What is a Consumer Loan and How Do They Work?

What is a Consumer Loan

Most adults will need a number of consumer loans throughout their lifetimes, even those who are considered wealthy. Few people have enough cash on hand to buy cars or homes outright; most of us need to work with a financial institution or lenders in order to pay for big purchases.

Consumer loans are a massive part of the financial industry in the U.S., and when managed properly they enable us to provide for our families—a loan may quite literally “put a roof over your head.” It can be a huge relief to see some money hit your checking account in a time of need.

However, consumers should proceed with caution! Loans can also be extremely tricky to manage, especially for those with little financial know-how or budgeting skills.

This is why it is important for borrowers to have a general understanding of how consumer loans work before they apply for loans and make agreements with lenders. In this article, we will walk you through the four main types of consumer loans and how they work.

Auto Loans

Whether you are searching for a used car on a modest budget or seeking a flashy sports car after a big promotion at work, auto loans are needed by most consumers to purchase cars.

The loan term for an auto loan is one of the most important things to understand, and it relates directly to the value of a car. While a home’s value will in most cases increase over time, an automobile’s value will generally decline over time.

This starts the minute you drive off the dealer’s lot. That’s why car loans have shorter loan rates.  The lender needs to know the car will be enough to cover their losses if you default on your loan.

These terms usually last anywhere from 24 to 84 months, and it is best for borrowers to bring a down payment to the table whenever possible to cut down on that loan term.

Unfortunately, some consumers will find themselves “upside-down” in a car loan, meaning they still owe more in loan payments than the car is worth. (This is often due to these loans’ fixed interest rate,  jacking up the price of your monthly payment.)

Taking the shortest repayment plan is advisable when it comes to car loans, and it is also worth trying to wait it out until you can save a considerable down payment. If public transportation is an option that could buy you six more months of savings, it could pay off for you in the long run with a much better auto loan.

Mortgage Loans

A mortgage loan is another way to purchase a big-ticket item–in this case a house–without having to fork over hundreds of thousands of dollars (or in some cases millions) to the seller.

Few people would ever be able to purchase a home without a mortgage, and they certainly would not be able to buy the “home of their dreams.” Mortgages allow us to pay for our homes over time, though of course, they come with some limits.

If you are making $15 an hour as a barista, no lender is going to willingly enter into a $750,000 mortgage with you.

Luckily there are mortgage programs designed to assist with home purchases for those in lower-income brackets. The main types of mortgages are:

Conventional Mortgages: These work well for consumers who are able to make a significant down payment on a home (preferably 20%).

FHA Loans: These are backed by the Federal Housing Administration and target low-income home buyers.

VA Loans: These are offered by the Department of Veterans Affairs to assist veterans in purchasing homes.

Most mortgages work as 30-year fixed-rate loans, meaning the consumer pays in monthly installments over the course of 30 years. Some 15 or 20-year mortgages do exist, but these are less common as the monthly payments are much higher and not feasible for as many borrowers.

People and Dog Sitting on Floor

While your monthly payment remains the same, what differs over time is how it is divided between interest (how the lender makes money) and principal (the original debt).

This process is called amortization, and at the beginning of your loan more of your payment will go toward interest and this will decrease over time.

Personal Loans

While home and auto loans are used widely, there are a variety of other reasons we may need funding. This is where personal loans come into the picture.

A personal loan can help a consumer pay for anything from financing a vacation to medical expenses to debt consolidation. Personal loans vary widely in terms of maximum loan amounts, interest rates, and the length of the loan.

Personal loans can be taken from most financial institutions, or common payday loan centers. The process is often as simple as filling out a consumer loan application to submit to a loan officer for approval.

Generally speaking, most lenders will cap a personal loan at $100,000, and again the limits will be specific to the borrower and their consumer credit report history and income. Personal loans are often helpful when life throws unexpected expenses our way, such as a sudden illness, a layoff, a divorce, or other challenging circumstances.

Student Loans

The cost of higher education can be crippling for many families; very few can afford to pay for four years of college outright, without some form of financial aid, scholarships, or student loans.

Federal student loan programs offer a fixed rate and the government pays the interest on the loan while the student is still enrolled in school. There are subsidized federal loans, which go to those students with the direst need, and there are also unsubsidized loans that can be used by students without stipulations on need.

A student may borrow up to $23,000 in unsubsidized federal loans (and up to $31,000 including subsidized), with the assurance that every borrower receives the same interest rate.

While these are popular programs, these amounts do not add up to enough funding for many students, with tuition costs constantly rising at colleges and universities across the country.

Private lenders also work with students who need a credit line for their education, and the interest rates will be dependent on that borrower’s financial situation.

Man in Library

A Final Tip on Consumer Loans

No matter what type of consumer loan you are seeking, be sure you read the fine print carefully and familiarize yourself with all penalties and fees before signing the dotted line.

Loans can be lifesavers, but they can also wreak havoc on your credit score if you enter into one that you cannot repay.

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Jen M.

Jen has been with DCCU since she graduated from UW Madison - a long time ago. As the Content Strategist she helps share all the amazing things DCCU does in our community and spreads the credit union philosophy of People Helping People. When she's not working for the best credit union in south central Wisconsin, she's busy with 4 kids and a feisty little dog at home. She formed her family through adoption and has a deep passion to support foster and adoptive parents and kids. Her favorite place to relax is poolside or in front of the fireplace.