Do you really need a loan?
The first thing anyone needs to know about loans is that they always, always increase the cost of things. If you take out a loan to purchase something, you will pay more than you would have had you saved your pennies and paid for your purchase outright.
So why do people take out loans? Convenience! A loan makes it possible to get something you want right away, rather than at the point in the (distant) future when you actually have the cash to buy it.
Borrowing is a lot like starting a bike ride on a downhill: things are suddenly so free and easy that you can lose sight of just how much work it’s going to be to get back where you started. But you do have to get back to where you started. Every penny borrowed is a penny to pay back… with interest.
How loans work
You apply for a loan by filling out a form that covers your personal details and financial history. The lender will check your credit history and approve or decline your application. If you are accepted, you will usually receive funds within several weeks, and you’ll begin paying back your loan within about a month.
Loans are repaid in monthly installments. Each installment includes part of the principle (the money you borrowed) and part of the interest incurred by your debt. These interest payments go straight into your lender’s pocket, and interest rates can vary wildly. Shopping around for a low rate (APR, for Annual Percentage Rate) is crucial. But what’s even more important is the TAR – as we’ll explain next!
The length, or term, of a loan
The term of a loan can be adjusted to your needs, with the caveat that it will likely need to be somewhere between three and 10 years. The term is usually dictated by how much you want to borrow, and how much you can afford to repay each month.
We suggest people borrow over the shortest term they can. Borrowing over the longer term is expensive: by stretching out your repayment period, you inflate your overall interest bill as you are paying money on your debt for longer.
Remember, banks and other loan providers are out to make a profit. To this end, they often use language that plays down the seriousness of the financial commitment, like describing terms in months instead of years. Another thing you will notice is that loan providers rarely advertise the total amount repayable (TAR). They are happy to tell you how much you will pay each month, but the number that includes principle, interest and fees tends to be relegated to the small print.
The TAR is the most important figure. It tells you how much you will pay over the term of the loan. This is the figure you should use to compare other loans when you want to check which is the cheapest.
Secured loans
Secured loans require you to provide your lender with some kind of collateral as a guarantee on your loan. Most secured loans are secured on the borrower’s home or car, which means that if you fail to pay back a secured loan, your lender has the right to take your home or car. For this reason, we strongly caution anyone to think very, very carefully before taking out a secured loan.
You can normally borrow more with a secured loan than you could with an unsecured loan. Secured loans also tend to have variable interest rates, so your monthly repayments can go up and down over the term of the loan. Before you commit, calculate what your monthly repayment would be if your interest rate went up two, three or four percent. Could you afford this? If not, walk away!
A mortgage is a type of secured loan, but it’s unique in a few ways. Firstly, mortgages tend to be cheaper (have lower rates) than secured loans. Secondly, you can often get a fixed-rate mortgage, which in turn fixes your monthly repayments. Finally, by remortgaging you move your debt from one lender to another.
Unsecured loans
Unsecured loans are often referred to as ‘personal loans’. They differ from secured loans in that you are not required to provide your lender with collateral against your loan. If you are unable to keep up with your payments, you are less likely to lose your home or your car… but this is not guaranteed. Lenders can apply through the courts to force the sale of your home.
Unsecured loans generally run from £2,000 to £25,000. They also usually have fixed interest rates, which means your monthly repayments will not vary.
The big print: APR
APR (Annual Percentage Rate) is the rate at which you are charged on the amount you borrow. This is always found in the big print, as banks are required by law to make this information clear to customers.
A ‘typical APR’ is the rate a lender offers two-thirds of their customers. It is not the APR everyone gets, but lenders quote it as it can be attractive to customers. The APR you will be charged will depend on your credit rating and how attractive you are to the lender. If you have a good credit record, you may qualify for a lower rate, but if you have a less than optimal credit history, the rate you are offered may be in excess of the typical APR.
The average APR for a competitive personal loan is usually less than 5% above the Bank of England Base Rate, but be aware: the APR is not the best way to assess the cost of the loan, as we mentioned earlier. For that, you will want to look at TAR (Total Amount Repayable).
The small print: TAR
TAR (Total Amount Repayable) is the total, to-the-penny amount your loan will cost. It includes interest, the principle, and any non-optional fees. We strongly encourage you to use the TAR to compare the cost of loans.
Consolidating debt
Many loan providers offer ‘consolidation loans’ and urge would-be customers to consolidate their debt into one loan. What this means is taking out one loan to pay off all your other debts (other loans, credit cards, store cards and the like). You are still in debt for the same amount (or more!), but you have just the one creditor.
Consolidating simplifies your finances: rather than having multiple payments to make each month, you will only have one. But consolidating can be tricky. Firstly, it only makes sense to consolidate if you are moving to a lower interest rate. Otherwise you will end up paying more overall. And secondly, consolidating can lead to a false sense of financial freedom. Many people consolidate and then run up all their individual debts again.
Be wary of consolidating unsecured debt, such as a personal loan, into secured debt, such as a mortgage. You are then putting your home at risk for this debt, when previously your home was not at risk at all.
Rather than consolidating, snowball your debts by making the minimum payments on all debts and putting every spare penny towards the debt with the highest APR. Once this is paid off, keep up the minimums on your other debts, and turn all spare money to the debt with the next-highest APR. This takes hard work, but it is effective and actually gets you out of the red and back in the black.
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