In this article we'll learn about loans and understand the differences between some common loan types.

A loan is a formal way to borrow money with the understanding that we'll repay the borrowed amount within a certain period (months or years) and that we'll pay the lender a periodic interest on the money borrowed. We usually do the repayment in an incremental way — a little bit every month, instead of as a lump sum at the end of the loan period.

Types of Loans

Different types of loans serve different purposes and therefore are structured differently. Loans differ mainly in a) the loan period — how much time we have to repay (pay off) the loan, b) the interest rate — how much interest we have to pay, and c) the collateral — our asset or property that we pledge to the lender to get the loan; if we're not able to make the loan payments, the lender can legally own the asset.

Home Loan

Home loan is a loan to help us buy a house. It is typically a large amount, sometimes up to 80-90% of the cost of the house.

The loan period can be anywhere from 10 to 30 years. Shorter- and longer-term loans are also possible, but rare. The interest rate is typically anywhere from 1% to 15% (and is typically tied to the base lending rate set by the country's central bank).

Usually the house that is being bought using the loan is itself offered as collateral. In other words, if we can't make loan payments, the lender can claim ownership of the house.

Home loans' interest rates can be fixed or variable. In a fixed interest rate loan, the interest rate doesn't change once the loan is taken (even if the central bank changes the basic lending rate during the loan period). In a variable interest rate loan, the loan period is split into segments. Just before the start of each segment, the interest rate is calculated for that segment. (Typically only two segments are created: a short segment for approximately the first few years of the loan period, and a longer one that lasts for the reminder of the loan period. The shorter segment usually has a much lower interest rate than the longer one.)

Home loan refinance

A home loan refinance is simply getting a new home loan for the amount remaining in the current home loan. We would typically do this if new loans are being offered at a much reduced interest rate than our current loan, thus reducing our monthly mortgage payment significantly.

Home Equity loan

As the value of our home increases after we bought it, it adds to our wealth, even though we can't just use the additional wealth (unless we sell the house). A home equity loan allows us to borrow money using our increased home value as a collateral. The interest rates for a home equity loan is similar to that for a home loan.

Unlike a home loan where the borrowed amount is used to buy the home, we can use a home equity loan to finance anything. However, home equity loans are typically used to extend/repair/remodel the home itself so that it is more attractive when we want to sell it some time in the future.

Auto loan

Auto loans help us buy a car right now and pay for it over several months or years. The loan period is typically smaller than that for a home loan (a few years to a decade or so, instead of up to 30 years). Because an auto loan amount is much smaller than a home loan amount (tens of thousands instead of hundreds of thousands or more), the process of getting an auto loan is much quicker than for a home loan (a matter of hours instead of weeks).

Indirect Loans

Another way to borrow money is from our own investments. For example, the government allows us to save money periodically in government-approved retirement accounts (e.g., Independent Retirement Accounts (IRAs), employer-provided 401K, etc.). The funds in the retirement account typically grow over time and we can withdraw the funds only when we reach a certain age. Similarly, annuities allow us to invest periodically when we are making money. Upon retirement, we can draw from the annuity for our monthly expenses. Often, these investments (IRAs, 401K, annuities) allow us to borrow (take an early 'short-term loan') from our own account, even before we are normally eligible to start drawing from the account. We are, however, required to repay the loan with any interest.

The interest rates for such loans are often high and so also are the penalties for not repaying the loan. Thus, using this mechanism makes sense only in emergency situations.

Line of Credit

There's an alternative way of borrowing money — through a line of credit. Let's understand how a line of credit is different from a traditional loan.

A traditional loan is a one-time thing: we take a loan for a specific purpose (to buy a home, pay for college, etc.) and for a specific loan period (i.e., we promise to pay off the loan within that period). In order to qualify for the loan, we need to first prove our credit worthiness — by providing documentation about our credit scores, wealth, etc. And, once we pay off the loan, we're done. To take another loan, we start all over again.

The key attributes of a traditional loan are: each loan requires us to qualify; a loan's interest rate depends on the type of loan (home loan, college tuition loan, etc.).

A line of credit, on the other hand, is a pot of money that is made available to us by the lender (typically a bank) to borrow from. Once we prove our credit worthiness, the lender essentially says "we know that you are credit worthy for up to X dollars, so we've set aside X dollars for you. You can borrow as often and as much as you need, as long as the total amount borrowed at any time from this pot doesn't exceed X dollars, and you make the interest payments promptly, and pay off what you borrowed in a reasonable amount of time."

Let's contrast this with the attributes of a loan: once we qualify and a line of credit has been established for us with a lender, we can borrow as often as needed from the line of credit; we don't need to requalify each time. However, because a line of credit is not for a specific purpose, the interest rate is typically much higher than for a traditional loan for a dedicated purpose.

Credit Cards

A credit card is an example of a line of credit. A credit card comes with a spending limit (the line of credit limit, i.e., the pot). Each time we use a credit card to buy something, we're 'borrowing' from the pot, with the understanding that we'll pay it back soon (typically within a month; any delayed payment incurs interest). As we all know, the interest rate for a credit is usually very steep.

The article Understanding Credit Cards explains credit cards in more detail.

Loan Terminology

Just as there are so many different kinds of loans, there are also several important terms and conditions that pertain to loans. Understanding these terms in loan documents is important and will help us differentiate between good loans/lenders and bad ones. In this section we'll examine some of them (this is by no means an exhaustive list):

• Fixed vs. variable term loans: fixed term loans have overall lower interest; a variable term loan has an initial lower interest and a higher interest later, resulting a slightly overall higher interest rate. The initial lower rate makes a variable interest loan attractive to the borrower. (The thought behind this is that if the asset for which the loan is acquired (e.g., a house) rapidly appreciates in value, the borrower will be easily be able to afford the higher interest rate later.)
• Balloon payment: this is an extreme case of a variable interest rate loan where most payments are kept really small, but the final payment is huge.
• Total loan cost: this refers to the cost of getting a loan: loan processing fee, closing costs, points, etc..
• Early repayment penalty: some loans come with a requirement that the loan may not be repaid in full before its term has ended. Lenders that want to maximize the interest from the loan typically add this clause to the loan.
• Acceleration: a clause put in by the lender that if the borrower can't pay (i.e., defaults), rest of loan becomes immediately payable in full.
• Attorney fee: a clause added by the lender that the borrower is to pay for any attorney fee that the lender incurs (to enforce acceleration, etc.).
• Wage garnishing clause: the lender may add a clause that they be allowed to access the borrower's wages if the borrower defaults on payment.
• Arbitration clause: this clause may be added by the lender to force the borrower to go to an arbiter in case of disputes, essentially removing the borrower's right to sue the lender. Often, the arbiter is selected by the lender.

Summary

Loans allow us to acquire and enjoy assets sooner than waiting to save up to be able to afford them. At the same time, loans also add extra costs (in the form of interest) to the actual price of the asset. Also, being legal contracts, loans also impose strict penalties for any lapses in repayment. Plus, different lending agencies have different lending criteria, often including some "fine print." Discussing our specific needs with a loan broker as well as with a qualified financial consultant is important in weighing all the pros and cons and in choosing the right kind of loan and lender.