantee in the event of a default by the contractor on the contract.

A personal loan is a good option for those who need to borrow a small amount of money and is confident of their capacity to repay it within a couple of years.

Credit Cards

Each time a customer pays with a credit card it’s similar to taking out a personal loan. If the balance is paid off in full in the first day and no interest is paid. If some of the debt is not paid, interest is charged every month until it is completely paid off.

The typical credit card interest rate carried a 16.88 percent APR as of the close on the final quarter in 2019 as per the Federal Reserve–down slightly from the 2019 second quarter rate of 17.14 percent, but almost exactly where it was (16.86%) at the close in the 4th quarter 2018.3 Penalty rates for customers who do not make one payment, could be increased further, for instance up to 31.49% on at least two of HSBC’s Mastercards.4

Revolving Debt

The main distinction between a credit card as opposed to a private loan is that the credit card represents revolving debt. The card is governed by a credit limit, and its owner can repeatedly borrow money up to the limit and repay it over time.

Credit cards are very convenient, and they require discipline to stay away from overindulgence. Research has shown that people are more inclined to spend when they use money instead of plastic. A short one-page application process can make it a much more efficient method to obtain $5,000 or $10,000 worth of credit.

Home Equity Credit

Owners of their own residences can borrow against the equity accrued in them. That is, they can borrow up to the amount they actually own. If the mortgage is half is completed, they are able to borrow the entire value of the house, or if the house has appreciated to 50% or more, then they can borrow that amount. In short, the difference between the property’s fair market value and the amount still due to the lender is what can be borrowed.

Lower Rates, Higher Risks

One advantage of the home-equity loan can be that the interest rate charged is much lower than that of a personal loan. According to a survey conducted by ValuePenguin.com The median interest rate for a 15-year fixed-rate home equity loan at the time of February. 5th, 2020, was 5.82 percent. As a result of changes made to the legislation of 2017 Tax Cuts and Jobs Act the interest rate on the home equity loan is no longer tax-deductible when the money can be used «buy, build, or substantially enhance the taxpayer’s home that secures the loan» according to the IRS.5

The most significant risk is that the house is used as collateral to secure the loan. The borrower could lose their home in the event of failure to pay the loan. The proceeds of the house equity loan can be used for any use however, they are typically used to upgrade or extend the property.

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

The value of homes can fall as well as up.

Employment is at risk in an economic downturn.

Home Equity Lines of Credit (HELOCs)

The home-equity line of credit (HELOC) functions like a credit card but uses your home to secure. A maximum amount of credit can be extended to the person who is borrowing. A HELOC can be utilized, repaid, and reused for as long as the account stays open, which is typically between 10 and 20 years.

Like a regular home-equity loan, the interest may be tax deductible. But unlike a regular home-equity loan, the interest rate cannot be fixed at the time that the loan is accepted. As the borrower may be using the funds at any point over a long period and the rate of interest is usually variable. It may be pegged to an index of the underlying, such as that of the prime rate.

Good or Bad News

A variable interest rate could be good and bad. When there is a rise in rates, the interest charges on a balance that is not paid will increase. A homeowner who borrows money to construct a new kitchen, and then repays it over the course of a few years for instance, might be forced to pay more in interest than expected due to the fact that the prime rate went up.

Another issue could be the cost. The credit lines are often very extensive and the introductory rates very attractive. It’s not difficult for customers to get in the middle of their finances.

Cash Advances on Credit Cards

Credit cards generally have a cash advance feature. In essence, anyone with a credit card has an unrevolving line of cash that can be accessed at any automated ATM (ATM).

This is an extremely expensive way to borrow money. To take one example the interest rate for a cash advance on the Fortiva credit card is 25.74% between 36% and 25.74%, depending on the credit score of your credit.6 Cash advances come with a cost, usually equivalent to 3% to 5 percent of the amount you are requesting or a minimum of $10. Worse yet, the cash advance is added to the balance of your credit card which is then able to accrue interest month after month until it is cleared.

Other Sources

Cash advances are occasionally available from other sources. Notably, tax-preparation companies may offer advances against an expected Internal Revenue Service (IRS) tax refund. If there’s no dire emergency, there’s no reason to forfeit a part of your tax refund just to get the money an extra bit faster.

Small Business Loans

Small-scale business loans are offered through a variety of banks and through the Small Business Administration (SBA). These are generally sought by people who want to start new businesses or expanding established ones.

These loans are granted only when the owner of the company has submitted a formal business plan for review. The conditions of the loan usually include personal guarantees, which means that the business owner’s personal assets will serve as collateral to protect against the possibility of non-payment upon the repayment. Such loans usually extend for 5 to 25 years. Rates of interest are often negotiated.

The small-business loan is a must for many, if not most, fledgling businesses. But, preparing the business plan and then getting approval for it can be challenging. The SBA has a wealth of information both local and online to assist get businesses launched.

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