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.

Here, we provide loan terminology, types of loans and the borrowing process so you can make an informed decision.

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

Therefore…

Is a Homeowner Loan the Right Choice for You?

A loan is a financial arrangement in which a lender provides a borrower with a specific amount of money, known as the principal, with the agreement that the borrower will repay the amount over time, usually with interest.

Loans are utilised for various purposes, such as purchasing a home, funding education, or covering unexpected expenses.

The terms of the loan, including the interest rate, repayment schedule, and any applicable fees, are outlined in a formal agreement between the lender and the borrower.

Homeowner loans can be beneficial, offering equity release, but require careful consideration of their pros and cons.

Learn more: Compare the Best Equity Release Deals

Are Homeowner Loans a Good Idea: Equity Release Pros and Cons?

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 may 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 also have other 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, a fall in house prices could result in negative equity, owing more than your property is worth.

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

What Should You Consider Before Obtaining 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 ensure 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. 

Who Can Benefit from Loan Forgiveness and How?

Individuals in specific professions or facing hardship may qualify for loan forgiveness, easing their financial burdens.

Who Qualifies for Loan Forgiveness Programs and What Are the Benefits?

Loan forgiveness programs are designed to alleviate the debt burden for individuals in certain professions or situations.

These programs often target sectors like education, healthcare, and public service, recognising the societal value of these professions.

Qualification criteria vary but generally include requirements on the type of loan, the borrower’s profession, and a history of consistent repayments.

Benefits include partial or total debt relief, significantly reducing the borrower’s financial burden.

However, it is crucial to understand the program’s specifics, as there are often stringent conditions and lengthy commitment periods.

Participants in these programs can enjoy reduced financial stress and the ability to focus on their professional contributions without the looming pressure of debt.

What Are the Consequences of Defaulting on a Loan?

Defaulting on a loan can have severe financial and legal consequences.

It can lead to a damaged credit score, making future borrowing difficult or more expensive.

Lenders may initiate collection actions, including lawsuits, to recover the borrowed amount.

Depending on the loan type, defaulting can result in the loss of collateral, such as a home or car.

Additionally, defaulting can lead to wage garnishment, where a portion of the borrower’s salary is directed towards loan repayment.

The repercussions of default extend beyond finances, affecting employment opportunities, housing options, and mental health.

What Are the Essentials You Need to Know About Loans?

Understanding the basics of loans, from terms to interest rates, is crucial for informed borrowing decisions.

What Defines a Loan and Is It a Good Idea?

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

The key characteristics of a loan are…

• It has to be repaid within a specified timeframe.
• The lender will charge interest on the total amount that you borrow.
• You repay the loan in regular instalments.
• A loan term is usually defined in 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.

How Do Loans Work: Understanding the Basics

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

The borrower must 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.

What Is a Loan Principal and How Does It Affect You?

A loan principal is the loan amount or the amount of money borrowed to be repaid under the loan agreement.

A lender can decide to add it’s 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 repaying the accrued interest and what remains toward paying the loan principal.

The minimum monthly payment required to repay a loan is the amount needed to repay 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.

What Is a Loan Term and When Are Loans a Good Option?

The loan term is the specified timeframe the borrower has to repay 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 two to seven years, whilst the average term for auto loans is six years.

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

Mortgages have the longest loan term of fifteen to thirty years.

How Do Interest and Fees Impact Your Loan?

Interest and fees are what the lender charges the borrower for providing the loan. 

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.

Consequently…

Finance charges include closing costs and origination fees.

Lenders use interest rates and APRs to advertise loan offerings. This allows borrowers 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.

*Whilst 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 repaying a loan early. Look for lenders who offer no prepayment penalty.

What Is the Difference Between Simple and 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.

What Are the Qualification Requirements for a Loan?

Qualification requirements to obtain a loan vary between lenders. 

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.

Why Opt for a Loan and What Are Your Options?

Loans offer financial support for various needs, with multiple types available to suit different circumstances.

Why Should I Apply for a Loan? Reasons for Taking 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.

What Types of Loans Are Available and Which Is Right for You?

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.

Are Secured or Unsecured Loans a Better Option for You?

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

If a borrower cannot repay 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 car 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 Loans: Which Is the Best Choice?

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 repays the loan over a specified time period in regular instalments.

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

When Should You Consider Refinancing Your Loan?

Refinancing can be a strategic move to secure better loan terms when financial or market conditions change.

When Is Refinancing Your Loan a Good Financial Move?

Refinancing a loan involves replacing an existing loan with a new one, often with better terms, to improve one’s financial situation.

It is considered a wise move when it leads to a lower interest rate, reduces the loan’s overall cost, or shortens the loan term.

Refinancing can also help consolidate multiple debts into a single loan with a lower monthly payment.

However, it is essential to consider refinancing costs, including potential fees and penalties, and ensure the long-term savings outweigh these expenses.

Borrowers should also assess their financial stability and goals to determine if refinancing aligns with their long-term financial strategy.

How Should You Approach 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.

How Do Personal Loans Compare Against Other Financial Solutions?

Personal loans provide a structured borrowing option, often more suitable than revolving credit for large, one-time expenses.

Personal loans offer a fixed amount of money with a set repayment schedule, contrasting with the revolving credit of credit cards or the secured nature of mortgages and car loans.

They are versatile, and usable for a variety of purposes without requiring collateral, which makes them accessible but potentially carry higher interest rates compared to secured loans.

When compared to credit cards, personal loans typically have lower APRs and are suited for larger, one-time expenses.

The decision between personal loans and other financing options hinges on the borrower’s financial situation, the purpose of the loan, and the terms available, emphasising the importance of tailored financial planning.

Are Emergency Loans a Viable Solution in Financial Crises?

Emergency loans offer quick funds during financial crises, providing a lifeline when unexpected expenses arise.

These loans can be beneficial for immediate, essential costs, such as medical emergencies or urgent home repairs.

However, they typically come with high-interest rates and short repayment terms, reflecting the risk lenders undertake.

Whilst they offer a rapid solution, borrowers should consider emergency loans cautiously, evaluating their ability to repay the loan promptly to avoid spiralling into further debt.

It is advisable to explore all options, including emergency savings or assistance programs, before resorting to an emergency loan.

Common Loan Questions: What You Need to Know

Addressing prevalent loan enquiries helps demystify borrowing processes and prepares individuals for informed decision-making.

Concluding Thoughts: Is Applying for a Loan a Good Idea?

A loan is when a lender provides you with funds ‌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 provide you with money you can spend, repay and spend again. Loans offer a fixed amount that is repaid 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 seeking 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 to provide an enhanced amount. To understand the features and risks, ask for a personalised illustration.