Loans explained: everything you need to know

A loan can be a useful way to help cover the cost of a large expense. But before you apply for a loan, it’s important to understand everything that goes with borrowing money. 

What is a loan?

When you take out a loan, you borrow a set amount of money and agree to pay it back within a certain timeframe, usually with interest. The amount you’ll be able to borrow and the interest rate on offer will depend on a number of things, like your credit score and how long you’ll take to repay it.  

Why do people take out loans?

There are lots of reasons people take out loans. For example:

  • buying a car
  • paying for a wedding
  • home improvements, like an extension or loft conversion
  • other large purchases, like a holiday
  • debt consolidation – if you have a few different debts, this can help bring all your repayments together and give you a clear loan term and repayment plan 

What are the different types of loans?

A personal loan is the most common type of loan, which you can use to cover the needs above.

Personal loans available will vary from lender to lender. They'll have different loan limits, interest rates and terms on offer.

Explore more: What are some of the different types of loans?

Are personal loans secured or unsecured? 

When researching borrowing options, you may see products described as either secured or unsecured.

Personal loans are typically unsecured, which means that the lender – a bank, for example – cannot take away any of your assets if you fail to repay what you owe. However, any late or missed repayments can negatively impact your credit score and your ability to borrow money in the future.

The lender will decide how much they’re willing to lend you based on things like your income, credit score and what you need the loan for.

The most common example of a secured loan is a home loan, or mortgage. In this case, the loan is ‘secured’ against your home. That means the lender could repossess your home if you fail to keep up with repayments.

Interest rates on secured loans tend to be lower than on unsecured loans. That’s because the lender reduces its risk by agreeing other ways of recouping its money if a borrower fails to repay the loan.

The amount you can borrow for a mortgage is based on the loan-to-value (LTV) ratio. This is the amount you’ll be able to borrow as a proportion of the value of your home. Other factors like your income and credit score will also impact how much you can borrow.

Is a loan or credit card better?

Depending on what you need to borrow money for and how much you want to borrow, you may want to compare loans and credit cards. Both work in a similar way – you borrow money and pay it back. But there are pros and cons to each, so weighing up which is right for you is important.

Credit cards may be better if you need to borrow small amounts on a regular basis. They’re also useful if you’re unsure how much you need to borrow or just want to have extra funds available in case of an emergency. It’s important to make sure you can afford to repay any money you’ve spent on a credit card. You may have to pay a fee if you miss a repayment and your interest owed can start to build up. This can also have a negative impact on your credit score.

Loans tend to be more useful when borrowing a larger amount of money over a longer period of time. You may be able to get a better interest rate with a loan and you’ll have a set repayment term. Again, you should only borrow what you can afford to pay back. Missing any repayments may impact on your credit score and your ability to borrow in future. 

Explore more: Credit cards vs loans: funding options explained

Things to consider before taking out a loan

Before applying for a loan, take some time to consider all your options. Think about whether you really need the item you’re wanting the loan for right now. If you don’t, look at saving some money. You may be able to save up the full amount you need, or a good proportion of it, so you’ll need to borrow less.

You may also want to take some time to build up your credit score. A better credit score may mean you get offered better interest rates and can choose from a wider range of products.

Explore more: How to improve your credit score

If you’re looking at loans, check the interest rates available to find the best one for you. This will often be expressed as an annual percentage rate (APR). You may be shown the ‘representative APR’ when searching for a loan. This isn’t necessarily the APR you’ll receive, it’s an example so you can quickly compare the potential cost of the different loan products you may be eligible for.

The APR you’ll get is based on your individual circumstances, so this may be different to the representative APR advertised. Always read the small print on any products you’re offered.

Explore more: What is APR?

You may also want to speak to your bank about what the repayments will be. Creating a budget with your incomings and outgoings can help you see if you can afford the repayments. If you’re unable to make the repayments, you may want to consider other options like borrowing less or saving up instead.

Explore more: Calculate your monthly loan repayments

Checking your credit score

Before a bank or financial lender offer you a loan, they’ll most likely check your credit score. This is so they can see what kind of borrower you’ve been throughout your borrowing history.

Your credit score can impact whether you’ll be successful in a loan application and also what interest rate you’ll get. There are two types of searches a lender will do – a soft credit check and a hard credit check.

Soft searches allow the lender to see what kind of products you’re eligible for and won’t leave a footprint on your credit report.

A hard credit search takes place when you’ve actually applied for finance. This is an in-depth look at your credit report and will leave a visible footprint. This means other lenders will be able to see you’ve applied for credit. 

It’s a good idea to check what information the credit reference agencies have on you. You may be able to sign up online to view your credit report or request a statutory copy from each of the credit reference agencies. There are 3 main credit reference agencies to check:

  • TransUnion
  • Experian
  • Equifax

There may be a small fee for checking your credit report, but you’ll be able to check if there’s any incorrect information.

Try not to apply for multiple loans at the same time, lenders will do a hard credit check which leaves a footprint on your credit file. Lots of hard credit searches in a short period of time may signal to a lender that you’re struggling to manage your money. This may impact your credit score and also whether or not you’ll be successful in a loan application.

Explore more: What is a credit score?

Applying for a loan

Applying for a loan should be done carefully. Make sure you’ve found the right loan for your circumstances and you have all the correct documentation. This may include:

  • your personal information
  • your bank details
  • your employment details
  • proof of address and previous addresses

Check with the lender to see if there’s anything else you may need – such as a P60 or any other official documentation. It can help the application move quicker if you have everything you need to hand.

If you’re applying for a loan with your existing bank, the process may be much simpler as they’ll already have a lot of your information on record. This may be able to be done in a matter of minutes online or through an app, which is why it’s so important to think through everything before applying.

Once you’ve completed your loan application, make sure to check it thoroughly before you submit it.

Explore more: What to check before applying for a loan

Repaying your loan

Keeping up to date with your repayments is important. When applying for a loan, look at what the repayments will be and make sure you’re able to afford these by including them in your budget.

Explore more: How to create a budget

You may want to set up a Direct Debit so the repayment is made automatically. If you do, it can be useful to check your account regularly so you can make sure there’s enough money to cover the repayments. 

If you’re unable to make a repayment, speak with your lender as soon as possible. They may be able to help find a solution. Falling behind on repayments can see you in arrears, which can be difficult to get out of. It can also negatively impact your credit score.

Explore more: How to manage your loan repayments

Can you pay off your loan early? 

If you can afford to, you may want to look at making overpayments on your loan. It’s not essential to do this, but it can help you pay your loan back quicker and save you money in interest payments.

There may be a fee for making an overpayment so make sure to check with your lender before you do. 

What next?

If you’ve decided to apply for a loan, take some time to find the right one for your circumstances. 

Definitions

What is APR?

APR is the cost of borrowing over a year. It takes into account the interest rate and any other fees. 

What is LTV?

LTV (loan-to-value) ratio is the amount you can borrow based on the value of your asset. 

What is debt consolidation?

Debt consolidation is when you move existing debts into one – giving you one single loan.

What is a variable interest rate?

A variable interest rate is where the interest rate can change during the term of your loan. 

What is arrears?

Owing money which should have already been paid. If you miss your loan repayments, you’ll fall into arrears with the lender.