What to Consider Before Borrowing
The type of loan that best fits your needs will vary based on factors such as your creditworthiness and the purpose of the loan. If you want to purchase a home or car, for example, there are specific loan types designed to meet those needs. However, if you have a more general financial need, there are also several categories of personal loans that may meet your needs, from small cash advances to traditional bank loans.
Below, we detail the different types of loans available — but before choosing the type of loan you want to apply for, there are some general terms and features to keep in mind.
Lenders charge interest so they can earn money when lending; the amount you pay back to the lender will be the amount you borrowed, plus interest. Interest will accrue throughout the life of the loan, and your rate will usually depend on your qualifications as a borrower. Lenders often charge higher interest rates for customers who have a poor credit score or negative marks on their credit history.
When borrowing money, you should always be aware of the interest you will pay before signing the loan agreement. In addition to the rate itself, keep in mind that there are two general types of interest rates: fixed and variable.
Fixed-rate loans have a set interest rate, which does not change throughout the life of the loan; you will accrue interest at the same percentage throughout your entire repayment period. This means that you will pay installments of the same amount each month until you pay the loan off.
Because they offer predictable monthly payments, fixed-rate loans are a good fit for borrowers looking for a steady repayment plan that won’t change. However, because the lender locks in your interest rate at the time you borrow, loans of this type generally have somewhat higher starting interest rates than variable-rate loans.
The interest on variable-rate loans can change at any time, which means that your loan payments may be higher in some months than they are in others. A loan that starts with low interest may reach a much higher interest rate by the time you reach the end of your payment period.
Loans with variable rates are best for borrowers seeking loans with shorter repayment terms; quickly paying off the loan will allow less opportunity for the interest to increase. You should consider the total amount you will pay in interest — not just the introductory interest rate — when choosing between a fixed- or variable-rate loan. You can estimate the lifetime loan interest by checking the variable loan’s maximum interest limit.
Loan vs. Line of Credit
Loans and lines of credit both allow you to borrow money to pay for purchases that you may not be able to pay for out of pocket. The difference is that a loan is for a single, predetermined amount while a line of credit is a revolving account. With a line of credit, after you borrow money and then repay it, you can borrow money again.
For example, a mortgage is a loan; you receive a lump sum, purchase a house, and repay the loan. A home equity line of credit (HELOC) on a home you already own is an open-ended form of credit, which you can borrow from more than once.
Both loans and lines of credit typically have a set maximum amount that you can spend. However, a loan will begin accruing interest immediately, while a line of credit will only accrue interest on your outstanding balance for a pay period; if you don’t use your full line of credit, you may pay less in interest.
General Drawbacks of Borrowing
While taking out a loan can allow you to cover emergency financial needs or make large purchases, there are potential drawbacks to borrowing that you should be aware of any time you consider a loan. Keep the following in mind when applying for loans of any type:
- Default is always a possibility. Unpredictable circumstances such as job loss or medical emergencies can impact your ability to repay a loan. Check the lender’s late payment, missed payment, and debt collection policies before borrowing funds.
- Some lenders have early repayment penalties. Lenders can charge fees for paying off your loan early; such fees are usually known as prepayment penalties. Quickly repaying your debts is good for you, but bad for the lender, as it earns less interest. Prepayment penalties are particularly common for mortgages but can also occur with other loan types as an incentive for paying off the loan on schedule. Some lenders allow negotiation of these fees.
- Your total cost will be greater than the loan amount. If you are seeking a small loan, consider whether you might be able to save up for your financial need or purpose rather than borrowing money. If you’re purchasing something you can save the money to buy outright within a few months, you will pay less by avoiding interest and fees.
- Not all lenders are trustworthy. It is best to carefully vet every lender at which you consider applying. While there are many legitimate lenders for all of the loan types discussed below, there are also scams and predatory loan companies, which often target customers who do not qualify for traditional loans.
Personal Loan Types
Unsecured Personal Loans
Unsecured personal loans do not require you to put up collateral to receive the loan. They may have fixed or variable interest rates, and loan amounts vary widely based on the lender and your qualifications. You can get an unsecured personal loan from a bank, credit union, online lender, or peer-to-peer private lender.
Benefits and Features
One of the significant benefits of an unsecured loan is that you do not need any collateral to get one. If you don’t own a car or home, or don’t want to put those things up for collateral, an unsecured loan may be a good option for you. Also, unsecured loans do not require you to use the funds for a particular purpose; you can use them for most financial needs. Not all unsecured loans offer fixed interest rates, but if you can secure one, you won’t have to worry about your payment amount changing each month or increasing over time.
Lenders of unsecured loans will consider your credit profile, income level, and debt-to-income ratio. Since there is no collateral for the loan, the lender needs to be sure that you can repay the loan. Interest rates and fees may also be higher for unsecured loans, depending on the lender. If you have a poor credit history or existing debts, a secured personal loan may be a better option for you.
Additionally, because there is no collateral, if you fail to make payments on the loan, the lender may send your account to collections or take you to court and try to garnish your wages for repayment.
Secured Personal Loans
Secured personal loans require you to put up collateral, so if you fail to repay the loan, the lender can claim your property to make up its losses. Some common types of secured personal loans include:
- Pawn loans: A pawn shop will loan you money for an item you own that has value. If you do not repay the loan within the terms set by the pawn shop, it can sell your item to recoup the loan amount.
- Title loans: You will temporarily surrender your vehicle title to the lender as collateral. If you do not repay the loan, the lender will take possession of your vehicle, and you will lose ownership.
- Certificate of deposit loans: You put up a certificate of deposit (CD) as collateral, and if you do not repay the loan, the bank can take the money in your CD.
Loans for specific purposes, which we detail below, are often secured loans as well. Mortgages and vehicle loans, for example, are both secured; if you default on these loan types, the lender can foreclose on your house or repossess your vehicle.
Benefits and Features
Using collateral as backing for the loan minimizes the lender’s risk and, as a result, secured loans often have less strict qualifications than unsecured loans. This can be a benefit if you have a poor credit score or negative marks on your credit history.
Depending on the value of your property, you may qualify for a larger secured loan than you would qualify for if applying for unsecured loans. Secured loans also tend to have lower interest rates.
When you accept a secured loan, understand that you are putting the property you use as collateral at risk. Ask yourself whether your financial need in taking the loan is worth the risk of potentially losing that property. No one agrees to a secured loan intending to lose their collateral, but due to unpredictable circumstances, you should be aware of that possibility.
Additionally, compared to unsecured loans, secured loans typically have fewer repayment term options; you’ll usually have less time to pay back the loan than you would with an unsecured loan.
Payday loans are short-term, high-interest loans that you must repay when you receive your next paycheck. Typical loan amounts range from around $100 to $1,000.
Benefits and Features
Payday loans, also known as payday advances or cash advances, are one of the fastest loan types for which you can be approved. They have low credit requirements, and your funds may be available immediately if you apply in person. Payday loans also have no restrictions, meaning you can use the funds for any financial need.
A considerable disadvantage of payday loans is that they are expensive. Interest rates range up to about 400% on average, and borrowers often fall into a cycle of debt. Your due date will typically be around two weeks from the date you apply for the loan, coinciding with your next paycheck; if you are unable to repay the loan at that time, the lender may roll it over. This extends the due date of the loan but also increases the fees you owe, which can make it harder to repay the loan during your next pay period.
You also take a risk by providing payday lenders access to your bank account. You usually must write a postdated check to get a payday loan; the lender can cash that check if you do not repay your loan and cannot roll it over. If you don’t have the funds in your account to cover that check, you can face overdraft fees and having a bounced check on your record.
Because of their risks and lending practices, payday loans are often considered a form of predatory lending. In most cases, you should only use a payday loan if you have an emergency financial need, which you cannot fund any other way.
If you do not qualify for a personal loan on your own, you might consider using a cosigner. A cosigner is a trusted friend or family member who will sign the loan with you, effectively agreeing to pay your debt if you do not make payments on the loan. The cosigner should have a stronger credit profile than you do in order to improve your approval odds for the loan.
Benefits and Features
Cosigned loans are a good fit for a borrower who has made financial mistakes in the past or has a minimal credit history — preventing singular loan approval — but is capable of and prepared to repay a loan now.
Cosigned loans are primarily a risk for the cosigner. That person is equally responsible for repaying the loan, and any late payments, missed payments, or defaults will also appear on their credit report. Both parties involved in a cosigned loan should understand their rights and responsibilities with regard to the loan and should have a plan in place to deal with any payment issues that might pop up over the lifetime of the loan.
Loans for Specific Needs
Auto loans allow you to begin driving a new vehicle immediately once you receive approval, paying off the purchase price over time rather than saving up for several months or years to buy a car outright.
Benefits and Features
Vehicles can be an expensive investment. Whether you are purchasing a new or used car, you may not be able to pay the entire purchase price at one time. An auto loan can also help you build credit, and might be preferable to leasing if your goal is to own the vehicle rather than use it temporarily.
While an auto loan can help you build credit, vehicles are quick to depreciate, meaning they lose value as assets over time. By the time you pay off your auto loan, the car will likely be worth less than you paid for it.
See our article explaining the credit tiers for auto loans.
Home loans allow you to purchase a house and move in after closing, paying for the house over a period of years rather than buying it with cash. There are several different types of home loan, including:
- Conventional loan: Bank-backed, traditional mortgages which usually require a down payment around 20%
- Jumbo mortgage: Loans for homes in high-cost areas with prices greater than federal loan limits
- Bridge loan: Designed for homebuyers who are purchasing a new home before selling their current home; combines your current and new mortgage payments into one payment until you sell your home
- FHA loan: Fixed-rate loan backed by the Federal Housing Administration (FHA); requires a lower down payment than a conventional loan
- USDA loan: Government-backed loan for families in rural areas
- VA loan: Backed by the U.S. Veterans Affairs Department (VA); allows military members to purchase a home with no minimum down payment
Terms also vary by loan. You can choose a 15-year or 30-year mortgage, for example, and like other loan types, you can select either a fixed-rate mortgage or a variable-rate mortgage.
Benefits and Features
For many people, purchasing a house in cash is not a feasible option; mortgages provide borrowers a path to homeownership. Your mortgage will help you build equity and, if you keep up with your payments, will also help improve your credit profile. In some cases, your monthly payment toward a mortgage will also be less than you would pay to rent a home or apartment in the same area.
Mortgages are typically large loans with long repayment terms. When you take out a mortgage, you’re committing to pay back a large amount of money, and to pay monthly installments on that amount over many years — sometimes several decades. The longer your repayment period is, the higher your total cost will be since your loan will accrue interest.
Mortgages are also secured loans, meaning that the lender can take possession of the home and force you to move if you fail to repay the loan. It is best to avoid overborrowing; you should choose a home which will have manageable loan payments, and have a savings cushion to cover your mortgage for several months in an emergency.
See our related article for information on mortgage lenders and banks that offer manual underwriting.
Federal and private loans are available to help students pay for the cost of college or university tuition and supplies if they cannot do so through other avenues like scholarships, grants, savings, or family assistance.
Benefits and Features
Many career fields require college degrees, and if you don’t have the funds to otherwise pay for college, student loans can make education attainable to you. If you avoid late or missed payments, student loans can also offer an opportunity to establish and build your credit history.
Federal student loans have several additional features to consider:
- You generally do not need to begin repaying your loans until six months after you graduate, though you can make early interest payments.
- There are deferment options available for periods of unemployment.
- There are flexible monthly repayment options, including income-based payments.
If you choose to take out student loans, you should take the responsibility of repaying them seriously; if you know the career you are interested in is in a lower-paying field, for example, you may want to borrow only the amount you need to cover your tuition rather than the maximum amount your lender allows each semester. Consider the total cost of your student loans, and estimate how much your monthly payments might be by the time you reach the end of your college program.
Note, as well, that private student loans have fewer repayment options than federal student loans. Federal student loans offer options like income-driven repayment, which can make loan repayment more affordable as you establish your career; private loans do not include these options.
Debt Consolidation Loans
A debt consolidation loan, also known as a debt settlement loan, allows you to take out one larger loan to pay off your existing debts. When you receive the new loan, you will use it to pay off your current debts, and then will only owe money on the debt consolidation loan. Debt consolidation loans may be secured or unsecured.
Benefits and Features
Debt consolidation loans allow you to make one monthly payment rather than several. They also provide a set schedule and plan for repayment of your debt — you’ll be able to track how many payments you have left and watch your amount owed decrease. This makes it easier to manage your finances.
Your new loan may also have a lower interest rate compared to your current accounts, depending on its terms, which can help you save money on the total cost of the loan.
There is an additional benefit if you consolidate credit card debt: by paying off your credit card balances, your credit utilization will decrease, which can help your credit score improve. Note that you may not see a positive impact if you pay off and then cancel all of your credit cards since accounts that you close will no longer count toward your utilization calculation. Additionally, you will not see a benefit if you pay off but then continue to overuse your credit cards, creating new debt.
Depending on the loan you choose or qualify for, you may pay a higher interest rate or pay more interest by the time you pay off the loan, compared to paying off your debts separately.
Additionally, there are a few types of fees to keep in mind when choosing a loan for debt consolidation: application fees, origination fees, and prepayment penalties. Along with the interest rate, consider how much these fees will increase the total repayment cost of your debt.
If you are looking to buy a car, buy a house, pay for your education, or consolidate your debt, there are loans specifically designed for those purposes that may be a good fit for you. Personal loans offer secured (collateral) and unsecured options for general financial needs; payday loans can cover short-term or emergency financial needs; and cosigned loans are available for those who do not qualify for traditional loans on their own.
Before borrowing any loan, you should consider the interest rate and whether it is fixed or will change throughout the life of the loan. You should also be careful which lender you choose to avoid scams and be aware of what you will pay for the total cost of the loan, including fees like prepayment penalties or loan origination fees. The type of loan that is best for you will depend on how much you need to borrow, what you are borrowing for, and your creditworthiness; regardless of the type, it is best to consider several lenders before signing a loan agreement.