The Best Types of Loans for Your Need and How to Get the Best Rate
So much time is spent talking about how to pay down debt and why you should avoid debt altogether that it’s easy to forget there are many different types of debt. Use any one type of loan for the wrong use and it could send you into a debt spiral.
Use the right loan for the right need though and it can help you do something not otherwise possible. Different types of debt can be broken down a few ways but the most common is secured versus unsecured debt and revolving versus non-revolving credit.
We’ll get a quick definition of the types of credit and then look at how to use each for your needs.
- Secured debt is loans that you get on something you own like your house, car or some other asset. They generally offer lower rates because the lender knows they can take the asset if you default on the loan. Unsecured debt doesn’t have this collateral so lenders usually want a higher rate for the higher risk.
- Revolving credit is a loan that doesn’t have a payoff date or fixed payments. The most common type is credit card debt where you can continue to borrow money and pay off a portion every month. Non-revolving debt is also called installment loans because you make a payment each month and the loan is paid off at a point in the future.
Secured Types of Loans
Mortgages are the most common types of loans with $13.3 trillion in mortgage debt held by Americans against their homes. Common terms are either 15- or 30-year fixed loans but you can also get a loan rate that resets after five years. While these variable rate loans usually come at a lower starting interest rate, the fixed-rate loans are often the better choice because it makes it easier to plan and make loan payments.
We outlined a few tips on getting a home loan in this post. Because people will usually pay their home mortgage before other debt, lenders see these types of loans as less risky and rates are usually the best available. We’ll detail how to use the different types of loans for different needs later but mortgage loans are usually your best choice if you can get approved.
The downside to mortgage loans is that you must make payments or risk losing your home and all the equity you’ve built up to that point. Make sure you only agree to a loan if you can make the payments. Home Equity Lines of Credit (HELOC) are a special type of mortgage loan that you can borrow from continuously. The bank will assess the value of your home and how much of that value you own after accounting for the remaining mortgage debt. You then get an account for a portion of that remaining value, from which you can borrow.
You’ll make monthly payments on the HELOC and may pay it off but you can continuously withdraw money. HELOC loans generally have higher rates than mortgage loans though still lower than types of unsecured loans.
Auto and appliance loans are another form of secured debt though a relatively small part of the total household debt held. Because these loans are for much smaller amounts, they are usually only made for five year terms. Rates are generally higher than for mortgage loans because the car or appliance depreciates quickly.
This means it loses its value so it’s not worth as much as collateral to the lender. You may also be able to borrow money against your life insurance policy or a retirement account. These loans are secured against the money you’ve built up in your account and are generally low rate loans because the lender can just take the money in your account if you don’t make payments. It might be tempting to borrow money against these accounts but isn’t usually a good idea.
Life insurance and retirement accounts are set up for very specific purposes and borrowing money isn’t one of them. You could be doing more harm than its worth, especially if you can’t pay back the loan. The final type of secured loan is payday or pawnshop loans. These may be unsecured in some instances but are usually secured against your next check or something you leave at the pawnbroker’s store.
Even secured against an asset, these loans have very high interest rates and should almost always be avoided. Most secured types of loans are non-revolving, meaning you make fixed payments each month until the loan is paid in full. You receive one lump sum and cannot generally withdraw more money. The exception is a HELOC loan where you can continuously take out more money up to your credit limit.
Unsecured Types of Loans
Student loans are the second largest form of debt with more than $1.2 trillion outstanding. Unlike other unsecured types of loans, student loans usually are made at fairly low interest rates. This is because you can’t get rid of your student loan in a bankruptcy so the lender is pretty certain they’ll get their money back eventually.
Student loans are usually deferred until you graduate or stop going to school and may be deferred even longer if you enroll in certain income-based payment plans. There’s been a lot of talk about the growing burden of student loans in America and whether they are worth it. Their worth might be questionable if used at some of the expensive, for-profit universities where the value of a degree is uncertain but the value of a community college or four-year university goes way beyond the tuition costs.
Besides the extra income you can expect from a two- or four-year degree, you’ll have a lot more job opportunities and won’t have to settle for whichever manual labor job you can get. I’ve had a lot of those jobs before I got my degree and can tell you that I like sitting behind a desk a whole lot more!
Personal Loans are another popular form of unsecured credit and usually available from $1,000 to $35,000 for between three and five years.
These are available from personal loan companies like PersonalLoans.com or from peer to peer lending sites like Lending Club. Since you aren’t putting up collateral for the loans, lenders look carefully at your credit score and your ability to repay the money.
Credit score requirements vary but you’ll usually need a FICO score of at least 580 or higher to get approved. Check your interest rate on a personal loan, click here to check your rate now Credit card debt is one of the larger forms of unsecured credit at just under $900 million. Credit cards are generally one of the easiest types of loans to get though that’s not always a good thing.
Being able to borrow instantly whenever you’re at the mall can get you in trouble if you don’t watch your spending. Credit cards usually come with an initial rate before increasing after the first six months or a year. These introductory deals are called teaser rates for a reason, enticing you to get the card and run up your credit charges before the rate resets higher and costs you a lot of money.
The final type of unsecured loan we’ll cover is small business loans, most commonly made by the Small Business Administration (SBA). Small business loans are also available from traditional lenders and from peer lending sites though they may look more like a personal loan on the rates offered.
Besides personal loans, Lending Club also makes small business loans up to $350,000 to borrowers with more than two years in business and $50,000 in annual sales. Rates typically start around 10% on fixed terms of one- to five-years.
Business loans are generally offered on terms up to seven years and rates can be very good…or very bad depending on your lender. Be extremely wary of short term business loans for a year or less, these usually charge very high rates and you’re better off taking out a longer-term loan and paying it off early.
Unsecured loans can be revolving or non-revolving, depending on the type of loan and the terms. Credit cards are the most common form of revolving debt though some business loans may also offer an account from which you can make withdrawals. Student loans and personal loans are almost always non-revolving.
Which Loan is Right for Me?
The interest rate and payment on a loan are going to be important but not the only factors in determining the best loan for your needs.
Though rates tend to be lower on secured loans, you’ll also have to put your home or car at risk against the debt. If you can give yourself six months before you need a loan, you can usually improve your credit score enough to save thousands in interest.
We outlined three credit score hacks to boost your score and get better rates on loans in an earlier post. Non-revolving credit is better for your credit score than revolving loans like credit cards and HELOCs.
The credit score rating agencies use types of debt as a factor in determining your score. Since you can continuously borrow from revolving debt and can get into trouble fast, it will hurt your credit score if you borrow too much.
This makes consolidation loans one of the most popular ways to increase your credit score, borrowing on non-revolving personal loans to pay off revolving credit card debt.
Revolving loans are more appropriate for regular daily expenses because you can withdraw money when you need it. This is the biggest reason in favor of credit cards but you may also be able to use a cheaper non-revolving loan. If you can take money out once on a non-revolving type of loan and then just hold it in savings or another account earning interest then personal loans and other non-revolving loans can work just as well for daily spending needs.
One of the biggest questions for revolving debt, and really any debt, is whether you can handle the payments. If that credit card is going to burn a hole in your pocket until you max it out then it’s best not to apply for the credit in the first place. Similarly, just because the bank approves you for a mortgage of up to a certain amount doesn’t mean you need to spend that much. Always stay well within your income and aim for having no more than 15% of your income going to loan payments each month.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.