What Type of Loan Should I Get?

Quick Answer

Choose a loan based on several factors, including: what you plan to use it for, the interest rate, the length of the loan term and the monthly payment.

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When you're shopping for a loan, you'll come across several options. At some point, you'll need to narrow the options to one type of loan that suits your needs. But how do you decide? Choose a loan based on what you plan to use it for, as well as factors such as the interest rate, length of the loan term and monthly payment.

How to Choose a Loan

Several factors will influence your decision when choosing a loan, and they may vary depending on how you plan to use it. Among them are:

  • Interest rate: How much is the interest rate, and is it fixed or variable? Picking the loan with the lowest interest rate possible can save you thousands of dollars in interest, which is the percentage of a loan a lender charges you to borrow money. The interest rate for a fixed-rate loan stays the same throughout the length of the loan, while the interest rate for a variable-rate loan might go up or down.
  • Length of loan: The length, or term, of the loan is also an important consideration. Typically, a loan with a shorter payoff period (such as five years) comes with a lower interest rate than a loan with a longer payoff period (such as 10 years). The shorter the payoff period, the more you can save in interest charges over time.
  • Monthly payment: You'll want to figure out what the monthly payment of a loan will be to ensure you've got enough room in your budget to make the payments. Keep in mind that a shorter-term loan might come with a higher monthly payment than a longer-term loan.
  • Fees: Lenders may include any number of fees to a loan, and those costs can quickly add up. From origination and underwriting fees to processing fees and more, you could be on the hook for a substantial sum. Take lenders' fees into consideration when determining the total cost of your loan.

Other considerations when you're choosing a loan include whether a down payment is required, how trustworthy a lender is and how your credit score might affect your eligibility and the loan's costs. Typically, a borrower with a high credit score can secure a lower interest rate than a borrower with a low credit score. Before applying for a loan, review your credit report and credit score, and take steps to improve your score if necessary.

Loans for Buying a Home

Before you look for a home loan, determine how much you can afford to pay. Consider the price of the home, how much you can put toward a down payment and what monthly loan payment you can afford.

Once you've come up with a budget, start exploring your mortgage options. Common types of mortgages include:

  • Conventional mortgage: A conventional mortgage is a loan from a private lender that is not backed by a government agency. While a conventional loan might offer a lower interest rate or higher lending limit than a government-backed loan, it also might require higher credit scores and down payments.
  • FHA loan: Benefits of a loan backed by the Federal Housing Administration (FHA) include the possibility of a down payment as low as 3.5% and a lower minimum credit score than conventional loans typically require. The downside is you must pay for mortgage insurance, which could boost the overall loan costs.
  • VA loan: The U.S. Department of Veterans Affairs (VA) guarantees loans from private lenders that are designed for active-duty servicemembers, military veterans and surviving military spouses. Advantages of a VA loan include the potential of low or no down payments and no mortgage insurance requirement.
  • USDA loan: Typically cheaper than an FHA loan, a loan backed by the U.S. Department of Agriculture (UDSA) is aimed at low- and middle-income borrowers from rural areas. One drawback: Mortgage insurance is mandatory for all USDA loans.

Once you've decided on a type of mortgage and are ready to start home shopping, reach out to several lenders to explore loan terms and rates, and find out if they offer the type of mortgage you're seeking (not all lenders offer all types of government-backed loans).

You can get lender recommendations from friends, relatives and other people you trust. Your real estate agent might also be a good resource. You can also look into using a mortgage broker, who will shop your information to a network of lenders and help you find loan terms.

Once you find a lender you'd like to work with, you'll provide them with the financial information they need to give you a prequalification or preapproval letter. This letter indicates a lender has made a preliminary decision to let you borrow money to buy a house. Keep in mind that a preapproval letter is not a commitment to finance: You'll need to undergo another check of your finances once you officially apply to solidify your terms.

Loans for Financing Home Improvements

A home improvement loan is geared toward paying for home maintenance, repairs or upgrades. Several kinds of home improvement loans are available:

  • Home equity loan: A home equity loan is a fixed-rate installment loan that allows you to borrow against a portion of your home equity. It gives you a certain amount of money, typically in one lump sum, that generally must be repaid in equal monthly amounts over a certain period of time. The amount of the loan is based largely on the market value of your home, and the interest rate remains constant over the life of the loan.
  • Home equity line of credit (HELOC): A HELOC typically allows you to borrow between 60% and 85% of the assessed value of your home, minus the current balance on your mortgage. HELOCs are a type of revolving credit, similar to a credit card, which enables you to tap into an available pool of money. A HELOC caps the amount of money you can borrow, and you can use it to take out money and pay it back repeatedly for a set time period, usually 10 years. A HELOC usually comes with a variable interest rate.
  • Cash-out refinance loan: A cash-out refinance loan replaces your existing mortgage with a new one that may come with a new interest rate, monthly payment and loan term. The loan amount will be larger than the remaining balance on your mortgage so you can use the extra money for home improvements or other purposes.
  • Personal loan: A personal loan generally features a repayment period of several months to several years, and comes with either a fixed or variable interest rate. In most cases, you can spend the proceeds of a personal loan for an array of purposes, including home improvements.
  • Credit card: A credit card is another option to pay for home improvements. If you have a good credit score (typically a FICO® Score of at least 670), you might be able to qualify for a card that offers a 0% introductory APR (annual percentage rate) and use the card to finance a home improvement project. If you pay off the entire balance before the intro period ends, you can avoid being hit with interest charges. If you rely on a credit card that you already have instead, you might wind up with a higher interest rate and a lower borrowing limit than you would with a personal loan.

Because home equity loans, HELOCs and cash-out refinances use your home as collateral, the interest rates are often lower than they are for personal loans or credit cards. However, because your home serves as collateral on these loans, you could lose your home if you fall behind on the loan payments.

Loans for Paying Off Debt

Paying off debt can be challenging, especially if you have high interest rates and several different debts. Two common tactics for reducing your debt include taking out a debt consolidation loan or using a balance transfer credit card.

  • Debt consolidation loan: A debt consolidation loan is a personal loan designed for paying off high-interest debt, often from credit cards. This type of loan lets you combine several debts into a loan with just one monthly payment. Ideally, a debt consolidation loan should provide a lower overall APR, enabling you to save money on interest over the long run. It's a good option if you already have a good credit score, which will help you get more favorable terms.
  • Balance transfer credit card: You might also turn to a balance transfer credit card to help pay off debt. This type of card enables you to save money by switching a credit card balance to a new card that charges a low introductory APR or no APR over a certain period of time. Like a debt consolidation loan, a balance transfer card can be attractive if you've got a good credit score.

Loans for Affording College

Broadly, there are two types of student loans: federal loans, issued by the federal government, and private loans, made by private lenders such as banks and credit unions.

  • Federal student loans: There are several types of federal student loans, each with its own set of requirements. Some are available only to students who have financial need, while others are offered regardless of need.

    Normally, a federal student loan is better than a private student loan for covering college expenses. For instance, you may be able to qualify for a federal student loan regardless of your income or credit, while a private lender takes these factors into account. Plus, federal loans can be easier to repay than private loans, thanks to government programs such as loan forgiveness and income-based repayment plans.

  • Private loans: A private student loan can give you more borrowing capacity if you've reached the limit for federal loans, but interest rates are often higher, and they tend to have less flexible repayment plans. When weighing your options for private student loans, look for low interest rates and reasonable repayment terms. You may also find that some private loans offer perks such as cash reward incentives for good grades or an interest rate discount if you sign up for automatic payments. Just keep in mind that you won't have access to the repayment programs that come with federal student loans.

Loans for Financing a Car

Just as you shop around for a car, you should shop around for an auto loan. Looking into several auto lenders may lead to a low interest rate and other favorable lending terms. Common sources of auto loans are banks, credit unions, car dealers and online lenders.

Keep in mind that a bank or credit union can preapprove you for a car loan, which can give you an edge in terms of securing the best interest rate and sale price.

Among the factors you should weigh when you're applying for a car loan are:

  • APR: Find a lender who can offer the most appealing APR. Remember that the higher your credit score is, the lower the APR might be.
  • Down payment: Lenders often have a minimum requirement for how much money you are required to put down for a car purchase. Also, if you are able to make at least a 20% down payment, a lender might offer better terms or lower interest rates.
  • Term: The term is the number of months you have to pay back the loan. Common loan terms are 36 to 72 months, but some can be longer. The longer the term, the more you will pay in total interest for the car.
  • Monthly payment: Consider how much room you have in your budget for monthly payments. One reason people take a longer loan term is to secure a lower monthly payment.

The Bottom Line

Regardless of what kind of loan you plan to get, check your free Experian credit report and credit score, ideally well before you start the application process. This knowledge can better equip you to make decisions about your loan and possibly give you time to improve your credit profile so you can get the best rates and terms possible.

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