A beginner’s guide to personal loans
Published Tue, Aug 23, 2016 Updated Tue, Feb 16, 2021
For many people, even those struggling financially, the idea of taking out a personal loan can be pretty daunting. But often a personal loan is a cheaper way of making large purchases or paying off your debts compared to using overdrafts and credit cards.
Here’s our guide to the basics of personal loans, to help you understand whether a loan is the best option for your financial situation…
A personal loan is one of the most general forms of lending. Put simply, it is a sum of money borrowed from a bank or building society for you to use for just about any private purpose. If you’re looking for a loan to start a business or commercial venture then a personal loan is not the right option for you.
Types of personal loan
There are two types of personal loan: unsecured and secured. The first is more common for smaller loans – typically between £1,000 and £25,000 – and involves your bank or building society lending you money without you having to offer any form of security in case you default on a payment. Car loans and home improvement loans, generally speaking, are types of unsecured loan, they’re just advertised under a different name.
Secured loans are associated with larger borrowing and require you to secure your home against the sum borrowed. The interest rate on these are often lower than unsecured loans because there is less risk to the bank or building society lending you the money. But beware: this means that your house could be repossessed if you default on a repayment.
Working out repayments
Once you’ve decided which type of loan best suits you, the next step is to work out how much you can realistically afford to pay back each month. When you’ve calculated this figure, do some online research to see which companies will offer you the amount you require at a manageable monthly repayment rate – a comparison website is a good way to work this out. Some of these websites also have loan calculators, which help you work out how much you can afford to pay back based on the amount you wish to borrow, your income and outgoings.
Another thing to look out for is the interest rate: loans with a higher rate will cost you more to repay and the longer you take to pay it off, the greater the interest will be. Banks and building societies will describe their interest rate as an APR, which stands for Annual Percentage Rate.
Be aware that many websites will quote an average APR, which may change when you input your details. This is because your loan terms are based on your individual credit rating score, which may be lower or higher than the national average. Borrowers with a good credit rating pose less of a risk to lenders than those with low ratings, which may mean they are offered a preferential rate as a result.
The general rule is to borrow the least amount of money for the lowest rate, paid back over the shortest amount of time. However, don’t overstretch yourself – you don’t want to end up in a situation where you’re taking out another personal loan to cover the repayments on your first loan!
Are there any fees when taking out a personal loan?
You may also have to pay an initial fee for setting up the loan, called an arrangement fee, and you could be subject to penalty charges if you miss a payment, which is why it’s important to pay it back at a realistic rate.
In addition, if you come into money, some lenders will charge you a fee if you decide to repay the balance of your outstanding loan earlier than initially agreed. It’s worth double checking with the bank or building society from which you borrowed the money before you make an overpayment.
Personal Loans and PPI
You may also be offered Payment Protection Insurance (PPI) to cover you if you miss a loan repayment. Think carefully before accepting this as often banks and building society standard PPI products do not cover you in many common situations; it is simply an opportunity for them to make more money by encouraging you to purchase two products at the same time.
So long as you do your research, pick the best loan for your needs and keep up with your payments, a personal loan can be a financially savvy way to fund major purchases – often working out far cheaper than buying the same item on your credit card or dipping into your overdraft – or pay off your debts.