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Explain the Characteristics and Costs of Consumer Loans

It is important to understand that different consumer loans have different characteristics—there isn’t just one type of consumer loan. Some of the different types of loans, which we will compare and discuss in the following paragraphs, include single-payment and installment loans, secured and unsecured loans, variable-rate and fixed-rate loans, and convertible loans. The following is a list of different types of consumer loans and their characteristics:

Single-payment loans: Single-payment loans are known as balloon loans. Normally, these loans are used for short-term lending of one year or less. They may also be used to temporarily finance a purchase until permanent, long-term financing can be arranged; this is why these loans are sometimes called bridge loans or interim loans. This type of loan is repaid in one lump sum, including interest, at the end of the specified term—for example, at the end of one year.

Installment loans: Installment loans are loans that are repaid at regular intervals—for example, every month. Each payment includes part of the principal and some interest. An installment loan amortizes over the length of the loan, which means that with each monthly payment you make, more of your payment goes toward paying off the principal and less goes toward paying for interest. The amount of interest that you pay each month is calculated based on simple interest. Installment loans are typically used to finance purchases of houses, cars, appliances, and other expensive items.

Secured loans: Secured loans are loans that use one of your assets, such as a home or a car, as collateral to guarantee that the lending institution will get the amount of the loan back, even if you fail to make payments. Examples of secured loans include home equity loans and car loans. Because these loans are backed by collateral, they usually have lower interest rates.

Unsecured  or signature loans: Unsecured or signature loans do not require collateral and are generally offered only to borrowers with excellent credit histories. Unsecured loans typically have higher interest rates, which may range between 12 and 26 percent—sometimes even higher.

Fixed-rate loans: The majority of consumer loans are fixed-rate loans. These loans maintain the same interest rate for the duration of the loan. Normally, lenders charge higher interest rates up front for fixed-rate loans than they do for variable-rate loans. This is because lenders can lose money if market interest rates increase and the loan rate remains lower than the current market interest rate.

Variable-rate loans: Variable-rate loans have an interest rate that is adjusted at different intervals over the life of the loan; there is usually a maximum interest rate that can be charged on the loan, or a cap, as well as a maximum that the interest rate can increase each year. The interest rates on these loans may change monthly, semiannually, or annually. The interest rate is adjusted based on an index, such as the prime rate or the six-month Treasury bill, as well as on an interest-rate spread. Lenders usually charge a lower interest rate up front for variable-rate loans because the lender will not lose money if the overall market interest rates increase.

Convertible loans: Convertible loans are loans in which the interest-rate structure can change. For example, a convertible loan may start off having a variable interest rate and then switch to having a fixed interest rate at some predetermined time in the future; the opposite process may occur as well.


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