The number of loans is limited only by creativity. Loans come in various different flavors and with a number of descriptors. Below, I'll run through some of the most common types of loans. Keep in mind that most loans fit in multiple categories, meaning one type (say, a mortgage) might fit many of the descriptions you see below.
Types of loans by repayment
Most commonly, loans tend to be defined by how they are repaid. Some common definitions are as follows:
- Amortizing loan: An amortizing loan is one in which the regular payments pay for the interest and principal. By definition, each payment on an amortizing loan will reduce the principal balance of the loan. Traditional mortgages are amortizing loans.
- Balloon loan: A balloon loan is a loan that requires routine payments for a predetermined period of time. When that time expires, the borrower will need to make a lump-sum payment to pay off the remaining balance. Some mortgages are balloon loans. A mortgage might require five years of small monthly payments before the entirety of the balance is paid off in full. Most often, the borrower cannot and doesn't plan to simply write a check for the remaining balance. Instead, the balloon payment is refinanced into a new loan. Balloon loans are usually amortizing loans, as each payment pays the interest due and reduces the principal balance by a small amount each month.
- Line of credit: A line of credit is a source of financing that allows the borrower to borrow or repay as needed. Think of it like a bigger credit card. In general, lines of credit allow the borrower to draw on the credit line for a certain period, usually only a few years. Thereafter, the line of credit becomes an amortizing loan, which requires routine monthly payments that will eventually pay the balance down to zero.
Types of loans by use
Loans also earn their names by their intended use. Here are a few:
- Personal loan: A personal loan is simply that, a personal loan. It isn't tied to any specific collateral (say, a car) and you can use the proceeds for virtually anything. Small by design, and risky for lenders, these loans typically have the highest interest rates.
- Mortgage: A mortgage is any loan to buy real estate. Mortgages can be used to buy residential, commercial, or undeveloped property. A mortgage is secured by the real estate the mortgage finances, and thus the interest rates tend to be some of the lowest.
- Commercial and industrial loan: Commercial and industrial loans are short-term loans to businesses, generally written for a period of just a few years. These loans are typically secured by some kind of collateral, from the business's inventories to the cash flow the business generates on an ongoing basis.
Types of loans by interest rates
Finally, loans are usually categorized by interest rate and how the general level of interest rate affects the loan. There are three broad distinctions here:
- Adjustable rate loans: An adjustable rate loan typically has a fixed rate for the first few years, until it is adjusted to reflect market rates. A 5/1 adjustable rate mortgage, for instance, offers a fixed rate for five years. Thereafter, the rate is reassessed each year (hence the "1" in the "5/1" name) and adjusted up or down to match market interest rates. Typically, an adjustable rate loan is based on some well-known benchmark, like the prime rate, LIBOR, or U.S. Treasury yields.
- Fixed-rate loans: Fixed-rate loans are just that: fixed. The rate on the loan will remain the same for the entirety of the loan period. A 30-year fixed mortgage, for example, will have the same interest rate in the 30th year as it had in the first year.
- Floating rate loans: Most common in commercial lending and in some loans to high net worth individuals, floating rate loans pay a rate of interest that "floats" with the market rate of interest. These are different from adjustable-rate loans because the rate is reset more frequently, often each quarter or each month, whereas adjustable-rate loans reset less frequently, perhaps once per year, or only one time at a specified date in the future.
Putting it all together
Loan types are not mutually exclusive, which results in some unnecessary complexity. For instance, a 30-year fixed-rate mortgage could be described as an amortizing loan, a mortgage, and as a fixed-rate loan.
Keep this in mind as you as you consider how borrow or pay for large purchases. Knowing that a loan can fit in a number of categories can take some of the confusion out of an industry that is often all too confusing for new and experienced borrowers alike.
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