You can arrange to borrow and repay the money you need for specific expenses.
When you need money to buy a car, pay college tuition, fix up your home, or anything else that requires an immediate cash outlay, you’re often able to borrow the amount from a lender such as a bank, credit union, or mortgage company. If you know how different types of loans work and the particular features they offer, you’ll be in a better position to look for the one that will be best suited for you.
Buying on time, or paying for something while you’re using it, was introduced by Isaac Singer in 1856 as a way to sell his sewing machines. At $5 down and $5 a month, the average family could afford a $125 machine — otherwise impossible on a typical $500 annual income.
In some ways, of course, all loans are alike. You borrow money, called the principal, and agree to pay it back over a specific term, or length of time, with interest. But the conditions of the loan, some of which are listed below, can affect how much you can borrow and how much the loan will cost you.
- The term of the loan
- Whether the interest is fixed or adjustable
- Whether the loan is secured or unsecured
The cost of borrowing If you take a five-year $20,000 loan at 8% interest:
- Monthly payments for 5 years: $386.66
- Total payment: $23,196.60
- Total interest paid: $3,196.60
When you take an installment loan, you borrow the money all at once and repay it in set amounts, or installments, on a regular schedule, usually once a month. Installment loans are also called closed-end loans because they are paid off by a specific date.
Your loan is secured when you provide something of value, called security or collateral, as a guarantee you will repay what you owe. The lender can repossess the collateral and sell it if you default, or fail to repay. Car loans and home equity loans are the most common types of secured loans.
An unsecured loan is made solely on your promise to repay. If the lender thinks you are a good risk, nothing but your signature is required. However, the lender may require a cosigner, who promises to repay if you don’t. Since unsecured loans pose a bigger risk for lenders, they may have higher interest rates and stricter conditions.
Fixed interest rate
Many installment loans have a fixed interest rate. The interest rate and the monthly payments stay the same for the term of the loan.
- Installments stay the same
- Easier to budget payments
- The cost of the loan won’t increase
- No surprises
- Interest remains the same, even if market rates decrease
- Initial rate usually higher than adjustable rate
Adjustable interest rate
An adjustable-rate loan has a variable interest rate. When the rate changes, usually every six months or once a year, the monthly payment changes also.
- Initial rate usually lower than fixed rate
- Lower overall costs if rates drop
- Annual increases usually controlled
- Vulnerable to rate hikes
- Hard to budget for increases
- Not always available
Lines of credit
A personal line of credit is a type of revolving credit. It lets you write a check against the line or use a linked debit card for the amount you want to borrow, up to a limit set by the lender. The credit doesn’t cost you anything until you access the line. Then you begin to pay interest on the amount you borrowed. You must repay at least a minimum amount each month plus interest, but you can repay more, or even the whole loan amount, whenever you want. Whatever you repay becomes available for you to borrow again.
Banks and credit card issuers sometimes offer lines of credit automatically to people they consider good customers. That doesn’t mean you have to borrow money this way if you prefer not to.
Using a line of credit If you have a $10,000 line of credit, you have access to that money over and over, as long as you repay what you use:
- Line of Credit: $10,000
- You Borrow: -$6,000
- Available Credit: $4,000
- You Repay: +$1,000
- Available Credit: $5,000
- Only one application
- Regular access to credit
- Potentially higher interest rates than other loans
- Easy to over-borrow
This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.