What Are the Pros and Cons of a Loan?

Need Money? Thinking About Taking Out a Loan to Make a Big Purchase? Get All the Facts About Loans. Find Out What Getting a Loan Entails and if It Is Right for You. Save Yourself Money and Frustration. Make an Informed Decision.
  • Last Updated: 02 Feb 2024
  • Fact Checked
  • Our team recently fact checked this article for accuracy. However, things do change, so please do your own research.

Contributors:

Francis Hui

Key Takeaways

  • Equity release loans can provide immediate funds to homeowners over 55, but they can also reduce the estate's value and may have high interest rates.
  • They benefit senior homeowners by offering a lump sum, regular income, or both without needing to move out of their homes.
  • The potential downsides of these loans include reducing the value of your estate, potentially affecting your entitlement to means-tested benefits, and potentially higher interest rates compared to traditional mortgages.
  • An equity release loan can be a viable method for retirement funding if you're a homeowner aged 55 or over and comfortable with reducing your estate's value.
  • The loan might reduce the amount you leave as inheritance due to the loan and accrued interest being repaid from the estate's value after death or when you move into long-term care.

If you have a large expense, a loan can be a useful way to help cover the cost, but what is a loan?

It is important to understand everything that borrowing money entails before you apply for a loan.

If you are considering a small personal loan or a big loan to buy a home or a car, understanding what a loan is and how it works will help save you money and frustration.

Let us walk you through the loan terminology, types of loans and borrowing process so you can make an informed decision.

In This Article, You Will Discover:

    We have done the research to provide you with the most up-to-date information on loans in 2024. 

    Here is what we want you to know about loans.

    What Are the Pros and Cons of Equity Release Loans?

    Equity release loans offer multiple benefits, primarily enabling homeowners to tap into their home's value without selling it. They provide a stream of income, especially useful in retirement when regular income might dwindle.

    Moreover, these loans are typically tax-free, enhancing their financial appeal. But remember, they can affect the inheritance you leave behind as they deplete the property's value over time.

    However, equity release loans have their drawbacks. They often come with high interest rates, which accumulate over time, increasing the amount you owe.

    Plus, they may impact your eligibility for means-tested state benefits. Also, if house prices fall, you could end up in negative equity, owing more than your property's worth.

    Unique to these loans is the no-negative-equity guarantee, ensuring you'll never owe more than your home's value, a crucial safety net for many.

    What Is a Loan?

    A loan is an amount of money you borrow and agree to pay back within a specified timeframe, usually with interest.

    The key characteristics of a loan are:

    • It has to be paid back within a specified timeframe.
    • The lender will charge interest on the total amount that you borrow.
    • You pay the loan off in regular installments.
    • A loan term is usually years.

    The amount you can borrow and the interest rate the lender will charge you depend on your credit score and how long you will take to repay the loan.

    Why Do People Take Out Loans?

    People take out loans for many reasons, for example:

    • To buy a car.
    • To pay for a wedding or special event.
    • To pay for college.
    • To cover the cost of home improvements.
    • To consolidate debt.
    • To expand a business.
    • To finance a new business venture.

    How Loans Work

    Loans take place when a person borrows money, usually a lump sum, from a lender. 

    The borrower has to make regular, monthly repayments for a specified period ‌until they repay the entire loan.

    Besides paying the loan amount, the borrower pays interest at a rate determined by the lender and any lender fees.  

    The lender includes the interest and fees in the monthly repayment amount.

    Loan Principal

    Loan principal is the loan amount or the amount of money borrowed to be paid back under the loan agreement.

    A lender can decide to add its fees to the principal, which will make the loan principal higher than the actual amount borrowed.

    Simply put

    When the borrower makes monthly payments, part of the payment goes toward paying off the accrued interest and what remains toward paying the loan principal.

    The minimum monthly payment required to pay off a loan is the amount needed to pay off the loan principal and interest within the specified loan timeframe.

    Any payments the borrower makes over and above the minimum payment, is applied to the loan principal.

    Loan Term

    The loan term is the specified timeframe the borrower has to pay back the loan.

    It is determined by the terms the lender offers and the borrower’s creditworthiness.

    Loans with longer terms result in smaller repayments, but the borrower usually pays more interest over the loan term.

    Loan terms for personal loans range from 2 to 7 years, whilst the average term for auto loans is 6 years.

    Student loans are often longer and can last up to 10 years.

    Mortgages have the longest loan term of 15 to 30 years.

    Interest and Fees

    Interest and fees are what the lender charges the borrower for giving them the money. 

    The interest rate is the cost of borrowing the money and is a charge by the lender to the borrower.

    The annual percentage rate (APR) is the total annual cost over the life of the loan.  It includes the interest rate and finance charges.

    Turns out

    Finance charges include closing costs and origination fees.

    Lenders use interest rates and APRs to advertise loan offerings. This allows borrowers like you to find the most competitive rates.

    Lenders mostly offer rates between 10% and 28%*. A good interest rate on a personal loan is one that is lower than an average of 12%*.

    Mortgage lenders charge rates between 3% and 8%*.

    Rates offered by lenders vary according to the borrower's creditworthiness, the loan amount and other factors.

    *While we regularly review our rates, these may have changed since our last update.

    Additional fees lenders charge when extending loans include:

    • Application fees. Lenders sometimes charge application fees. Look for lenders who offer free applications.
    • Origination fee. This fee covers the cost of processing applications, including verification of borrower information. Personal loan origination fees ‌range between 1% to 8%.
    • Late payment fee. Lenders can charge fees when borrowers make late payments or for payments that are returned because of insufficient funds.
    • Prepayment penalty. Some lenders charge a fee for paying off a loan early. Look for lenders who offer no prepayment penalty.

    Simple vs Compound Interest

    Simple interest is interest calculated on the principal loan. 

    Compound interest is interest on interest, meaning the lender applies interest to the principal loan and the accumulated interest from previous periods.

    Banks rarely charge simple interest, mostly they charge compound interest.

    With compound interest

    The borrower owes the lender the principal loan amount plus interest for the year in the first year.

    In the second year, the borrower owes the lender the principal loan amount and interest for the first year plus interest on the interest for the first year.

    Compound interest means the interest owed is higher than simple interest because the lender charges monthly interest on the principal loan plus the accrued interest from previous months.

    With shorter loan terms, the interest calculation is similar for both simple and compound interest. However, as the loan term increases, the difference between the two increases.

    Qualification Requirements

    Qualification requirements to obtain a loan vary between lenders. 

    However, common qualification requirements include:

    • Debt-to-income ratio (DTI). The amount of income a borrower brings in every month vs what they pay toward monthly debt.
    • Credit score. A borrower’s credit score is an indicator of creditworthiness and represents the borrower's level of risk.
    • Income. A borrower's income determines their ability to repay a loan.
    • Stable employment. A borrower with stable employment is more likely to continue to have sufficient income in the future.

    Types of Loans

    Types of loans include secured or unsecured loans. A secured loan requires collateral, usually a valuable asset. An unsecured loan does not require collateral.

    Lenders classify loans as revolving or term. With a revolving loan, you can access funds as needed. With a term loan, you receive a lump sum and repay the full amount over a specified time period.

    Secured vs Unsecured Loan

    Secured loans require collateral in the form of something of value, for example, a home or a vehicle.

    If a borrower cannot pay back the loan, the lender can repossess or seize the collateral to recoup the outstanding loan.  

    Secured loans pose less risk to lenders and therefore attract lower interest rates.

    Common examples of secured loans are auto loans and mortgages.

    Unsecured loans do not require collateral and the lender cannot seize any valuable asset if a borrower defaults on payments.

    Unsecured loans pose more of a risk to the lender and therefore attract higher interest rates.

    Common examples of unsecured loans include student loans and personal loans.

    Revolving vs Term Loan

    A revolving loan involves a lender extending credit with a set limit that the borrower can access as needed. The lender charges interest on the outstanding balance only.

    A term loan involves a borrower receiving a lump sum payment upfront. The borrower pays the loan back over a specified time period in regular instalments.

    Term loans usually run from 2 to 7 years, and borrowers have to pay interest on the entire loan amount at a fixed or variable rate.

    Things to Consider Before Taking Out a Loan

    Consider all your options before applying for a loan.

    Do you need the item you want the loan for now?

    Could you look at saving the money you need or a portion of the money you want to loan?

    You will want to make sure you build up an excellent credit history. Having a good credit score will give you better options on interest rates and types of products to choose from.

    When you look at loans check the different interest rates being offered to find the best one for you.

    Do not forget to read the fine print on any products a lender offers you.

    Know what your repayments will be and create a budget to make sure you can afford the repayments. 

    Repaying Your Loan

    Repaying your loan is important. You need to make sure that the repayments fit into your budget.

    We recommend that you set up a direct debit so that the repayments happen automatically.  Make sure that you have enough money in your account to cover the repayments.

    Failure to make repayments will result in penalty payments and can negatively impact your credit score.

    Common Questions

    Are Personal Loans Secured or Unsecured?

    What Is the Difference Between a Loan and a Credit?

    When Is the Right Time to Get a Loan?

    Is a Loan or Credit Card Better?

    What Are the Pros and Cons of Equity Release Loans?

    How Do Equity Release Loans Benefit Senior Homeowners?

    What Are the Possible Downsides of Equity Release Loans?

    Is an Equity Release Loan a Good Idea for Retirement Funding?

    How Can an Equity Release Loan Impact My Family's Inheritance?

    In Conclusion

    A loan is when a lender gives you money ‌and you agree to repay the loan principal plus interest within a specified time.

    Both the lender and the borrower agree on loan terms and interest rates before the money is granted.

    Loans can be secured with collateral (e.g. mortgages) or unsecured with no collateral.

    Credit cards or revolving loans give you money you can spend, repay and spend again. Loans offer a fixed amount that is paid back over a fixed term. 

    Loans have longer terms, usually years with lower interest rates than credit.

    If you have a good credit score and can afford the monthly payment, a loan gives you access to a lump sum of money that you can use to make large purchases.

    It is always a good idea to consider getting financial advice before you make any life-changing financial decisions.

    The features mentioned and the amounts raised, are subject to the lender’s criteria, terms and conditions. These may take into account the age, health and lifestyle factors in order to provide an enhanced amount. To understand the features and risks, ask for a personalised illustration.

    Related Articles
    Steps for Retirement Planning Checklist

    If You are Preparing for Retirement, Discover the 5 Crucial Steps for Effective Retirement Planning, Including Setting Goals, Estimating Income Needs, and Seeking Professional Advice…

    Retirement Financial Planning Calculator

    Do You Think about How Much Money You will Need for Retirement? Learn about How to Start Planning and Saving with Secure Financial Advice. Our Guide Shows You How…

    Equity Release Beneficiaries Guide

    Learn All About Beneficiaries in the UK and How to Choose Them and Update Them. Read This Guide So You Can Make Informed Decisions.

    Scroll to Top