It's always ideal to save money ahead of time in anticipation of making any large purchase. However, that isn’t always possible, especially for expenses such as a home, car, or school. Loans can help you manage these unexpected or large purchases.

Before you apply for a loan, you’ll need to know your options and have a plan for repaying your debt. This guide will provide you with all the information you need about the different types of loans available, how they work, and how you can apply for one.

What Are Loans?

A loan is any amount of money that is lent to a borrower in exchange for repayment of the original principal amount in a lump sum or over a series of periodic payments (usually monthly). In most cases, the lender will add finance charges and interest to the principal amount that must be repaid.

Loans can be made as a one-time up-front amount, or they can be available on a periodic “as needed” basis as an open-ended line of credit. They come in different forms, such as secured loans, unsecured loans, personal loans, business loans, and more.

6 Types of Loans You Should Know About

Here are some of the most common loan options available, along with their key features:

1. Personal Loans

Personal loans can be used for any purpose the borrower chooses (hence, the term “personal”). These loans are usually unsecured, so you don’t need to provide collateral. Instead, these loans are made, based on the borrower’s ability to repay using his/her income and other financial resources, as well as his/her recent loan history (if any).  

Personal loans may have variable or fixed interest rates and repayment terms of six months to a few (5-7) years. The funds can be used for things like home improvement, weddings, or emergency expenses.

2. Auto Loans  

If you are planning to purchase a car, an auto loan will allow you to borrow the price of the vehicle after deducting the down payment, which is an equity contribution of your own money out of pocket, toward the purchase of the vehicle. Auto loans are available from 36 months to much longer, depending on the price and age of the vehicle.

A car loan is secured, so your vehicle will be used as collateral that can be sold in case the borrower does not make the scheduled payments. This means that if you fail to make payments, your car can be repossessed, and you will not be able to recover your down payment. 

3. Student Loans

Student loans are offered by private lenders and the federal government to cover the significant costs of undergraduate and graduate education. When you accumulate federal student loan debt from the U.S. Department of Education, they will offer various repayment terms that many borrowers find as attractive alternatives to the standard repayment plan, including income-based repayment options, forbearance, deferment, and other features.

Federal student loans are offered through schools as financial aid. The loan terms, interest rates, and repayment periods are the same for all students. 

With a private loan, the terms, fees, and interest rates will vary. If you don’t qualify for federal student loans or if you want to attend a non-traditional school, a private lender loan may be your next best option.

4. Mortgage Loans

Mortgage loans provide funds to cover the purchase price of a home minus the down payment you will provide as an equity contribution to the home’s purchase out of your own pocket. Your house will act as collateral, and if you fail to make mortgage payments, it can be foreclosed on and sold by your lender to recover the money that is currently due on the loan. When this happens, the same as when your car is repossessed, you will lose any down payment you made when you bought your home.

Mortgages usually carry a term of 10 to 30 years. Some borrowers may qualify for mortgage loans backed by agencies like the Veterans Administration (VA) or the Federal Housing Administration (FHA) which offer assistance in setting up an affordable down payment and loan repayment structure.

Conventional mortgages are loans that are not insured by government agencies. Mortgages may carry a fixed interest rate that remains the same throughout the term or an adjustable interest rate that changes annually, based on some sort of interest rate index that changes according to prevailing conditions in the economy and/or actions taken by the Federal Reserve in terms of setting interest rates.

5. Debt Consolidation Loans

Debt consolidation loans are a type of personal loan that can be used to pay off your high-interest debt. These loans are usually available at a lower (often fixed) interest rate when compared to credit cards.

They can help you save money and simplify repayment because they allow you to consolidate multiple debts into a single loan. Paying off your high-interest credit card debt with a debt consolidation loan can also improve your credit utilization ratio and your credit scores with all three credit reporting bureaus.  

6. Business Loans

There are several different types of business loans available such as equipment loans, term loans, working capital loans, and Small Business Administration (SBA) loans. These loans are designed to fund the short and long-term operations of small businesses.

When compared to personal loans, the qualifying criteria for business loans can be more stringent, especially when you apply for an SBA loan. However, compared to other financial options, such as cash advances or the owner taking out personal loans individually, business loans are more affordable. They can also provide you with the financing you need to grow your business.

It’s also important to note that when applying for a business loan, it doesn't necessarily mean it's only tied to the business EIN. Typically, most lenders will ask for a personal guarantee in order to get a business loan. This means if you default on the business loan, the lender can come after you personally. Ensure you fully understand the terms of a business loan before committing to one.

How Do Loans Work?

Knowing how loans work will allow you to understand what to expect when you apply for one. While each type of loan is different, here’s how they usually work: 

  • You can apply for a loan at a financial institution, bank, or credit union. The application process is usually very straightforward.
  • Depending on the type of loan you’re applying for, you’ll have to provide specific information such as your personal and/or business income details, Social Security Number, and financial history with your loan application.
  • The lender will then review the information you provided to determine your debt-to-income ratio. This allows them to decide if you’ll reasonably be able to repay the loan based on your obligations to service your other existing debts. Lenders will also make a credit inquiry on one or more of your credit reports before making a decision on the application.
  • If your loan is approved, you’ll need to sign a contract that provides the details of the loan, such as the loan term, annual percentage rate (APR), origination fees, prepayment penalties, the payment you are to make each month on the payment due date, and the loan’s term (which indicates how long you have to repay the loan).
  • Once the contract is signed, the lender will disburse the loan amount to your bank account. 
  • You’ll then have to repay the amount along with the interest and any additional charges, typically through a monthly payment.

Most Important Loan Terms To Know

When applying for a loan, you’ll come across some of the terms we’ve listed below. Here’s what they mean.

Loan Principal

The principal is the amount of money you initially borrow. It is also used to describe the amount of the original loaned funds that you still need to repay once you start making payments. Usually, the principal is equal to the initial loan funds that you received. As you continue to make payments, your loan’s principal will reduce.

Loan Term

This is the amount of time over which you need to repay the loan. The length of your loan will depend on the repayment terms set forth by the lender and the type of loan you are taking out (secured vs unsecured or auto loan vs mortgage loan, etc). 

For some loans, such as automobiles, you have more flexibility to determine the number of months you can take to repay the debt. On the other hand, if you're pursuing a personal loan or payday loan, you'll likely be working with short-term loan companies that limit the length of your loan to less than 6-12 months. 

Repayment

Loan repayment is the process of paying back the funds you borrowed, along with any interest or other charges that may be due. Typically, repayment involves fixed amounts paid on a monthly or quarterly basis. A part of each payment goes to the interest, and the rest will go toward the principal.

Secured Loan

A secured loan involves using an asset as collateral. If you don’t repay your loan in full, the asset can be taken and sold by the lender to recover the money that was lent to you. Collateral can be your home in the case of a mortgage or your car in the case of an auto loan.

Unsecured Loan

Unsecured loans don’t require any collateral. However, they typically come with a higher interest rate because the risk for the lender is higher. Examples of unsecured loans include personal loans, student loans, and payday loans.

Revolving Credit

This type of loan allows you to borrow up to a set credit limit, for example, on credit cards. At the end of the billing cycle, you can repay the entire amount you borrowed or make a payment that is less than the full balance and carry over the remaining balance to the next billing cycle. At this point, your carried balance will start to accrue monthly interest charges that you must pay until you pay off the entire balance in full.

Installment Loan

This is also known as a term loan. This involves making fixed loan payments over a set period of time, typically with a fixed interest rate Once you pay all your installments, you will no longer owe any debt to your lender. You will also receive full ownership of the home or automobile that was used to secure the loan, if any.

Fixed Interest Rate

The interest rate remains the same and does not change, during a set period for debts such as a mortgage or a personal loan. The interest rate may remain fixed during the entire loan term or for a part of the term.  

Variable Interest Rate

The interest rate can change based on the prime rate or some other predetermined interest rate index. When the prime rate increases, the interest rate for your loan can also increase. Variable interest rates can be found in revolving-debt personal loans, credit cards, and mortgages.

How To Be Eligible for a Loan

You’ll need to demonstrate your creditworthiness to qualify for a loan and get competitive rates. To be eligible for a loan, you’ll have to show lenders that you can use credit responsibly and that you have both the willingness and the ability to repay the loan–including the interest charged–in a timely fashion. 

Avoid taking out unnecessary loans and pay off your credit cards and loans regularly. Good credit will also allow you to get lower interest rates. There are many factors that lenders consider when determining the risk involved with extending credit to any one particular borrower.

Credit History

Your credit history and FICO scores with the three major credit reporting firms (Experian, TransUnion, and Equifax) are based on your history of repayment on all of your debts for the last several years (typically for the last 7-8 years). Missed payments, bankruptcy, and late fees can lower your FICO scores significantly and make it much more difficult to qualify for a loan. Those with excellent credit usually qualify for a lower rate.

Loans for bad credit are available if you have poor credit and/or a lot of debt. These loans usually come with a very high interest rate (28% or higher) and can be more expensive for you in the long run.

Income

For certain loans, especially for larger amounts, lenders may have an income threshold. You will need to have several years of employment to qualify for mortgages to ensure that you won’t have trouble repaying. You can also use a cosigner or a larger down payment to qualify for mortgage loans if needed.

Debt-To-Income Ratio

Loan providers also look at your debt-to-income ratio (DTI) to determine how much you earn and how much debt you currently have. A high DTI ratio indicates that you may have difficulty repaying your debts, especially if an additional loan is extended to you. Try to reduce your DTI ratio to get loan offers with the lowest rates possible.

Loans Vs. Credit Cards

Loans offer borrowers funds in a lump sum. The amount you borrow must be repaid within a determined amount of time, with payments that are typically fixed.

Loans are usually available at a lower interest rate when compared to credit cards, mainly because the amount of debt outstanding is always declining as the borrower makes on-time payments to the lender. As the balance declines, the financial risk to the lender decreases instead of remaining flat or even increasing.  Loans of this type can be either secured or unsecured.

Credit cards are revolving, which means that they give you access to funds up to a predetermined limit when you need them. As you pay off your balance, you can take additional advances for purchases or withdraw cash.  Credit cards are usually unsecured and carry a higher, often variable interest rate.

Loans Vs. Debt

A loan is a type of debt, but it’s an agreement between two parties where one party lends funds to another. The repayment terms, interest rate, and when the money needs to be repaid are set by the lender.

Debt can involve anything you borrow, such as money, property, or service. It can be a loan, credit card, mortgage, or line of credit.   

Have a Repayment Plan in Place Before Borrowing a Loan

Regardless of the type of loan you borrow, it’s important to have a plan to repay the loan beforehand. If you are overwhelmed with a lot of debt, debt relief is available to help you repay your outstanding balances faster.