Loan proceeds can be used for a variety of purposes, from funding a new business, to buying your fiancée an engagement ring. But with all of the different types of loans out there, which type is best? In this article, we'll take you through a list of some of the more popular types of loans, as well as their characteristics and their usefulness in meeting consumers' financial needs.
1. Personal Loans
These loans are offered by most banks, and the proceeds may be used for virtually any expense (from buying a new stereo system to paying off a common bill). Typically, personal loans are unsecured, and range anywhere from a few hundred to a few thousand dollars. As a general rule, lenders will typically require some form of income verification, and/or proof of other assets worth at least as much as the individual is borrowing. The application for this type of loan is typically only one or two pages in length. Approvals (or denials) are generally granted within a few days.
The downside is that the interest rates on these loans can be quite high. According to the Federal Reserve, they range from about 10-12%. The other negative is that these loans sometimes must be repaid within two years, making it impractical for individuals looking to finance large projects.
In short, personal loans (in spite of their high interest rates) are probably the best way to go for individuals looking to borrow relatively small amounts of money, and who are able to repay the loan within a couple of years.
2. Credit Cards
When consumers use credit cards, they are essentially taking out a loan with the understanding that it will be repaid at some later date. Credit cards are a particularly attractive source of funds for individuals (and companies) because they are accepted by many - if not most - merchants as a form of payment.
In addition, to obtain a card (and, by extension, $5,000 or $10,000 worth of credit), all that's required is a one-page application. The credit review process is also rather quick. Written applications are typically approved (or denied) within a week or two. Online / telephone applications are often reviewed within minutes. Also in terms of their use, credit cards are extremely flexible. The money can be used for virtually anything these days from paying college tuition to buying a drink at the local watering hole. (To find out more about this process, see The Importance of Your Credit Rating and How Credit Cards Affect Your Credit Rating.)
There are definitely pitfalls, however. The interest rates that most credit-card companies charge range as high as 20% per year. In addition, a consumer is more likely to rack up debt using a credit card (as opposed to other loans) because they are widely accepted as currency and because it's psychologically easier to hand someone a credit card than to fork over the same amount of cash. (To read more on this type of loan, see Take Control Of Your Credit Cards, Credit, Debit And Charge: Sizing Up The Cards In Your Wallet and Understanding Credit Card Interest.)
3. Home-Equity Loans
Homeowners may borrow against the equity they've built up in their house using a home-equity loan. In other words, the homeowner is taking a loan out against the value of his or her home. A good method of determining the amount of home equity available for a loan would be to take the difference between the home's market value and the amount still owing on the mortgage.
The loan proceeds may be used for any number of reasons, but are typically used to build home additions, or for debt consolidation. The interest rates on home-equity loans are very reasonable as well. In addition, the terms of these loans typically range from 15 to 20 years, making them particularly attractive for those looking to borrow large amounts of money. But, perhaps the most attractive feature of the home-equity loan is that the interest is usually tax deductible.
The downside to these loans is that consumers can easily get in over their heads by mortgaging their homes to the hilt. Furthermore, home-equity loans are particularly dangerous in situations where only one family member is the breadwinner, and the family's ability to repay the loan might be hindered by that person's death or disability. Even a 1% increase in interest rates could mean the difference between losing and keeping your home if you rely too heavily on this style of loan.
Note: In situations like these, life/disability insurance is frequently used to help protect against the possibility of default. (To keep reading on this subject, see Home-Equity Loans: The Costs and The Home-Equity Loan: What It Is And How It Works.)
4. Home-Equity Line of Credit
This line of credit acts as a loan and is similar to home-equity loans in that the consumer is borrowing against his or her home's equity. However, unlike traditional home-equity loans, these lines of credit are revolving, meaning that the consumer may borrow a lump sum, repay a portion of the loan, and then borrow again. It's kind of like a credit card that has a credit limit based on your home's equity! These loans may be tax deductible and are typically repayable over a period of 10 to 20 years, making them attractive for larger projects.
Because specific amounts may be borrowed at different points in time, the interest rate charged is typically pegged to some underlying index such as the "prime rate". This is both good and bad in the sense that at some times, the interest rates being charged may be quite low. However, during period of rising rates, the interest charges on outstanding balances can be quite high.
There are other downsides as well. Because the amount that can be borrowed can be quite large (typically up to $500,000 depending upon a home's equity), consumers tend to get in over their heads. These consumers are often lured in by low interest rates, but when rates begin to rise, those interest charges begin racking up and the attractiveness of these loans starts to wane.
5. Cash Advances
Cash advances are typically offered by credit-card companies as short-term loans. Other entities, such as tax-preparation organizations, may offer advances against an expected IRS tax refund or against future income earned by the consumer.
While cash advances may be easy to obtain, there are many downsides to this type of loan. For example:
- They are not typically tax deductible.
- Loan amounts are typically in the hundreds of dollars, making them impractical for many purchases, particularly large ones.
- The effective interest rate charges and related fees can be very high.
In short, cash advances are a fast alternative for obtaining money (funds are typically available on the spot), but because of the numerous pitfalls, they should be considered only as a last resort. (Learn more about cash advances in Payday Loans Don't Pay.)
6. Small Business Loans
The Small Business Administration (SBA) or your local bank typically extend small business loans to would-be entrepreneurs, but only after they've submitted (and received approval for) a formal business plan. The SBA and other financial institutions typically require that the individual personally guarantee the loan, which means that they will probably have to put up personal assets as collateral in case the business fails. Loan amounts can range from a few thousand to a few million dollars, depending on the venture.
While the term of the loan may vary from institution to institution, typically, consumers will have between five and 25 years to repay the loans. The amount of interest incurred from the loan depends on the lending institution in which the loan is made. Keep in mind that borrowers can negotiate with the lending institution with regard to the level of interest charged. However, there are some loans on the market that offer a variable rate.
Small business loans are the way to go for anyone looking to fund a new or existing business. However, be forewarned: getting a business plan approved by the lending institution may be difficult. In addition, many banks are unwilling to finance "cash businesses" because their books (ie. tax records) often do not accurately reflect the health of the underlying business.
The Bottom Line
While there are many sources that individuals and businesses may tap for funds, all consumers should assess both the positive and negative aspects of any loan before signing on the dotted line.
To read more on this subject, see Getting A Loan Without Your Parents.