It’s unlikely that you’ll get through life without needing to borrow money at some point. People can get away without using credit cards, but it’s much harder to pay for life’s biggest expenses in cash. Loans are often used to finance larger purchases so you don’t have to delay the purchase by years while you save.
Debt isn’t uncommon. The average American has $ 104,215 in debt across various types of loans. When used correctly, loans can be an advantage that helps you get ahead.
But before you take on any loan, it’s essential to understand what you’re getting yourself into.
Keep reading for a quick rundown of the most common loan types.
Four Main Loan Types
There are four main types of loans you should know the basics of:
1. Auto Loans
An auto loan is taken out to finance the purchase of a used or new vehicle.
You can get a car loan directly from the dealership where you purchase the car or from a traditional lender (bank or credit union).
Auto loans don’t require a down payment, but having one can get you better loan terms and a lower interest rate. Additionally, car loans can generally be given to those with low or no credit. However, the lower your credit score, the higher your interest rate will be.
Most car loan terms are between 36 and 84 months. The average car loan term in the United States is six years. However, lenders can offer shorter or longer terms.
Generally speaking, the advice from personal finance experts when taking out an auto loan is to follow the 20/4/10 rule. You should have a 20% down payment, a car loan term of no more than four years, and your total monthly transportation costs (payments, insurance, gas) shouldn’t exceed 10% of your monthly income.
Of course, you can still get a car loan even if you can’t achieve the 20/4/10 rule. However, you may receive a higher interest rate and feel tighter in your budget.
As of 2023, the average new car was financed for a loan amount of $40,000 and an interest rate of 7.2%.
Note that an auto loan is a secured loan, meaning it’s guaranteed by the vehicle. If you stop making payments on the loan, your lender can seize the car and then sell it to recoup their money.
2. Student Loans
Attending college isn’t cheap. In 2024, the average annual cost of attending a four-year public university was $11,011. A private university’s was $43,505.
Considering that most college students are young, having access to that sort of cash isn’t usually possible. So, the majority of students end up taking out student loans to finance their education.
There are two primary student loan types:
- Federal Student Loans: Funded by the government, you must qualify for this loan type. Federal student loans have various repayment plan options, often offer lower interest rates, and are the only way to get into the Student Loan Forgiveness Program.
- Private Student Loans: Offered by private lenders, these loans are often taken out by individuals who don’t qualify for a federal student loan. A private loan usually comes with a 5 to 25-year loan term, might require repayment to begin while you’re still in school, and can come with higher interest rates. However, you can always refinance a private student loan to get more favorable loan terms.
The good news is that you can qualify for a federal student loan with a low credit score. The main things that might disqualify you from a federal student loan are your parents’ income being too high or your status as an American citizen.
Most experts agree that federal student loans are preferable to private student loans—at least initially. However, some individuals who know they’ll never qualify for the Student Loan Forgiveness Program may choose to refinance and switch from federal to private student loans later on.
Many students take on substantial student loans without understanding the full repercussions of their actions. You’ll likely be paying your student loan for many years after graduation. It’s important only to borrow what you need and understand your loan’s specifics around when repayment begins, your interest rate, and your expected timeline until you’re fully paid off.
Student loans are usually unsecured, meaning you haven’t put up collateral for them. But you can’t just ignore your student loan. Most types of student loans will follow you even if you declare bankruptcy.
3. Mortgage Loans
At some point, you may want to become a homeowner. The usual way to do this is to secure a mortgage to help pay for the purchase of property or land. After all, the average price of a home in the US is $402,000.
You typically sign up for a 30-year mortgage. However, most homeowners refinance, sell, or repay their loans within 7-12 years. However, you don’t have to get a 30-year mortgage. Mortgages are also available for 5, 10, and 15 years.
A mortgage is a secured loan, with the house being the asset used as a guarantee. Your lender can foreclose on the home if you stop making payments.
There are many different types of mortgages, including ones that offer fixed or adjustable rates.
You must apply and be approved for a mortgage loan. Your lender will consider many variables, including:
- Your credit score and credit report
- The size of your downpayment
- Your income and work history
- Your outstanding debts
- The amount of loan you wish to acquire
Typically, you’ll get the best mortgage loan terms if you have great credit and a sizable down payment.
However, getting a mortgage without strong credit or a down payment is possible. The government has several federally funded mortgage programs that aim to make homeownership more accessible to individuals.
4. Personal Loans
Personal loans can help you pay for various expenses. Most often, people get personal loans to:
- Pay medical debt
- Cover bills during unexpected job loss
- Cover moving costs, furniture purchases, or renovations
- Help fund a small business
A personal loan is often unsecured, so you may need excellent credit to qualify with a traditional lender.
Personal loans can be as little as a few hundred dollars or as much as several thousand. The loan term can be six months to several years.
Applying for a personal loan is relatively straightforward. You’ll usually provide proof of income, and the lender will do a credit check. You’ll receive an answer to your application within a few business days.
If you’re denied a personal loan, you may be tempted to seek funding from an unconventional lender. However, a lender who provides loans to people with low credit scores offsets their risk by charging an enormous interest rate.
Being Loan Smart
Now that you know the basics, you should feel comfortable applying to one of these above loan types. Always review the terms and know how much interest you’ll pay overall, your monthly payment, and how long you’ll be paying the loan back. Loans are only wise if you understand them well and properly budget for them.
You might also be interested in: A Complete Guide to Amortization Loans
