When it comes to making it in this world financially, you can go it alone, or you can get a loan.
Simply put, loans are when one party gives money to another party in exchange for that amount to be repaid (usually with interest).1 They can help borrowers out of a bind, assist borrowers in purchasing expensive items or advancing their careers, or be used by unscrupulous lenders to take advantage of the desperate.
Understanding the basic types of loans can help borrowers recognize which ones are appropriate. Plus, it even helps them get better deals! To help make that happen, this article will provide basic definitions of the most common types of loans for both individuals and businesses, with links to resources that can help readers learn more if they feel like those loans might be right for them.
Table of Contents
- Consumer Loans
- Small Business Loans
- Loans: What to Avoid
- Video: Every Type of Loan, Explained
Personal Loans from Financial Institutions
Personal loans from financial institutions are a common way for lenders to get money from a bank or credit union.2 They can be made without having to put down something expensive they own as collateral (unsecured) or by putting up collateral to lower the interest rate (secured).3 They are typically fairly versatile, with borrowers being able to spend the money on just about anything, as long as it is legal. The interest rate for a personal loan is generally dependent on the borrower’s credit score.
Personal Loans from Friends/Relatives (“IOU loans”)
Another common way for a borrower to get money is to ask family or friends to lend it. This can be advantageous to the borrower as a friend or family member is less likely to charge interest or care about a bad credit score.
Many times these “back-of-the-napkin loans” are agreed upon with a hastily-written record of the transaction and a handshake. However, setting down a more formal document (like a family loan agreement or an IOU form) can help minimize the risk of relationship damage from a family loan or IOU gone wrong.
Pawn Shop Loans
Pawnshops will let a borrower bring in an item as collateral and receive cash for a percentage of what the item is worth (usually 20-60%). The borrower can then return and pay the amount owed back (plus interest) within the allotted time to get their item back. If they fail to do so, the pawnshop can sell the item to get its money back.4
As the name suggests, payday lenders loan money to people by letting them borrow against an upcoming paycheck. Despite attempts to regulate the industry, payday lenders can still charge exorbitant fees that wind up being multiple times the value of the loan if the borrower can’t repay quickly, so a 15% two-week loan winds up being 380% APR if the loan stretches out over a year. While it’s not technically illegal as states place some limits on loan amounts and interest, calling payday lenders a last resort is an understatement.5
An auto loan is a loan specifically for the purchase of a vehicle where the vehicle itself is used as collateral for the loan. This usually results in lower interest rates for the borrower. It also means the lender can repossess the vehicle if the borrower falls behind on their payments.6
Car Title Loans
A car title loan puts the title of the vehicle up as collateral for a loan (usually up to 25-50% of the car’s value), which means that the lender can take the car if the borrower does not repay the loan on time. Because of the high fees and the short terms usually associated with car title loans, they usually wind up not being a very good deal for the borrower.7
The mortgage loan is the most common method for people to purchase a home. The lender provides the funding for the purchase of the home, which the borrower agrees to pay back over a certain period of time (usually 15 or 30 years). Should the homeowner “default” on the mortgage by being unable to pay, the bank can foreclose on the house.8
Home Equity loans
Like a mortgage, a home equity loan is a lump sum that is repaid over fixed monthly payments. The difference is that the home equity loan is based on how much money you’ve put into paying off your mortgage. Typically, a home equity loan will allow you to borrow up to 85% of the equity in your home (ex: if you’ve paid off $100k, you can borrow up to $85k in a home equity loan). Like a mortgage, the home equity loan uses your home as collateral, and can take your home if you default on the loan.9
A reverse mortgage is a type of home equity loan where the bank pays a homeowner age 62 or older a set monthly amount based on the equity built up in their home until the homeowner dies, sells the home or moves away. At that point, the loan is repaid, either by the bank receiving the home or by the loan being repaid. There are federal rules that make sure the amount of the loan cannot be greater than the value of the home, and that the borrower’s estate is not liable to pay the difference if that should happen (through a drop in the property’s value, for example).10
A credit card is essentially a revolving personal loan. Each month, the borrower can borrow up to the limit set on the credit card, and pay it off without interest. If the month passes and there is still debt, then the borrower is charged interest on the debt.11
Personal Line of Credit
A personal line of credit is essentially a credit card without the card. Like a personal loan, a line of credit allows the borrower to receive a certain amount of money. However, like a credit card, the line of credit remains open once the borrower has paid it off, allowing the borrower to use it whenever it is needed.12
Home Equity Line of Credit
Just as a line of credit is like a personal loan that can be used repeatedly, a Home Equity Line of Credit (HELOC) is like a Home Equity Loan that the borrower can use whenever they need extra cash, provided that it is paid off within the allotted time.13
As the name implies, a student loan is a loan that a student takes out in order to pay for higher education. Unlike a personal loan, student loans are generally meant to be for school or school-related items, such as books, housing, food and transportation costs incurred while going to school. The federal government subsidizes loans for students who meet certain requirements, while other students who don’t qualify choose between unsubsidized federal loans and private loans.14
So far, the loans we’ve talked about have all been what are known as “consumer” loans, meaning that they are designed for just about anyone who qualifies for them. In addition to consumer loans, there is an entire class of loans dedicated to entrepreneurs and small business owners to help them make capital improvements, manage economic uncertainty, and accelerate growth. Many of these tools are similar to their consumer counterparts, but structured with business owners in mind.15
Just as consumers can secure a line of credit to help them handle unexpected financial hurdles, so too can many small business owners. Business owners can get a line of credit giving them anywhere from $1,000-$500,000 to help them manage their businesses, with rates from 8-24%.16 While they often have strict eligibility requirements, business lines of credit offer flexibility and generally lower interest rates than, say, a business credit card. It is important to know that lines of credit are usually tied to the person requesting them, not their company. This means the person requesting the line will ultimately be responsible for paying it back, even if the business fails.17
While business credit cards usually have higher interest rates than business lines of credit, they incentivize business owners to choose them by giving them greater flexibility as well as access to various rewards programs that could give business owners who use them responsibly a healthy boost.17 However, like a personal credit card, those high-interest rates make it easy for business owners to get in over their heads if the credit card is not paid off promptly. Like a business line of credit, most business credit cards are tied to the person requesting them, not the company. The exception to this is corporate credit cards, which are paid by the business, not the individual.
Think of this as the de facto type of loan for most small business owners. Structured like a personal loan, the business term loan allows a business owner to borrow up to $2M dollars, and then pay that money back over the next 1-5 years. Business term loans generally have very attractive rates (some as low as 6%).18 Business term loans generally have a flat interest rate or fee, which also helps business owners in deciding how much they can borrow responsibly.
A short term loan is like the standard business term loan, but as the name implies, it gets paid off over 1-3 years. They have slightly higher interest rates, but they are built for speed, meaning that you could be approved and receive the funds for a Short Term Loan within 24 hours of applying.18
An equipment loan or equipment financing is created for the express purpose of giving business owners the ability to purchase or replace equipment. Because of this, the turnaround is usually fairly fast and the documentation process is less extensive than other small business loans. Despite that, equipment loans can have limits of up to $5,000,000 for businesses to purchase the vital (but sometimes pricey) tools they need to make their business run.19
This is something akin to a payday loan for a business. With accounts receivable financing, a lender agrees to purchase the businesses outstanding invoices or receivables. In exchange, the lender provides an immediate infusion of cash to the business, and assumes the risk of nonpayment for the outstanding invoices. Because of this risk, the interest rates or fees associated with accounts receivable financing are usually higher than other forms of small business lending.19
The U.S. Small Business Association helps business owners acquire SBA loans through a large network of participating lenders. Generally, these loans of between $5,000 and $5.5 million are only available to business owners that have already exhausted their other loan options. Once a business receives an SBA loan, they cannot get loans from other lenders. Businesses must also officially register and operate legally. They must do business in the U.S. and have a U.S. address. They also must have invested their own time and money into the business before requesting the loan.20
If all those prerequisites are met, SBA loans can wind up providing business owners with some of the best annual percentage rates on the market.21
You’ve had the “a-ha!” moment. You know how you’re going to disrupt an industry and become the next big thing. You’ve got your business plan ready to go and you know you’ll be a hit.
That’s where the startup loan comes into play. A startup loan can help an entrepreneur scale up their business, lease office space, hire employees, develop prototypes, purchase equipment or do any number of other things related to getting a new business up and running without selling a bunch of equity to outside investors or borrowing from family and friends. These loans take many forms, from SBA loans to lines of credit, but they’re all tailored for startups. Because of that, the interest rates and terms on these loans vary wildly – some can have terms of up to 25 years. The amount of the loan, collateral, interest rate, and term will all be factors in determining the monthly payments on these loans.18
A relatively recent innovation in the lending world, crowdsourcing gives both consumers and business owners the ability to make their case to the internet in the hopes of getting large quantities of micro-loans from people online who are moved by their story.
Whether it is a GoFundMe to raise money for a needed operation for the family pet or a Kickstarter campaign to raise the capital necessary for an innovative new gadget, crowdsourcing campaigns can be very attractive to recipients because in many cases, the money doesn’t have to be repaid. The crowdsourcing site usually takes a cut of the final amount raised, and the rest goes to the recipient. Other times, lenders will back a crowdsourcing campaign in exchange for a “gift” that the campaign designates for those who hit certain tiers.
While this sounds great in theory, crowdsourcing is hardly a guarantee. Many campaigns have difficulty cutting through the “noise” of the thousands upon thousands of other pleas out there elbowing into social media feeds trying to be heard. Also, depending on the site, certain campaigns are only funded if they meet a predetermined threshold. Meaning, the borrower could put in the effort of building and marketing a campaign only to see it receive nothing.
However, for those campaigns that strike internet lightning, immediate windfalls of hundreds of thousands or even tens of millions of dollars can give them the capital they need to bring their ideas to life (or, failing that, sell them to Fitbit).
America loves the “rags-to-riches’ story. In most versions of this tale, the plucky young entrepreneur with a big idea and the determination to make it happen goes from tinkering in a garage to sitting at the head of a multi-billion dollar company. And yet, when these stories are transposed into legend, the part where that entrepreneur sits down with a lender and explains their business plan to get their start-up loan is usually glossed over (if it’s even told at all). It may not be as romantic as them pulling themselves up by their bootstraps, but it’s true nonetheless. The old adage of “it takes money to make money” has lasted as long as it has for a reason.
Loans are important financial tools that can open doors that would otherwise be closed to consumers. However, in the wrong hands, some of those can wind up being trap doors. Be sure to enter into a loan with a solid plan on how to get out. Even if things don’t wind up going exactly as planned, the mental exercise will help focus your intent. They also improve your chances of avoiding many of the financial pitfalls associated with being in debt.
Loans come with undeniable risks. They also unlock the potential for unlimited rewards. With the proper planning and research, consumers and entrepreneurs can leverage their buying power through shrewd borrowing to achieve personal and professional advances that would otherwise be out of reach.