How do loans work?
When you take a loan from a bank, building society or other type of institutional lender you take receipt of a sum of money up-front and then repay that debt over a pre-agreed period of time. This repayment is usually made in regular - often monthly - instalments although arrangements can be more flexible, especially with shorter-term loans. As well as the capital, you also pay back interest on your debt.
What types of loan are there?
There is now a varied range of loan types available on the market, with different product types and terms suited to different circumstances. Loan types include:
- Unsecured loans: loans where no asset is placed as a security against defaulting on repayments. The term 'unsecured loan' is often associated with mid- to long-term loans from traditional banks and building societies, but it can apply to any loan with no guarantee.
- Secured loans: loans where an asset such as a house or something else of value is nominated as security against default, in the act of which the asset may be repossessed by the lender.
- Payday loans: Smaller loans offered over a matter of days or weeks for small amounts of money, typically with high APR rates but flexibility over repayments.
- Short-term loans: similar to payday loans, but offering terms of weeks or months, usually up to a year, with mid-range interest rates.
- Credit line accounts: a type of lending that offers flexibility to increase or decrease your overall borrowing level, over a period of up to a year. Similar to an overdraft on a current account.
- Bad credit loans: loans offered to those who have previously experienced financial difficulties or who have limited history of managing debt facilities.
- Car loans: loans used to buy vehicles, sometimes through dealers directly, including through 'hire purchase' schemes.
- Logbook loans: a way of borrowing money by, in effect, handing over ownership of a vehicle, while still retaining the use of that vehicle, until the loans is repaid.
- Guarantor loans: a loan where a third party agrees to cover your repayments if you are unable to.
- Peer-to-peer loans: loans between two individuals or businesses, or mix thereof, facilitated through online, open market places.
- Business loans: loans offered to commercial organisations.
- Instalment loans: loans where the overall borrowing is staggered over multiple payments.
For more detailed information on each of these types of loan, visit Know Your Money's dedicated loan types guide.
Who provides loans?
Loans are available from a wide range of financial institutions. These include traditional high street banks and building societies, credit unions, specialist start-up companies, pay day lenders (both on the high street and online), and from individuals through peer-to-peer platforms.
How much can I borrow?
With a short-term loan you can borrow under a hundred pounds to one or two thousand, depending on the lender. The typical borrowing range from traditional high street banks and building societies is £1,000 to £25,000, rising to over £100,000 for secured loans. Businesses can often borrow larger amounts, into the hundred of thousands, depending on circumstances.
How long can I borrow for?
Short-term lenders offer borrowing periods of a matter of days up to weeks or months. Traditional banks and building societies usually offer borrowing periods of between one and seven years, although longer terms may be agreed.
How do repayments work on loans?
If you repay your loan in regular instalments (typically monthly) you will usually pay a consistent amount in each repayment throughout the term of your agreement. To facilitate this, the bank works out how much interest you'd pay throughout the whole term of the loan, taking into account the reduction in capital debt as the loan is paid off, and adds this figure to the initial capital level. It then divides this conjoined amount equally over the number of payments scheduled throughout the term. This is also known as an amortized loan.
However, some lenders offer loans where the repayment reduces over the course of the loan as the balance of debt decreases, especially where there is flexibility in the amount and regularity of repayments.
How is interest calculated on loans?
The interest you pay on your loan is typically fixed at a certain level at the beginning of your agreement, at a set percentage rate, which will remain in place throughout the term of the arrangement.
The interest that is owed on the debt is either calculated on a daily, monthly, or sometimes less frequent basis. At the point when the interest is calculated, the percentage rate you agreed is applied to the overall borrowing level left at that time, taking into account repayments you've already made, for the period since the interest was calculated last.
Can I repay a loan early?
Some lenders will decline requests to repay loans early. Others may allow you to do so but might stipulate that you will face additional charges on top of the remaining capital you owe. This is to cover some or all of the interest that you would have paid had you completed the whole of the pre-agreed lending term.
What is 'APR'?
APR stands for annual percentage rate. It is a measure for comparing the value of two different loans. The APR takes into account the amount of interest you'd pay each year on the loan, as a percentage of your debt level, as well as any fees you are charged through the normal and agreed terms of the arrangement.
How do I apply for a loan?
You can usually apply for a loan over the Internet, via the telephone, or in branches where they are available. You will need to complete an application form, indicating your personal circumstances and, in some cases, what you require the loan for.
You will usually need to provide two forms of ID - one for your name and one for your address - if these documents have not already been verified and stored by the lender.
How do I choose the right loan?
It is important to assess your current and future financial prospects carefully when weighing up which type of loan is right for you. You'll need to ensure that you will be in a position where you are able to - and desire to - continue making the required repayments throughout the course of the term. If you are unsure of your long-term economic prospects then a shorter-term loan may be advisable.
The APR rate is an important factor for comparison but ensure that you calculate the real-money repayments involved. If you only need to borrow in the short-term then an APR rate that is substantially higher may still be cheaper than paying a lower rate over a longer term.
As well as costs you should assess the access to customer service offered by your lender, including the channels through which you can administer your account. Also consider any charges or grace periods offered in the case of defaulted repayments.
Will I be accepted for a loan?
The success of your loan application will be dependent on your credit profile, previous financial history, demographic profile, personal circumstances including occupational status and earnings, and sometimes your relationship with the lender.
Short-term lenders often offer relaxed stipulations. Some specialist lenders provide loans for those who may not meet the criteria demanded by high street banks and building societies.
Can missed repayments affect my credit profile?
If you default on your loan repayments this will usually be detailed on the credit profile held on you by the major credit ratings agencies. This could then prevent you from being able to secure other financial services and loans in the future, or may mean you are offered less competitive rates.