Understanding Different Loan Types

Borrowed money can be used for many purposes, from funding a new business to buying your fiancee an engagement ring. But with all of the different types of loans out there, which is the best and for which purpose? Below are the most common types of loans and how they work.

Personal Loans

Most banks, physical and online alike, offer personal loans, and the proceeds may be used for virtually anything from buying a new smart TV to paying bills. This is an expensive way to get money because the loan is unsecured, which means that the borrower doesn’t put up collateral that can be seized in case of default, as with a car loan or 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.

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. A personal loan calculator can be a useful tool for determining what kind of interest rate is within your means.

Credit Cards

Every time a consumer pays with a credit card, it is effectively equivalent to taking out a small 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 carried a 21.19% APR in the third quarter of 2023, according to the Federal Reserve up from the 2022 fourth quarter rate of 19.07%, bringing it to its highest rate since 2018.

Many credit cards offer promotional rates to sign up, with some going as low as 0% interest as an introductory rate. But those rates are temporary, and when the promotional period ends, they will return to their standard level.

Revolving Debt vs. Installment Loans

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. Personal loans are paid out once and repaid in installments over the agreed upon term.

Home Equity Loans

People who own their own homes can borrow against the equity 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 fair market value and the amount still owed on the mortgage is the amount that can be borrowed.

Small Business Loans

Small business loans are available through most banks and 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. 

What Happens if I'm Late on a Credit Card Payment?

If you miss a credit card payment, it can trigger a penalty interest rate that is considerably higher than the normal rate, in addition to a late payment fee. If the missed payment is a rare event, you may be able to call the customer service line and request that the fees be returned and the interest rate remains the same. It will be up to the customer service representative, but you may find clemency.