Looking to buy a house, start a business or return to school? Most financial decisions are made with the help of a loan. Consumers can apply for all types of loans with various interest rates.
After receiving a loan, borrowers must make monthly payments in a predetermined amount. Making these payments on time is essential to maintaining a good credit score, which is necessary for securing loans in the future.
What Are the Different Types of Loans?
There are several types of loans available depending on your financial plans. Here are some of the most common types.
About Student Loans
To help cover the cost of higher education, students can apply for loans through the federal government or private lenders. The Free Application for Federal Student Aid (FAFSA) must be submitted each school year to determine if you are eligible for aid. Once you are granted a federal student loan, your monthly payments begin six months after you graduate or stop attending school. You may also secure a private student loan, although these tend to have higher interest rates.
If you’re like most Americans, you don’t have the financial means to buy a house in full. Thus, banks and private lenders make it possible for consumers to purchase a home through a loan. Mortgages typically have the lowest interest rates among the different loan types.
About Auto Loans
An auto loan helps you to afford a vehicle. You can typically secure an auto loan through a bank or the dealership from which you are buying the car. However, auto loans offered through car dealerships usually have higher interest rates. Auto loans are granted after evaluating your credit and financial history.
About Small Business Loans
You can receive a small business loan to help you get your company off the ground. These types of loans are offered by the U.S. Small Business Administration (SBA), banks or private lenders.
About Consolidated Loans
If you owe money to a variety of lenders, you can apply for a consolidated loan. Rather than paying these debts separately, the loan pays off all your outstanding debts and combines them into one single source. With a consolidated loan, you’ll have fewer monthly payments and a lower interest rate.
Short-Term vs. Long-Term
Short-term loans are generally up to three years, but most short-term loans are paid in less than one year. Repayment terms usually mean higher monthly payments to fund the entire amount of the loan plus any interest.
Related Article: How to Receive a Low-Interest Loan
Long-term loans are usually repaid over multiple years. Long-term loan repayment periods vary drastically depending on the type of loan. For example, SBA loans may be repaid anywhere between two and 20 years, while mortgages can last for 30 years.
|Interest Rates||8% – 13%||4% – 7%|
|Difficulty to Obtain||Easy. Most lenders have few requirements for short-term loans and do not usually check credit. In many cases, borrowers can access their money in as little as 48 hours.||Difficult. Long-term loans are not granted overnight. Many lenders examine the borrower’s financial history and credit to determine if they qualify for the loan. Borrowers must meet certain criteria to receive various loan types.|
Learn About Interest Rates
An interest rate is the amount charged by a lender to a borrower expressed as a percentage. There are several types of interest rates you may encounter depending on the type of loan you secure.
Simple interest means there is a set percentage charged on the total amount of the loan each year. For example, if you borrow $10,000 at a simple interest rate of 5%, the total interest you must pay at the end of the first year would be $500. In the second year and beyond, the total amount of interest you pay is set at $500.
With compound interest, the amount of interest you pay varies. Let’s use the previous example. If you borrow $10,000 at a compound interest rate of 5%, you would still pay $500 in interest after the first year.
However, in the second year, the 5% interest is now calculated based on your entire new balance of $10,500. The new interest payment for the second year is now $525. This amount is then added to the total amount for the third year, and so on.
A variable interest rate fluctuates in response to changes in the cash rate in addition to other changes by your lender. The benefit of a variable rate is that it decreases if the cash rate goes down, meaning you pay less interest in total. However, it may also increase if the cash rate increases, meaning you pay more interest.
You can choose to lock in at a specific interest rate for a determined period. If the cash rate increases, your interest rate will not increase. However, if the cash rate decreases, you cannot benefit from a lower rate. If you end your fixed-rate agreement, you may end up paying a hefty fine.
About Banks vs. Private Companies
You can borrow money from a bank or a private lending company. Before you choose, it’s important to understand the differences between each lender.
|Interest Rates||Banks and credit unions typically offer lower interest rates than private companies. It costs the bank less in interest to lend money to borrowers, which is why they can offer loans at such low-interest rates.||It usually costs private lenders more money to secure the funds needed to lend money out to borrowers. They receive their money from investors or other banks that charge higher interest rates. Thus, these financial institutions tend to have higher interest rates for borrowers to compensate.|
|Approval Process||Medium/Hard. Most banks adhere to strict regulations that restrict them from granting loans to new businesses. Other regulations for borrowers depend on their credit score, length of time in business and ratio of debt-to-income. Because of this, the approval process is lengthier.||Easy/Medium. These financial institutions don’t usually adhere to strict regulations. Most borrowers are approved rather quickly.|
How Loans Affect Your Credit
Before you secure a loan, the bank or private lender examines your credit. Having a poor credit score does not mean you can’t get a loan. In fact, some private lenders may specialize in lending money to individuals with poor credit. Here are a few ways that loans affect your credit:
- Loans help build credit. As long as you make your payments on time, a loan can be a good credit reference for the future. Having a good repayment history shows that you are a responsible borrower. Future lenders will assume you will continue to make timely payments, increasing your chances of getting approved.
- Secure a variety of loans. Your credit score factors in your “credit mix,” which is all types of loans you have on your report. For example, having a mixture of credit cards, auto loans and home loans helps increase your credit score.
- Missed payments hurt your credit. If you miss payments or make them after your due date has passed, your credit score drops. This also hurts your chances of securing loans in the future, as lenders are unsure of your ability to repay.
Related Article: How to Improve Your Credit Score
- Financial Panning