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What is a personal loan?

What is a personal loan? How do you know if this the best way to borrow? Here's what you need to think about when it comes to personal loans

03 February 2017 4 min read
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We’ll explain everything you need to know about personal loans and how to get the best loan rate for you.

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 may be looking at getting a personal loan. There are plenty of lending options out there, so it’s important to understand what a personal loan is and make sure 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 commercial 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 pay back the loan, you’ll also pay interest on the amount you’ve borrowed.

APR is a helpful phrase to understand if you are looking at personal loans. APR stands for Annual Percentage Rate and describes the percentage of interest you’ll pay over the course of a year on a loan. APR also includes any fees and charges you will pay over the year as well – so it’s an overall figure of the annual cost of the loan. APR is calculated in the same way for every company (it’s the law that any loan / credit card / hire purchase agreement must show APR). APR is a way of helping customers make comparisons between different products. The lower the APR, the less you’ll pay for your loan.

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

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Before you’re given the loan, you will 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 – and 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% APR 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% APR for 36 months

Monthly repayments = £327.08

Total amount to repay = £11,774.85

Total amount paid for the loan = £1,774.85

So 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 will 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)

However, you may 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. Be aware this may 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 loans

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 they’re owed. 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 yourself!)

Unsecured loans

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.

Fixed-interest loans

A fixed-interest loan means the interest you agree to when you take out the loan will always stay the same – it is 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.

Variable-interest loans

A variable-interest loan 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.

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