August 30, 2021

Loan Class 101: Why Is it Important?

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Whether your lending business only deals with certain types of loans or you're happy to lend for any type of purchase, it's important to know the different types of loans out there. The difference between a mortgage loan and a personal loan can be several orders of magnitude, and as a lender you don't want to sign off on a loan that ends up being an outlier of its type. 

In  fact, some smaller loans may be more complicated than larger, more standardized loans since the amounts can vary so much, in addition to the APR and repayment terms. Some loans may be ideal for your lending business while others may be financial products that you don't want to deal with, either because of the amounts involved or because of prospective issues with collecting.

Knowing the different classes of loans can help you optimize your lending business according to the loans that you offer and the customers that are attracted to each product, and understanding the wildly varying timelines and percentage rates can help you get a handle on your cash flow issues. To make matters more confusing, some loans may be secured by collateral, such as auto title loans and home equity loans, while others may be unsecured loans not attached to anything other than the money coming in.

The basics, however, are pretty straightforward. Most loans are a one-time, lump sum payment (the loan amount) that is paid off over time (the term) according to certain interest stipulations (the APR). Some loans are exceptions, but let's take a look at different loan classes below.

Personal Loans

As the most versatile and common of the different loan class types, a personal loan is a powerful financial vehicle to pay for just about anything. Some lenders may put restrictions on what you can purchase with a personal loan, such as prohibiting a personal loan to be used for a college education, for example, but that's up to your business and the needs of your customers.

If a customer has medical bills, a wedding coming up or they just want to consolidate their debt by paying off credit cards or other bills, a personal loan is a good match. Keep in mind that if you place too many restrictions on your personal loans, you may be sending potential customers interested in this loan class to a competitor, so resist the urge to be too strict with your lending.

Typically, personal loans have a loan length of 12 to 60 months, though sometimes they can extend to 84 months and beyond, and have a typical APR in the 6% to 30%+ range. Most personal loans are a few thousand dollars to the high five-figure range. Credit scores should be between 600 and 700, and you'll only need collateral for a secured personal loan, not an unsecured loan.

Auto Loans

If your customers need money to buy a new car, an auto loan is a loan classification that can help them purchase that vehicle today while giving them time to pay it off as they earn money. Most times, it means financing the car, giving the lender the ability to repossess the car to make their money back if payments stop for any reason, which can make auto loans a good loan class for lenders that are worried about repayment issues.

Depending on whether the vehicle is new or used, the payoff timeline and rates can vary between 24 and 72 months and 3% to 7% APR on average. There's no minimum credit score for an auto loan, but better scores tend to get better rates since they're most likely to be able to pay the entire amount without issue. If payments stop at any point before the loan has been paid off, the financed vehicle will be repossessed. 

Note that auto loans don't necessarily stop at cars and trucks -- people can take out loans for boats, aircrafts and other types of vehicles.

Student Loans

This type of loan class helps students pay for their education and education-related expenses such as tuition, housing, textbooks, food, transportation and more. While student loans aren't supposed to be used for costs unrelated to their schooling or education, lenders don't monitor the money as it's spent. 

The payoff timeline for a student loan is typically more than 10 years and up to 25 and 30 years in some instances. Both the federal government and private lenders can create a student loan, though federal loans typically have a lower APR in the 5% to 8% range; private loans have a wider APR range between 4% and 14%.

After a certain amount of time, some federal student loans may be forgiven based on years in public service or if other criteria are met.

Mortgage Loans

By allowing customers to purchase a home without needing all the cash up front, mortgage loans are a crucial loan classification for just about all homebuyers. With real estate prices the way they are today, many consumers need that mortgage loan to make their dream of owning a home a reality, and the best part is that the customer gets to live in the home while they're paying off their debt.

That means that the lender actually owns the home until the mortgage is fully paid off, and the loan itself is secured by the house in question. Mortgage loan lengths are commonly 10, 15, 20 or 30 years, depending on how much financing is needed, but APRs are typically low, such as 3% to 6%. 

Consumers will need a decent credit score in the mid-600s to qualify, though they may be able to get away with a lower credit score with a government-insured loan. 

Home Equity Loans

Another type of loan class is the home equity loan. They're versatile products that are loaned against the equity built-up in a home, and therefore it means that what can be borrowed depends on how much you've paid into your home (house value minus mortgage remainder). Because it's backed by a huge piece of collateral -- a house -- home equity loans are typically larger than most personal loans.

Loan lengths vary from 5 to 30 years depending on the loan amount, and APRs are commonly in the 4% to 8% range. A decent credit score of almost 700 is preferred, but there's always the house that can be foreclosed if there are any issues with repayment.

Payday Loans

For those that need money before their next paycheck, a payday loan can enable borrowers to get back on track if there are any issues with their cash flow. Instead of an APR, there's typically a fee equivalent that must be paid back -- with interest -- when the customer's next paycheck comes in. 

Securing the loan is done by looking at the customer's pay history, determining when they will be paid and when the loan can be paid in full. Most payday loans are smaller amounts -- often $500 or less -- so that can mean a shorter turnaround in getting paid, though the profit is decidedly less than other types of loan classes.

For people with bad credit, a payday loan may be the only loan that they're able to get in short order, which can help keep the lights on, gas in the car and food on the table.

Auto Title Loans

Those that own their car outright have the option of another type of loan class: an auto title loan. By putting up the value of their car up as collateral, an auto title loan can generate as much as a quarter to half of the car's value in an immediate loan. The terms of most auto title loans are short, commonly two to four weeks, after which the loan is paid in full and both lender and consumer go their separate ways.

However, if an auto title loan is not paid off in full by the expiration of the loan, a roll-over may be needed, which is basically a continuation of the original loan for additional fees. If the borrower is unable to pay off the entire loan, the lender will be able to take the car to satisfy the debt.

Credit-Builder Loans

Customers that don't need to borrow money but that would like to build credit can take advantage of a little-known loan class called a credit-builder loan. Instead of receiving the money directly, the loan amount is deposited into a savings account and the borrower works on paying off the entire loan amount plus interest over the next 6 to 24 months. 

At the end of each month, the lender reports timely payments to the credit bureaus, which will help to build up the borrower's credit history. When the loan matures, the borrower gets the savings account and the entire amount contained within.

In a way, credit-builder loans are the opposite of a normal loan -- the borrower isn't getting money up front and then paying it off, they're paying it off then getting the money at the end.

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