11 Types of Loans Explained: Learn How to Qualify for a Loan
November 14, 2023
There are multiple types of loans available for individuals and business owners alike. The question is, can you pinpoint which loan type is best suited for your financial goals?
Loans differ based on the payment terms, interest rates, and requirements set by the lender.
That said, gaining substantial background on each type of loan will help you find loan terms that fit your needs and plan your finances accordingly.
This article will delve into the different variations of loans, including the required documents and steps needed to apply for one.
- The different types of purpose-based loans vary based on their usage. Mortgages, auto loans, and land loans are used to acquire properties. Student, medical, and personal loans are used to fund essential and leisurely expenses.
- Secured loans are protected by collateral, while unsecured loans are not. Unsecured loans also entail lower loan amounts and limits for debtors with low credit scores.
- The two types of interest rates are simple interest and amortized interest. Interest rates also depend on the debtor’s credit history and payment behavior.
- Pay stubs, proof of identity, proof of address, employer, and financial history are some of the required documents when applying for loans.
What Are Loans, and How Do They Work? [226 words]
Loans are borrowed sums of money by an individual, a business, or an entity from a financial institution, corporation, or government organization. There are different reasons why a person or business may need to borrow money.
When a group or individual borrows money, they are referred to as the debtor or borrower. On the other hand, institutions that lend money are called lenders.
Depending on the type of loan and the amount that a debtor plans to borrow, each type of loan may vary based on its specific terms and conditions, interest rates, finance charges, and payment deadlines.
The higher the amount borrowed, the stricter the screening process for the debtor.
Some lenders conduct a thorough background check on the borrower’s credit and employment history, while others require borrowers to provide collateral.
Lenders will also evaluate the borrower’s debt-to-income ratio, or the fraction of the borrower’s gross salary that goes into paying their loan. Other loan requirements may also include the debtor’s social security number and copies of their pay stubs and bank statements.
Banks and lending companies typically ask borrowers to provide their pay stubs or bank statements to serve as their proof of income. It is also worth noting that not all debts come in the form of cash.
Non-cash debts can either be in the form of bonds or deposit certificates.
Types of Loans Based on Security
The different types of loans are categorized based on security and purpose. Security-based loans are characterized mainly by the presence or absence of collateral that helps guarantee a debtor’s commitment to repay their loan in full.
A secured loan is a debt that’s protected by collateral.
Some loans that fall under this category include:
- Auto loans
- Business loans
- Land loans
- Mortgages and other types of loans for homes
Secured loans often come with lower interest rates, higher loan amounts, and higher loan limitations. On the other hand, repayment terms may also take longer compared to unsecured loans.
Collaterals vary based on the type of loan. For instance, the vehicle or property that a borrower wishes to purchase becomes collateral for a car loan or mortgage. For business loans, collateral can either be the business’s capital, real estate, machinery, or equipment.
When a borrower defaults on their loan or fails to repay their loan amount and interest in full, the lender automatically seizes ownership of the collateral.
In some instances, a debtor may qualify for tax deductions upon settling their mortgage interests.
Unlike secured loans, unsecured debts do not require collateral.
Examples of unsecured loans include:
- Student loans
- Credit cards loans
- Personal loans
- Consolidation loans
Since this type of loan does not offer lenders any sort of protection against non-paying debtors, approval for unsecured loans depends on the borrower’s credit score. Good credit scores merit higher loan limits and more flexible interest rates.
Debtors who fail to meet their repayment schedules instantly reduce both their credit score and their chances of getting approved for other loans in the future.
While unsecured loans may yield higher financial risks for lenders, lenders must still uphold fair and reasonable assessments and refrain from discriminating against a debtor’s financial background.
9 Types of Loans Based on Purpose
The types of loans based on purpose are defined and categorized based on the debtor’s reasons for borrowing their desired sum of cash. Some might wonder, ‘How many types of loans are there’?
In truth, there are several purpose-based debts, but the ones listed below are by far the most common:
#1. Personal Loans
Personal loans are a generalized type of loan in that each borrower has distinct reasons for seeking to acquire the said loan. Most of the time, debtors apply for a personal loan to cover existing debts, fund home improvement projects, and pay for their travel and vacation expenses.
Personal loans are unsecured, come with fixed interest rates, and are evaluated based on the borrower’s earnings, debt-to-income ratio, and credit score.
It is fairly easy to apply for personal loans. In fact, debtors can take advantage of online tools such as a pay stub generator to produce copies of their most recent paychecks. They can also use credit score simulators to estimate their credit scores.
#2. Auto Loans
Auto loans or car loans are used to purchase a vehicle or car. Car loans entail a large sum of money, and so lenders likely require borrowers to submit recent copies of their pay slips to assess their financial capacity to afford the vehicle’s price.
Most auto loans follow fixed installments, meaning the debt is paid on a fixed payment schedule with a set interest rate on the loan amount. Also, lenders usually require debtors to fulfill a downpayment before they can withdraw the borrowed sum.
Borrowers looking to secure an auto loan the fast and easy way must consider dealer financing. Dealer financing enables debtors to acquire financing for their debt while shopping for their vehicle of choice at the same time.
Alternatively, you may apply for a car loan through credit unions, online lending services, or bank financing.
#3. Mortgage Loans
Mortgage loans are an agreement between a debtor and a lender or loan financier, wherein the latter acquires the right to seize the asset or property if the debtor defaults on their loan and interest fees.
A mortgage is used to purchase a house or residential property. Here, the lender gives the borrower the money needed to purchase the home. In turn, the borrower repays the acquired amount plus interest over a span of years.
Some factors that lenders and banks look into when evaluating mortgage applications are interest rates, prepayment penalties, loan terms, balloon clauses, and the annual percentage rate (APR).
#4. Small Business Loans
There are different types of small business loans, including:
- Small business line of credit. It follows a loan structure similar to credit cards. Businesses can loan cash at a fixed limit and then pay interest charges only on the amount borrowed. It is important not to go over the credit limit to repay the borrowed funds without hassle.
- SBA small business loans. This type of small business loan is guaranteed by the U.S. Small Business Administration. A guarantee refers to the amount or percentage of the loan that the SBA covers in case the borrower is unable to repay the lender. For loan amounts worth $150,000 or less, the SBA guarantees 85% of the loan. Loans that exceed $150,000 get a 75% guarantee from the SBA.
- Small business term loans. It is a small business loan used for small business investments. The lender grants the debtor a lump sum of capital, which is then repaid at regular repayment intervals with a fixed interest rate.
#5. Student Loans
Student loans help cover college tuition fees, student living expenses, books, and other educational expenses. Students can choose between federal student loans and private loans.
Federal student loans come with fixed interest rates and loan limits but do not entail reviewing a student’s credit history or score.
There are subclassifications of federal student loans, namely:
- Direct subsidized loans for undergrad students
- Direct unsubsidized loans, which are available for undergraduate, graduate, and professional students
- Direct consolidation loans are a combination of different types of federal student loans. The loan amount, interest rates, and repayment conditions are merged into a single monthly payment.
Private loans, on the other hand, require a credit score of at least 670 and a co-signer, particularly if the debtor is an undergraduate.
#6. Payday Loans
Payday loans are unsecured loans notoriously known for their exploitative risks. The interest rates are often magnified, and there are also high penalty charges for missed repayment due dates.
In fact, interest rates for payday loans can go as high as 780%.
Despite the impossibly high interest charges, payday loan lenders require borrowers to present their government ID, pay stubs, and other valid proof of income. At the same time, repayment terms are strikingly shorter—spanning 30 days or less.
Debtors should think carefully before applying for a payday loan because of the potential risks that they may face.
#7. Medical Loans
This type of loan is used to cover medical expenses, particularly during an emergency. Medical loans are also used to fund hospitalization expenses, planned treatments, and expensive medications and tests.
Loans used for medical expenses can either be secured or unsecured. However, the lender’s policies and requirements, as well as the debtor’s credit and loan history, ultimately determine the interest fees and qualification for flexible payment terms.
#8. Land Loans
Land loans refer to a type of loan meant to pay for the costs that come with enhancing a plot of land, leasing land property to businesses, or building residential properties. There are two types of land loans: improved and unimproved land loans.
Improved land loans cover the expenses for further developing plots with existing infrastructure or installed power lines.
In contrast, unimproved land loans suit vacant lots or land with no visible property built on it.
Land loans have higher interest rates and more strenuous assessment processes. Debtors are also required to provide a down payment. Moreover, their debt-to-income ratio must not exceed 43%, and their credit scores should not go lower than 600.
#9. Debt Consolidation Loans
Borrowers with multiple debts should try applying for a debt consolidation loan. A debt consolidation combines all existing debts into a single loan.
This type of loan effectively regulates repayment responsibilities and reduces the monthly dues and interest rates that debtors owe.
Note that having multiple debts does not automatically qualify a borrower for a debt consolidation loan. Lenders will still review their financial status and credit score to determine whether they are fit for a unified loan.
Interest Rate on Loans
The interest rate on loans is the additional amount that a lender charges a borrower. It is a percentage of the principal amount. In calculating a debtor’s interest rates, lenders review a debtor’s credit score and assess whether a borrower is low-risk.
A low-risk debtor has a good credit history and does not have any past records of unpaid debt or missed repayment deadlines.
There are also two types of interest commonly used by lenders: simple interest and amortized interest.
Simple interests include the principal or loan amount, loan term, and interest rate in the equation. The monthly payments are fixed, but the interest rates may change depending on the remaining or outstanding balance.
Amortizations have compound interest, meaning the interest rate is based on the accrued interest and principal loan.
The interest rates on amortizing loans comprise a small portion of the monthly loan payments at the beginning but take up the majority of the principal outstanding balance by the time the debtor is about to reach the end of their repayment schedule.
What Lenders Look For When Approving Your Loan
Now that you know the different types of loans, you must also know what lenders look for when approving your loan:
#1. Credit Score
A credit score is a three-digit number that ranges from 300 to 850, with 850 being the highest possible score. It is an indicator of your capacity to repay your debts on time and in full.
There are several instrumental factors in determining your credit score, such as how consistently and timely you pay your bills, existing loans (if any), available credit, and the length of time you have had your existing debts.
#2. Debt-to-income Ratio (DTI)
Your debt-to-income ratio is the resulting value when you divide your monthly loan payments by your gross monthly earnings. Lenders use your debt-to-income ratio to check whether you are financially equipped to fulfill your monthly loan payment responsibilities.
#3. Employment History
Lenders are also keen to learn about your relationship with your work and your past employers. If you have noticeable gaps in your employment history, then it may diminish your chances of qualifying for a loan.
A consistent and stable job certifies your capacity to afford your desired loan amount. Your employment history also reflects your ability to maintain amicable business relations.
Multiple instances of disciplinary measures from your previous supervisors may be interpreted as an unwillingness to follow strict loan approval policies and repayment protocols.
Documents Needed When Applying For Loans
The following are the essential documents needed when applying for loans:
- Application form. The application form and process may differ depending on the type of loan. However, most loan application forms entail the same information, such as your name, address, and contact information.
- Pay stubs. Banks and most financial institutions use pay stubs to verify a borrower’s income. For freelancers and independent contractors, use a pay stub generator to generate your own pay stubs and keep track of your earnings regularly.
- Proof of identity. The proof of identity verifies a debtor’s eligibility for their loan of choice. Examples of proof of identity include a birth certificate, passport, driver’s license, and social security card.
- Proof of address. Proof of address refers to documents that inform lenders whether a borrower has a permanent residence at their current address or lives a consistent and stable routine. Utility bills, voter registration cards, and rental agreements are examples of proof of address.
- Financial and employer history. Tax returns, 1099 forms, and W-2 forms are documents that help prove a borrower is currently employed or has a reliable income source.
How to Apply For a Loan
Last but not least, here are the steps to applying for a loan:
- Define the amount you need. Specify your reason for securing a loan. Do you need money for emergency or personal purposes? By knowing the exact sum that you require for your expenses, you can plan your loan without compromising your budget and other essential expenditures.
- Settle any existing debts and financial obligations. Unless you are faced with an emergency or crisis, it is best to pay any existing loan in full first before applying for another debt. Avoid accumulating multiple debts over time; otherwise, you may end up with an endless stream of unpaid balances or, worse, face legal action.
- Choose a loan. Pick a specific type of loan based on your financial objectives. You can also opt for a secured or unsecured loan, depending on your current financial status and the amount you plan to borrow.
- Compare banks and lenders. Don’t be afraid to compare offers, repayment terms, and interest fees from different banks. Find a lender whose policies coincide with your current budget limit or one that offers a flexible payment structure with careful consideration of your financial background.
- Fulfill the loan application requirements. The loan application requirements comprise a loan application form, a thorough assessment of your credit history, proof of income, employment status, and history, and a verification of your identity and residence.
Keep in mind that the steps are subject to modification based on the type of loan and your eligibility.
The next time you encounter a financial emergency or simply want to acquire extra funding for your personal expenses, use this article as your guide.
Explore the different types of loans you can apply for, find out the pros and cons that each entails, and learn how you can qualify for each.