Life places financial demands on us from time to time. Fortunately, a variety of financial tools can help us meet those demands. One of the most important tools for many people is a consumer loan. This type of loan provides funding or credit to help with personal or household purchases.
There are many reasons to take out a consumer loan. Some loans help us afford major purchases, like a house or a car. Others help us organize and streamline our finances. To get the loan that best fits your needs, it’s important to understand what kinds of loans are available and how they work.
Secured vs. unsecured loans
One way to categorize loans is as secured and unsecured. A secured loan is one that is backed by collateral (an asset like a car or home). If the borrower defaults (fails to make regular payments on the loan), the lender can recoup the loan by taking the collateral. In the case of a car, the lender can repossess the car and sell it as compensation for the borrower failing to repay the loan.
An unsecured loan is not backed by collateral, and is based solely on a borrower’s creditworthiness. If the borrower defaults, than he or she has nothing at immediate risk. However, the lender can seek other means to collect the debt such as wage garnishment or a judgment lien. Unsecured loans are riskier for the lender than secured loans because the borrower has no assets to immediately recoup if he or she fails to pay off the loan. Because of this increased risk taken on by the lender, unsecured loans tend to come with higher interest rates.
Open-end vs. closed-end loans
Most open-end loans have no set deadline by which the borrower must pay off the entire amount (except for secured HELOCs with a set draw period before repayment occurs). Instead, the borrower must make regular, minimum payments on the loan (including interest) but can access more of the loan. This type of loan is also known as revolving credit, and credit cards are a common example. Open-end loans are typically unsecured.
A closed-end loan, also known as installment credit, enables a consumer to borrow money for a fixed period. During that time, the borrower makes regular (usually monthly) payments on the interest and principal until the loan (the amount originally borrowed) is paid off. Closed-end loans may be secured or unsecured.
Why the kind of loan matters
Whether a loan is secured vs unsecured, or closed-end vs open-end is important because those characteristics may make different loan types suitable for different financial needs. For example, if you need money to cover the costs of a small home improvement project, you may not want to risk losing an asset with a secured loan. And a closed-end loan for a fixed amount may be unworkable if you don’t know the exact amount to borrow for your project. In this case, a credit card or line of credit is a popular option.
Here are a few examples of common loan types.
A personal loan is flexible and can be used for almost any reason—funding a home-improvement project, paying off (higher interest) credit card debt and more. This loan may be secured or unsecured, depending on the situation, and is closed-end, meaning the loan must be paid off at the end of the loan term. Personal loans can help you build a credit history, but they may come with interest rates that are higher than other loans.
This loan is used for purchasing a new or used car and is typically available from a traditional lender (like a bank) or from the car dealer that is selling you the car. The loan is often secured, so if the car you are buying serves as the collateral backing the loan, you can lose the car if you fail to make the payments. This loan is closed-end, with the length of the loan varying from three to seven years or more depending on who issues your loan. A longer loan term means lower monthly payments, but you may not want to take out a loan that lasts longer than the car does.
You may not think of a credit card as a type of loan, but it is. The credit card issuer allows you to make purchases through a revolving line of credit. At the end of a month, you can pay off the balance and pay no interest or make a smaller payment and incur interest charges on the balance carried over to the next month. Credit cards are open-end loans, and because they are unsecured, they tend to charge higher interest rates than other loan types.
Applying for a consumer loan
When you apply for a loan (or credit card) you will likely be asked to provide personal identification, your address, proof of income, bank statements and other documents to qualify. Your income and your credit history / score will affect your eligibility for the loan and sometimes the interest rate you are charged.
How long does it take to get approved for a loan? A personal loan typically takes one to five business days; an auto loan, can be typically approved faster. Creditors are required by law to review your completed application within 30 days. Depending on the product you choose, approval can vary in length of time.
For informational/educational purposes only. The information in this content is not advice on legal, tax, investment, accounting, regulatory, technology or other matters. You should always consult your own financial, legal, tax, accounting or similar advisors before making any financial or investment decisions, or entering into any agreement for Valley products or services. All loans products are subject to credit approval. Additional terms and conditions apply. Certain restrictions apply.