What are the various types of consumer loans and why would I use them?

Consumer loans are available in many forms and for a variety of purposes such as purchasing a home, financing a vehicle, and consolidating high interest credit card balances. These financial tools range from ultra specific (e.g., mortgage) to extremely flexible in helping you purchase desired goods and services. The cost of consumer loans will vary greatly depending on the potential profit available to the lender and the risk they assume by lending to you.

Your financing requirements will vary across different phases of your life. If you need financing, it is important to find a loan that best suits your budget and needs. 

Loan categories and structures

To find the right loan for you, it’s first necessary to understand the various classes of loans and what this means for how you can use the loan, your repayment requirements, and the consequences for not repaying your debts. There are four key categories you’ll typically hear about:

Secured or unsecured

A secured loan means you, as a borrower, must offer collateral in the form of cash or property which the lender has a claim against if you fail to repay the loan. Common examples are a house or condo in the case of a mortgage, or a vehicle in the case of an auto loan. Secured loans typically have lower interest rates. However, if you default on your payments, the lender has the right to seize (i.e., repossess) the collateral.

Conversely, an unsecured loan has no collateral attached to it. Unsecured debt is higher risk to the lender, as their recourse is limited in the event of default. This typically means higher interest rates for consumers.

Revolving or installment

A revolving loan (commonly known as credit) is debt you can continually borrow against and repay for as long as you and the lender agree to keep the account active. Generally, you’ll have a set limit for how much you can borrow at any given time and the lender will require a monthly maintenance payment to keep your account in good standing.

Examples include: Credit cards, lines of credit

An installment loan is a lump sum amount that you borrow once and make regular payments against until the original principal value (plus interest) is repaid in full. You cannot easily make additional withdrawals against an installment loan — though lenders may be willing to re-finance a loan, which generally requires filing a new loan application and may impact your interest rate and repayment terms.

Examples include: Personal loans, mortgages, vehicle loans, etc.

Types of loans

There are numerous types of loans available for consumers — each with specific rules, functions, and restrictions that make them suitable for a range of financial applications. While lenders may encourage you to apply for various types of loans throughout your life, that doesn’t necessarily mean what they’re selling is appropriate for your current situation, much less your financial and lifestyle goals.

Credit cards and cash advances

A credit card is an unsecured, revolving loan which has a set limit you can repeatedly borrow against and repay from month to month. Credit cards are a convenient form of payment at most retail establishments and restaurants — however, this also makes them easy to abuse. Because of the higher risk to lenders, they typically have higher interest rates than other types of loans. Depending on the type of card, the benefits offered and the borrower’s credit history, this can usually range anywhere between 15 and 30 percent.

Cash advances
Some credit cards will allow borrowers to withdraw a small amount of cash directly from a bank branch or ATM against the credit card as a short-term loan. These so-called cash advances may seem convenient. However, they can also be quite costly. Firstly, the interest rates on cash advances are typically five to 10 percent higher than for regular credit card purchases. Also, interest starts accumulating immediately, compared to the following month with most other loan types.

Mortgages

A mortgage is a secured installment loan which allows consumers to purchase a home. It typically requires monthly payments over a 15-, 20-, or 25-year timeframe.

The collateral is the real estate property itself (i.e. house or condo). If borrowers fail to make payments, the lender may repossess the property through foreclosure proceedings.

Interest rates are generally quite low on mortgage loans — and are either fixed (and re-negotiated every few years) or variable and subject to market fluctuations. Mortgage brokers can assist consumers in finding the most competitive rates.

Reverse mortgages

A reverse mortgage allows consumers to borrow against the equity in their home, up to 55 percent of the property’s total value. The amount you may be entitled to borrow depends on your age, the appraised value of your property, and the lender.

Borrowers are not required to make any monthly payments against a reverse mortgage. Rather the loan is paid back when they (or their estate) sell the home. There is an interest component, however this too theoretically comes out of the equity earned through the sale of the property.

Like a mortgage, the borrower puts the home up as collateral. If the house falls into disrepair or the real estate market collapses, the lender could repossess the home.

Home equity loans and lines of credit

Home equity loans (HELs) and lines of credit (HELOCs) allow consumers to borrow against equity (i.e., the difference between the current market value and original purchase price) in their homes.

As it sounds, a HEL is a secured installment loan which the borrower will repay over several years. A HELOC, on the other hand, is secured revolving credit which borrowers may draw against and repay as their financial needs require. Many homeowners leverage HELs and HELOCs to upgrade their home and hopefully increase its equity value even further — however, there are not typically restrictions around what borrowers can and cannot use this money for.

Both HELs and HELOCs offer several potential benefits and risks for borrowers. The benefits include:

1. a potentially significant amount of cash (depending on available equity),
2. low interest rates (often lower than an unsecured personal loan), and
3. affordable monthly payments (many HELOCs only require borrowers to repay the interest accrued each month).

HELOCs also offer flexibility to continually draw against the home’s equity and repay the debt as needed for as long as the line of credit remains open.

The drawbacks in both cases are:

• the home is collateral and may be repossessed if the borrower fails to repay the loan, and
• (2) HELOC interest rates are typically variable and can become unaffordable if interest rates rise.

Vehicle loans

There are two types of loans available to purchase a vehicle:

Collateral loan

A collateral loan is obtained by borrowing funds from a lender in the amount of the vehicle’s purchase price. The borrower will make monthly installment payment, and the lender will take the vehicle as security. 

Conditional sales contract
In a conditional sales contract, the seller retains ownership of the vehicle until the borrower makes full payment toward the auto purchase. These are typically issued by car dealerships via financing agreements. Once the contract is signed, dealerships will often sell these agreements to a third-party finance company. These are secured installment loans with monthly payment requirements. If the borrower fails to make payments, the dealership (or finance company) may repossess the vehicle. 

Consolidation loans

A consolidation loan is a (typically) unsecured installment loan which consumers may access to pay off several outstanding higher-interest rate debts such as credit cards and payday loans. The goal of a consolidation loan is to reduce the number of monthly payments into a single affordable monthly payment with a lower average interest rate than they were paying previously.  

Consolidation loans are often an effective strategy to pay debt down faster, avoid missing payments, reduce the amount they’re paying in interest. However, it’s important to check (and recheck) the math before proceeding with a consolidation loan as some predatory lenders may seek to unfairly profit off borrower’s perception that consolidation loans are always cheaper — which they’re not.

Payday loans

Payday loans are short-term, high cost, unsecured installment loans offered through private lenders. They are sold to consumers as an affordable and effective solution to short-term financial emergencies. In reality, they’re a predatory loan which is designed to trap consumers in a permanent cycle of debt.

The typical process is as follows: A consumer visits a payday lender to borrow enough money to get them through to their next payday. This amount is repayable within one or two weeks, plus interest and service fees. However, because these fees and interest typically average out to roughly 400 percent per year, borrowers often find themselves having to borrow even more to make it to the next payday and the next.

For context, the interest rate for a comparable personal loan is usually in the rage of 10 to 20 percent. Credit cards usually charge between 15 and 30 percent.

Student lines of credit

Student lines of credit are a revolving, unsecured loan offered through a bank or private lender which a student can continually borrow against and repay throughout their post secondary education. This can be a helpful tool to cover tuition costs, books, housing, and other expenses a student typically encounters as a student. Lenders will typically require proof of enrollment every semester to keep the account active.

Interest rates on student lines of credit are comparable to government student loans. And these can be beneficial for individuals who either do not qualify for government student loans or for whom government student loans are insufficient to cover all their education and life-related expenses.

However, monthly interest payments are required on most student lines of credit throughout the lifecycle of the loan. In contrast, government student loans do not become payable (or begin accumulating interest) until six months after the student graduates or leaves their program.

Business loans

Many banks and private lenders offer loans for individuals to establish or expand a business. These are usually installment loans, but some lenders may be willing to extend a revolving line of credit depending on the financial means and prospects of the business. Most lenders will require a business plan from the borrower before extending the loan.

Although the loan is for the business entity, lenders will often require a personal guarantee required by the business owner. In the event the business defaults, the debt becomes the individual borrower’s responsibility to repay. Some lenders may also require security depending on the size of the loan.

Do your homework

Debt can be a useful tool to support your financial goals, but it’s also important to recognize you too are taking a significant financial risk every time you borrow money. Review your budget carefully prior to taking on any debt to determine a monthly payment you can afford.

Also be sure to read and make sure you fully understand the agreement. Are you agreeing to a revolving or installment loan? Are you pledging any collateral against the loan — and, if so, what? Is your interest rate fixed (stays the same from month to month) or variable (changes with the market) — and is it competitive with other lenders?

What is your monthly obligation? How long will it take to repay the debt in full? Are there consequences of missing a payment or paying the debt off early?

It’s exciting to think about all the ways a loan can help you move forward, but first it’s critical to make sure the borrowing makes sense and won’t end up holding you back.