When you are ready to secure financing for a significant purchase or investment, such as a home or vehicle, the chances are good that you will be in negotiation with lenders to obtain some form of loan. Generally speaking, there are two primary forms of loans offered to individuals today, those being open-end and closed-end loans. Whereas an open-end loan allows borrowers to continually adjust their borrowing amount and pay back the funds they have used over an indefinite period of time, a closed-end loan is far more stringent. A closed-end loan allows borrowers to obtain a fixed sum of money that must be paid back by a designated point in time.
A closed-end loan allows individuals to access a fixed sum of money that can be used to finance the purchase of a major asset, such as a home or vehicle. The principal and interest of the loan must be paid completely in the timeline established by the lender.
Exploring the Basics of Closed-End Loans
As mentioned previously, a closed-end loan is a highly regulated form of borrowing in which a lender offers a specific sum of money to a borrower that must be repaid within an agreed-upon timeframe. These loans will generally have a fixed rate of interest attached to them (although variable rates are possible), and will require the borrower to pay back both principal and interest within the designated timeframe.
Failure to do so could have a severely negative impact on the borrower's credit score and, consequently, could negatively impact their ability to borrow funds in the future.
Examples of Closed-End Loan Funds
Some of the most common examples of closed-end loans used today are home mortgages and auto loans. In each scenario, the borrower will receive a loan that is equitable to the cost of the item they are buying, be it a new home or a car. The sum of money borrowed as part of the closed-end loan is explicitly designated for the purchase in question. Because of this, the loaned sum will not exceed the amount of the purchase itself.
Unlike a credit card, which is an excellent example of an open-end loan, closed-end loans do not allow borrowers to continually access new funds when they have paid back a portion of the original borrowed amount. Once the funds have been transferred to the borrower, they must be paid back entirely to satisfy the terms of the borrowing agreement and conclude the lending arrangement.
Getting Approved for a Closed-End Loan
Although a closed-end vs. open-end loan comparison can highlight a variety of differences between these two borrowing formats, they are identical in the means by which individuals are approved for loans. A borrower's credit score is instrumental in determining exactly how much money they will be able to access. A credit score has become the de facto standard for lending institutions when it comes to measuring the default risk posed by a single applicant.
In some situations, individuals with average or mediocre credit scores may be able to borrow the funds they need in exchange for a higher rate of interest attached to them. In other scenarios, applicants with below-average credit scores may be denied funds entirely. With these ideas in mind, it is essential for borrowers to be fully aware of their own financial credentials before they pursue financing. This will ensure that they are not surprised by any potentially adverse borrowing conditions that may accompany the loan. After all, the consequences for defaulting on a closed-end loan can be immense.
Ryan Cockerham is a nationally recognized author specializing in all things innovation, business and creativity. His work has served the business, nonprofit and political community. Ryan's work has been featured at Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.