A Guide to Loans
What Are Loans?
Loans are a tricky topic and not understanding what they are can be a huge mistake. Loans are borrowing money from a lender to make a large purchase or payment that you can’t pay for in full at that moment.
The loan has an interest rate attached to it that builds over time. Large loans, such as a home loan, will be accruing interest for during your payment period, meaning you’re paying much more than the value of your purchase.
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What's Your Credit Score?
You’re going to learn very quickly that your credit score is a very important part of determining your loan type and interest rate. However, you need to know what a credit score is. A credit score is a numerical score given to you based on your credit history, income, and amount of open credit to determine your worthiness for specific loans.
What’s a good credit score? Usually, over 700 is a good score to aim for if you plan on taking out loans for a home, car, or college. However, the closer you can get to 800, the better. An average credit score is around 650 and anything under 600 is concerning.
While it’s very important to know your credit score, you shouldn’t be checking it constantly. The more you check your credit score, the more you’re hurting it. Every time you check your credit score, it’s assumed you’re taking another loan. The more loans you take, the lower your credit score will be.
Types of Loans
As we’ve mentioned above, there are many different types of a loans available. Getting the right loans based on your credit rating, specific needs, and desired interest rate is the key to paying off the loan as quickly as possible. Below, we’ll go over every type of loan available and their pros and cons, so you can make an educated decision when picking your loan.
Fixed Rate Loans
With most loans, the interest rate varies over time. It could increase but also could decrease. However, with a fixed rate loan, your interest loan will remain the same. It’s a much safer loan knowing that your interest rate won’t change unless you refinance.
Fixed rate loans are best for long term investments such as a home or a car. This is because it’s much safer than a variable rate loan. You know exactly what you’re going to be paying. If interest rates are falling, you can always refinance and will never feel the effects of a rising interest rate.
The opposite of a fixed loan is the variable-interest loan. These are loans where the interest rate fluctuates over time which can be beneficial or detrimental. It’s a riskier loan than a fixed rate loan because of the instability.
These types of loans are better for smaller investments. You wouldn’t want to get a variable-interest loan for your 30-year mortgage or a student loan. This is because interest will fluctuate greatly over 30 years.
Secured Personal Loans
Secured loans are loans backed by some type of collateral. This could be any asset such as a home or car. The purpose of the collateral is to ensure that the loan is paid on time. If the loan isn’t paid, the lender becomes the owner of your assets. The borrow can then sell the asset in order to pay the remainder of the loan. If the sales value isn’t high enough to completely pay the loan, the borrower is still held responsible to finish the payment of the loan.
While these aren’t the safest loans, they can be used for short term investments that you know you’ll get the money for in the not-too-distant future. You need to make sure that the money you’re getting is enough to pay off the loan, so you don’t have to worry about your home or car being lost.
Unsecured Personal Loans
Unsecured loans differ from secure loans because you don’t need to offer assets as collateral. Your loan is based on your income and credit history. This is a traditional loan that most people think about when they think of “loan”.
Many times, you see unsecured loans with student loans and credit cards. These loans are 100% based on your credit history. Think of the last time you opened a credit card; they asked for your income and social security number, so they could check your credit history.
Lines of Credit
A line of credit is a type of loan that’s offered by the government, businesses, or individual banks. The borrower is given an amount of credit that they can draw from. The only time they would have to pay interest is when they draw money from the line of credit.
The purpose for this over a typical loan is because you’re approved for a set amount of money that you can draw from as you need it. You won’t get the money as a lump sum and won’t be paying interest unless you draw from it.
Common seen with student loans, a co-signed loan is when the borrower has a second person sign onto the loan to ensure they get it at a certain interest rate or can borrow enough money. What this means is that if the primary borrower can’t pay the loan for any reason, the responsibility falls on the co-signer.
The reason these loans are often seen with student loans is because most students don’t have enough established credit to receive a loan of that amount. They need someone more established to back them up, so the lender feels comfortable that they’ll be paid.
If you’re co-signing on a loan, be very careful. Only co-sign for someone you can trust to make their monthly payments and is going to completely pay off the loan on their own. As soon as they default on a payment, the loan is your responsibility – be careful!
Often seen with mortgages and other high-priced loans, conventional loans are not backed or insured by any government agency. Some federal agencies include the Federal Housing Administration or the Department of Veterans Affairs. These loans are also typically fixed loans meaning the interest rate won’t fluctuated during the life of the loan unless your refinance.
You’re probably wondering who insures or backs these loans? Conventional loans are backed by private lenders and the insurance is paid by the borrower. Being backed by a private lender versus a bank or government makes this type of loan a bit riskier.
Another loan typically used for mortgages, conforming loans are only granted for equal or less than an amount set by a federal agency. What this does is make the interest rate low if you have a great credit score. You won’t be approved for a conforming loan if you don’t have a high enough credit score.
Also, conforming loans are backed by a federal agency such as the Federal National Mortgage Associate or Federal Home Loan Mortgage Corporation. This makes these loans much safer by being backed by a stronger entity.
Non-conforming loans are mortgage loans for people with a lack of sufficient credit for the loan. That means it fails to meet the bank’s criteria for funding and the loan is often given by a hard money lender. Also, non-conforming loans typically have a high interest rates.
While this gives options for people with bad or no credit to take out a significant loan, be very careful when using non-conforming loans. Shop around and try to find the best rates so you’re able to make the monthly payments.
Open-end loans are an extremely unique style of loan. You’re pre-approved for a specific amount of money that you can borrow repeatedly up to a certain amount. These are also backed by banks or the government which makes it a safer loan. You must have a great credit score to be approved for an open-end loan.
A very common type of loan, closed-end credit must be repaid in full by the end of the term. The payment also will include whatever interest you accrue over the life of the loan. These loans are often used for home and auto loans.
Purpose of Loans
Now that you know the types of loans that are available, you need to know why you need the loan in the first place. Certain types of loans are better in certain situations. We’ll go over some of the most common uses for loans to help you determine what type of loan is best for you.
Most people have a mortgage – it’s the largest loan you’ll ever have in your lifetime. These are the loan you take out on your home. Unless you have six figures sitting in the bank, you probably won’t be paying cash for a new home.
The key to finding a great loan for your home mortgage is determining the duration of the loan you want. Many homeowners opt to do a 30-year loan because the monthly payments will be less. However, you will accrue more interest with longer loans meaning you’re paying more for your home than it’s worth.
Another option available is a 15-year loan. While the monthly payments will be much higher, you’ll pay the loan off faster and accrue less interest in that time frame. It all depends on your household income and what you’re willing to pay each month for your home.
Your credit score also plays a big role in what type of loan you can get, especially when it comes to a large loan like a mortgage. Certain loans require higher credit scores, so they might not be an option. Make sure you know your credit score before settling on the type of loan you want for your home mortgage.
Outside of a home, purchasing a car is the biggest purchase for many people. Having a large sum of money sitting in the bank to make a car purchase isn’t feasible most of the time. That’s where auto loans come in to help.
Much like home loans, you want to ensure that you know the duration of the loan you want. Longer loans accrue more interest but have smaller monthly payments. Shorter loans accrue less interest but have higher monthly payments.
That being said, there are no 30 and 15-year car loans. You’re going to be looking at 72-month, 84-month and 96-month loans.
Student loans are much different than auto and home loans. The student or parents (or both with a co-sign loan) take out money each year based on the price of the school. You won’t have to make payments until 6 months after the student finishes their final semester of school.
There are two different types of student loans that you need to be aware of: subsidized and unsubsidized loans. Subsidized loans will not accrue interest while the student is at school while unsubsidized loans will accrue interest during the student’s duration at school.
Small Business Loans
It isn’t cheap to start your own business. That’s why many aspiring business owners take out small business loans at the start of their business. This allows the entrepreneur to get started with the supplies they need or rent/purchase the space they need.
Small business loans can also be used in the acquisition of a small business or putting more money into a business that already exists. Using a loan this way allows the borrower to use the money to improve the business now and pay back a lender over time.
Loans for Veterans
Serving your country is a noble act and many members of the military come home without any money or opportunity. Several lenders offer personal loans for former and active-duty members of the military no matter their credit. While these loans tend to have high interest rates, it gives members of the military an opportunity to get back on their feet once they get home.
A retirement loan isn’t a loan you take once you retire to help you figure things out once you have a job. You’re borrowing money from yourself. You’ll take money from your retirement fund and must pay yourself back. This could be a 401k, social security or IRA.
There’s no interest associated with paying yourself back, but you’re losing money on interest that your retirement fund would otherwise be accruing over time. The more money you have in your retirement fund, the more money you’ll earn over time. You want to make sure that you put as much money into your retirement fund and remove as little as possible.
One of the smallest loans is a payday loan. Payday loans are small loans with high interest rates with the intention of paying them back quickly - as early as the next pay check. Waiting too long to pay off your payday loan can have huge ramifications. These loans are typically used for immediate, relatively low-cost purchases like a large TV or surround-sound system.
Home Equity Loans
Another unique loan is the home equity loan. The borrower uses equity in their home as collateral for a loan. This loan is heavily based on the value of your home, which is based on an appraisal. These loans are very risky because you’re putting a portion of your home as collateral for a loan.
In order to be qualified for a home equity loan, you need to have a great, even excellent, credit score. Home equity loans are also known as opening a second mortgage on your home.
There’s also the option to get a home equity line of credit. While it’s still considered opening a second mortgage on your home, these are used for more short-term loans. If you make enough money to pay off the loan quickly, consider opening a home equity line of credit.
Debt Consolidation Loans
If you have a lot of loans and you’re struggling to pay them off, you can take out a debt consolidation loan. This type of loan is used to pay off your other debt in order to condense them into one monthly payment. You’ll also be accruing less interest because you’ll only have one loan with one interest rate.
While a debt consolidation loan is a great way to lower the intensity of your debt, be careful taking out so many loans to require a debt consolidation loan. Having a lot of outstanding debt will end up hurting your credit score.
Finance Guru Will Help You Find the Perfect Loan
As you can see from above, there are many types of loans available. It could be overwhelming choosing one that’s right for your situation. Thankfully, Finance Guru is here to help you with your loan. Our comparison tool will help you compare loans and interest rates to find the best loan for your situation with the most manageable payments. Get started today!