Types of Loans

David Kane, Aaron Hill
  • Author
    David Kane

    David has taught multiple grades and subjects in his twenty-five year career. He has a bachelor's in Education/Humanities from St. Peter's University.

  • Instructor
    Aaron Hill

    Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Explore what a loan is. Learn about the types of loans with examples. Understand the entire process of a loan and some of the common advantages and disadvantages. Updated: 10/08/2021

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What is a Loan?

A loan is money borrowed from a bank or financial institution. The borrower agrees to pay back the principal amount of the loan plus interest. There are several types of loans, including car loans, student loans, and home mortgages.

Attributes of Loans

Although there are several different types of loans which will be discussed below. All loans have several common attributes:

  • Principal: The original amount of the loan or the money borrowed.
  • Interest: A percentage of the principal the lender charges the borrower. This money must be paid along with the original amount borrowed.
  • Term: The length of time it will take for a borrower to repay the original principal and interest completely. A loan that is expected to be repaid within a year or less is considered short-term, while anything longer than a year is considered a long-term loan.
  • Payment Amount: The dollar amount the borrower agrees to repay each month. This payment includes both the principal and interest. If a borrower chooses to pay over the payment amount in a given month, the extra money will directly pay down the interest.

The Loan Process

If someone wants to apply for a loan, there are several important steps to follow. These may vary slightly depending on the type of loan, but in general, those steps are:

  • Check Your credit score: Your credit score tells lenders how likely you are to repay your loan. A score over 700 is considered very good. A high score will not only improve your chances of getting the loan but may also give you a more favorable interest rate. Applying for a loan with a low score runs the risk of being denied the loan altogether.
  • Apply for prequalification: Contact the bank or financial institution about taking out a loan. They will want to know how much you want to borrow, what the money is being used for, the borrower's employment status and income, and their social security number. Getting prequalified gives the borrower a good idea of what the loan terms will be and whether they will be approved or not.
  • Compare offers: It's a good idea to submit several prequalification applications to several different banks or financial institutions. The borrower can then compare the loan terms and choose the best option for them. Some important factors to consider are the amount the borrower may qualify for, interest rate, term of the loan, monthly payment, and other fees associated with the loan.
  • Submit a formal application: Once a borrower decides upon the best loan offer, it's time to apply. The lender will need documents verifying their monthly house payment, identity, monthly income, and the borrower's social security number.

A loan application is considered a hard credit inquiry and may affect the borrower's credit score slightly.

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Types of Loans

There are many types of loans, such as personal loans, car loans, and student loans. Even credit cards are considered a type of loan. Generally, they are classified into a few categories.

Secured Loans and Unsecured Loans

In a secured loan, the borrower must offer some collateral, an asset that the lender may seize if the borrower fails to make a payment. A home deed is a common form of collateral. Secured loans are usually for a large amount of money. Car loans and home mortgages are common examples of secured loans.

Secured loans have strict borrowing limits, extended repayment plans, and usually, low-interest rates compared to other loan types. For example, if a borrower is seeking to buy a house, the amount borrowed would be the exact dollar price of the house, plus any additional fees, and the term could be as long as thirty years.

An unsecured loan does not require collateral. These a generally shorter-term loans for smaller amounts. Credit cards, student loans, and personal loans are common examples. Since there is no collateral, lenders will often be very thorough in assessing borrowers' financial status.

Open-End Loans and Closed-End Loans

An open-end loan allows a borrower to repeatedly use a pre-approved amount of money as long as the money is repaid. A credit card is the most common form of an open-ended loan. Based on the borrower's credit score and annual income, the credit card company will determine a credit limit or maximum amount that may be borrowed at any given time. A borrower may then use up to the credit limit. Once the borrower has paid some or all of the amount, they are free to borrow again.

A closed-end loan has a set amount, interest rate, and repayment window. A car loan is an example of a closed-end loan. Unlike a credit card, once the terms of a closed-end loan have been established, they do not change. For example, if a borrower takes out a car loan and then wants to buy a second car a few years later, they would need to apply and get approved for a separate loan.

Credit cards are a form of open-ended loan.

Credit cards are a form of open-ended loan

Conventional Loans

A conventional loan is a home mortgage that a government agency does not insure. Conventional loans usually require higher credit scores than government-backed loans. They often have higher interest rates and may require mortgage insurance payments.

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Frequently Asked Questions

What is a loan and its types?

A loan is money borrowed from a bank or other financial institution. The borrower agrees to repay the principal amount, plus interest. Loans may be secured or unsecured, and they may be open-ended or closed-ended.

What is an example of a loan?

One example of a loan is a car loan. This is a closed-end loan, meaning there is a fixed principal amount, term, and regular monthly payments.

What are the five types of loans?

There are many types of loans. Some of the most popular ones are car loans, student loans, home loans (mortgage), business loans, and credit cards.

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