Banks and other financial institutions lend money and change interest on loans to generate revenue. Banks offer a variety of loans that can be used for many purposes such as buying homes or cars, funding small businesses and paying for living expenses. Loans differ in terms of how they set interest rates, whether funds are received in a lump sum or through a line of credit and whether debt is secured by collateral.
Fixed-rate loans have a set interest rate that doesn't change over the life of the loan. Mortgages, auto loans and personal loans can all potentially be fixed-rate loans. Fixed-rate loans can be advantageous to borrowers in that they are not affected by changes in current interest rates. If interest rates rise after a borrower takes out a fixed loan, he continues paying the same rate even if current rates are much higher.
Adjustable-rate loans or variable-rate loans have interest rates that can change over time based on current economic conditions. Adjustable-rate loans can be beneficial if interest rates fall over time, since loan rates may adjust downward. Adjustable loans are risky, however, because loan rates may rise if interest rates in the economy go up or if the bank chooses to increase its rates.
A hybrid loan includes elements of both fixed-rate loans and adjustable loans. Hybrid loans begin with a period of fixed interest, followed by a period where interest rates are adjustable. For example, a "5/25 ARM" is a mortgage that offers a fixed interest rate for the first five years and adjustable rates for 25 years. Hybrid loans may offer low promotional or introductory rates during the fixed-rate period, but rates are likely to adjust upward when the fixed interest period ends.
Secured vs. Unsecured Loans
Every loan a bank makes is either secured or unsecured. A secured loan is a debt where the lender has the right to take ownership of some form of collateral if the borrower fails to pay the loan. Homes act as collateral to secure mortgages and cars can act as collateral to secure auto loans. Unsecured loans are debts that are not secured by collateral.
Traditional loans involve a single lump sum payment that the borrower receives all at once. Banks also offer credit lines or lines of credit that let customers borrow money up to a predetermined limit. Credit lines can be secured or unsecured; home equity loans are a common type of credit line that lets homeowners use home equity as collateral for a credit line.
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