Loans explained

Borrowing money is something done by many households simply because some of the straightforward items available to us are too expensive to pay for up front. In fact, lending is the only way in which many things like cars are obtainable for ordinary people. But not fully understanding how loans work can be disastrous, as the more they get out of hand, the harder they tend to be to deal with. Choosing the right product is the first step towards managing your debt comfortably.

Loans are available from banks, building societies, and specialist companies. All involve an amount of interest, as that is how the firm itself makes money on giving up cash. Some might include interest free periods, usually in the first few months of the loan, but some way or another you will end up paying back more than you have borrowed.

The two main loan types are secured and unsecured. Secured loans are normally more associated with larger purchases and are often quite quick to arrange. For example, someone might borrow 18,000 pounds from a bank to help finance a home extension. They can also be spent on new cars or even to fund someone’s higher education.

This ’secured’ part of the deal involves the borrower offering up some form of collateral as proof that they are going to pay back what they owe. This usually involves someone’s home, meaning it can be repossessed from them if they fail to keep up with the repayments. In this sense their house is acting as security for the bank or lender as an assurance that they’re going to get the money back. The plus side of this is that it can help someone to get a large amount of money, but the downside is that if someone fails to keep up with it, they can eventually lose the roof over their head.

The availability of secured borrowing is linked to house prices, the more prices tend to fall, the less secured loans can be available. This is because banks become concerned that the effective value or strength of the security someone can offer is unstable and may be decreasing.

Unsecured borrowing, although it might sound somewhat unstable and risky, actually involves the borrower and not putting up any asset. As a consequence they are usually only granted for smaller amounts and attract higher interest rates. Because a loan is unsecured does not mean you can get away with not paying it back. Banks can still take legal action through the courts and can refuse to lend you any more money in future. You’re also likely to end up with a significant mark on your credit rating, significantly affecting your ability to borrow and even open up and run bank accounts in future.

A vast array of different interest rates are available from different providers, and these can fluctuate wildly. Of course the interest rate is the key to how much you are going to pay back overall, so it may seem that the smallest possible interest rate means that product is the best possible deal. But it can pay to look carefully at the payment plans of different loans, and particularly at any low or no interest free introductory periods. Once you come off this introductory rate the interest may switch to a very high level, negating what you otherwise would have saved - so it can pay to look carefully at the small print.