Understanding loans

As is often the case when it comes to finance, the world of loans seems to have its own language and can get complicated, very quickly.

Here we aim to explain some of the language and answer some of the common questions about loans, to help you if the need to borrow money ever arises.

What is a loan?

Loans come in all shapes and sizes; from a friend lending you £5, to a mortgage to buy a home. However, the principle of all loans is the same. A loan is an agreement between you and a lender where they give you money, and you agree to pay it back.

How do loans work?

When you borrow money from a bank, finance company, credit union, or some other regulated lender, you enter a legal contract to repay the amount you borrow, plus interest and charges, over a set period.

As you make your repayments, the amount you owe reduces until, one day, you make the final payment, and your debt is cleared. However, the amount you repay will be more than you originally borrowed because the lender adds charges, interest and fees, which is how they make their money.

What is the APR (Annual Percentage Rate)?

The APR (annual percentage rate) is the amount you'll pay each year in addition to the amount you have borrowed, and includes interest, fees, and charges. It is shown on websites, adverts, and leaflets as a percentage, usually something like: “APR of x%”.

When looking at loans it is important to look at the APR, rather than just the interest rate as some loans have assorted fees attached to them and, despite having lower interest rates, prove to be more expensive!  That is why the APR for loans varies considerably between different lenders and different types of loans. However, one of the most important things to remember about APRs is that the higher the APR on a loan, the more it will cost you.

It’s also worth checking whether the APR on a loan is fixed or it can change (variable APR). If the APR is fixed, you will repay the same amount each month, which makes budgeting to repay a loan easier. If it is variable, your repayments can change as the APR changes.

How much will a loan cost me?

Working out how much a loan will cost you each year, isn’t simply a case of multiplying the amount you are borrowing by the APR.

With most loans, as you make your repayments, the loan’s balance will reduce, and so will the amount of interest your loan will attract. However, to make things easier, when you take out a loan, lenders will calculate how much interest the loan will attract over its duration, add this to the amount you borrow, and then divide the total by the number of monthly repayments you are to make. This means that, from the outset, you will know how much your monthly loan repayment will be.

The exception to this is when a loan has a variable rate, although in those cases your lender is required to inform you what your repayments will be before you make them.
There are lots of “loan repayment calculators” available online, such as at Money Helper, where you can see how much a loan will cost you based on different amounts borrowed, different APRs and over different time scales.

What is a “representative APR”?

The important thing to remember about interest rates and APRs, is that the rate you are offered on a loan is based on several checks a lender will make on you. This can include looking at your credit file, assessing your income, knowing how you plan to use the loan and how affordable the loan will be to you.

If you score highly in these “credit checks”, you will be offered a lower APR but, conversely, if you score poorly, the APR is likely to be higher or you may not be offered a loan at all.

As a result, with the APR on loans being undecided until a person applies, lenders advertise loans using a “representative APR”, which is the maximum APR that 51% of their customers are paying on that loan product. However, it may not be the APR you would end up with if you took out that loan.

What a “representative APR” does provide though, is a benchmark that allows you to compare loans from different lenders and shop around for the best deal – something you should always do when it comes to borrowing.

Does the length of a loan matter?

The length of a loan, or its “term”, in finance speak, is something you should consider carefully before taking a loan out. Whilst spreading a loan over a longer repayment period will reduce the amount you have to repay each month, having a loan over a longer term does mean you will end up paying more in the long run.

For example:

A £1,200 loan at 10% APR repaid over 1 year would mean a monthly payment of £88, and you would pay back £1,263 including interest by the time you have paid it back. However, if you were to repay the same loan over 5 years, whilst your monthly repayment would be far lower, around £25 a month in fact, by the time you repay the loan you will have paid £1,515, a whopping 20% more.

Money Experts tend to agree that it is better to have debt for as short a time as possible because it costs you less overall and you risk still paying for something in several years’ time that is long forgotten. but affordability should always be your main consideration, both when you take a loan out, and in the future.

What is the difference between a secured and an unsecured loan?

Whilst there are many different types of loans, they generally fall into one of two types – secured and unsecured.

Secured loans

A secured loan is, as the name suggests, secured (attached) to an asset. The most common types of secured loans are mortgages and vehicle finance, but it is also possible to take out loans which are secured against other assets you already own. The most common example is when people own a property and secure their loans against their home.
In practice, a secured loan gives the lender a legal right to take possession of the asset the loan is ‘secured to’ if you fail to keep up your repayments. There are certain legal hoops they must go through to do this, but the rationale is that by doing so, they can then sell the asset and recoup some, or all, of the money you owe them.

The benefit of secured loans is that they tend to attract lower interest rates. However, the big downside of them is that, if you fail to keep up your repayments, you could lose whatever the loan is secured against. Secured loans also tend to have more conditions and charges attached, can be less flexible if you want to repay them early and they also, generally, take longer to arrange than unsecured loans.

Unsecured Loan

By contrast, unsecured loans provide the borrower with money that is not secured against an asset.  Instead, lenders will assess your creditworthiness to decide if they think you are the sort of person they want to lend to. Most loans, such as personal loans, payday loans, credit cards and overdrafts, are unsecured loans and, whilst generally more expensive than a secured loan, they can be used for far more things and can be obtained quickly if you are considered suitable.

Can you pay loans back early?

Yes, you can pay loans back early, but doing so can attract early repayment charges or fees, which should be clearly explained in the agreement you sign when you take a loan out. You can also contact your lender and ask for a “settlement statement” which will show you how much it will cost you to repay your loan.

What if you change your mind, and want to cancel a loan?

You get 14-days from the date you sign the loan agreement, or when you receive a copy of the agreement, whichever is later, to cancel a credit or loan agreement. This is regardless of whether the agreements were made in person, online or over the phone. If you do cancel, you then have 30 days to repay the money, and any extra fees you have paid have to be refunded. However, you might have to pay interest for the period you had the loan.

The exception to this is mortgages, where there is no official “cooling off” period but you can choose to cancel at any time before the final transfer of funds. However, if you have exchanged contracts on a property, you are legally obliged to continue with the purchase.