In finance, a loan is simply a borrowed sum of money that the lender, such as a bank, expects to be paid back with interest (i.e. the cost of borrowing the money) on top. This means when you take out a loan, you will pay back more than you borrow.

There are many different types of loan, so it's important to know how they all work before you borrow money. With a better understanding of loans, you can save money and make informed decisions about debt – including when to avoid it. Not all loans are suitable for everyone, so it is vital to do your research and compare loans to find the one that best suits your needs.

Understanding the jargon

The loans industry tends to use a lot of jargon, and it can get confusing. Since you will be taking on financial risk when you take out a loan, it's important to know what the terms you come across mean.

  • Principal. This is the amount you borrow and have to pay back, not including any interest or lender fees. As you repay your loan, your principal amount will decrease.

  • Interest. This is the amount the lender is charging you for borrowing money. It is usually calculated based on the amount of your loan, and is normally expressed as a percentage of the principal. Though the total amount you will pay back on your loan principal won't change, the amount of interest you pay could vary over the lifetime of the loan, depending on how long you borrow the money for and your monthly payments.

  • APR. This stands for Annual Percentage Rate and relates to the interest that the lender will charge you for taking out the loan. It is a legal requirement for lenders to display their APR - making it easier for borrowers to compare loans. An APR incorporates both your interest rate and any lender fees to give you a better picture of how much your loan will cost you.

  • Term. This refers to the amount of time that a loan lasts. When you take out a loan, you must specify the time frame in which you intend to pay back your loan. Longer-term loans with lower monthly repayments might seem more appealing, but they are far from ideal as your total repayment will be higher. This is because you’re taking longer to clear the loan while the interest stacks up. If you opt for a short-term loan, you usually end up paying less interest overall, though your monthly payments will be higher.

  • Monthly payments. During your term you will pay back your loan plus interest in monthly instalments, known as monthly payments.

  • Credit score. This is a metric used by lenders to determine how likely a borrower is to pay back a loan on time. It is usually expressed as a 3-digit number – the higher the number, the more likely you are to receive the credit you're after. Credit scores are calculated based on your credit report, which shows how well you have managed credit in the past – for example, if you have always paid your bills on time, or if you have defaulted on a previous debt. Many different pieces of credit data go into your credit report, all of which affect your credit score.

  • Broker. A broker is a professional who will act as an intermediary between yourself and the lender. A broker shops around on your behalf to find the best loans available based on your circumstances.

  • Security. This is an owned asset, such as a house or a car, that the borrower offers the lender as security for the loan. If the borrower stops making the promised loan payments, the lender can seize the asset to cover the debt. It’s often commonly known as collateral.

  • Early repayment charge (ERC). This is a fee you may be required to make to a lender if you pay off a loan before the scheduled term ends. Lenders often include ERCs in loan agreements to compensate for the interest they'll lose if the loan is repaid early.

What are the different types of loans?

Personal loan. This is a fixed amount of money borrowed at a fixed rate and repaid over a fixed amount of time. You can get a personal loan from a bank, credit union or online lender.

Personal loans can either be secured or unsecured. A secured personal loan requires some type of security, whereas an unsecured loan doesn't. Unsecured personal loans are granted (or not) based purely on the borrower's credit score and their ability to pay the money back. People take out personal loans for a variety of different reasons, including to pay for a new car, home improvements, or holidays. As they tend to have lower interest rates than credit cards, some people also use personal loans to consolidate multiple debts into a single, lower-cost monthly payment.

Business loan. These are similar to personal loans, but are specifically designed for business use. You are lent a certain sum of money over a period of years – again, subject to affordability and a credit check – and pay it back with interest. A business loan can be secured or unsecured.

Car loan. This is a loan you take out specifically to buy a car. It is similar to a secured loan in that the money you borrow is secured against the vehicle you intend to purchase. If you default on your repayments, the lender can seize the vehicle.

Bridging loan. These help you to ‘bridge the gap' when you need to pay for something but are waiting for funds to become available. For example, bridging loans are often used by people who are buying a property, but are waiting for the sale of another property to go through. Bridging loans tend to be secured loans, so you will need a high-value asset to get one, such as property or land.

Homeowner loan. A type of loan secured against your property and are thus only available to homeowners.

Guarantor loan. This is a form of unsecured personal loan that requires a third party (such as a parent) to guarantee the repayments should the original applicant default at any time. These loans are a way for those with poor or no credit history who may have been turned down by a lender previously to get approved for a loan.

Debt consolidation loan. This is a loan in which an individual borrows money to pay off several different existing debts, e.g. credit cards, or overdrafts. Combining these different loans into one means there is only one monthly repayment to make, instead of several. This can help make things easier and manageable for some people - allowing them to keep track and manage their cash flow and debts.

How do I find the best loans?

If you want to get a loan, it’s important to shop around. Doing a loan comparison will mean you can compare loans and find cheap loans that meet your needs.

There are a few features to think about when you’re looking:

  • Eligibility: It’s best to work out what you’re likely to be accepted for before you apply. It’ll save you time and it means your credit rating won’t be affected by applying and being rejected.

  • Amount: Work out how much money you need. You’ll also need to make sure you can afford the monthly repayments.

  • Interest: You’ll be offered an interest rate based on your credit history. Different lenders will offer different rates so you’ll need to find the best loan rates for you.

  • Term: The longer you spend paying your loan back, the smaller the monthly repayments. But you'll normally pay more in interest if you take a long time to pay it back, even with the cheapest loans.

  • Fees: Even when you think you’ve found the best loans, check the small print. Even the best loan companies can charge fees for paying the loan back early or making an extra repayment.

Where can you get loans in the UK?

There are a variety of different places to get loans from, including:

  • High-street banks

  • Building societies

  • Internet loan providers

  • Supermarkets and high-street stores

  • Secured loan providers

  • The government

You should always shop around to find a loan provider that can offer the best deal for you and your circumstances.

Who can get a loan?

You must be at least 18 years old to apply for a loan in the UK. In addition, you normally have to:

  • Be a UK resident, with proof of address

  • Provide proof of your income to show the lender you are capable of paying back the loan

  • Pass a lender’s credit check

How much can you borrow?

Loan companies will assess how likely you are to be able to repay your loan. The amount you can borrow and the interest rate you receive will be based on this assessment, which factors in your income, your financial assets (savings, investments, possessions of value, etc.) and your credit history.

How much will your loan cost?

The amount your loan will cost you will be dependent on the APR that you agreed to when you took out your loan. You are more likely to pay a higher rate of interest on a debt of just a couple of thousand pounds than you would on a larger debt. As larger loans typically have lower APRs, some people consolidate different debts into one large one in order to try and obtain a better rate and save money overall.

Be aware that some lenders may charge upfront fees, and may include early repayment charges (ERCs) in their terms should you want to repay the debt early. Before taking out any loan, make sure you understand what the additional costs will be. Some common types of fees include:

  • Application fee – pays for the process of approving a loan

  • Processing fee – similar to an application fee, it covers the costs associated with administration

  • Origination fee – the cost of securing a loan (common for mortgages)

  • Late fee – this is what your lender will charge you for late payments

  • Broker fee - using a broker will incur a fee for services like negotiations, sales, purchases, communication with lenders, delivery and advice on transactions.

You can use our loan repayment calculator to help you work out what a loan may cost you.

How to know if you will qualify for a loan?

A lender will only provide a loan if they are reasonably certain it will be repaid. As your credit score helps lenders determine your level of risk, improving that score will help you qualify. Generally, the higher your credit score, the more likely you are to qualify for a loan. Your credit score may also impact the interest rate you're offered.

You will need to present proof that you have sufficient income to repay the money borrowed, plus the interest and additional fees.

Can I get a loan if I have bad credit?

If you don’t have a strong credit rating or if you are borrowing a substantial amount of money, you may have to secure the loan with an owned asset, such as a car or a property (secured loan). This provides reassurance for the lender – if you fail to pay off your debt, the lender can repossess your asset and sell it to get their money back. Therefore, secured loans are less risky lenders, but more risky for borrowers.

Some lenders offer bad credit loans specifically for people with poor credit histories. These loans typically have much higher interest rates and lower maximum credit limits. These can be useful for people to help improve their credit score so they can qualify for cheaper loans in the future.

Alternatively, if you have a poor credit rating, you may consider a guarantor loan. This is where a family member or friend with a good credit rating guarantees the loan, meaning they will promise to repay it if you can’t.

How to apply for a loan

When you ask a lender for any kind of credit, you will have to go through the application process. However, before you apply for a loan, it is important to review your credit report and your credit score so you can better understand what lenders might see when they pull up your details.

In general, you can apply for a loan online, over the phone, by post, or, if applying with a bank, by visiting a branch.

You will also need the following paperwork and proof of identity:

  • Bank details

  • Current address, and previous address for the past 3 years

  • Employment details

  • Personal details e.g. date of birth, etc.

As part of your loan application, you will have to include your salary and monthly income. Some income sources are not accepted by certain lenders. The following could be examples of incomes that lenders do not accept:

  • Reimbursement for expenses

  • Maintenance payments from an ex-spouse or partner

  • Overseas income

  • Rental income from any buy-to-lets that you own

  • Student loans

  • Benefit payments – child benefit, universal credit or jobseeker's allowance (JSA)

You will usually be required to provide your three most recent bank statements and payslips that can prove your earnings along with your application.

If you are self-employed, you will need at least one full year of audited accounts to apply for a loan. Depending on the lender, you may be asked for more, and some lenders may even exclude self-employed earnings altogether from their assessment. Make sure you check the requirements before you apply to save you time and reduce the chance of a rejection.

Can I overpay or pay off my loan early?

Some loan providers penalise you if you try and repay your loan early by applying an early repayment charge (ERC). Generally, the earlier in the term you repay your loan, the higher the charge you may incur.

Not all loan companies do this, so if you think you may be able to repay your loan early, then shop around for a lender that does not apply early repayment penalties.

Should you consolidate your debts?

Some loans are specifically advertised as debt consolidation loans - these allow you to merge your existing loans into a single loan.

These are harder to obtain and should only be considered once you have explored all other options, as they are often secured against your home or other assets.

They can seem an attractive option as they tend to have lower interest rates and repayments - making it easier and more manageable to pay off your debts. However, they can also cost you more in the long run if you are unable to stick to the repayments.

Defaulting on your loan could find you losing your home, car or any other collateral you used to secure the loan. You need to know how you are going to repay your debt, and what your contingency plan is if your circumstances were to change before you decide to consolidate.

You can find you more about whether debt consolidation is the right option for you.

The bottom line on loans

Before taking out a loan, you need to spend time to compare loans to figure out which one will work best for you and your circumstances. You then have to assess whether you can afford the loan, and how you intend to meet your monthly payments.

Taking out a loan, or any form of credit, should never be a quick and uninformed decision. Failure to repay an unsecured loan will result in additional interest and late fees added to the loan. Worse – it will make it harder to repay the money you owe, and the lender can apply to have a county court judgement (CCJ) or bankruptcy order made against you. Among other consequences, this will have a hefty impact on your credit score, making it extremely difficult to secure a loan in the future.