What Kind of Loans Do You Need In Different Situations?

Summary / Teaser: Different types of loan are available for diverse financial situations. And there are loans that help you deal with other kind of loans. Here is an exhaustive account of the kind of loans for various purposes.

General Overview

Most of us face a funds crunch at least once in our lives. You may want money for a house, car, or higher education. Or you might want the money immediately for an emergency such as paying medical bills or paying a loan installment to avoid heavy penalties. The list is endless.

Citibank in Brooklyn: Banks are a Popular Source of LoansImage Courtesy of Beyond My Ken at https://en.wikipedia.org/wiki/File:People%27s_Trust_Company_Building_183_Montague_Street_Brooklyn.jpg

Banks, credit unions, and other financial institutions offer different loans for diverse situations. Interest rates, duration of repayment, and conditions of repayment vary according to the purpose of the loan and your creditworthiness.

Know your credit score and have documents to prove it before starting the hunt for loans. Most lenders use the FICO Score, a number based on a proprietary tool by the Fair Issac Corporation. A score of 740 or higher gets you favorable loan terms.

Federal and State regulations offer you protection from unethical lenders. Always, carefully study the loan conditions of various lenders viz. interest rates, possible interest rate changes, default terms, collection terms and the like.

Types of Loans

Two basic types of consumer credit are:

  1. Open-End / Revolving Credit is automatically available again at the end of the billing cycle (usually 1 month) if you do not exceed the credit limit and make the minimum repayment
  2. Closed-End Credit / Installment Loans end after you pay the balance, they are not automatically re-available. These fund a specified purpose for a specified duration. Repayment is through periodic (usually monthly) installments

Open-End / Revolving Credit

Credit Cards are the simplest example. You can use them month after month to purchase on credit so long as you do not exceed the monthly credit limit and make the minimum monthly repayment.

Ideally, pay back the full credit amount before the billing cycle ends to avoid interest charges on the outstanding balance. Average credit card interest is 13.68% but can hit a staggering 30%. Use credit cards only if you can payback the minimum monthly amount at least.

Home Equity Lines of Credit (HELOC) is another example of open-end credit. Under HELOC, your house serves as collateral. Many use HELOC as a second mortgage.

Interest is variable but lower than on credit cards. HELOCs may also be tax-deductible. Average rates for a $30,000 HELOC in mid-2016 was 5.2%. Your creditworthiness and the equity of your house i.e. the difference between your house’s value and what you owe for it determine your credit limit.

You cannot borrow your entire credit limit at once but can make multiple borrowings in the draw period (5 to 25 years). The total of all borrowings cannot exceed the credit limit. Some HELOCs require minimum monthly repayments.

HELOC is best used for value addition viz. home upgrades, college fees, debt consolidation, and major medical bills. Don’t use it to finance luxuries and essentials because default can mean losing the house.

Closed-End Credit / Installment Loans

Mortgages fall under closed-end credit. They finance house purchase and the house is collateral. These are usually the most expensive loans that Americans avail because your home is generally your most valuable possession.

Credit Unions Offer Favorable Terms of Loan to their Members
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In Q3 2016, total outstanding mortgages in the U.S. amounted to $14.2 trillion, the highest for any loan. Mortgages are paid back over 10-30 years. Average processing time to get a mortgage was 45 days in 2015. Debt.org specifies the following for quick, hassle-free obtaining of mortgages:

  • 780 minimum credit score (680 for FHA mortgages)
  • cash for closing fees and 3.5-20% down payment
  • 36% total debt-income ratio
  • 28% housing expense debt-income ratio
  • job for minimum 2 years
  • employment and salary verification
  • professional appraisal
  • documents to prove all this

Mortgage durations can be short (5 years), medium (15 years), and long term (30 to 40 years). Interest rates can be fixed or adjustable. Freddie Mac calculated the average rate for a 30-year, fixed-rate mortgage in the week ended February 5, 2017 at 3.72%.

Conventional Mortgages are not backed by government agencies. You get these with good credit scores and 10-20% down payment. Federal government backs

Federal Housing Administration (FHA) Mortgages for those with poor credit and who cannot afford down payments. Average FHA loan interest was 3.74% in October 2016.

U.S. Department of Veteran Affairs (VA) guarantees 25-50% of the amount in VA mortgages for veterans, National Guard members, military personnel on active duty, reservists, and some surviving spouses.

A World War II FHA Loan Poster: FHA Loans to Veterans Come at Favorable Terms
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Also used to improve or repair homes, VA loans charge less interest and don’t require down payment, private mortgage insurance, or pre-payment penalties. Average VA loan interest was 3.53% in October 2016. But the amounts in VA loans are limited and hidden fees can add to the expense.

Student Loans finance higher education at the college and graduate level. They form the second highest outstanding debt ($1.2 trillion in 2015, average of $35,051 per graduate) in the United States after mortgages.

Federal Student Loans offer lower interest rates and better terms than Private Student Loans. For academic year 2014-15, interest on various federal student loans ranged from 4.66% to 7.21%.

Falling government investment in higher education has made colleges hike tuition fees. Government financial aid to students has come down and salaries have stagnated. One in four student loan borrowers is in default or delinquency.

Student debt limits your capacity to obtain further loans for business, house, and marriage. Before applying for student loan, check if you are eligible for the U.S. Department of Education’s (DOE’s) Free Application for Student Aid (FAFSA).

Auto Loans are similar to mortgages because the automobile serves as collateral. Simple Interest Auto Loans allow penalty-free early repayment and are preferred over Pre-Computed Loans. Good credit score for auto loans are 750-plus. Those below 550 are bad.

Borrowed amounts and durations of American auto loans are rising. In mid-2016, average car loan was at $30,032 with average 68-month duration. Average interest rates were at 4.32% in December 2016.

Banks offer low interests and reasonably-quick auto loans. Car Dealerships fast forward the process but are expensive. Credit Unions provide competitive interest rates for members.

Some financiers allow you to buy a car with Home Equity Loans. The interest on these loans is lower and can be tax deductible. But default can mean losing your house.

Personal Loans finance any personal need viz. settling credit card debt, vacation, luxury items etc. Available quickly, these charge lesser interest than credit cards. You can settle credit card debt with these. Banks and Credit Unions usually offer personal loans.

Secured Personal Loans are backed by your asset(s) and are cheaper than Unsecured Personal Loans. Best rates start at 5% interest. Unsecured loans for those with poor credit can cost 18-36% interest. You may not require to payback unsecured loans if you declare bankruptcy.

Personal Loans can be:

  • HELOC
  • Home Equity Personal Loan
  • Second Chance Personal Loan for personal tragedy or financial emergency
  • No / Bad Credit Personal Loan for those with bad credit
  • Short Term Personal Loan for financial emergencies
  • Fast Cash Advance / Payday Loan for financial crisis
  • Military Payday Loan for certain military personnel

Because of numerous personal loan scams, beware of those who guarantee loans, use misspellings of large financial companies, or those who ask for personal information, electronic fund transfer, or upfront fees.

Home Equity Loans allow you to borrow when the value of your house exceeds what you owe for it. You get this as lump sum and have to repay like any closed-end loan.

Essentially, this is a second mortgage suitable for home improvement, consolidation loan, and settling student and credit card debt. Interest is tax-deductible and lower than on credit cards. Average interest on a $30,000 home equity loan was around 5% in mid-2016.

Payday Loans are super-short-term loans availed by low-income people with bad credit who run out of money before receiving their monthly paycheck. Average interest is very high at 400%, but can hit an exorbitant 900% per annum. Average duration is 30 days that can be rolled over for extra fees.

Lenders lend out between $100 and $1,500 with little or no credit checks. The borrower writes him a post-dated check for the amount plus interest. Payday loans are a financial quicksand because the borrowers get trapped in debt.

Although government requires payday lenders to disclose their fee structure under the Truth in Lending Act, the desperation of the borrowers who cannot access bank credit ensures that such predatory lending continues with little oversight.

Payday Loan Center: Payday Loans come at an Average 400% Per Year Interest
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Cash Advances are short-term cash loans used where credit cards are not acceptable. You withdraw cash from banks or ATMs with your credit card for cash emergencies when your account holds insufficient balance or when your paycheck is coming late.

Payday lenders also offer these loans. Lenders charge a 5% transaction fee and an average 24% interest. And they charge it immediately unlike credit card purchases that levy interest after 30 days.

Life Insurance Loans are good for emergency spending on medical bills or mortgage payments. You can borrow up to the cash surrender value of your permanent life insurance policy.

No credit checks are needed and rates are lower than on personal loans (10.47% for two-year term) or credit cards (13.68%). You don’t have to repay these loans but the borrowed amount plus interest is deducted from the maturity payment.

Retirement Plan Loans are available from 401(k), 403(b), and 457(b), profit-sharing, and money purchase plans to finance emergencies and home building. Individual Retirement Accounts (IRAs) and IRA-based plans do not offer loans. These are tax-free if repaid.

Maximum borrow-able amount is the lesser of $50,000 or 50% of vested account balance. If 50% of vested account balance is less than $10,000, you can borrow $10,000. Interest rate is around 5% and you have to repay within 5 years.

Negatives include limited borrowing amount, short repayment term, cuts in gains and retirement savings, penalties for missed payments, and complications if you lose or leave the job.

Borrowing from Family and Friends in the U.S. amounts to $89 billion a year. Such loans usually finance new business or house purchases. Lenders are more flexible but default can mean strained relationships. Lend your money and lose your friend, as they say.

Consolidated Loans help you lower your interest and monthly payments while protecting your credit and getting you out of debt faster. Instead of making multiple payments to different creditors every month, you make one repayment to one creditor who handles other creditors.

Use them to get out of student and credit card debt. These suit you if you owe $10,000-plus to numerous creditors, have taken high-interest loans, cannot negotiate low interest, and are getting calls from collection agencies.

Banks, credit unions, and consolidation specialists provide these loans. Transferring balances from high-interest credit cards to a zero-interest credit card is the best way to consolidate credit card debt under $3,000. Other consolidation loans include home equity loans, HELOC, mortgage refinance, life insurance loans, and retirement plan loans.

Finally

Credit is an inseparable part of present-day lifestyles. But credit does not mean you have to fall in the debt trap. With some research, you can get the most suitable type of loan and pay it back as well.

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