Understanding Different Loan Types

Borrowed money can be used for many purposes, from funding a new business to buying your fiancée an engagement ring. But with all of the different types of loans out there, which is the best—and for which purpose? Below are the most common types of loans and how they work.

Personal Loans

Most banks, physical and online alike, offer personal loans, and the proceeds may be used for virtually anything from buying a new smart TV to paying bills. This is an expensive way to get money because the loan is unsecured, which means that the borrower doesn’t put up collateral that can be seized in case of default, as with a car loan or home mortgage. Typically, a personal loan can be obtained for a few hundred to a few thousand dollars, with repayment periods of two to five years.

Borrowers need some form of income verification and proof of assets worth at least as much as the amount being borrowed. The application is typically only a page or two in length, and the approval or denial is generally issued within a few days.

Best and Worst Rates

The average interest rate for a 24-month personal loan was 12.17% in the third quarter of 2023, according to the Federal Reserve. But interest rates can be more than three times that amount: Avant's APRs range from 9.95% to 35.99%, for instance. The best rates can only be obtained by people with exceptional credit ratings and substantial assets. People with bad credit can expect to pay more in interest and fees.

A personal loan is probably the best way to go for those who need to borrow a relatively small amount of money and are certain they can repay it within a couple of years. A personal loan calculator can be a useful tool for determining what kind of interest rate is within your means.

Credit Cards

Every time a consumer pays with a credit card, it is effectively equivalent to taking out a small personal loan. If the balance is paid in full immediately, no interest is charged. If some of the debt remains unpaid, interest is charged every month until it is paid off.

The average credit card interest rate carried a 21.19% APR in the third quarter of 2023, according to the Federal Reserve—up from the 2022 fourth quarter rate of 19.07%, bringing it to its highest rate since 2018. Many credit cards offer promotional rates to sign up, with some going as low as 0% interest as an introductory rate. But those rates are temporary, and when the promotional period ends, they will return to their standard level.

Credit Card Cash Advances

Credit cards usually include a cash advance feature. Effectively, anyone with a credit card has a revolving line of cash available at any automatic teller machine (ATM).

This is an extremely expensive way to borrow money. Cash advances also come with a fee, typically equal to 3% to 5% of the advance amount or a $10 minimum. Worse yet, the cash advance goes onto the credit card balance, accruing interest from month to month until it is paid off. To take one example, the interest rate for a cash advance on the Chase Freedom credit card is 29.99%.

Cash advances are occasionally available from other sources. Notably, tax-preparation companies may offer advances against an expected IRS tax refund. However, unless there’s a dire emergency, there’s no reason to give up part of your tax refund just to get the money a little faster.

Revolving Debt vs. Installment Loans

The big difference between a credit card and a personal loan is that the card represents revolving debt. The card has a set credit limit, and its owner can repeatedly borrow money up to the limit and repay it over time. Personal loans are paid out once and repaid in installments over the agreed-upon term.

Credit cards are extremely convenient, and they require self-discipline to avoid overindulging. Studies have shown that consumers are more willing to spend when they use plastic instead of cash. A short one-page application process makes it an even more convenient way to get $5,000 or $10,000 worth of credit.

Home-Equity Loans

People who own their own homes can borrow against the equity they have built up in them. That is, they can borrow up to the amount that they actually own. If half of the mortgage is paid off, they can borrow half of the value of the house, or if the house has increased in value by 50%, they can borrow that amount. In short, the difference between the home’s current fair market value and the amount still owed on the mortgage is the amount that can be borrowed.

Low Rates, Bigger Risks

One advantage of the home equity loan is that the interest rate charged is far lower than for a personal loan. According to a survey conducted by ValuePenguin.com, the average interest rate for a 15-year fixed-rate home equity loan as of Jan. 7, 2019, was 5.82%. As a result of changes in the 2017 Tax Cuts and Jobs Act, interest on a home equity loan is now only tax deductible if the money borrowed is used to “buy, build, or substantially improve the taxpayer’s home that secures the loan,” per the Internal Revenue Service (IRS).

The biggest potential downside is that the house is the collateral for the loan. The borrower can lose the house in case of default on the loan. The proceeds of a home equity loan can be used for any purpose, but they are often used to upgrade or expand the home.

A consumer considering a home equity loan might keep in mind two lessons from the financial crisis of 2008–2009:

• Home values can go down as well as up.
• Jobs are in jeopardy in an economic downturn.

Home-Equity Lines of Credit (HELOCs)

The home-equity line of credit (HELOC) is a revolving line of credit, similar to a credit card, but uses the home as collateral. A maximum amount of credit is extended to the borrower. A HELOC may be used, repaid, and reused for as long as the account stays open, typically 10 to 20 years.

Like a regular home equity loan, the interest may be tax deductible. But unlike a regular home equity loan, the interest rate is not set when the loan is approved. As the borrower may be accessing the money at any time over a period of years, the interest rate is typically variable. It may be pegged to an underlying index, such as the prime rate.

Variable Interest Rates: Good or Bad News

A variable interest rate can be good or bad news. During a period of rising rates, the interest charges on an outstanding balance will increase. A homeowner who borrows money to install a new kitchen and pays it off over a period of years, for instance, may get stuck paying much more in interest than expected, just because the prime rate went up.

There's another potential downside. The lines of credit available can be very large, and the introductory rates are very attractive. It’s easy for consumers to get in over their heads.

Small Business Loans

Small business loans are available through most banks and the Small Business Administration (SBA). These are typically sought by people setting up new businesses or expanding established ones.

Such loans are granted only after the business owner has submitted a formal business plan for review. The terms of the loan usually include a personal guarantee, meaning that the business owner’s personal assets serve as collateral against default on repayment. Such loans usually are extended for periods of five to 25 years. Interest rates are sometimes negotiable.

The small business loan has proved indispensable for many, if not most, fledgling businesses. However, creating a business plan and getting it approved can be arduous. The SBA has a wealth of resources, both online and locally, to help get businesses launched.

The Bottom Line

Borrowing money is simply part of life for many people, but how you borrow money and how much you pay for the privilege varies widely. Look for options that charge low-interest rates and fit into your budget to ensure you can repay your debt promptly.