Borrowed money can be used for many 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 is best?
Below are the most common types of loans and how they work.
1. The Personal Loan
Most banks, online and on Main Street, offer personal loans, and the proceeds may be used for virtually anything from buying a new stereo system to paying bills. This is an expensive way to get money because the loan is unsecured. That is, the borrower doesn't put up collateral that can be seized in case of default, as in a car loan or a home mortgage.
Typically, a personal loan can be obtained for a few hundred to a few thousand dollars, with repayment periods of two to five years.
- Personal loans and credit cards come with high interest rates but do not require collateral.
- Home equity loans have low interest rates but the borrower's home serves as collateral.
- Cash advances typically have very high interest rates plus transaction fees.
Borrowers need some form of income verification and proof of assets worth at least as much as is being borrowed. The application is typically only a page or two in length and the approval or denial is generally issued within a few days.
Best and Worst Rates
Interest rates can range from as little as a 4% annual percentage rate (APR) to as much as 36%. The best rates can only be obtained by people with exceptional credit ratings and substantial assets. The worst must be endured only by people who have no other choice.
A personal loan is probably the best way to go for those who need to borrow a relatively small amount of money, and are certain they can repay it within a couple of years.
Bank Loan Vs. Bank Guarantee
A bank loan is not the same as a bank guarantee. A bank may issue a guarantee as surety to a third party on behalf of one of its customers. If the customer fails to fulfill the relevant contractual obligation with the third party, that party can demand payment from the bank.
The guarantee is typically an arrangement for a bank's small business clients. For example, a corporation may accept a contractor's bid on the condition that the contractor's bank issues a guarantee of payment in the event that the contractor defaults on the contract.
2. The Credit Card
Every time a consumer pays with a credit card, he or she is taking out a personal loan. If the balance is paid in full immediately, no interest is charged. If some of the debt remains unpaid, interest is charged every month until it is paid off.
The average credit card interest rate carries a 16.86% APR, according to the Federal Reserve. A consumer who misses a single payment can get bumped up into a penalty rate as high as 29.9%.
The big difference between a credit card and a personal loan is that the card represents revolving debt. The card has a set credit limit, and its owner can repeatedly borrow money up to the limit and repay it over time.
Credit cards are extremely convenient, and they require self-discipline to avoid over-indulging. Studies have shown that consumers are more willing to spend when they use plastic instead of cash.
A short one-page application process makes it an even more convenient way to get $5,000 or $10,000 worth of credit.
3. The Home-Equity Loan
People who own their own homes can borrow against the equity that they have built up in them.
That is, they can borrow up to the amount that they actually own. If half of the mortgage is paid off, they can borrow half of the value of the house. Or if the house has increased in value by 50%, they can borrow that amount.
In short, the difference between the home's current market value and the amount still owed on the mortgage is the amount that can be borrowed.
Low Rates, Big Risks
One advantage of the home-equity loan is that the interest rate charged is far lower than for a personal loan. In late 2019, the average interest rate was 5.76%. Even better, the interest is usually tax-deductible, just like mortgage interest.
The potential downside is that the house is the collateral for the loan. The borrower can lose the house in case of default on the loan.
The proceeds of a home equity loan can be used for any purpose, but they are often used to upgrade or expand the home.
A consumer considering a home-equity loan might keep in mind two lessons from the financial crisis of 2008-2009: 1) Home values can go down as well as up, and 2) Jobs are in jeopardy in an economic downturn.
4. Home Equity Line of Credit (HELOC)
The home equity line of credit works like a credit card but uses the home as collateral. A maximum amount of credit is extended to the borrower. The credit line may be used, repaid, and reused for as long as the account stays open, which is typically 10 to 20 years.
The average interest rate for a cash advance on a credit card.
Like a regular home equity loan, the interest may be tax-deductible.
Unlike a regular home equity loan, the interest rate is not set at the time the loan is approved. Since the borrower may be accessing the money at any time over a period of years, the interest rate is typically variable. It may be pegged to some underlying index such as the prime rate.
Good or Bad News
This can be good or bad news. During a period of rising rates, the interest charges on an outstanding balance will increase. A homeowner who, say, borrows money to install a new kitchen and pays it off over a period of years may get stuck paying much more in interest than expected, just because the prime rate went up.
There's another potential downside. The lines of credit available can be very large, and the introductory rates very attractive. It's easy for a consumer to get in over his or her head.
5. The Cash Advance
Credit cards usually include a cash advance feature. Effectively, anyone who has a credit card has a revolving line of cash available at any ATM machine.
This is an extremely expensive way to borrow money. The interest rate charged is higher even than the rate for credit card purchases. The average currently is 23.68% APR. The advance also comes with a fee, typically equal to 5% of the cash advance amount or $10 minimum.
Worse yet, the cash advance goes onto the credit card balance, accruing interest from month to month until it is paid off.
Cash advances are occasionally available from other sources. Notably, tax-preparation companies may offer advances against an expected IRS tax refund.
Unless there's a dire emergency, there's no reason to give up part of your tax refund just to get the money a little faster.
6. The Small Business Loan
Small business loans are available through most banks and through the Small Business Administration (SBA). These are typically sought by people setting up new businesses or expanding established ones.
Such loans are granted only after the business owner has submitted a formal business plan for review. The terms of the loan usually include a personal guarantee, meaning that the business owner's personal assets serve as collateral against default on repayment.
Such loans usually are extended for periods of five to 25 years. Interest rates are sometimes negotiable.
The small business loan has proved indispensable for many, if not most, fledgling businesses. However, creating a business plan and getting it approved can be arduous. The SBA has a wealth of resources both online and local to help get businesses launched.