Loans 101: The different types of lending options explained

Your financial needs and goals will change throughout your life. Fortunately, there are plenty of lending options that can help you meet changing needs and objectives. Here’s what you need to know about how loans work and how to know which one is best for your needs.

Key takeaways:

• Personal loans offer flexibility for unexpected or large expenses, with both secured and unsecured options available based on the type of collateral.
• Secured loans, such as mortgages and home equity loans, use property as collateral, often offering lower rates but carrying foreclosure risks.
• Payday loans, pawn shop loans, and credit card cash advances are high-interest, short-term options that offer quick cash but can result in costly debt cycles.

What are the different kinds of loans?

The basic framework of any loan is the same, but the details may differ significantly. Here’s an overview of loan types and what you need to know about each option.

Personal loans

Personal loans can help fund almost anything. Whether you need help paying for your wedding or emergency vet surgery for Fido, a personal loan can provide the cash you need now.

There are two different types of personal loans:

• Unsecured personal loans. Unsecured personal loans do not require collateral. This means you aren’t putting any of your possessions at risk. 
• Secured personal loans. Secured personal loans require collateral. This might be your car, home, or a certificate of deposit. You risk forfeiting your asset to the lender if you default on the loan.

One of the benefits of a personal loan is that it could offer a lower APR or interest rate than a credit card. It’s a good option if you need to cover a large or unexpected cost and don’t have an emergency fund. Likewise, if you are struggling to pay down your debt, a personal loan can help consolidate your loans into a single, manageable payment.

“The advantages of personal loans include flexibility and predictability. However, unsecured personal loans can carry higher interest rates, and borrowers with limited credit history may find approval challenging,” says Tyler Abney, a financial consultant with Tidemark Financial Partners in San Diego.

Mortgages

A mortgage is a secured loan used to buy or refinance a home, with the property itself serving as collateral. In exchange, you agree to repay the lender via monthly payments, which usually cover the loan’s principal, interest, and fees. If you don’t repay your debt as agreed, the lender can legally take ownership of your home.

“A mortgage is a long-term loan that usually lasts 15 – 30 years. The main benefit is that it allows you to become a homeowner without paying the full price upfront,” says Nadia Evangelou, senior economist and director of real estate research for the National Association of REALTORS^® in Washington. “Monthly payments are typically fixed and made over time, allowing you to build equity. As you pay down your loan and your home appreciates, you can build long-term wealth.”

Dreaming about buying your first home? A home purchase is one of the most significant transactions most people ever make. While it’s true that housing costs are climbing in most parts of the country, there’s an easy way to quickly secure a mortgage through our sister company, Rocket Mortgage.

Home equity loans

Home equity loans are second mortgages that allow you to borrow your home equity with your home as collateral. Home equity is the difference between how much your home is worth and how much you owe on it. As you pay down your mortgage balance, you increase your equity. When you have enough equity, you can borrow it as a lump sum with a home equity loan or cash-out refinance, or as a home equity line of credit (HELOC).

“Think of a home equity loan as borrowing against your house’s value minus what you owe,” says Andrew Lokenauth, a personal finance expert in Tampa, Florida. “You’ll get a lump sum at closing with fixed payments. And interest rates are decent since your home backs the loan.”

Lower interest rates on these loans can be attractive. However, keep in mind that you risk losing your home if you can’t make the payments.

“Still, this is a good option for big one-time expenses such as renovations, student debt, or medical bills,” says Evangelou.

Auto loans

The vehicles you purchase over your lifetime can be costly. If you cannot afford to buy a car in cash, auto financing can be a lifesaver.

“An auto loan is used to buy a new or used vehicle and is repaid over a fixed term. Your car serves as collateral,” Abney says. “The benefit here is spreading out the cost of the car over several years. But the downsides include depreciation and potentially being underwater on your loan early in the term.”

Typically, you must make a down payment to get a car loan, which is one of the primary differences between personal loans and auto loans.

You’ll find that both dealerships and financial institutions offer auto loans. Although it can be more convenient to secure a car loan through the dealership, it is usually more affordable to work with a bank or credit union. That’s because these lenders typically offer lower interest rates and fewer added fees than a dealership. Dealers usually don’t offer the “buy rate,” which is the direct rate they receive from their partner lenders. They’ll commonly offer the “contract rate” instead, which is more expensive to you, allowing them to pocket the difference as profit.

This is a common practice in car financing that can set you back hundreds, if not thousands, of dollars over the term of a loan. However, by pursuing financing independently through a credit union or bank, you’ll likely benefit from more competitive and transparent rates, minus the hidden markup.

Keep in mind that auto loans are just one type of loan your bank or credit union may be able to offer when you want to purchase a vehicle.

Payday loans

When you need a smaller amount of money in a pinch, payday loans come in handy. Most payday loans have a borrowing threshold of up to $500. The goal is to help you make it to the next paycheck. However, high interest rates and short repayment periods can make it challenging to pay off this loan on time. 

“Also, this high-interest loan is typically due by your next paycheck. It’s easy to access, but payday loans can trap borrowers in a cycle of debt due to exorbitant fees and interest rates,” says Abney. “These loans are best avoided unless all other options are exhausted.”

Pawn shop loans

If you own something of value, such as jewelry or musical equipment, you can borrow money from a pawn shop. These loans are typically for a few hundred dollars, depending on the item you have available for collateral. Although the loan terms will likely vary, interest rates are relatively high.

“If the loan is repaid on time, your item is returned. If not, the pawnshop sells it,” Abney says. “They offer fast access to money, but pawn shop loans come with steep fees and the risk of losing your valuables.”

Credit card cash advances

Already have a credit card? If so, you may be able to secure a cash advance. Some credit cards offer cash advance terms that allow you to borrow against your available balance. Similar to credit cards, these advances often come with high interest rates and numerous fees.

“The fees are usually steep, often 3% – 5% up front plus an interest rate around 25%. There’s also no grace period,” says Lokenauth. “I tell my clients a credit card cash advance is usually a last resort.”

Do your research before choosing this option. It may be more financially sensible to pursue a personal loan if you have a good credit score. 

FAQ

Here are answers to common questions about loan types.

Is a personal loan an installment loan or a revolving loan?

A personal loan is an installment loan. That means it’s repaid over a fixed term with equal monthly payments. This is different from revolving loans like credit cards, where you can borrow repeatedly up to a set limit.

Is a home equity loan a second mortgage?

Yes, a home equity loan is often referred to as a second mortgage because it uses your home as collateral and is subordinate to your original mortgage. That means it ranks behind your primary mortgage loan in priority when it comes to repayment if your property is sold due to foreclosure. Because your primary mortgage is repaid first, second mortgages are riskier to lenders, causing them to charge a higher interest rate.

How do I get preapproved for an auto loan?

Preapproval for an auto loan involves submitting financial information to a lender, who will evaluate your credit, income, and debt-to-income ratio. If approved, you’ll receive a quote outlining potential loan terms, which can help streamline car shopping.

Is a payday loan secured or unsecured?

A payday loan is an unsecured loan, which means you don’t need to pledge your home, vehicle, or other asset as collateral. However, lenders may require access to your checking account or a postdated check for payday loan repayment.

What is a cash advance fee on a credit card?

A credit card cash advance fee is a charge, often 3% to 5% of the amount withdrawn, paid to your credit card issuer when you take out a cash advance, not including high interest rates charged.

The bottom line: There is a loan product to meet your financial needs

Whatever your specific needs, there’s a loan option out there for you. As you search for the best form of financing, also consider working to improve your credit score to secure the best loan terms possible.

Whether you need a mortgage to finance the purchase of your first home or a personal loan to fund your short-term need, you now know the basic terms for understanding your loan options. Now, pay it forward by sharing this information with friends and deciding the type of loan that works best for you.