It started out as a simple question on the Credit.com forum, “Anyone know the difference between a consolidation loan and a personal loan? I see both on this site and others, but not sure what the difference is — are they the same?”
A simple question? Perhaps. But it reminded us how confusing loan terminology can be, even for those of us who spend a lot of time researching and writing about it.
Loans can be described and marketed under a number of monikers; secured or unsecured, revolving or installment are just a few. And sometimes more than one term applies to the same loan, as in the case of an unsecured debt consolidation loan, for example.
Here’s a cheat sheet to the terminology you may encounter when shopping for a personal loan:
Collateral
Secured
A secured loan is one where you pledge collateral in order to get a loan. “What’s collateral,” you ask? It’s something the lender can take (and hopefully sell) if you fail to pay the loan back. Think auto loan or mortgage. If you don’t pay, the lender can take steps to repossess the car or foreclose upon the home. Because there is collateral to at least partially backing up the loan, these loans often carry lower interest rates.
Unsecured
With an unsecured loan, there is no collateral to repossess. If you don’t pay, the lender will have to take you to court and sue you. Only then will it be able to go after things like the money in your bank accounts. (There are a few exceptions to this rule, such as federal student loans, where there are greater collection powers than granted most unsecured creditors.) Because unsecured loans aren’t backed up by collateral, they are more risky, so interest rates will likely be higher than for secured loans.
Term
Installment
An installment loan is one where you borrow a specific amount of money and pay it back according to a set payment schedule; usually that means you make monthly payments for a specific amount. Keep in mind, though, that payments can sometimes change on installment loans if, for example, the interest rate changes or there is an introductory period where the payment or interest rate on the loan is lower.
Repayment Term
With installment loans, you may be given a choice of how long you want to repay the loan. If you are shopping for a car, for example, you may be offered a 36-month (or three year), 48-month (or four year) or 60-month (five year) loan. The longer the loan, the lower your payments — and the higher your overall interest charges. Interest rates may also be higher for longer term loans.
Revolving
With a revolving loan, your balance can vary, and as a result your payments can vary as well. A credit card is a good example of one of these loans. You can pay your balance in full or “revolve” a balance by paying just part of it.
Line of Credit
A line of credit is a type of revolving account. The term “line of credit” is often — though not always — usually associated with home equity borrowing. If you are approved for a line of credit, you’ll be able to borrow up to the total amount of the credit line. You can take out money when you need it or borrow all of the money at once, and then pay it off quickly or over time. The main difference with a revolving account (like a credit card) is that there may be a period of time when you can no longer borrow (the “draw” period) and instead must start repaying the loan over a set period of time.
Purpose
Loans may be described by the main purpose for which you’ll use the funds. Some types of loans are less flexible than others. If you get a new vehicle loan, for example, you have to use the proceeds to buy a new vehicle! But it’s not always that clear cut, as in the case of mortgages and home equity lines of credit.
Personal loans
The term personal loan probably arose to distinguish these loans from business loans. You can usually use a personal loan for about anything you want, including debt consolidation.
Debt consolidation loans
A debt consolidation loan is typically more of a marketing gimmick than anything. Yes, you can use the loan to consolidate debt, but in most cases the lender isn’t going to look over your shoulder and make you prove you used the loan for that purpose. The exception would be a loan where you have to designate which other debts you want to pay off and the lender actually pays those off for you.
Source of Funds
Retirement account loans
With these loans, you borrow from yourself by actually borrowing money you’ve stashed in a 401(k), 403(b), pension plan or something similar. You can’t borrow against money in your IRA. You can use the money for anything you like and there’s no credit check. But watch out: You may rob your retirement.
Credit union loans
A credit union may offer all different types of loans from personal, auto and mortgage loans, to small business loans. Rates are, on average, slightly better than those at banks and you may get more of a personal touch than you would with, say a large bank.
Bank loans
Most banks offer the gamut of loans from personal to business loans. With smaller community banks, the underwriting may be done there; with larger banks your loan application may go into a computer for a decision that’s made somewhere else (or with the help of the computer alone). The advantage? Getting a loan from a bank may earn you other perks, like free checking.
Payday loans
These are short-term loans that act as an advance against one’s paycheck. Interest rates can be very high — 200 percent or more! — and borrowers may find themselves deeply in debt if they can’t pay these loans back quickly. On the other hand, they are very easy to get, which is why they are so popular with consumers who have poor credit histories. Online payday loans are especially risky because these have been associated with overseas debt collection scams.
Social lending or P2P loans
These types of loans typically bring borrowers and lenders together to lend and borrow money. Consumers with money they want to invest essentially become the “lenders.” Borrowers typically get an installment loan with a repayment period of 1-3 years. The most popular platforms for these loans are currently LendingClub.com and Prosper.com.
Home equity loans
This is one of those examples of where things get confusing. A home equity loan can often be obtained from a bank, credit union or even a private lender. It’s a secured loan, and it can be used for all kinds of purposes from debt consolidation to home improvement. It may be offered as a line of credit or an installment loan. So where does it fit? Depending on the individual loan, it may fit in many of the categories above.
No wonder borrowers get confused!
Still More Loan Terms
APR
The annual percentage rate (APR) is the interest rate expressed as a yearly rate. It can be helpful when comparing loans. Fees can be equally important, so look for a disclosure of costs before you apply for a loan.
Underwriting
This is the process a lender uses to decide whether you are approved for a loan, and it may also determine the terms of your loan. It can be entirely or partly computerized, depending on the lender or the type of loan. “Manual underwriting” describes someone actually reviewing the loan application and making a decision, within guidelines of course.
We’ve made this guide as complete as possible. Did we miss something? Still confused? If so, share your question in the comments below.
Image: iStockphoto
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