We run through everything you need to know about personal loans, from representative APRs to the danger of being hit with an early repayment charge.
Sections
What type of loan do you want?
There will be times when you need to borrow some cash, and your credit card simply won’t do the job.
Perhaps you are planning on getting a new kitchen or bathroom, or you need to upgrade your car to cope with your growing family.
Ideally, you’d have the money sat in a savings account that you could turn to, but if that’s not an option then a personal loan might be just the ticket.
Here we will run through what you need to consider when going for a personal loan, the different types available, and how to get the most out of your borrowing.
We'll start by looking at the unsecured personal loan, which is the most common option, before looking at what guarantor, peer-to-peer and secured loans have to offer.
Credit history is vital
The first thing to highlight is that, as with any other form of borrowing, your credit history will play a big role.
The market-leading personal loans are reserved for borrowers with impeccable credit records.
If you have the odd black mark in your credit history ‒ a missed payment or two perhaps ‒ then while you may still be able to find a decent loan, it will likely come with a higher interest rate, meaning it costs you more in the long run.
That’s why it’s so crucial to keep your credit record in the best possible condition. There are all sorts of things you can do to improve your score, from making your repayments on time to ensuring your details are correct on the electoral roll.
For more, check out our guide on how to improve your credit rating.
Will you get the headline rate?
When a lender advertises their personal loans, there will be an interest rate on display, which is described as the ‘representative APR’.
This is really important.
You might think that if you apply to that lender, and they accept your application, then you will get that advertised rate.
The truth may be rather different, however.
Lenders are only obliged to offer that representative APR to 51% of successful applicants.
In other words, almost half of people who apply for a loan and are accepted may be told that they will have a higher interest rate on their loan instead.
This again comes back to your credit record. If you want to improve your chances of being in that 51%, and getting the advertised rate you’re applying for, then you will need to have your credit record in excellent shape.
Take a look at the best personal loan rates currently available
How much you can borrow
The appeal of personal loans is that you can borrow a more substantial amount than with a credit card.
For example, while your credit card limit might be £5,000, with a personal loan you could borrow anything from £1,000 up to £35,000.
However, it’s worth bearing in mind that lenders approach these loan sizes differently. For example, the best rates tend to be on personal loans from £7,500 to £25,000.
While you can borrow smaller sums, these are clearly not as attractive an option to lenders, as the interest rates tend to creep up.
While you can find a personal loan for sums above £25,000, again the interest rates are more substantial than for that middle range of loan sizes.
Why do you need to borrow?
When you take out a credit card, the lender doesn’t ask you why you need it. Similarly, if you apply for an overdraft with your bank, you don’t need to explain yourself.
That isn’t always the case with a personal loan though, as the lender may want to get a few details from you on precisely why you want the money.
Don’t worry, they aren’t going to ask for a full breakdown of precisely what home improvements you are planning or what colour you’re repainting the kitchen, but they will want a steer over why you are borrowing.
This can influence the term they are willing to provide for your personal loan.
How long will it take you to repay?
The loan term is an important consideration when going for a personal loan. From the outset, you are setting out exactly when the loan will be paid off in full.
The loan terms on offer will vary between different lenders, but they can range from as little as a year to as long as eight years.
Going for a shorter loan term will mean the balance is cleared quicker, and cost you less in total as interest is charged on the sum you’ve borrowed for a smaller period of time. This does mean that your monthly repayments will be a bit higher though.
The counter to that is that longer terms may mean smaller, more manageable monthly repayments but will cost you more overall.
Let’s look at an example to demonstrate this. If I wanted to borrow £10,000 at a representative APR of 6%, then over a two-year term it means monthly repayments of £442 and in total, I would pay back a little over £10,619.
But if I went for a five-year term, those repayments would drop to around £192 a month, yet the total repaid would creep up to £11,555.
The cost of paying it off early
Imagine that a couple of years into a five-year loan term, your circumstances change. Perhaps you receive an inheritance or move to a higher-paying job, and you fancy paying off your outstanding debts.
This can result in you having to pay an additional charge however. Many personal loans come with early repayment charges (ERCs). This is a fee you’ll have to pay if you manage to clear your loan balance ahead of schedule.
The exact size of the ERC will vary between different lenders, so it’s worth checking precisely what it will cost you to pay off the loan early before you actually apply.
Peer-to-peer personal loans
While you can get a personal loan from a mainstream high street bank, you may find that your best option is to borrow through a peer-to-peer platform.
Peer-to-peer platforms like LendingWorks have become popular among both investors and borrowers in recent years.
Such platforms allow investors to fund loans which are then offered to individual borrowers, and receive a rate of interest in return.
From a borrower's perspective, there is very little difference between borrowing a personal loan from a high street bank and from taking one out with a peer-to-peer platform.
As with a traditional lender, the rate you get will be influenced by your credit score, with the best rates on offer for those with an excellent history.
These peer-to-peer platforms are all regulated by the FCA in much the same way as high street banks too.
Guarantor personal loans
Guarantor loans are an option for people who might struggle to get a personal loan from banks or peer-to-peer platforms.
With these loans, you need to find a guarantor ‒ perhaps a parent or other member of your family ‒ who will guarantee your payments.
This means committing to stepping in to cover those repayments in the event that you cannot.
Because the guarantor’s financial position is taken into consideration by the lender when you apply, it can counter any issues with your own credit history (assuming your guarantor has a better record of course)
From a practical perspective, borrowers won’t see much difference if they take out a guarantor loan compared to a regular personal loan. You will borrow over a specified term and make monthly repayments towards clearing the balance you’ve borrowed.
As well as helping people with a patchy credit score get their hands on a needed loan, a guarantor loan can also help those borrowers to improve their score, making it easier for them to secure credit in future.
An important thing to bear in mind with guarantor loans is that the interest rates tend to be far higher than those on offer from regular personal loans.
There is also the danger of relations with your guarantor turning sour if you find yourself having difficulties in making your repayments, requiring them to step in and cover the payments.
Secured loans
When you talk about a personal loan, usually you’re talking about an unsecured loan.
The name here is self-explanatory ‒ the sum you’re borrowing isn’t being secured against an asset, like a car or a house.
However, if you’re looking to borrow a larger sum you might want to consider a secured loan.
This is sometimes referred to as a second mortgage or a second-charge mortgage.
A crucial element to remember with a secured loan is that if you find yourself unable to meet your repayments, the lender can repossess the asset the loan is secured against.
So if you’re secured the loan against your property, it could put your home at risk if you don’t keep up with your repayments.
Secured loans work rather like mortgages in that you borrow a set amount over a specified period, make monthly repayments, and when the term ends the loan is fully repaid.
There is an important difference though, in that the amount you can borrow is restricted to the equity you hold in the property, rather than the overall value of the property.
If your home is worth £200,000 and you have a £100,000 outstanding mortgage, then you hold £100,000 in equity in the property.
As with a regular mortgage, lenders will have maximum loan-to-values in place for their lending on secured loans.
But the value referred to is the value of your equity rather than the value of the property.
So in our example above, if you took our a secured loan at 75% LTV then that would be £75,000.
The interest rate charged on a secured loan can be either fixed or variable. With a fixed interest rate, you know exactly what your repayments will be each month, which can help with budgeting.
However, with a variable interest rate, your repayments could go up or down over time. As with a personal loan, the advertised APR is simply representative ‒ even if you are accepted, you may be offered a higher rate.
The interest rate isn’t the only fee to include in your calculations though. Like mortgages, plenty of secured loans come with application fees ‒ a charge just for taking out the product.
Another factor that will play a big part in how much a secured loan costs you will be the term of the loan.
Again this works in a very similar way to a traditional mortgage, as you can take out a secured loan over just a couple of years or stretch your borrowing over decades.
The longer the term, the smaller the monthly repayments will be, though the more your debt will cost you overall.