Personal Credit & Types of Consumer Loans
Types of Consumer Credit & Loans
Consumer loans and credit are a form of financing that make it possible to purchase high-priced items you can’t pay cash for today.
Banks, credit unions and online lenders are the source for most consumer loans and credit, though family and friends can be lenders, too.
The loans and credit come in many forms, ranging from something as simple as a credit card to more complex lending like mortgages, auto and student loans.
Regardless of type, every loan – and its conditions for repayment – is governed by state and federal guidelines to protect consumers from unsavory practices like excessive interest rates. In addition, loan length and default terms should be clearly detailed in a loan agreement to avoid confusion or potential legal action.
In case of default, terms of collection for the outstanding debt should specify clearly the costs involved. This also applies to parties in promissory notes.
If you need to borrow money for an essential item or to help make your life more manageable, it’s a good thing to familiarize yourself with the types of credit and loans that might be available to you and the terms you can expect.
Secured vs. Unsecured Loans
Lenders offer two types of consumer loans – secured and unsecured – that are based on the amount of risk both parties are willing to take.
Secured loans mean the borrower has put up collateral to back the promise that the loan will be repaid. The borrower risks losing that collateral if he/she defaults on the loan. Lenders offer lower interest rates on secured loans because they have the collateral to fall back on.
Homes, cars, boats and property are good examples of secured loans.
Unsecured loans have no collateral backing them. This means there is nothing to repossess and sell if the borrower defaults. That puts more risk on the lender, who seeks protection by charging a higher interest rate.
Credit cards and personal loans are examples of unsecured loans.
Types of Credit
The two major categories for consumer credit are open-end and closed-end credit.
Open-end credit, better known as revolving credit, can be used repeatedly for purchases that will be paid back monthly. Paying the full amount due every month is not required, but interest will be added to any unpaid balance.
The most common form of revolving credit is credit cards, but home equity lines of credit (HELOCs) also fall in this category.
Card holders incur interest charges when the monthly balance is not paid in full. The interest rates on credit cards average around 17%, but can be as high as 30% or more, depending on the consumer’s payment history and credit score.
Loans for bad credit may be hard to find, but lower interest rates are available through nonprofit debt management programs. Credit scores are not a factor.
Closed-end credit is used to finance a specific amount of money for a specific period of time. They also are called installment loans because consumers are required to follow a regular payment schedule (usually monthly) that includes interest charges, until the principal is paid off.
The interest rate for installment loans varies by lender and is tied closely to the consumer’s credit score. The best interest rates go to borrowers with credit scores of 740 and higher. Interest rate charges go up, as credit scores go down.
The lending institution can seize the consumer’s property as compensation if the consumer defaults on the loan.
The difference between “fixed-rate” loans and “variable rates” is that the interest rate on a fixed loan never changes. The interest rate on variable rate loans goes up or down based on a benchmark rate or index that changes, usually annually.
Types of Loans
Consumers can get a loan for just about anything they want to purchase, which tells you approximately how many loan types there are available. Loan types vary because of interest rate or repayment period, but if you want to borrow money to make a purchase, there probably is someone available, somewhere, who will lend it to you.
Here is a list of some of the most popular varieties of loans:
- Debt consolidation
- Small business
- Borrowing from friends and family
- Cash advances
- Home equity
Each type has a purpose in mind, so don’t just look for the one with the lowest interest rate and think that will be your final choice. Do some research and make sure the loan you choose is the one you actually need. Here is a little explainer for each loan.
Debt Consolidation Loans
A consolidation loan is used to simplify your finances by combining multiple bills for credit cards, into a single debt, repaid with one monthly payment. This means fewer payments each month and lower interest rates.
Consolidation loans are just another name for unsecured personal loans.
Learn more about debt consolidation loans
The best thing about personal loans is they can be used for any reason. Secured and unsecured personal loans are an attractive option for people with credit card debt, who want to reduce their interest rates by transferring balances. Like other loans, the interest rate and terms depend on your credit history. Here is a look at some facts you should know about personal loans:
- Common personal loan term: 12-60 months
- APR interest range: 6% to 36%
- Minimum loan: $1,000-$3,000, based on lender
- Maximum loan: $25,000-$100,000 based on lender
- Required credit score: Above 660, but some online lenders allow it as low as 560, but increase the interest rate as the score goes down.
- Collateral requirements: Required for secured loan; not required for unsecured loan
Learn more about personal loans
Auto loans are secured loans tied to your car. They can help you afford a vehicle, but you risk losing the car if you miss payments. This type of loan may be offered by a bank, credit union, online lender or by the car dealership but you should understand that while loans from the dealership may be more convenient, they often carry higher interest rates and ultimately cost more.
- Common loan term: 12-84 months
- APR interest range: 1.04%-13.97%
- Required credit score: 780 or above to get the very best interest rate; 600 or higher for average rate; under 600 usually gets double-digit interest rate
Learn more about auto loans
Student loans are offered to college students and their families to help cover the cost of higher education. Interest rates were reduced to 0% when the COVID-19 pandemic hit and remain there until at least Aug. 31, 2022. There are two types of student loans: federal student loans and private student loans. Federally funded loans are better, as they typically come with lower interest rates and more borrower-friendly repayment terms. Only the federal loans qualify for the 0% interest rate through Aug. 31, 2022.
- Common loan terms: 10 years to 25 years
- APR interest range for federal loans during COVID-19 crisis: 0%
- APR interest range on undergraduate federal loans when COVID-19 rules are removed: 3.73% for undergraduate loans; 5.28% on graduate loans; and 6.28% on PLUS loans. All those numbers could increase as the Federal Reserve increases borrowing rates in 2022.
- APR interest range for private loans: 2.99%-12.99%. Those numbers also are expected to rise in 2022.
- Loan forgiveness: Possible with federal loans; not available for private loans.
Learn more about student loans
Mortgages are loans distributed by banks, credit unions and online lenders to allow consumers to buy a home. A mortgage is tied to your home, meaning you risk foreclosure if you fall behind on monthly payments. Mortgages have among the lowest interest rates of all loans because they are considered secured loans.
Though variable rate loans occasionally are offered, most home buyers prefer fixed-rate mortgages, which were at all-time lows at the end of 2021, but are creeping back up as the Federal Reserve increases borrowing costs.
- Common loan terms: 15 and 30 years
- APR interest range: As low as 5.33 % and high as 6.4%
- Credit score requirements: The higher your credit score, the lower the interest rate you pay. Generally, lenders like a minimum score of 660 or better, but you can qualify for an FHA loan with a score of just 500.
- Possible lenders: Every national bank (Chase, Bank of America, Wells Fargo, etc.) and community bank offers mortgage loans. Local and national credit unions are good sources and online lenders such as SoFi, Rocket Mortgage and better.com would be worth investigating.
Learn more about mortgages
Home Equity Loans
If you have equity in your home – the house is worth more than you owe on it – you can borrow against that equity to help pay for big projects. Home equity loans are good for renovating the house, consolidating credit card debt, major medical bills, paying off student loans and many other worthwhile projects.
Home equity loans and home equity lines of credit (HELOCs) use the borrower’s home as collateral, so interest rates are considerably lower than what you pay on credit cards. The major difference between home equity and HELOCs is that a home equity loan is a lump-sum payout; has a fixed interest rate and regular monthly payments are expected. A HELOC is a line of credit for 15-30 years. It has variable rates and offers a flexible payment schedule.
- Common loan terms: 5-10 years for home equity loans; 15-30 years for HELOCs
- APR interest range: 3.29%-11.99%
- Credit score requirements: 660
- Collateral requirements: the home serves as the collateral
Learn more about home equity loans and home equity lines of credit
Balloon Mortgage Loans
A balloon mortgage loan is one in which the borrower has very low, or no monthly payments for a short-time period, but then is required to pay off the balance in a lump sum. This is an extremely high-risk loan. It could be structured so that the borrower pays no interest or makes no payments for a short time period, but at the end of that time period, must make a “balloon payment” that covers the accumulated amount of principal and interest. The only reason to consider this would be if you intend to own a home for a very short time period and expect to sell it quickly, or you hope to refinance the loan before the balloon period expires.
Learn more about balloon loans
Loans for Veterans (VA Loans)
The Department of Veterans Affairs (VA) has lending programs available to veterans and their families. With this loan, the money comes from a bank, not the VA. The VA guarantees the loan and effectively acts as a co-signer, helping you earn higher loan amounts with lower interest rates.
Learn more about VA loans
Small Business Loans
Small business loans are granted to aspiring entrepreneurs to help them start or expand a business. The best source of small business loans is the U.S. Small Business Administration, which offers a variety of options depending on each business’s needs.
Learn more about small business loans
Because interest rates go up-and-down based on borrowing costs set by the Federal Reserve, it is sometimes a good idea to refinance a variety of loans you may have.
Refinancing means taking out a new loan to pay off one or more existing loans. The new loan should have lower interest rates and probably lower monthly payments than the loans you pay off.
Some of the loans that could be refinanced include:
- Credit cards
- Student loans
- Auto loans
- Cash out refinancing
- Small business loan
When you need money immediately, especially in a crisis situation, borrowing from a non-traditional lender might be the only way to solve the problem.
It is costly and not advisable, but there are some situations that demand immediate action, and you would hard pressed to get one from a bank, credit union or online lender.
Here are some of the places you could find immediate help.
A cash advance is a short-term loan against your credit card. Instead of using the credit card to make a purchase or pay for a service, you bring it to a bank or ATM and receive cash to be used for whatever purpose you need. Cash advances also are available by writing a check to payday lenders.
Learn more about cash advances
Payday loans are short-term, high-interest loans designed to bridge the gap from one paycheck to the next. These loans are used predominantly by repeat borrowers living paycheck to paycheck. The repayment period – and 399% APR interest that goes with them – makes consumers ripe for loan scams. The government strongly discourages consumers from taking out payday loans because of excessive costs and interest rates.
Learn more about payday loans
Pawn Shop Loans
This is a high-interest loan similar to secured loans, but with far more risk. The borrower offers some sort of property (jewelry, coin collection, electronics, etc.) as collateral for a loan. The pawn shop owner provides the loan and sets the terms for repayment. If the borrower repays the loan on time, the property is returned. If the loan is not repaid on time, the pawn shop owner can sell the item to recover the unpaid amount.
Learn more about pawn shop loans
Borrowing from Retirement & Life Insurance
Those with retirement funds or life insurance plans may be eligible to borrow from their accounts. This option has the benefit that you are borrowing from yourself, making repayment much easier and less stressful. However, in some cases, failing to repay such a loan can result in severe tax consequences.
Learn more about retirement accounts
Borrowing from Friends and Family
Borrowing money from friends and relatives is an informal type of personal loan. It can result is considerably less interest and administrative fees for the borrower, but it isn’t always a good option. A few missed payments may strain a relationship. To protect both parties, it’s a good idea to sign a basic promissory note.
Learn more about borrowing from friends and family
What Type of Loan Should I Choose?
Whenever you decide to borrow money – whether it is to pay the bills or buy a luxury item – make sure you understand the loan agreement fully. Know what type of loan you’re receiving and whether it is tied to any collateral you own.
Also, familiarize yourself with your repayment terms: what your monthly obligation will be; how long you have to repay the loan; and the consequences of missing a payment. If any part of the agreement is unclear to you, don’t hesitate to ask for clarifications or adjustments.
Finally, be sure the loan repayments fit comfortably in your budget. If you over-extend yourself, the consequences can be severe.