It may often seems that having a higher degree in financial jargon is a requirement to understanding the types of loans accessible to you. Open-ended loans, variable-rate mortgages, unsecured debt…the list continues on and on. But what does it all mean?
If you’re feeling overwhelmed by the complicated world of loan lingo, this easy guide may help get you crystal clear on your credit options very quickly.
Closed-ended loans compared to open-ended loans
A closed-ended loan is an one-time debt that you incur for a set amount that you consent to repay according to predetermined payment terms. For example mortgages, personal loans, and auto loans.
Here’s how it operates: You borrow a fixed sum of money—say, $10,000—to buy a new car. The terms of the loan dictate that you have 36 months to settle the loan completely according to a specified payment schedule. Once you pay up, the loan is closed. If you wish to buy another car on credit at a later debt, you’ll need to secure another car loan.
An open-ended loan is a revolving form of credit which allows you to borrow from a predetermined credit limit. Common examples include credit cards and home equity lines of credit (HELOCs).
Here’s how it operates: Suppose your credit card offers a $5,000 credit limit. In a single month, you charge $1,000, lowering your available credit to $4,000. If you pay off the balance in full, you’ll again gain access to the full $5,000 limit. If you pay just the minimum owed, you’ll have less credit accessible to you, and you’ll owe interest on the outstanding balance. Your card remains open—regardless of whether you tap into the funds—so long as you or your creditor chooses to leave it as such.
Fixed-rate loans vs. Variable-rate loans
A fixed-rate loan guarantees you an interest rate that doesn’t change. The rate will stays the same through the duration of your loan. Since your rate never varies, you understand how much your monthly payment will be throughout the loan term.
Here’s how it operates: When you buy a home and choose a 30-year, fixed-rate mortgage to supply the funds you need for closing. Your lender guarantees the interest rate—say, 4.75%—for the full 30 years. Because of this, you owe the exact same amount each month to your lender (the loan repayment plus 4.75% interest) for the next three decades.
A variable-rate loan carries a changing interest rate that’s linked with the movement of interest rates available in the market. When rates are dropping, you take advantage of a reduction in your loan’s interest due, while an upward shift in the market can mean you wind up paying quite a bit more.
Here’s how it operates: When buying your home, you decide on an adjustable-rate mortgage (ARM). The terms of your loan state you’re fully guaranteed a fixed rate of 4.1% for the first five years, however your APR may be adjusted once each year from then on. Depending on some predetermined market index, that rate may possibly go up or down, and the change you see is likely capped by the terms of your contract.
Secured loans vs. Unsecured loans
A secured loan is a debt that’s backed by collateral you provide to your creditor. Because that collateral reduces a creditor’s risk, you’ll typically find lower interest rates attached with secured loans than unsecured loans. But, if you don’t meet your payment obligations on a secured loan, the lender is legally eligible for seize the property backing the loan and liquidate it to cover your unpaid financial obligations.
Here’s how it functions: You took a car loan and a home mortgage. You fall behind on payments, which means that your lender repossesses your car and forecloses on your house. They sell the property, keeping the outstanding balance to cover the debt and returning the rest of the amount from the sale to you.
An unsecured loan is a debt which has no collateral backing it. Best examples of an unsecured loans are credit card debt, student loans, medical bills, and utilities owed. If you don’t repay the loan accordingly, your lender can’t legally seize your belongings. Because of this, interest rates have a tendency to be higher for unsecured debt over secured loans.
Here’s how it works: You owe on an outstanding credit card balance on an unsecured debt, but it’s been months since you’ve put back any towards repaying the account. The lender can’t simply take your house or other property, however your non-payment is probable destroying your credit score. In addition, your lender may want to close your line of credit, send your debt to collections, or even sue you for the amount you borrowed from. (FYI, a legal judgment against you can force you to pay or subject you to wage garnishment until the amount is repaid.)
Therefore, what’s the very best type of loan? Well, there’s no one-size-fits-all answer. However now you understand how exactly to evaluate your alternatives and know very well what each type of loan means for you along with your bank account. Armed with this knowledge, you are able to confidently pick the best loan for your very own situation.