Taking out a loan is a significant financial commitment and should not be taken lightly. Loans are not a solution if you are struggling to pay essential costs like household bills, rent or mortgage payments, but they may be a helpful option for those looking for a cash injection before payday. There are plenty of factors to take into consideration before you get a loan, including your current financial situation, the lending terms and whether you can repay it on time and in full.
What are the different types of loan?There are two main forms of loan you can get: secured and unsecured. Secured loans are tied to an asset you own, like your property or car, and are typically for sums between £1,000 and £100,000 or higher. Common types of secured loans are mortgages, vehicle finance contracts and some debt consolidation allowances. As they are tied to something you own the lender may place restrictions on what the money can be used for – for example, some may stipulate that the loan be used to purchase property. Unlike secured lending, unsecured loans are not directly tied to your belongings. They tend to be for smaller amounts up to £25,000 and span from one to five years. The money can be used for almost anything, with common types being credit cards, student finance, payday loans, short term loans and instalment loans. Instalment loans are an alternative to payday loans and are repaid in smaller instalments over a period of time, rather than in a lump sum.
Should I get a loan or is there another option?Although short term loans can provide the funds needed in a variety of situations, they may not be the best choice. Even if you think that getting a loan is the best option for your situation, it is a good idea to take the time to compare various credit options available. Some of the alternatives include:
- Advance on wages. If you need money but don’t want the responsibility of a loan, you may want to consider asking your employer to provide an advance on your next wage.
- An authorised overdraft. If you have a current account, your bank may offer the option of taking out an authorised overdraft, rather than getting a loan. Although the interest rates can be expensive they are generally cheaper than using a loan.
- Borrow from a family member. If a family member or friend offers to help you meet a shortfall in funds, it’s important to get an agreement in writing and work out a sustainable repayment plan.
- Borrow from a credit union. A more affordable alternative to getting a loan is borrowing from a credit union. Credit unions have a cap on the amount of interest they can charge, currently set at 3% per month for England, Scotland and Wales.
Can I afford to get a loan?The most important thing to do before you get a loan is to evaluate your current financial situation and work out how much you can afford to take out and repay. As well as considering the annual percentage rate (APR), you should look at the deposit amount and the total amount repayable (TAR) over the loan period. The deposit amount required depends on the financial institution and not all providers need an initial payment. The APR is the annual interest rate you will be charged for borrowing. Providers must show you a representative APR that reflects the interest rate most applicants will pay, but you may end up being charged a higher rate once you apply. The TAR takes into account the APR alongside the loan amount to reveal the full amount you will end up paying over the loan period. While the APR may seem attractive on a loan, it may end up being more expensive in the long run. For example, consider these two short term loan options: Option 1: £400 loan at a 939.5% APR over six months with a monthly payment of £126.75 Option 2: £1,000 loan at a 939.5% APR over four months with a monthly payment of £161.47 Although the first option has a lower APR and smaller monthly payments, you will pay a total of £760.50 over the loan period. In comparison, you will pay £645.88 with option 2 – resulting in a saving of £114.62.
What are the exact terms of the loan?Before signing a loan contract, you need to make sure that you fully understand the terms of borrowing, particularly any additional fees you may incur and the penalties for missing a payment. Some of the associated costs you may need to take into account are:
- Processing fee. Some providers may charge you a fee for processing your application, typically around 1% of the loan value. This is more common with mortgages but can also be a feature of short term loans.
- Missed payment penalty. A late payment will not only negatively affect your credit score, but you may also be charged a fee if you do not have the funds in your account to meet a payment.
- Prepayment penalty. This is a charge that the provider will make if you pay the loan off early and is a common feature of mortgages. This allows the lender to claim the full amount of interest.