A personal loan can be used to pay for big-ticket expenditure such as a new kitchen
If you’re looking to borrow money, an unsecured personal loan can be a convenient and flexible option. Here, we take a look at how personal loans work, who they best suit, as well as what watch out for.
How do personal loans work?
Personal loans allow you to borrow a fixed amount of money that you repay over a fixed term. Loan terms are typically between one and five years, although it is possible to borrow for seven years or more.
You can usually borrow any amount from £1,000 to £15,000, with some providers offering larger loan amounts of up to £25,000. Interest rates are usually the most competitive if you borrow £7,500 or more.
Personal loans are also known as unsecured loans because they are not secured against an asset such as your home.
With a secured loan, if you default on the debt, the lender has the right to take the asset concerned and sell it in order to recoup their money.
Who are they suitable for?
Personal loans can be a good choice if you are looking to borrow a lump sum to finance a large purchase, such as home improvements, a wedding, or a new car.
They are also worth considering if you are looking to consolidate existing debts into a single place with one monthly repayment so they are easier to manage – and ideally at a lower rate of interest.
What are the advantages?
Some of the advantages of taking out a personal loan include:
- Monthly payments are usually fixed, which can make budgeting easier.
- You can choose how long you need to repay the amount borrowed, usually up to five years but sometimes longer.
- You can usually borrow a larger amount of money than you could through a credit card or overdraft.
- Interest rates can be competitive, particularly if you’re looking to borrow sums of £7,500 or more.
- A personal loan can be a great way to consolidate existing debts into one manageable monthly payment with one provider. Consolidating debts in this way can help to lower monthly repayments, saving you money.
What are the disadvantages?
Although personal loans have many advantages, there are a few drawbacks to be aware of. These include:
Higher interest rates for smaller loans
If you’re only looking to borrow a relatively small sum, say £2,000, interest rates can be much higher than if you were borrowing £7,500 or more. This could tempt you to take out a larger loan than you need – or can afford.
Interest rates can also be higher the longer you need to repay your loan.
You may not get the interest rate advertised
Loan providers must offer the advertised annual percentage rate (APR) to at least 51% of borrowers, but this also means 49% could be offered a higher rate.
Usually, higher rates are offered to those with poorer credit scores, while the best deals are reserved for those who have an excellent credit rating.
Payments are not flexible
Keep in mind that while fixed loan repayments can help you budget, there is no flexibility, so you’ll need to ensure you can afford to pay this amount each month and every month.
If you miss a payment, your provider will usually tell you to make it up the following month, but if you continue to miss payments, the consequences can be more serious.
For example, you may have a ‘missed payment’ logged on your credit file, which could make it harder for you to access financial products further down the line.
Talk to your lender as soon as possible if you have any concerns about meeting your repayments. Your lender may be able to arrange a repayment holiday or come to some other arrangement with you to help repay your debt.
Early repayment charges may apply
On the other hand, should you wish to pay off your loan early, you may have to pay an early repayment charge. This is often the equivalent of one to two months’ interest.
You may have to pay an arrangement fee
Some personal loans also have arrangement fees so be sure to check before applying.
What else should you consider?
If you plan to apply for a personal loan it is worth checking your credit rating first through a fee-free service such as Experian, Clearscore, Credit Karma or MoneySavingExpert’s Credit Club. This will give you a good indication of how likely you are to be accepted for the most competitive deals.
If your credit score isn’t up to scratch, there are steps you can take to improve it, such as:
- Checking you are registered on the electoral roll
- Spacing out credit applications by at least three months, preferably six
- Correcting any mistakes on your credit report or adding a Notice of Correction to explain a missed payment
- Paying your bills on time
- Closing down unused accounts.
You should also carefully consider how much you need to borrow. While interest rates can be more competitive for larger loan amounts, remember it’s important not to borrow more than you can afford to pay back.
Also consider how long you need to repay your loan and make sure you will be able to keep up with your monthly repayments before you apply.
Always do your research before applying for a loan as interest rates can vary considerably between providers.
Should you change your mind once you’ve been accepted for a loan, you have a 14-day cooling off period to cancel once you have signed the credit agreement. If you have already received the funds you will need to pay them back within 30 days.
What is a secured loan?
A secured loan is secured against your home. This means if you are unable to keep up with your repayments, you could be forced to sell your home to repay what you owe.
Secured loans often let you borrow larger amounts, but interest rates are generally higher. Interest rates can also be variable so your monthly repayments could change at any point.
Are there any alternatives to a loan?
If you are not sure whether a personal loan is right for you, there are several other options to consider:
0% purchase credit card
This type of credit card can be a good option if you’re looking to make a one-off purchase such as a new car. It can be cheaper than a personal loan if only need to borrow a small amount as you can spread your payments over several months interest-free. However, if you don’t clear your balance before the 0% ends, interest will kick in.
0% balance transfer credit card
This type of plastic can be useful for consolidating existing credit card debts. You simply transfer over your existing balances and you won’t need to pay interest on that debt for several months. The downsides are that you will usually have to pay a transfer fee and once the 0% period ends, you will start paying interest.
0% money transfer credit card
With this type of credit card, you can move funds from your card into your bank account. These funds can then be used to pay off existing debts more cheaply, or to put towards purchases or unexpected bills. Again, there is usually a transfer fee to pay and once the 0% deal ends, you’ll pay interest.
Low cost overdraft
A few current accounts offer interest-free overdrafts. If you’re looking to borrow a small amount over a short timeframe, this could be another option. But be aware that interest charges can be high if you go over your overdraft limit, and some interest-free options only last for around 12 months, so you’ll need to have paid off your overdraft before then.