Taking out a loan can be a stressful process. On top of the financial commitment it entails, taking out a loan can be a seriously long and complex process.
Both credit cards and 30-year fixed-rate-mortgages are loans, yet the nature of either is vastly different. Understanding the different types of loans that are available can help borrowers avoid potentially disastrous decisions.
The following list is not comprehensive. There are different types of loans that exist, from the jumbo loan to deposit swaps and various other options. The most common loans are broken into three separate categories, however: open or closed; fixed or variable rates; secured and unsecured. This guide should help a prospective buyer understand the differences between these choices.
Open Loans or Closed Loans
The single biggest difference in the common commercial lending options is the difference between open and closed loans. This distinction is sometimes referred to as revolving credit and fixed-end credit.
A credit card is a perfect example of an open or revolving credit product. A borrower has a certain amount of credit attached to their card. Money is spent from that account, but once the borrowed money is paid back, the credit is available again. As long as the balance is paid off, the credit limit is restored; hence the term ‘revolving’ credit, as the total amount of credit recycles as long as the balance is paid off. Home equity lines of credit (HELOC) and various lines of credit fall into this category.
The opposite of an open loan is, predictably, a closed loan. The closed loan is operated on an installment repayment system. A car-loan is a good example of this sort of loan. Once the lender dispenses the funds, the borrower must repay the loan in installments. As the borrower repays the balance of the loan, more credit does not become available. With a car loan, the loan was to purchase the car. As car payments are made, more credit does not become available.
Fixed Rate Loans or Variable Rate Loans
The next major distinction involves interest rates. The interest rate is the interest charged on the money that was lent to the borrower. An interest rate of 1.9% is the principle (the amount borrowed) with interest of 1.9% added to the principle daily, monthly, weekly, etc.
Fixed rate loans are exactly as advertised. The lender and borrower agree to terms at the start of the loan with an agreed upon fixed interest rate. Whatever the rate is when the loan is agreed upon will be the interest rate for the duration of the loan. A fixed-rate of 4.99% will remain at 4.99% for however long the loan is open.
Variable rate loans are different. Variable rates have fluctuating interest based on lending conditions. A variable rate loan might start at 5.99%, for example, but if the overnight rate is cut by the Fed, the loan rate might drop to 5.49%, or even lower. Similarly, if interest rates rise over the duration of the loan, the borrowers interest rates might rise accordingly. In periods of low interest rates, financial institutions probably prefer variable rates in hopes of getting higher returns as conditions turn favorable; in periods of high interest rates, borrowers prefer variable rates in hopes of getting lower payments as conditions turn favorable.
Secured Loans or Unsecured Loans
The final major distinction is between secured or unsecured loans. This simple difference is explained with the word ‘collateral.’ This does not include a down-payment against the loan principle, which does not establish a loan as ‘secured loan.’
With a secured loan, the borrower must offer some sort of assurance to the lender. This could include anything of financial value, such as a car, a boat, a stamp collection, etc. Secured loans are usually reserved for people with unestablished or poor credit, and typically comes in the form of a down-payment before a loan is granted.
In an unsecured loan, the lender and borrower come to terms without any collateral being offered by the borrower. While a secured credit card requires a borrower to give the credit company a small amount of money up front, an unsecured credit card means the borrower is given a card and a line of credit without needing to hold any money with the lending institution.
Current receivership laws make it unnecessary for banks to seek collateral in most cases, since any sort of delinquency agreement would require the borrower to repay the bank in one form or another.
While this is a somewhat simplistic overview of various types of loan differences, this should help to clear up some of the differences that exist across loan offerings. Anyone who is new to the commercial credit arena may find themselves overwhelmed by all of the various options they have before them, so defining those options in easy to understand terms can be greatly helpful.