Understanding Loans

At first glance, loans seem to be a pretty simple concept that everyone understands. You need to borrow some money, you apply for the loan and then spend it on the stuff you want or need. But, there are many loan options and each of them offer some differences in their benefits and features. There is no one-size-fits-all loan solution and you need to know the details to ensure that you’re making the best financial decision. In this article, we will take a look at some common loan types and explain how they work to help you choose a loan that’s right for you.

What is the Difference Between Fixed and Variable Rates?

The first challenge is to understand the differences between fixed and variable rates which will have an impact on how much you will repay over the long-term:

Fixed Rate Mortgages

As the name suggests, these mortgages have a fixed rate of interest that’s usually set for a specified period. This rate may apply for the whole mortgage term or it could be fixed rate for the first few years and then become a variable rate mortgage. The main benefit of a fixed rate is that you will know exactly what you’re paying every month. But, the main drawback is that the capital tends to be repaid at a slower pace and you’re likely to be locked into a higher rate compared to a variable rate product. The lender is locking the rate to promote stability to make budgeting easier for other expenses. Of course, this isn’t a purely altruistic move on their part because you’re going to pay more in the medium to long-term. This may be a condition of the mortgage for those with a lower credit score that lack financial credibility for a large scale purchase. Access to a variable mortgage may be available later where the interest payments may change. But, the interest can go up or down and you may pay more than the fixed rate repayments. Timing is everything, if you can get a fixed rate deal when the market trends are in your favor, you could be in better financial shape for years to come.

Variable Rate Mortgages

The interest of a variable rate mortgage adjusts to changes in the market. If a FED policy causes an interest rate change this will cause your mortgage payment to increase or decrease accordingly. So, you can take advantage of interest rate decreases and vice versa. This makes planning for monthly expenditures a challenge over the long term. But, the lender will provide notice that an interest rate change is going to occur. This is typically applied in the next month and you won’t have much time to plan for those extra funds. For this reason, it’s a great idea to have an emergency fund in place to cover any shortfall until you can adjust to future repayments. 

5 Common Loan Types Explained

Many loans are tailored to meet certain needs and choosing the right one is important. They are:

1. Personal Loans

A personal loan is usually unsecured, no collateral is required to secure the loan and it can be a flexible way to borrow. The funds can be used for pretty much any purpose from a large ticket item purchase to an unexpected bill or credit card consolidation. A typical personal loan term is 3-7 years which can be used to spread repayments into manageable chunks that are easier to handle. The interest rate is usually fixed for the entire duration of a personal loan to ensure that you know exactly how much you need to pay. This is why it’s important to time a personal loan carefully to take advantage of lower interest rates if you can.

2. Auto Loans

These loans are designed purely for vehicle purchases and the collateral is the vehicle itself. This gives you access to a lower interest rate in comparison to a personal loan but if you default the vehicle can be seized and sold to settle the outstanding debt. Auto loans are available with terms of ten years or longer, but spreading the cost out over too long will mean that your vehicle will be worth much less due to depreciation. Essentially you will be paying far more in real terms than you can repay on the term of the loan. It’s a smart ideal to purchase extra vehicle insurance to cover the difference if the vehicle is worth less than the outstanding loan amount. Otherwise, you may be out of pocket if the vehicle is written off after an accident. 

3. Mortgages

We’ve already covered the difference between fixed and variable rate mortgages above. For most people, a mortgage is the largest loan that they will ever take. It’s important to remember that the borrowing is secured on the property and defaulting could lead to a repossession. 

4. Home Equity Loans

These are similar to a mortgage because the amount borrowed is secured on the property. But, these products are designed to release equity that you’ve built up on the home. A lump sum is offered along with a fixed rate over the long-term. This can be a good option for lenders facing significant expenses due to a home renovation project.  

5. Student Loans

These products are designed to fund an education and they can be offered by a private institution or the federal government. A student loan can be used to cover tuition fees, purchase educational materials and pay for living expenses. These are long-term loans with lower interest rates in comparison to other loan types. A federal student loan tends to have flexible payback options with greater protection than privately sourced alternatives.

These are the most common loan types and as you can see they are pretty self explanatory. There are circumstances that lie outside these loan options, but they would be extremely specific and beyond the scope of this article. That said, the best advice we can offer is to research the loans that you’re interested in and look for market trends that foresee a reduction in the interest rate. When the interest rate drops secure a fixed rate loan, if it doesn’t and you can’t wait or you anticipate future interest rate reductions go with a variable rate deal.