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 is best?
In this article, we'll chart 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 bills). 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 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 in comparison to other types of loans. According to data from the Federal Reserve, a 24-month personal loan averaged 10.36% in February 2019. The other negative is that these loans sometimes must be repaid within two years, making it impractical for individuals looking to finance very large or long-term 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.
Bank loans are different from bank guarantees. Guarantees do not involve a direct cash transfer from the bank to the borrower. Instead, banks issue guarantees as surety to a third party on behalf of one of the bank's customers. If the bank's customer fails to fulfill some contractual obligation with the third party, that party can call the bank guarantee and receive payment.
These typically occur in small-business situations – a contractor negotiating with a new corporate client, say. The corporation might only accept the contractor's bid on the condition that he receives a guarantee from his bank, stating that in the event of default on the contract by the contractor, the bank will agree to pay a sum of money to the corporation.
2. Credit Cards
When consumers use credit cards, they are essentially taking out a loan, drawing on a line of credit on the card. 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.
There are definitely pitfalls, however. The interest rates that most credit-card companies charge can be as high as 25% 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 so widely accepted as currency and because it's psychologically easier to "charge it" rather 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 residence using a home-equity loan. In other words, the homeowner is borrowing 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 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 keep up payments might be hindered by that person's death or disability. In situations like these, life/disability insurance is frequently used to help protect against the possibility of default.
4. Home-Equity Line of Credit – HELOC
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 a period of rising rates, the interest charges on outstanding balances go up too.
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 extends 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 (i.e. tax records) often do not accurately reflect the health of the underlying business.
(For more details, see "Need a Loan for Your Startup? Here's How to Prepare a Thorough Loan Package.")
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."