Meeting in an office for home loans

5 types of loans and how they work

Few of us get through life without needing to take out a loan at some point along the way. If you're one of the few that doesn't, then congratulations to you! Feel free to share your tips—or independent wealth—with the rest of us.

If not, then it's worth it to familiarize yourself with the different types of loans that exist and the way in which they work. You never know when your time to get one might come around.

1. Car

Borrowing money to purchase a car is a necessity for most buyers. A car loan allows people to soften the blow of making such a large expenditure at once, and to hold on to savings that might be needed unexpectedly.

Financing a car can happen in a few different ways. One option is to go to a bank, credit union, or alternative lender in advance and ask for pre-approval. This allows buyers to go into a dealership with the full confidence that they will be able to walk away with the cars they want, so long as they fit into the pre-determined price range. Another is to negotiate with the dealer directly and come to an agreement based on his or her level of comfort in lending to you. This may necessitate the dealer doing some investigative work on your credit history or shopping your loan around. And finally, you can always borrow the old fashioned way, by making an agreement with a friend or family member, which may save you the trouble of going through a formal process that involves interest and monthly payments. In any event, there's a good chance the car—or another valuable item—will be used as collateral, rather than having the loan be completely unsecured.

2. Mortgage

Taking out a mortgage loan is even more common among home buyers than a car loan is among car buyers—and that's saying something. Mortgages usually amount to something like a decade's salary, so only the most prudent of savers will be able to cover one on the spot.

A mortgage is different than a car loan in the sense that the party brokering the deal is unlikely to provide financing for it (as an automotive dealer would). Mortgage financing mostly comes from banks, but it often comes from credit unions, cooperatives, and other miscellaneous institutions. It is paid back over a set period, but depending on how it is negotiated, could be subject to fluctuations to the prime lending rate. A mortgage that falls into that category is called a variable rate mortgage, whereas one with pre-determined rates would be considered a fixed rate mortgage. It is both possible and common for mortgages to be secured in the same manner that car loans are.

3. Personal

Personal loans are certainly the most nebulous of all the loans that are available. By definition, they are tied down to no purpose—beyond satisfying the needs of the individuals that take them out. A personal loan that gets used on a vacation is no different in process than a personal loan that gets used to buy collector's items.

You can get personal loans from banks and credit unions, but the number of alternative lenders that make them available is much greater than the number who offer car loans or mortgages, simply by virtue of the fact that they tend to be much cheaper than those two loan types. The repayment options are often a bit more flexible. Depending on what is arranged, it could end up being an instalment-based system (divided by months or weeks), an all-at-once repayment, or something in which the borrower gets a repayment schedule but can make payments ahead of time. Personal loans are unsecured, but they do come with interest rates that are determined based on credit history. When a personal loan is a payday loan, lenders often get away with charging unfairly high interest rates simply because of the leverage they have.

4. Business

A business loan is the push that helps many young or struggling businesses get over the hump between success and failure. To be successful, a business needs to show its customers either results or major promise, and that often isn't possible unless it has a certain amount of capital to begin with. That's where the business loan comes in.

Unlike the other loans on this list, a lender cannot be assured that a business loan will be repaid in due time based on the job situation and credit history of the applicant(s). Often that can only be determined by the success of the business venture itself. Therefore, business owners can usually only secure a loan if they have written out a detailed business plan that looks like it will come to fruition. From there, the two parties can get into loan specifics such as the repayment term, interest rate, and late penalties.

5. Student

Education is the best type of investment. It enables people to increase their earning potential and pretty much always pays for itself. However, it's a big enough investment that it often calls for money to be borrowed. When that happens, we call it a student loan.

Scholars can apply for student loans both publicly and privately. The public route is the more common one, since it has often been funded with government subsidies that can make the loan terms more attractive to students. However, it also may be restricted to certain demographics or not go far enough in providing assistance. That's when private loans can serve as an alternative or complement. The specifics of student loan repayment will differ by lender. Payments may be expected to start being made immediately following graduation, or there could be a grace period that lasts either until the student finds a job, or after a set amount of time has passed.