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Understanding Different Loan Types

Choose the one which best fits your financial situation

By Glenn Curtis

Updated June 19 2021

Reviewed by Thomas Brock

Borrowed money can be used for many motives, from financing an entrepreneur’s new venture to buying your fiancee an engagement ring. With all the different types of loans available what is the best one, and for what purpose? Here are the most popular types of loans and the way they function.

The most important takeaways

Personal loans and credit cards are characterized by the highest interest rates, however they don’t require collateral.

Home equity loans are low-interest, but the borrower’s home is used as collateral.

Cash advances typically come with high rates of interest and transaction fees.

Personal Credit

Most banks, online or located on Main Street, offer personal loans, and the proceeds may be used for virtually everything from buying a brand-new 3D 4K smart TV to paying bills. This is a costly way to borrow money, as the loan is unsecured, which means the borrower does not put up collateral that can be seized in case of default, like a car loan or home mortgage. In general, a personal loan is available from a few hundred dollars to several thousand dollars with repayment periods of two up to 5 years.

Borrowers need some form of income verification as well as proof of assets that are at least as large as the amount being borrowed. The application usually only a few pages in length, and the approval or denial are usually granted within a few days.

The Best and Worst Rates

The median interest rate for a commercial bank’s 24-month loan was 10.21% in the fourth quarter of 2019, as per the Federal Reserve.1 But , the rates can be higher than three times that amount: Avant’s APRs range between 9.95 percent to 35.99%.2 The best rates can only be obtained by those who have outstanding credit scores and large assets. The worst rates must be endured by those who have no other choice.

Personal loan is probably the best way to go for those who need to take out a small amount of money and know that they will repay the loan within some years. The personal loan calculator can be an effective tool to determine the interest rate that is within your reach.

Bank Loan vs. Bank Guarantee

The term “bank” refers to a loan cannot be the same as a bank guarantee. A bank may provide a guarantee as a security to a third party for one of their customers. If the customer fails to meet the contract with that third party that third party may demand repayment from the institution.

The guarantee is usually an arrangement that banks make for their small-business clients. A company may agree to a contractor’s bid for instance, under the requirement that the contractor’s bank offers a payment guarantee in the case of default in the terms of their contract.

A personal loan is a good option for someone who needs to borrow a relatively small amount of money , and is sure of their ability to pay back the loan in a few years.

Credit Cards

When a person uses a credit card to pay it’s essentially similar to getting a small personal loan. If the balance is paid in full within a few hours there is no interest due. If a portion of the debt is still unpaid, interest is charged every month until it is paid off.

The typical credit card interest rate was 16.88 percent APR at the end of the fourth quarter of the year according to Federal Reserve. This was a slight decrease from the second quarter of 2019 rate of 17.14%, but nearly exactly the same as it was (16.86%) at the close in the 4th quarter 2018.3 Penalty rates for those who fail to make one payment, could be raised even more–for instance up to 31.49 percent on at least two of HSBC’s Mastercards.4

Revolving Debt

The major difference between a creditcard and a personal loan can be seen in the fact that the credit card represents revolving debt. The card has a set credit limit and the owner can borrow it repeatedly up to that limit, and pay it back over the course of time.

Credit cards are extremely useful, but they do require self-discipline to avoid overindulging. The research has proven that consumers are more willing to spend when they use money instead of plastic. A short one-page application process is a easier way to secure an amount of $5,000 or $10,000 in credit.

Home-Equity Credit

Owners of their own residences can borrow against the equity they have built up in the properties. In other words, they are able to take out loans up to the amount they actually have. If the mortgage has been paid in half is completed, they are able to borrow half of the value of the house or, if the home has appreciated to 50% or more, then they can borrow the entire amount. In short, the difference between the home’s current fair market value and the remaining amount owed on the mortgage is the amount that can be borrowed.

High Rates, Riskier, and Lower

The benefit of a home equity loan has to do with the fact that the interest rate charged is far lower than for a personal loan. Based on a survey conducted by ValuePenguin.com, the average interest rate for a 15 year fixed-rate home equity loan as of Feb. 5, 2020 was 5.82%. In light of the changes in the tax law of 2017, the Tax Cuts and Jobs Act the interest rate on home equity loan is no longer tax-deductible when the money borrowed will be utilized to “buy or construct, or significantly improve the taxpayer’s home that secures the loan” as per the IRS.5

The most significant risk is that the house is the collateral for the loan. The borrower can lose their home in the event of failure to pay the loan. The proceeds of a home equity loan can be used for any use but are usually utilized to improve or increase the size of the house.

If you are thinking about a home equity loan may be able to recall two lessons learned from the 2008-2009 financial crisis:

Home values could go down or up.

Employment is at risk in an economic downturn.

Home-Equity Lines of Credit (HELOCs)

The home-equity line of credit (HELOC) is similar to credit cards but utilizes your home to secure. A maximum amount of credit can be extended to the person who is borrowing. A HELOC can be utilized to repay, or used again until the time that it stays open, which typically between 10 and 20 years.

As with a typical home equity loan it is possible that the interest will be tax-deductible. However, unlike a traditional home equity loan however, the interest rate cannot be set at the time the loan is granted. Because the borrower is accessing the money at any point over the course of a few years The interest rate is typically variable. It could be tied to an underlying index, like the prime rate.

Good or Bad News

A variable interest rate can be either good or bad news. In times of increasing rates, the amount of interest charged on an outstanding balance will increase. Someone who takes out a loan to install a new kitchen and pays it off over a period of years such as this, could get stuck paying much more interest than anticipated due to the fact that the prime rate jumped.

Another issue could be the cost. The credit lines available can be very large and the initial rates are very appealing. It’s not difficult for customers to get in the middle of their finances.

Cash Advances with Credit Card

Credit cards generally have an option to cash advance. Effectively, anyone who has credit card benefits from an unrevolving line of cash available at any automatic ATM (ATM).

This is an extremely expensive option to take out a loan. As an example the interest rate for cash advances with Fortiva credit card is Fortiva credit card ranges from 25.74% up to 36 percent, based on the quality of your credit.6 Cash advances are also accompanied with a fee, typically equivalent to 3% to 5% of the advance amount or a minimum of $10. Even more troubling, the cash advance is added to the balance on the credit card, accruing interest from month to month until it’s cleared.

Other Sources

Cash advances are occasionally available from other sources. Notably, tax-preparation companies may offer loans against the expected Internal Revenue Service (IRS) tax refund. But, unless you’re in a urgent need, there’s no reason to give up part of your tax refund to receive the money a little faster.

Small Business Loans

Small-scale business loans are available through the majority of banks as well as through the Small Business Administration (SBA). These are generally sought by those who are setting up new companies or expanding existing ones.

The loans are granted only when the owner of the company has provided a formal business plan for review. The conditions of the loan typically contain personal guarantees, which means that the business owner’s personal assets serve as collateral in case of default on the repayment. The loans generally are extended for periods of 5 to 25 years. The interest rates can be negotiated.

The small-business loan has proved indispensable for several, if certainly not all small businesses that are just beginning to emerge. However, creating the business plan and then getting it approved can be arduous. The SBA has a wealth of resources , both online and locally to help get businesses launched.