Our Simple Guide to the Types of Loans Available
It can often seem like having an advanced degree in financial jargon is a requirement to understanding the types of loans available to you. Open-ended loans, variable-rate mortgages, unsecured debt…the list goes on and on. But what does it all mean?
If you’re feeling overwhelmed by the complicated world of loan lingo, this easy guide will help get you crystal clear on your credit options in no time.
Closed-ended loans vs. open-ended loans
A closed-ended loan is a one-time debt that you incur for a set amount which you agree to repay according to predetermined payment terms. Examples include mortgages, personal loans, and auto loans.
Here’s how it works: You borrow a fixed sum of money—say, $10,000—to buy a new car. The terms of the loan dictate that you have 36 months to repay the loan in full according to a provided payment schedule. Once you pay up, the loan is closed. If you want to buy another car on credit at a later debt, you’ll have to secure another car loan.
An open-ended loan is a revolving form of credit that allows you to borrow from a predetermined credit limit. Common examples include credit cards and home equity lines of credit (HELOCs).
Here’s how it works: Suppose your credit card offers a $5,000 credit limit. In one month, you charge $1,000, reducing your available credit to $4,000. If you pay off the balance in full, you’ll again have access to the full $5,000 limit. If you pay just the minimum owed, you’ll have less credit available to you, and you will owe interest on the outstanding balance. Your card remains open—regardless of whether you tap into the funds—so long as you or your creditor chooses to leave it as such.
Fixed-rate loans vs. variable-rate loans
A fixed-rate loan guarantees you an interest rate that is… well, fixed. In other words, it stays the same for the duration of your loan. Since your rate never varies, you know exactly how much your monthly payment will be throughout the loan term.
Here’s how it works: You’re buying a home and you choose a 30-year, fixed-rate mortgage to provide the funds you need for closing. Your lender guarantees the interest rate—say, 4.75%—for the full 30 years. As a result, you owe exactly the same amount each month to your lender (the loan repayment plus 4.75% interest) for the next three decades.
A variable-rate loan includes a changing interest rate that’s tied to the movement of interest rates in the market. When rates are dropping, you benefit from a decrease in your loan’s interest due, while an upward shift in the market can mean you wind up paying quite a bit more.
Here’s how it works: When buying your home, you decide on an adjustable-rate mortgage (ARM). The terms of your loan state you’re guaranteed a fixed rate of 4.1% for the first five years, but your APR may be adjusted once every year after that. Depending on some predetermined market index, that rate may go up or down, and the change you see is likely capped by the terms of your contract.
Secured loans vs. unsecured loans
A secured loan is a debt that’s backed by collateral you provide to your creditor. Because that collateral reduces a creditor’s risk, you’ll typically find lower interest rates attached to secured loans than unsecured loans. However, if you don’t meet your payment obligations on a secured loan, the lender is legally entitled to seize the property backing the loan and liquidate it to cover your unpaid financial obligations.
Here’s how it works: You take out a car loan and a home mortgage. You fall behind on payments, so your lender repossesses your car and forecloses on your house. They sell the property, keeping the outstanding balance to cover the debt and returning the remaining amount from the sale to you.
An unsecured loan is a debt that has no collateral backing it. Some examples are credit card debt, student loans, medical bills, and utilities owed. If you don’t repay the loan appropriately, your lender can’t legally seize your belongings. As a result, interest rates tend to be higher for unsecured debt over secured loans.
Here’s how it works: You owe on an outstanding credit card balance on an unsecured debt, but it’s been months since you’ve put anything toward paying back the account. The lender can’t take your home or other property, but your nonpayment is likely destroying your credit score. Additionally, your lender may choose to close your line of credit, send your debt to collections, or even sue you for the amount you owe. (FYI, a legal judgment against you can force you to pay or subject you to wage garnishment until the amount is repaid.)
So, what’s the best type of loan? Well, there’s no one-size-fits-all answer. But now you know how to evaluate your options and understand what each type of loan means for you and your bank account. Armed with this knowledge, you can confidently choose the best loan for your personal situation.