What Is A Consumer Loan?
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Summary:
A consumer loan is any loan that an individual or business takes out in order to receive financing, often for a specific purchase. The most common consumer loans are mortgages, student loans, car loans, and personal loans.
The majority of individuals must secure a loan at some point in their lives. This can be to purchase a house, pay for their college education, or establish a line of credit. Small businesses also rely on loans in order to establish and grow their business. These are consumer loans, and they vary in their application purposes and conditions.
Before you take out a loan, it is important you fully understand all the options available to you in order to make the best financial decision. Continue reading to discover different types of consumer loans, the difference between secured and unsecured loans, and the difference between open- and closed-end loans.
What is a consumer loan?
If you ever took out a loan to make a down payment on a house or pay for a new car, you took out a consumer loan. Similarly, if you use a credit card, you are also using a form of a consumer loan.
In fact, most loans that you—the consumer—take out from a creditor is a consumer loan. A consumer loan is any loan taken out to make certain purchases.
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Types of consumer loans
There are many different types of consumer loans, and each may support different purchases. The most common types of consumer loans are mortgages, student loans, auto loans, personal loans, and credit cards.
When a consumer applies for a loan, their future lender reviews the consumer’s credit score and debt-to-income ratio to determine if they are eligible for that loan (and if so, for how much).
Pro Tip
Understand all the different types of consumer loans available to you to ensure that you are making the wisest financial decision as a future borrower.
Personal loans
Though consumer loans refer to several loans (many of which we’ll discuss in this article), they often refer specifically to personal loans.
You can use a personal loan to finance various personal expenditures. Unlike mortgages, student loans, and auto loans, which must be used for their specific purchases, personal loans can fund a variety of purchases. This includes debt consolidation, living expenses, vacations, or starting a business. Personal loans may also be secured or unsecured.
Mortgages
Mortgages are used to finance the purchase of a home. The majority of homes cost significantly more than the average person makes in a given year, so mortgages are very common in order to make home-buying accessible and possible.
When you apply for a mortgage, you should expect to pay back the loan in monthly installments over several years, usually between 10 and 30 years. Depending on your financial situation, you can apply for a fixed or adjustable interest rate mortgage.
- Fixed. This means the interest rate on your mortgage stays the same throughout the loan term. Because the interest rate doesn’t change, you would make equal monthly payments over 10 to 30 years until your mortgage loan is repaid.
- Adjustable. An adjustable-rate mortgage (ARM) indicates that the interest rate may change from year to pear depending on the current market.
Home equity financing
Home equity financing includes both home equity loans and lines of credit. Though both options allow you to borrow money by leveraging the equity built in your property, the two options differ in how the funds are disbursed.
When you get a home equity loan, you receive the funds in one lump sum and make monthly payments on the balance. A home equity line of credit, on the other hand, works like a credit card in that you have a line of revolving credit that you can continue to borrow against until you reach the credit limit.
Student loans
Student loans finance higher-level education and are either sponsored by the federal government or private financial institutions.
Most repayment schedules for these loans don’t begin until after the student graduates. In some cases, such as federal subsidized loans, the government will also make interest payments on the loan until the student graduates. However, due to the funding limits on federal loans, most students borrow a combination of federal and private student loans.
Auto loans
You can use an auto loan to purchase either a new or used vehicle. While the term length varies anywhere from 24 to 84 months, it is in your best interest to secure the shortest loan term possible. Car loans with long terms can trap borrowers in a cycle of negative equity and result in more interest payments over the life of the loan.
Interest rates can also vary based on the age of the car. Older cars are riskier to finance because the car value declines over time, so shorter term lengths are standard for older cars. Be sure to get the best deal possible by comparing multiple lenders before signing the dotted line.
Pro Tip
Before taking out an auto loan, evaluate how quickly your car will depreciate. Defaulting on a car loan can come with severe consequences, and you will likely have to continue making loan repayments even after default.
Credit cards
Credit cards are used to pay for everyday purchases and are one of the most common sources of consumer debt. A 2021 report by the Consumer Finance Protection Bureau estimated that 70% of adults (181 million out of 258 million adults) in the United States had a credit card account in their name.
Small business loans
Small businesses will secure a consumer loan for reasons similar to individuals, whether it be to pay for daily expenses or to purchase property. These loans are helpful for business owners who want to expand their inventory or scale their business in some capacity.
Refinance loans
If you have trouble affording your current payments, you may want to look into a refinance loan. Essentially, when taking out a refinance loan, you use the funds from that loan to pay off a different loan with unfavorable terms. Depending on changes in your credit score, you may be able to receive more favorable loan terms by refinancing. You’ll often see this approach among mortgage loans, but you can also refinance auto and student loans.
Open-end vs. closed-end loans
There are two categories of consumer loans: open-end loans and closed-end loans. Generally, consumer loans are in the form of closed-end loans, also known as installment loans.
Open-end loans
An open-end loan, or revolving credit, is a loan in which the borrower must repay a minimum amount of the loan before a specified date. Interest is charged only to the portion of used credit, not the maximum credit limit.
Closed-end loans
A closed-end loan, or installment loan, has pre-determined monthly payments. When you take out a closed-end loan, you will receive the amount in one lump sum and your lender will tell you how much they expect you to repay each month. This amount will go towards repaying the principal and interest until the loan is completely paid off.
Secured vs. unsecured loans
Consumer loans can come as either secured or unsecured loans. In general, larger and specific-purchase loans are secured, while smaller and non-specific purchase loans might be unsecured.
Secured loans
Secured loans are backed by collateral, which means an asset is held to cover the cost of the loan should the borrower default. These loans are beneficial to the borrower and lender. While the borrower can receive greater amounts of financing, longer repayment periods, and lower interest rates, lenders take on less risk if the borrower defaults.
Unsecured loans
Conversely, unsecured loans are not backed by collateral, such as student or signature loans. If the loan is not repaid, the lender is unable to seize any possession to try and recoup their losses. Due to this high risk, these loans normally have limited financing, a shorter repayment period, and higher interest rates.
| Personal loan | Mortgage | Home equity loan | HELOC | Student loan | Auto loan | Credit card | |
|---|---|---|---|---|---|---|---|
| Open-end | ✓ | ✓ | |||||
| Closed-end | ✓ | ✓ | ✓ | ✓ | ✓ | ||
| Secured | ✓ | ✓ | ✓ | ✓ | ✓ | ✓ | |
| Unsecured | ✓ | ✓ | ✓ | ✓ |
Key Takeaways
- A consumer loan is any kind of loan that involves a lender providing credit to a borrower.
- The most common types of consumer loans are mortgages, student loans, auto loans, and personal loans.
- Depending on the type of loan, a consumer loan may have a fixed or variable interest rate as well as a fixed monthly payment (closed-end loan) or a minimum payment (open-end loan).
- Consumer loans can also be secured by collateral or unsecured without any collateral.
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