Different types of loans: which is best for your needs?
There are many types of loans available on the market, allowing you to borrow different amounts of money at various rates. We explain the basics of the most common types of loans you are likely to encounter and consider, from personal loans to student and business loans, plus many more.
How loans work
Loans are a way of borrowing money so that you can purchase something sooner which may take a long time to save up for, such as a car, a holiday or a house. There are many different types of loans and ways to use them.
People also take out loans to deal with unexpected emergencies, such as a faulty boiler or medical procedure, to consolidate more expensive debts, to renovate their kitchen or to take a holiday. And a loan to buy a house is known as a mortgage. There are also business loans specifically designed for lending to businesses.
With the vast majority of loans, you sign an agreement committing yourself to pay the sum borrowed, plus interest, over a fixed period of time. For example, 60 monthly payments over five years. The amount of interest charged on a loan is set by the lender and can vary depending on the type of loan, such as unsecured or secured (see below), the credit score of the borrower, the amount of money borrowed, and the length of the loan agreement.
When you apply for a loan, the lender will carry out a credit check to see your current financial score and situation, including the amount of debts you already have, and will then decide whether to accept or reject your application.
Before applying for a loan, it is a good idea to do a ‘soft search’ to find out your chances of being accepted without leaving a mark on your credit report.
You can also use a loan eligibility checker to find out your chances of being accepted without leaving a mark on your credit report.
» MORE: How to check your credit report
A personal loan is a form of credit provided to an individual from a financial institution, such as a bank, building society, credit union or lending company. When you borrow, you repay the loan amount over the loan term, which is agreed upon in advance as part of the credit agreement. Personal loans can be secured or unsecured and can come with fixed or variable interest rates and short or long borrowing terms.
A personal loan can be used for vehicles, home improvement, debt consolidation and large purchases. The loan agreement, including how much you can borrow, the interest rate and the term, will depend on your creditworthiness and the lender. Depending on the loan agreement, you may be able to receive a refund of interest if you repay the loan early.
After signing or receiving a copy of the loan agreement, whichever happens last, you will have a 14-day cooling-off period. During this period, you can decide to cancel the loan. If you do, you will have to repay the borrowed amount within 30 days without being charged interest.
» COMPARE: Personal loan rates and deals
A fixed-rate loan is a loan that has a fixed rate of interest throughout the term of the loan.
A fixed interest rate gives you the security of knowing that, whatever happens to interest rates in the future, such as a change to the Bank of England’s base rate, the interest on your loan will not change. This means your repayments will stay the same every month. The downside could be that if interest rates fall, you don’t get the benefit of lower rates, but if interest rates rise, you will not be impacted by a higher rate. Nearly all consumer credit agreements (personal loans) are a fixed rate contract.
Variable-rate loans work in the opposite way to fixed-rate loans. If interest rates fall, then the interest rate on your variable-rate loan may fall too.
Equally, if interest rates rise, your loan could become more expensive. This means your monthly repayments could rise and fall with rate adjustments, which could make it harder to set a budget. Variable rate loans apply mainly in the mortgage and commercial markets.
A secured loan is a loan that is backed by an asset, such as your house, vehicle or other property. If you default on a secured loan, the lender can claim your asset to recover the debt that you owe.
Because secured loans pose less risk to the lender than unsecured loans, they are usually cheaper than unsecured loans and come with a lower interest rate. They can also often come with higher lending limits, depending on the equity level that you hold within the asset.
Secured loans can help people borrow money who would find it difficult to qualify for an unsecured loan because of low credit scores or limited credit history.
If you can’t pay your secured loan, the lender can force you to sell the asset, usually property, which was put up as collateral in order to recover the debt that you owe.
» COMPARE: Secured loan rates and deals
An unsecured loan is a loan that is not secured by a property. Instead, it is simply an agreement between the bank or lender and the borrower that the loan will be repaid.
Because they pose more of a risk to the lender if borrowers can’t repay, unsecured loans are generally more expensive than secured loans and attract a higher interest rate. They come with a fixed interest rate, and repayments stay the same until the end of the term, which averages between one and seven years. Borrowing levels are generally capped at around £25,000. However, some lenders set the maximum amount you can borrow at significantly less.
Unsecured loans are offered through traditional banks and building societies as well as credit unions and specialist lenders. Although the term is associated mostly with traditional personal loans, it also applies to payday, short-term loans. If you fail to repay an unsecured loan, the lender can make you pay through court action.
» COMPARE: Unsecured loan rates and deals
Short-term loans refer to the lending of relatively small amounts over a matter of weeks or months. Payday loans and instalment loans (see below) are examples of short-term loans.
Short-term loans can be used by people looking for a quick loan to meet a funding gap or to cover an unforeseen emergency. Once a loan is approved, the money should be in your bank account instantly, which can make them useful in an emergency. But short-term loans are not designed for long-term borrowing because the interest rates attached to these products can be thousands of times higher than with traditional personal loans.
Short-term or instalment-loan providers charge the highest rates. Credit unions offer small short-term loans of up to £3,000, but at much lower interest rates.
A payday loan is an unsecured short-term and high-interest option designed to fill a financial gap before your next regular instalment of money, for example when you are paid by your employer.
A typical payday loan is expected to be paid back within a pre-agreed period, such as between one and 30 days. At the end of your agreed term, you must pay back the original amount you borrowed plus the interest accrued.
Payday loans are for smaller amounts of money than you'd usually be unable to borrow through a more traditional personal loan. Between £50 and £1,000 is typical.
The main feature of a payday loan is that the borrower does not have to enter into long-term borrowing arrangements and the decision process is very fast. For this reason, payday loans are sometimes called 'same day loans', 'instant loans', 'fast cash loans' or ‘short-term loans’.
There is a high price for the speed and convenience of payday loans. They carry significantly higher interest rates than other forms of lending, often hundreds or thousands of percentage points higher than the most competitive personal loans, credit cards, overdrafts and credit union loans, and as such should only be used when other options are not available and you are very confident you can repay the debt in full.
The term instalment loan refers to any sort of loan that is repaid through multiple, scheduled repayments.
In recent years the term has become more regularly associated with short-term loans that are paid back in a number of instalments.
In the context of short-term payday loans, borrowers of “instalment loans” can typically access anywhere from £50 to around £1,000, which they can repay over a period of three to 12 months through weekly or monthly payments.
Bad credit loans
Bad credit loans are loans that are made available to individuals who have poor credit scores or limited credit history, which prevent them from accessing lending products through traditional routes.
Bad credit loans carry higher interest rates, so they are more expensive and could therefore mean there is a higher chance of defaulting on this type of loan. They are sometimes offered by high street banks and building societies, but they are more commonly provided by smaller, specialist lenders.
Credit unions, guarantor loans, peer-to-peer loans and government budgeting loans may also be accessible to borrowers with bad credit.
» COMPARE: Find loans for borrowers who have bad credit
Buy now, pay later loans
‘Buy now, pay later’ loans are usually offered at the point of purchase, such as when paying for goods online. They allow you to buy things that you cannot immediately afford with a commitment to pay at a later date.
These schemes are an increasingly common way of paying for purchases, by either deferring payment until a later date or paying in instalments. This can be seen as a convenient way for consumers to pay for things by spreading out the costs or delaying it until funds are available, or a way of getting people to take on debt.
The largest buy now, pay later brands in the UK are Klarna, Clearpay, PayPal and LayBuy. The FCA has promised stricter regulation for the industry in the future to make sure that payment terms are completely transparent. While the initial payments are interest-free, missed payments often incur hefty penalties and could lead to the involvement of debt collection agencies.
A logbook loan is a type of secured loan where your vehicle - such as a car, van or motorbike - is put up as collateral against the debt.
The logbook loan lender takes ownership of your vehicle until the loan is repaid. However, while the lender takes possession of the logbook and other ownership documents, the vehicle will be 'loaned' back to you so that you can continue to use it. When the debt is repaid, the ownership of the vehicle is transferred back to you. Terms typically last up to 78 weeks, but you can repay earlier if you are able.
You can usually borrow up to half the market value of your vehicle. However, if the vehicle depreciates in value during the loan term and, in the event of a default, the sale does not cover the outstanding debt including accrued interest, the borrower will still be liable to meet the shortfall.
Credit card cash advance
The most common form of credit card cash advance is when you withdraw money from an ATM cash dispenser using your credit card.
While using your debit card in this way does not incur a fee from your bank, using your credit card to take out money is very likely to come with a high handling fee.
The amount of cash you withdraw will also be subject to a much higher interest rate than a credit card purchase, and interest will be charged on the amount from the moment of withdrawal, unlike a purchase, which usually has an interest-free period.
Other forms of credit card cash advance include buying foreign currency, buying gambling products such as lottery tickets and electronic cash transfers.
Credit union loans
Credit union members come together to support each other financially, such as by pooling their money to offer loans at low interest rates.
Members typically have something in common. They may live in the same area, work in the same industry or for the same employer, or belong to the same trade association.
Because of the way credit unions are structured, they charge low rates of interest.
Depending on the credit union, you might be able to have your loan repayments deducted directly from your salary each month.
Many credit unions expect you to prove that you are able to manage your money responsibly and might ask for you to save regularly with them before taking out your first loan.
A guarantor loan involves a third party - such as a parent, legal guardian or employer - agreeing to meet the monthly repayments or pay off the loan completely in the event that the borrower defaults. The guarantor will be legally bound to comply with the terms and conditions agreed to and can be subject to court action and debt recovery measures if they fail to do so.
Because of the added security to the lender, guarantor loans can sometimes enable the borrower to obtain cheaper interest rates than they would be able to without it. The arrangement can also enable people with a poor or limited credit history to obtain lending if they are unable to do so through other routes.
Guarantor loans are offered through traditional high street banks and building societies, as well as credit unions and other specialist lenders.
» COMPARE: Find guarantor loans
A joint personal loan is a way of borrowing money with someone else, usually a partner, friend or a member of your family.
If you are approved for a joint loan, your credit files will be linked, which means future lenders are likely to look at both your credit scores when you apply for another loan or credit facility.
The benefit of taking out a joint loan is that both incomes will be taken into account, so you might be able to borrow more than if you were applying as an individual.
The risk is that you are both held ‘jointly and severally liable’ for the debt, which means that you are held accountable for the entire debt if the other person is unwilling or unable to pay. You might also find your own credit rating is damaged by linking with someone with a poor credit rating.
Joint loans are not available in all the different forms of lending, so check this with a provider before proceeding.
Peer-to-peer loans refer to money lent and borrowed between individuals or small businesses, rather than traditional financial institutions like banks and building societies.
Internet-based companies act as the facilitator for the deals. Available for any amount of money, over varying term lengths, if you have an excellent credit rating, peer-to-peer loans can be cheaper than going through traditional routes. However, if you have a poor credit rating they may be more expensive.
The negative is that the money individuals lend through peer-to-peer loans is not covered by the Financial Services Compensation Scheme as it would have been if it had been invested in savings accounts. However, individual lenders can choose the level of risk they are amenable to. The facilitators of peer-to-peer loans take steps to verify that borrowers are creditworthy and help to recover debts that are defaulted on.
» COMPARE: Find peer-to-peer business loans
Business loans can range from as little as a few hundred to hundreds of thousands of pounds and are specifically designed for business use. Lenders will make the decision whether to approve a business loan application on a number of factors, including the business credit score, trading history, profitability of the business and reason for the loan.
Business loans are usually issued through lenders' retail banking arms, which may also offer financial services to individuals, such as personal loans, mortgages and current accounts. Funding for larger companies usually falls under the lenders' corporate division.
Under some arrangements, usually for micro startups, the individual business owner that takes out the loan can get an unsecured loan, meaning they are personally liable for the repayment. For established businesses, secured loans can be obtained with business assets such as premises, machinery or vehicles placed as collateral. Depending on the way that the business is structured, liabilities can be limited to the business, with the directors' personal assets safeguarded. However, lenders can add clauses of personal liability to most agreements with small business owners.
Peer-to-peer loans for businesses are also available.
» COMPARE: Business loan rates and deals
A bridging loan, also sometimes called a bridge loan, is a loan that will cover a short-term financial gap.
A bridging loan can be used to bridge the gap - hence the name - between a purchase and the funds being made available to you for that purchase, such as if you want to buy a home before the sale of your current home has completed.
Bridging loans can be ‘closed’ or ‘open’ loans depending on what is best for your circumstances. A closed bridging loan will come with a fixed repayment date, for example, if you are buying a new house and have already exchanged contracts on the sale of your house. An open bridging loan will have no fixed repayment date but is typically for up to one year.
As bridging loans are short-term financial instruments, interest is usually charged monthly rather than annually and these loans tend to attract higher rates than long-term loans. There are also set-up fees to consider.
When you take out a bridging loan, a charge will be placed on the property, meaning that the property will act as security for the loan and could be repossessed if you fail to meet the repayments.
» COMPARE: Business bridging loans
A mortgage is a type of loan that helps you borrow money to buy a house. The loan is secured against the property you are buying.
In all but a few cases, the mortgage will not cover the entire cost of the property. You will need to put at least 5% down as a deposit to cover some of the purchase. The rest will be repaid over a specific term, typically 25-30 years, and you make monthly payments, with interest, until the end of the mortgage contract at a fixed rate or variable rate.
As you continue to pay off your mortgage, your loan-to-value - the size of your mortgage compared to the value of the property you are borrowing against - will reduce. Over time, this will give you more house equity, which can help you remortgage and acquire homeowner loans.
» COMPARE: Mortgage rates and deals
A homeowner loan allows you to borrow a sum of money that’s secured against your property.
Because you have used your home as collateral, you are likely to be offered a lower interest rate compared to unsecured loans, and might be able to borrow more money. However, your home could be at risk if you fail to keep up with your monthly loan repayments.
Home improvement loans
A home improvement loan is a loan taken out to pay for big home improvement projects, such as a new kitchen, bathroom or extension. It could be work such as upgrading your central heating, doing a loft conversion, or even landscaping your garden. Getting a home improvement loan is a way of paying for the work without increasing your mortgage.
A loan allows you to spread the cost of the purchase or building work over several months or years and repay the sum with fixed monthly payments. It also means that you can substantially improve your living space without having to move house.
Home improvement loans can be unsecured or secured. A secured loan is likely to have a lower rate of interest and it is likely you will be able to borrow more than with an unsecured loan, but you will have to put your home as security for the loan. This could mean that your home is at risk if you can't keep up with repayments.
Car loans mean both traditional personal loans that are used to buy vehicles and car finance.
Traditional personal loans can be obtained through high street banks and building societies and specialist lenders, on secured or unsecured terms, for the purpose of purchasing a car or other vehicle.
Hire purchase schemes are usually arranged through vehicle dealerships. They typically require an upfront deposit followed by monthly repayments. The car does not belong to the borrower until the agreed term is finished. With some schemes, the monthly repayments throughout the term will have been enough that the car is owned outright by the borrower at the end.
With others, the borrower will have cheaper monthly repayments but will need to make an additional final bulk payment if they wish to take ownership of the vehicle. Unlike with logbook loans, borrowers signing up to a hire purchase scheme have their consumer rights protected under the Consumer Credit Act 1974.
Student loans help meet the cost of studying at higher education establishments such as colleges and universities. There are two types of student loan: a tuition-fee loan and a maintenance loan, and many students will take both out and repay them together.
A tuition-fee loan covers the cost of lectures and seminars and is paid directly to your place of study, while a maintenance loan pays for rent, food and essentials and is paid into your bank account.
How much you get depends on your household income, where you live and whether you are living at home or living in your place of study.
To qualify for a student loan you need to be a UK national or have settled status, you must have been living in the UK for three years before the start of your course.
You start repaying the loan from the first April after graduation if you are earning above the repayment threshold.
Debt consolidation loans
Debt consolidation loans allow you to move existing borrowings into one loan so that you have just one monthly payment rather than several. It can be a way to move several debts with their own high interest rates to one loan with a lower interest rate.
The benefits of using a debt consolidation loan are that it can be easier to keep track of your total debt balance; you will only have one repayment rather than several; and you may be able to pay off your debts quicker with a lower interest rate.
If you have a poor credit score, then you might have to use your home as security for the loan, which could mean you risk losing your home if you fail to keep up repayments.
If you are able to manage the consolidated debt well, then it could be a way of paying off debt quicker and boosting your credit score. It should be noted that you could potentially end up paying more overall, if debt consolidation increases the term of your debts, even if it reduces monthly repayments.
Refinance loans can help save you money by moving an existing loan onto a new loan with a lower interest rate.
You might choose to do this if interest rates have come down since you took the original loan out, or if your personal credit rating has improved since then and you might qualify for a lower interest rate loan.
You can also refinance to take out a loan for the same amount over a shorter period of time (meaning your monthly repayments will be higher but you will pay off the loan earlier and save on interest) or a longer period of time (meaning your monthly repayments will be lower but you will take longer to pay it off and pay more in interest). You could also refinance to switch from a fixed rate loan to variable one (or vice versa). It is important to also consider any fees involved when refinancing loans.
Government Budgeting Loans
A government budgeting loan can provide assistance if you or your partner are on benefits and are struggling to afford an unexpected or essential cost, such as moving house, funeral expenses, travel, purchasing needed clothing and furniture, finding a new job, or more.
If eligible, you can borrow as little as £100 or as much as £812. Budgeting loans do not charge extra interest and repayments are taken directly from your benefits.
Credit lines (or 'lines of credit', or 'credit accounts') offer flexible access to borrowing to individuals and businesses over a period of up to one year, although some lenders cap term lengths at a few months. Account holders can draw credit from their allowance whenever they choose within their term, and in any increments up to their agreed limit.
Credit lines are expensive compared with credit cards and overdrafts and interest rates can be thousands of per cent when expressed as an annual percentage rate.
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Sarah Bridge has been writing about business and finance since 2000. She was formerly Deputy Editor, Personal Finance, The Mail on Sunday and was previously the paper's Leisure Correspondent. Read more