A beginner’s guide to different types of loans
- What are the main types of loan?
- So what now?
Loans can seem confusing. That’s partly because there are so many options out there, and isn’t helped by the jargon that many loan providers use.
In fact, most forms of lending are relatively simple. And because there are so many options out there, there’s a good chance you’ll be able to find a type of loan that works for you, whether you want to borrow tens of thousands or just a few hundred pounds.
In this article, we’ll explain how the most common forms of lending work, so that you can make an informed decision.
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What are the main types of loan?
- Personal loan (can be secured or unsecured)
- Guarantor loan
- Debt consolidation loan
- Credit card
- Friends and family loan
- Credit union loan
- Small business loan
Before we start, let’s clear up some of the jargon that lenders use:
Annual percentage rate – the total annual cost of a loan (including all fees). Want to know more? We’ve put together a detailed explanation of how APRs work
The Financial Conduct Authority – regulates consumer credit lending
The length of time you borrow for. Often this is given in months (e.g. a loan with a term of 36 months is repayable over three years)
If you’re a homeowner, equity is the amount your home would be worth after subtracting the mortgage. So if you have a £100,000 mortgage and your home is worth £150,000, you have £50,000 of equity
A personal loan is any loan made to you as an individual. They can be secured or unsecured (more on that below), and generally require you to repay the original amount you borrowed, plus interest, over a fixed period. Find out what credit score you need for a personal loan.
The loans listed below generally have a fixed interest rate (as opposed to a mortgage, where the interest rate might vary).
Secured versus. unsecured loans
A secured loan is one where a lender has taken security – usually some kind of claim over a residential property you own, such as a house or flat. This is very common for large loans such as mortgages, but can also be an option for personal loans.
If you fail to make repayments on a loan secured against your home, the bank may ultimately be able to take control of your home and sell it, in order to recover its losses. Clearly this is a disadvantage for the borrower, and it’s usually better to choose an unsecured loan if one is available for you, but there are three potential advantages.
Benefits of a secured loan
By borrowing against the value of an asset, usually your home:
- You can usually borrow a larger amount
- You might be charged a lower rate
- In some cases, a lender who wouldn’t offer you an unsecured loan might be prepared to consider a secured loan
The most common type of secured loan is a mortgage, but it’s also possible to take out a personal loan and use your home as security, through what’s known as a homeowner loan. You can borrow large amounts (loans of £100,000 are not uncommon, although they generally start at £10,000).
With all this said, you should be very cautious when considering a secured loan. You’ll usually see these products advertised with a warning that “your home may be repossessed if you fail to make payments”, and this is a real risk. You should think extremely carefully before securing any debts against your home.
Unsecured loans are far more common. Because your lender doesn’t have the comfort of security if things go wrong though, you might be looking at higher interest rates and lower loan amounts – typically between £1,000 and £25,000.
However, they’re flexible, simple compared to other forms of credit, and you don’t have to put your home at risk. There are lots of different types of unsecured personal loan, and most are very simple arrangements where you borrow an agreed amount of money for a fixed period, and pay that back in instalments. However, there are some more nuanced products out there, and we’ve listed some of the most popular below.
Guarantor loans occupy a grey area between secured and unsecured loans. If you have a bad credit score, you may find that lenders are only willing to lend to you if someone else (usually a close family member with a good credit history) “guarantees” the loan. That means that if you fail to make repayments, the guarantor becomes liable – something both parties should think carefully about.
If you’re thinking about a guarantor loan but want to weigh up different options, we’ve put together a detailed guide to guarantor loan alternatives.
Debt consolidation loan
A debt consolidation loan is a way to take lots of different forms of credit and combine them into one, manageable monthly payment.
You do this by borrowing a lump sum, paying off all your other creditors at the same time, and then repay that loan over an agreed term.
As well as only having one form of credit to deal with, you can often save money with a debt consolidation loan, since these loans usually have a lower interest rate than other forms of debt such as credit cards. However, if you choose a longer repayment period, you may end up paying more.
If you want to find out if this option is right for you, here’s an in-depth look at debt consolidation loans.
Credit cards are designed to help you spread the cost of a purchase, usually over a few months or years. They don’t work like other personal loans – you don’t borrow a fixed amount of money, but instead have a maximum amount which you can have outstanding at any given time.
You pay interest on the amount outstanding: generally, if you pay a credit card off in full each month, you will not pay interest. However, if you fail to do so, this form of borrowing can become very expensive, particularly over long periods.
The amount you’re able to borrow will usually depend on your credit score – borrowers with poor credit histories will usually pay higher interest rates and have lower credit limits.
Related post: Unsure of the best way to pay for a holiday? We wrote a guide that summarises 4 different ways of how to pay for a holiday including cash, credit cards, and personal loans, helping you to make the best decision.
If you have a current account, your bank may allow you to use an overdraft. Like with a credit card, you pay interest on the amount outstanding, although some banks offer free overdrafts to certain customers.
There’s an important distinction between arranged and unarranged overdrafts though:
- Unarranged overdraft (not cleared with your bank) are very expensive, and generally a bad way to borrow money.
- Arranged overdrafts usually have much lower interest rates, and can be a cost-effective way to borrow money.
Friends and family loan
Rather than going to a bank or loan provider, you might be able to get a loan from a close friend or family member. Whether or not this is a good idea depends on your circumstances and your relationship with the lender, but generally this is a low-cost form of credit since friends and family usually do not charge interest, particularly for short term loans.
However, borrowing money can put a strain on your relationship, especially if you’re worried about paying it back. Debt charity Step Change has a useful guide on what to think about if you’re considering a loan from family or friends.
Credit union loan
Credit unions aren’t open to everyone: unlike banks or other commercial lenders, credit unions are non-profit organisations, where members pool their savings to offer loans to other members. Credit unions are formed by people who share a common bond.
There are credit unions set up by:
- Geographical area (e.g. city, town or village)
- Church or other religious group
Each will have set criteria to decide who can join. If you are able to join a credit union though, it can be a relatively low-cost way to borrow, since interest is capped at 3% per month.
Small business loans
If you run a small business, there are many forms of lending available to you. As with personal loans, the main difference is between secured (for example on your workshop) and unsecured.
One newer type of loan introduced by the government in response to the economic damage caused by the coronavirus outbreak is a Bounce Back Loan. These loans allow eligible businesses to borrow between £2,000 and £50,000 (the limit is determined by your business’s turnover) with no fees or interest payable for the first year.
You can find out more and apply for a Bounce Back Loans on the UK Government website.
So what now?
Now that you have a clearer understanding of the lending options that may be available to you, and you are considering borrowing money, it’s time to think about your circumstances. Take the time to consider which product would work best for you.
Now that you’ve read our article on different lending options, you might want to take a look at some of the options available to you. Our loan calculator is a great place to start.