September 19, 2024

8 Types of Loans and How to Choose the One That Fits You

The beauty of the modern financial system is that there are so many products. But that means it’s hard to decide which is right for you.

Loans are one of the most common financial tools out there, and there are many types and rates based on the lender’s and your needs. Choosing the right one is key to having a positive experience and paying everything back on time.

Here’s a guide to various types of loans, their possible interest rates, and how they may be the right fit for you.

Understanding loans

Loans are financial products in which a lender, typically a bank or credit union, provides funds to you (the borrower) with an agreement to repay over time with interest. Usually, you apply for a loan for a specific purpose, like to buy a house or pay for college tuition.

The lender uses a few different factors to decide if it should lend to you. Your credit score, annual income, and overall debt load all contribute to the approval calculation. If accepted, the funds go directly into your bank account or to the merchant you’re buying something from, depending on the type of loan.

Here are three key elements of different kinds of loans that are helpful to understand:

Secured versus unsecured. With secured loans, you give the lender collateral, like your house or car. If you can’t pay the lender back, it takes the collateral away. Although these low-interest loans are more risky, they generally come with lower loan rates, which makes them a good option if you’re confident in your ability to repay. Unsecured loans, on the other hand, don’t involve collateral. Interest rates are higher, but there’s significantly less risk.
Loan duration. Loans take years to repay, so make sure you're comfortable carrying the long-term commitment. In general, the more you borrow, the longer the repayment period. For example, a mortgage on a house sees repayment over 25–30 years, while an auto loan might only be five years.
Loan cost. Loans aren’t free money. The costs vary depending on your credit score and history, but you have to pay interest and some fees — which lenders represent through the annual percentage rate (APR). The APR is the industry-standard way to communicate the total cost of borrowing. The lower the APR, the less you pay over time. Shopping around various providers can help you get the best deal.

8 different types of loans to know

Let's review eight loan options and when to use each one:

1. Personal loans

Personal loans are unsecured loans that you can apply to almost anything. Some of the most popular uses are home improvements, medical expenses, and emergencies. Their versatility is definitely appealing, but that means it’s easy to take on a loan you don’t necessarily need. If you do need a personal loan, aim for the lowest amount possible to cover your needs, and do research to find the best rates for you.

2. Mortgage loans

Most people don’t have hundreds of thousands of dollars on hand to buy homes, which puts mortgages among the most popular loan types in the world. The cost of borrowing is often lower, but that’s because the home is collateral. If you fail to repay the mortgage, the lender could repossess your house, and that’s a risk that may not be worth taking.

While mortgages take decades to pay off, you aren’t stuck with the same APR forever. You can refinance, which means changing your interest rate, payment duration, or even your lender entirely. This could help you hit a number of goals, like paying less over time or taking out money from the mortgage to pay a debt, but you might also encounter more costs than just the mortgage. High origination fees and even more interest over time are possibilities.

3. Auto loans

Car loans are another loan type for a specific use — buying a car. You can purchase new and used cars through financing rather than buying one outright in cash, making ownership much more accessible. Some dealerships even offer these loans themselves.

4. Student loans

It’s difficult to pay for college or university when you don’t have an income yet. That’s what student loans are for. As the name suggests, they help people study at post-secondary institutions and enhance their skill sets. They’re typically government-backed, but banks can also privately provide them.

Student loans are unsecured and can cover the cost of books, tuition, and living expenses — whatever the student needs. The downside is that they notoriously take a long time to repay. On average, people pay back their loans in 20 years.

5. Home equity loans

Over time, homeowners pay their mortgage while the home increases in value. The difference between what they owe on the mortgage and what the house is worth is equity.

When homeowners want to do renovations like roof repairs and kitchen upgrades, home equity loans provide a way to borrow money at a low cost. These loans operate like mortgages, where the homeowner offers the house as collateral if they fail to repay. In exchange, the loan issuer provides a low interest rate.

6. Debt consolidation loans

It’s normal to have multiple types of debt, but having different loans to pay back at once gets stressful (and expensive). With debt consolidation loans, you can put all of those debts into one payment with a lower interest rate. These are most helpful for people looking to optimize their debt structure and get better loan terms. The downside is that it could take longer to pay off the new loan.

7. Business loans

Entrepreneurs looking to start their own companies may be eligible to apply for business loans. These help start, run, or expand businesses by covering startup costs and equipment purchases and providing working capital. The key difference between these loans and others is that the lender looks at the business’s credit score — not the person’s. Some business loans also have lower interest rates.

8. Credit-builder loan

Credit-builder loans are special financial products for people looking to improve their credit scores. The issuer approves you for a small amount, often a few hundred dollars, and puts those funds into a savings account or certificate of deposit (CD) they control instead of giving you the money. You pay the loan in regular installments, and when the term is over, you get the cash you paid for.

Credit-builder loans are a low-risk way to improve your credit score. Because if you can’t use the money, you can’t lose it. It’s also a great option for people who don’t have any credit history yet.

How to choose the best loan

Here are some questions to consider to help you identify which loan type is suitable for you:

What are your financial goals? Because there are so many different loan types, identifying what you want to accomplish can help you narrow down which is right for you.
Does this loan type have any restrictions on its use? When taking out a loan with a specific purpose, make sure your loan allows for the purchase you have in mind.
How much can you afford to borrow? The point of getting a loan is to pay for something you couldn’t otherwise. But that doesn’t mean you should just withdraw thousands of dollars — you have to pay it back. Consider what monthly payments you can afford to make, and adjust the loan amount accordingly.
How long do you feel comfortable repaying the loan? When taking out a new loan, you want to feel comfortable making the repayments to term. After all, the longer you pay off a loan, the more you might experience high interest rates.
Do you have any assets to use as collateral? Suppose you own a home or have investments. If so, you can get a loan with a lower interest rate by using those assets as collateral. Just make sure you’re okay with the risk of losing that collateral if you don’t repay.

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5. Calculated on the VantageScore 3.0 model. Your VantageScore 3.0 from Experian® indicates your credit risk level and is not used by all lenders, so don’t be surprised if your lender uses a score that’s different from your VantageScore 3.0. Learn more: https://www.experian.com/assets/consumer-information/product-sheets/vantagescore-3.pdf