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Beginners' guide to loans

Learn the basics of loans with our guide, with details of borrowing options, how to apply, repayment, what to watch out for, and more…

Key points

  • There are many different types of loan and other sources of credit, so do your research and shop around
  • How much you can borrow and the interest rate will depend on your circumstances and credit score
  • Our comparison service lets you see how likely you are to be accepted without affecting your credit score

At first glance, a loan is a simple enough product; you agree an amount to borrow and you pay it back, plus interest, over an agreed time.

However, taking the time to think about the best loan for you and to compare credit deals could save you a lot of money.

It may also keep you safe from riskier debt options such as doorstep lenders and expensive overdrafts.

Loan options

If you’re new to borrowing, a personal loan is the most typical choice, a product which is often known as an unsecured loan.

Other common options include secured loans – secured against an asset, usually your home – or extending your mortgage.

Peer-to-peer lending is an innovative and fast-growing area that’s worth considering alongside more traditional options.Wads of £10 notes

Then of course, there are more problematic options such as payday loans, logbook loans or doorstep lenders.

Such options are notorious for high charges and could see you running the risk of becoming trapped by unaffordable debt. They are unlikely to be the right choice for would-be borrowers.

How much can you borrow?

The amount of money you can borrow will depend on your circumstances and any existing debt you have.

If you have credit facilities that you aren’t using but could use, such as an overdraft or credit card, these can be taken into account too. The lender wants to know you won’t suddenly find yourself with unaffordable debt.

As a rule, most lenders will agree to a maximum personal loan of £25,000. After that they’ll probably want to secure the debt against something, most commonly your house.

If you only need a small loan then it might be worth considering some of the following alternatives.

Alternatives to loans

If you only need short-term credit and you know you’ll be able to repay it within a few months, a credit card could be worth a look

A loan isn't necessarily the best way for you to borrow the cash you need.

For example, if you have savings then you may want to consider spending those funds rather than borrowing money - you’ll almost certainly pay more in interest in your loan than you would earn on your savings.

If you only need short-term credit and you know you’ll be able to repay it within a few months then a credit card could be worth a look.

Some offer 0% APR for an introductory period, meaning you could potentially borrow money for nothing.

Credit cardsBear in mind that the interest charged after that is likely to be far higher than with a loan, so only use this alternative if you’re sure you can clear the debt. And, of course, if you’re confident you won’t be tempted to run up a larger debt than you meant to!

For small levels of borrowing, an arranged overdraft on your current account could be cheaper, as well as giving you greater flexibility over when you repay.

Just make sure that you check all charges associated with overdrafts and that you talk to your bank before plunging into the red. Unauthorised overdrafts can be particularly costly.

Loans from credit unions are worth considering as alternatives to more traditional lenders. Their rates may be attractive, and they could be an option if you have a poor credit rating.

APR and what you pay for a loan

APR stands for annual percentage rate and reflects how much your debt would cost over a year.

Did you know...?

  • A lender’s headline rate only has to be offered to 51% of successful applicants
  • If you’re struggling with repayments, speak to your lender - they may be able to help

Lenders have to include any automatic fees as well as the interest in the figure, so it should give you a simple idea of what you’ll pay a year.

Lenders will advertise their headline APRs to attract customers.

But there is a big BUT. If you’ve seen a market-leading loan rate advertised, that doesn’t necessarily mean you could qualify for that rate.

That’s the lender’s headline rate and they must offer it to at least 51% of successful applicants.

They could reject your application or offer you a higher rate; it depends on your credit score, income and outgoings.

The bank may even be influenced by its statistics on how borrowers similar to you have behaved in the past.

You should also bear in mind that a larger loan tends to have a lower APR than a smaller loan. So, you’re likely to pay a higher rate on interest on a debt of just a couple of thousand pounds than you would on a debt of £7,000 or more.

This can lead to some bizarre circumstances where it’s cheaper overall to borrow a large sum of money - for example, £7,000 rather than £6,500. However that will depend on the rates you’re offered so make sure you look carefully at the numbers.

Because larger loans typically have lower APRs, some people can save money by consolidating their debt in order to get a better overall rate.

It’s also worth being aware that a few lenders charge upfront fees and possibly also early redemption charges if you want to repay the debt early. Make sure you’re clear on any additional costs before you arrange the loan. How to improve a credit score

Credit scores

Before a lender agrees to give you a loan, it will look at your credit history.

This includes your existing credit agreements, whether you’ve been a reliable customer in the past and whether you’ve ever defaulted on a debt, among other things.

Frustratingly, if you’ve never had any debt in the past then this can work against you because there’s no proof you’ll be a good customer.

The good news is that there are steps you can take to improve your credit score.

You can get an indication of how attractive lenders think you are by obtaining a credit report from a credit bureau or agency.

Why applying for loans can cost you money

As with any financial product, you can save money by comparing loans and looking for the best rate. However, when it comes to credit this can be a little trickier.

Gocompare.com's smart search facility lets you input your details and see how likely you are to be accepted before you apply

It’s tempting to apply for a loan to see what rate a lender might offer you, and then apply for another to see if you get a better deal.

Unfortunately, if you make a formal application for a loan then that leaves a footprint on your credit history, even if you don’t accept the money.

If you go on to make further applications then other lenders can see you’ve made additional requests for credit and this makes them very wary.

By making several applications you may damage your credit score and be forced to pay a higher rate, or even be refused credit entirely.

But don’t despair; Gocompare.com has a solution. Our smart search tool lets you input your details and make what's known as a soft search, which will reveal how likely you are to be accepted for a loan before you apply.

That allows you to compare realistic loan rates without damaging your credit history, helping you find the right lender and deal for your circumstances.

Loan terms: How long should your deal be? Cutting the cost of loans

By improving your credit score, comparing loan rates and only applying for deals you’re likely to qualify for, you can be confident that you’ve found the right loan for your circumstances.

However, you may then be tempted to extend the term in order to reduce your monthly payments.

This isn't necessarily a bad thing – after all, you need to be confident you can afford the monthly amount.

However, if you’re tempted to extend the loan by an extra year or two then take a look at the overall interest you’ll pay.

Extending your loan beyond what you need to could cost you hundreds or even thousands of pounds in additional interest.

Problems repaying loans

It's important to consider the unexpected when arranging a loan; a change in circumstances has the potential to leave you in financial problems and unable to make repayments.

That's why it's worth considering income protection insurance when you take on debt. The right policy could help you financially if you're unable to work due to accident, illness or unemployment.

If you're struggling to make repayments, a ‘payment holiday’ may be an option.

Such a holiday is not possible with all deals, but you may be able to put off payments for around three months.

If you choose to do this, remember that you’ll take longer to pay off your debt and will pay more interest in the long run.

If you’re struggling with repayments, speak to your lender as a first port of call. The lender won’t want you to default on the debt, and may find a way to help.

You can also contact your local Citizens Advice Bureau, National Debtline or StepChange Debt Charity (formerly the Consumer Credit Counselling Service) for free advice.

By Felicity Hannah