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What is a personal loan?

We’ll explain everything you need to know about personal loans and how to get the best loan rate for you.

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If you’re thinking of doing some much-needed home-improvements, finally taking that trip of a lifetime or paying for a fairytale wedding, you might be considering a personal loan. There are plenty of lending options out there, so it’s important to understand what a personal loan is and whether it’s the right choice for you.

A personal loan is an amount of money lent to an individual by a bank, building society or other lender. You’ll be given the loan in one lump sum and will have to pay it back in monthly instalments over a set amount of time. When you repay the loan, you’ll be charged interest on the amount you’ve borrowed.

Interest rates are calculated in the same way for every company (it’s the law that any loan/credit card/hire purchase agreement must show the rate). It’s is a way of helping customers make comparisons between different products; the lower the interest rate, the less you’ll pay for your loan.

Be aware that adverts for loans often state the ‘typical’ or ‘representative’ interest rate. This is the average rate offered to customers for this product – it’s not necessarily what you will actually be offered. You may be offered a different rate once you apply for the loan as this is based on your credit score; the better your credit score, generally the lower the rate you’ll be offered.

Many peer to peer lenders offer rates based on your credit score (known as ‘risk based pricing’) and we’ll be partnering with some of these companies. Look out for products with risk based pricing the offers section of your ClearScore account.

Before you’re given the loan, you’ll have to agree the terms with the lender. The terms are how much money you want to repay each month and how much time you will need to pay back the loan. You may choose to spread out the loan and make smaller repayments over a longer period of time – if you’re on a budget this may seem like the best thing to do.

However, taking longer to pay back a loan will probably cost you more overall - even if it seems cheaper to pay back smaller monthly instalments.

Example - taking out a $10,000 loan for 24 months compared to 36 months

Cost of $10,000 loan at 11.5% comparison rate for 24 months

Monthly repayments = $465.78
Total amount to repay = $11,178.64
Total amount paid for the loan = $1,178.64

Cost of $10,000 loan at 11.5% comparison rate for 36 months

Monthly repayments = $327.08
Total amount to repay = $11,774.85
Total amount paid for the loan = $1,774.85

In this example you can see it costs $596.21 more to borrow for 36 months rather than 24 months.

Remember that since you pay interest on a personal loan, you’ll always pay back more than you’ve borrowed. So it’s worth thinking about if a personal loan is right for you as there might be better options out there.

A personal loan could be a good choice if you want a steady way of borrowing. Since you agree to the terms of the loan beforehand, you should know how much your monthly repayments will be and how long you have to pay off the loan. This will help if you need to work to a strict budget each month. (Obviously it’s a little different if you take a variable interest loan – see below)

You might not want to take out a personal loan if you can borrow the amount you need on a credit card. For example, if you can get a credit card with a 0% interest offer you may be able to borrow the money for little or no charge. Bear in mind this will only save you money if you’re able to repay the full balance before the 0% interest period ends.

A personal loan can be secured or unsecured.

Secured - a secured loan means the loan is being secured by an asset you have, such as your car or house. If you fail to repay the loan, the lender can sell your asset to help recoup the money you owe. Because of this, secured loans usually have lower rates of interest than unsecured loans because there’s less risk for the lender (but of course there’s a much bigger risk for you!)

Unsecured - an unsecured loan is a loan that is not secured to anything you currently own. This might have a higher rate of interest than a secured loan, but you won’t lose your car/house if you fail to repay it.

There are two types of interest options you might be offered on a personal loan: a fixed-interest loan or a variable-interest loan.

A fixed-interest loan- this means the interest you agree to when you take out the loan will always stay the same; it’s fixed. So you’ll pay the same amount of interest on each repayment you make. This might be a better option if you’re on a tight budget because you’ll never be caught out if rates go up.

A variable-interest loan - this means the amount of interest you pay on your loan might go up and down. A variable interest loan might offer a lower interest than a fixed-interest loan, but remember this can change and it could become more expensive for you.

  • Check your credit score

Your credit score is really important when it comes to personal loans because lenders use this as a basis to determine how much money they will loan you and how much interest they’ll charge. So before you apply it’s worth checking your credit rating and finding steps you can take to improve it. This could save you a lot of money over time.

Next step: Log in or sign up to ClearScore to get your credit score for free.

  • Make a budget

Before you take out a loan, it’s worth making a budget to work out exactly how much money you need to borrow and what you can afford to pay back each month. It may sound obvious but you need to make sure you can afford the loan.

  • Do the maths

Some companies will offer you a lower rate of interest if you borrow more money. This has both good and bad points. You may find that if you borrow slightly more money at a lower interest rate, you could end up paying less interest overall.

However, you might end up falling for the temptation of borrowing far more money than you need and paying even more interest. So before you sign anything, it’s wise to do some calculations to see what you could save.

  • Check the small print

Sometimes loans include fees or conditions that you won’t immediately see (such as early repayment fees) so make sure you've read through the small print before you sign anything.

Lucy has a wealth of personal finance knowledge, and is one of our in-house experts.