What is a personal loan?

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 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.

The interest rate sets out how much you’ll be charged on top of the original loan amount every month or year. The interest rate doesn’t include any fees or charges so make sure you factor those in as well.

Be aware that adverts for loans often state the ‘typical’ or ‘representative’ interest rate. This is the average interest rate typically offered to customers for this product – not necessarily what you will actually be offered. You may be offered a different rate of interest once you apply for the loan yourself. Every application will be assessed on an individual basis. The lender will consider your credit report, as well as other factors such as your income, and any requirements set out in the NCA. The National Credit Act (NCA) put a limit on the amount of interest you can be charged on a personal loan.

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.

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 - 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 - 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 - 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.

A variable-interest loan - 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.

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.