There is a general awareness that loans can be used to help individuals to purchase items that they might otherwise not be able to afford. However, beyond that very basic understanding, there is often some confusion around the specifics of how loans work and what types of personal loans are available. Loans are a form of debt, and can be an expensive way to fund purchases, so it is very important that people make decisions on whether to take out a loan from a fully informed position.
Personal loan definition:
A loan can be defined as a legally binding arrangement where one company or individual agrees to lend a sum of money to another company or individual, usually on the basis that the capital sum will be paid back, along with monthly interest, within an agreed time-frame. Where the term “personal loan” is used, this just denotes that the lender is making their loans available to individuals rather than to companies.
Credit scoring:
Individuals don’t have an automatic right to a loan. Instead, it is necessary to apply for a loan and the lender will then assess your suitability for the requested amount based on a number of factors. This is a process called credit scoring and it’s also used to determine eligibility for other lending products such as credit cards, overdrafts, and mortgages.
In some cases, people may find that they are more likely to be accepted for a loan where they have existing bank accounts with a financial institution. For example, it’s much easier for a bank to assess whether you are a good risk if you hold a checking/current account and/or credit cards with them so that they have previous experience of how reliable you are at managing your finances.
Interest rates:
A quick glance at a money comparison website will reveal that there are usually hundreds of different loans being offered by various banks and other lenders. When considering which loan to apply for, it’s important therefore to consider the interest rates that are being charged.
Most personal loans (in contrast to mortgages) have a fixed interest rate. That is to say that the interest rate is agreed when you take out the loan and will not change for the duration of the loan no matter what happens to base rates or the general economy. This provides certainty in terms of how much money you need to set aside each month but you still need to be sure that you can comfortably afford to keep up payments on the loan.
Clearly, it’s important to try to find a personal loan that has as low an interest rate as possible. Shopping around is the key to this and you will often find that there are some large differences in the rates offered. In particular, consumers should be wary of obscure lenders who target people who have previously been rejected for a loan by a mainstream banks. Such lenders may sometimes prey upon the vulnerability of those with poor credit history to offer loans at astronomical interest rates.
Loan protection:
There has been a longstanding practice within the lending industry for lenders to offer loan payment protection policies when people are taking out a loan. The idea is that the individual will be asked to pay a monthly premium and this would protect them if they were suddenly unable to make repayments due to redundancy or ill health, etc. The practice of selling loan protection policies has been heavily criticized, however, so those taking out a loan should pay careful consideration to whether they need such protection.
Loan terms:
One bit of terminology that you are likely to encounter when taking out a personal loan is the word “term”. This simply refers to the duration of the loan. So, for example, if you take out a loan for $10,000 over 5 years, then the loan term is 5 years.
Personal loans generally are unsecured:
When you take out a mortgage, the mortgage sum is provided on the basis that the lender can claim your house and sell it to recover the full loan sum if you happen to default on payments. In this case, the mortgage is said to be a secured loan, with your property being the “security” underpinning the transaction.
The vast majority of personal loans, on the other hand, are unsecured. If you fail to repay on them, the lender will chase you to recover costs and will probably apply charges but they won’t have an automatic right to take possession or your car, boat, or whatever else you used the loan funds to buy.
Loans are an expensive way to buy things:
This should be an obvious point but it’s worth stressing nonetheless. Buying a product or service using a loan will generally be considerably more expensive than buying the same item using cash or a debit card. The reason for this is that you will pay the advertised price but, on top of that, will have to pay interest on top of that capital sum. However, on the other hand, personal loan interest rates tend to be lower (on average) than credit card interest rates, so a loan may be a more prudent purchase decision than simply lumping large purchases onto an expensive credit card.
Before taking out a personal loan, it’s worth going through this checklist:
Do I really need this item? Can I not purchase the item without needing a loan? Have I shopped around to get a good interest rate? Can I comfortably afford the monthly repayments? Am I comfortable that all the features of the loan have been explained to me? Am I aware of the consequences of not being able to keep up on repayments?
This can help ensure that you are making an informed and sensible decision based upon real needs and will hopefully minimize the risk of nasty surprises further down the line.