Guide to understanding how loans work

Nov 08, 2021
The way loans work can seem complicated and complex. There are many different lending options each with their own terms, payment schedules, and interest rates. Banks may offer a particular loan product that other lenders may not. And credit cards have their own unique features and benefits.
As you familiarize yourself with the various types of financing available, you can choose the best option for your situation. We’ll explain how different loans work and the definition of each, so you can make the most informed decision possible.

Financing can be broken into two main categories: secured financing and unsecured financing. Before applying for financing of any kind, it’s important to understand how it works, as well as the pros and cons.

Secured financing

Secured financing is asset-based, meaning that any amount of money you borrow must be backed, or “secured” by an asset. An example is when you get a mortgage for a new home. The value of the home is the asset used as collateral for the mortgage. Or when you’re trying to start a business and use the assets of the business, such as equipment or real estate, to obtain a business loan.

Secured financing means you’re using an asset as collateral, to obtain the funds you need. This means that the asset used as collateral will be at risk of being repossessed if you default on your loan.

Unsecured financing

Unsecured financing is referred to as a non-asset-based debt, which means you are not using collateral to obtain financing. An example of unsecured financing includes traditional personal loans, or credit cards.

Now that you understand the difference between secured and unsecured financing, these two fundamental categories can be explained even further. Consumer lending is made up of two main types of financing you should also be aware of: a revolving line of credit and installment loans.

Revolving line of credit

Revolving credit, also referred to as open-end credit, includes credit that does not have an end date for when purchases must be paid back. An example of revolving line of credit is a home equity line of credit (HELOC), where your financial institution allows you to withdraw the funds, pay back, withdraw funds, and pay back on a revolving basis.

One thing to keep in mind is that the credit limit is set by the bank. If you exceed your line of credit, there may be additional fees. It may even ding your credit score. Although paying off the balance every month is not required on revolving credit, you’ll pay interest on the balance due.

Installment loans

installment loans, sometimes referred to closed-end credit, is financing with a specified date for repayment. Unlike a revolving line of credit, where you can choose to repay the balance as much or as little as you like (making the minimum payment), an installment loan requires the same amount be repaid each month. You must follow a regular payment schedule until the entire loan balance has been paid.

An auto loan is an example of an installment loan, where you repay the money borrowed in a specific time frame, usually between 3-5 years. Another example is payday loans, where you repay the amount borrowed with your next paycheck, or within 15-30 days.

Loan types vary widely because of their specific purpose. For instance, mortgages are only allowed for buying or refinancing real estate.

Each type of financing will have different timelines, terms, interest rates, payment dates, and other conditions, so be sure to read and understand the fine print before signing any agreement.

1. Purchase money loans

A purchase money loan is a debt incurred for a specific purpose, and sometimes requires the asset purchased to be put up as collateral. Purchase money loans include mortgages, student loans, and auto loans. These kinds of debts are sometimes viewed as a good debt since it’s seen as an investment-type loan, with the payoff of owning a home, receiving higher education to secure a better job, or having a car you can use to drive to and from work.

2. General borrowings

Opposite of purchase money loans, general borrowings do not require an asset as collateral to approved for funding. Traditional credit cards, personal loans, and other lines of credit, such as a home equity line of credit (HELOC), are examples of general borrowings. You may use the funds for anything you like as they are not usually tied to specific purchases like purchase money loans.

3. Working capital 

Working capital is funding for starting or owning a business. The definition of a working capital loan is quite broad and can include funds for:

  • Starting or expanding a business
  • Construction for building office space
  • Purchasing machinery, inventory, or furniture

Keep in mind that working capital, does require giving up a portion of the business assets - whether it’s stock or equipment - as collateral for the investment.

4. Time-based loans

Time-based loans come in a variety of lengths, from short term to long term and everything in between. These loans are for a specific period and are to be repaid within that time frame.

  • Short-term loans include payday or title loans, both of which are to be paid back within 15-180 days depending upon the lender
  • Medium to long-term loans take a year or longer to be repaid, depending on how the funds are to be used

5. Consolidation loans

Finally, consolidation loans are meant to help you streamline your finances as a faster way to get out of debt. You do this by combining multiple debts - such as several credit cards - into one consolidation loan with one monthly payment and a smaller interest rate.

This reduces the stress of trying to juggle multiple due dates and saves you money on interest rates from other loans. Most consolidation loans come in the form of a personal loan or second mortgage.

When it comes to the different types of financing, the options can be overwhelming. But when carefully broken down, you’ll see that they have many features in common. Now that you understand the definition of these types of financing, you’ll be able to apply and feel comfortable choosing the right loan for your personal situation.

The content of this article is for informational purposes only and should not be construed as personalized legal, financial, or other advice. This article represents paid promotional material provided by or on behalf of Snap Finance, LLC, or its affiliates.
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