What is a loan and how do they work?
A loan is a simple financial agreement where one party (the lender - like a bank or financial institution) gives a sum of money to another party (the borrower), and the borrower agrees to pay that money back over a set period of time.
This repayment is not just the original amount (principal) but also an extra charge called interest, which is the cost of borrowing the money.Â
Loans allow you to make a large purchase or cover a significant expense now, which you wouldn't otherwise be able to afford.
How do loans work?Â
While there are many types of loans, the mechanics of how they operate are fundamentally the same.
Key loan features
Principal: This is the original amount of money you borrow.
Interest rate: This is the cost of borrowing money, expressed as a percentage. It determines how much extra you'll pay on top of the principal.
APR (Annual Percentage Rate): This is a legal requirement that gives you the total cost of the loan over a year, including the interest rate and any mandatory fees. It's the best figure for comparing different loan offers.
Loan Term: This is the length of time you have to repay the loan, usually expressed in months or years. A longer term generally means lower monthly payments but a higher total amount of interest paid.
Repayments: These are your fixed, regular payments (usually monthly) that cover both a portion of the principal and the interest due.
How to calculate the total cost of the loan
When you take out a loan, the total amount you repay is always more than the amount you borrowed. This extra money is the true cost of credit.
The total amount you pay back is made up of three simple parts:
Principal + total interest + total fees = total amount repayable
The total interest and total fees are fixed amounts determined by the lender based on the APR they offer you. The APR is the key number that includes all these costs.
This final figure, the total amount repayable, is what is used to set your fixed monthly payment for the entire life of the loan.
Paying off the loan early
In the UK, if you take out a consumer credit loan, you typically have the right to pay off the loan early, either in full or by making extra payments.Â
If you choose to do this, you may be entitled to a refund of interest. This means you will not have to pay all the interest that was originally planned for the future, which helps you save money on the total cost of the loan.
Lenders might charge a small fee for closing the loan early, called an Early Repayment Charge (ERC). However, this fee is limited by law and is usually small compared to the amount of interest you will save.
Different types of loansÂ
The UK credit market offers many types of loans, each suited to a specific need.
Personal loans
A personal loan (or consumer loan) is one of the most common types. It's typically a fixed amount for a fixed period with fixed repayments. They are often categorised by whether they are secured or unsecured:
Unsecured personal loan: This loan does not require you to put up any asset (like your home or car) as collateral.
Secured personal loan: This loan does require you to provide an asset as collateral. If you fail to repay, the lender has the right to repossess the asset.
Debt consolidation loans
A debt consolidation loan allows you to take out a single, new loan to pay off several existing debts (like credit cards, overdrafts, or other loans).
It aims to simplify your finances into one monthly payment and can potentially save you money if the consolidation loan has a lower overall interest rate than your existing debts.
Home improvement loans
With home improvements loans, the funds are specifically intended for carrying out repairs or renovations on your home.
These can be either unsecured or secured. Secured loans use your home as collateral.
Wedding Loans
Wedding are taken out to cover the often high cost of a wedding.
They are often structured as an unsecured personal loan and marketed for this specific purpose, allowing you to spread the cost over several years.
Bridging Loans
A bridging loan is a type of short-term loan (often 12–24 months) designed to cover a temporary gap in your finances.
The most common use is when you're buying a new house but haven't yet received the money from the sale of your old house. The loan acts as a ‘financial bridge’ to help you complete the new purchase on time.
They are usually secured against property, meaning your assets are at risk if you cannot repay.
Lenders always require you to show a clear plan (an 'exit strategy') for how you will pay off the loan when the time comes (for example, proof that your old house sale is confirmed).
Reasons you might take out a loanÂ
People borrow money for many different purposes. Common reasons include:
Large purchases: Funding major expenditures like a car, a new kitchen, or expensive furniture.
Debt management: Using a debt consolidation loan to simplify and potentially reduce the cost of existing debt.
Home projects: Paying for extensions, repairs, or energy-efficient upgrades to a property.
Life events: Financing major costs associated with a wedding, a significant holiday, or educational fees.
Emergencies: Covering unexpected bills, such as medical costs or emergency home repairs.
Loan vs credit card
Both loans and credit cards are forms of consumer credit, but they work very differently:
Feature | Personal loan | Credit card |
|---|---|---|
Structure | A fixed lump sum is borrowed all at once. | A revolving credit limit is available to spend as needed. |
Repayments | Fixed monthly payments over a set term. | Flexible payments, with a minimum payment required each month. |
Interest | The rate is fixed (for fixed-rate loans) for the entire term. | The rate is variable and only charged if you don't pay the full balance. |
Use | Best for large, one-off expenses where you need a predictable repayment plan. | Best for everyday purchases or as a flexible emergency fund. |
Things to consider before taking out a loanÂ
Before committing to a loan, it's important to understand your financial situation and the commitment you're making.
Can I afford the repayments? Always budget for the monthly payment to ensure you can comfortably meet it, even if your income slightly changes.
Is the loan necessary? Determine if borrowing is truly the best option, or if you could save up for the purchase instead.
What is the total cost? Focus on the total amount repayable (principal + interest + fees), not just the monthly payment.
Check eligibility without impacting credit: Use eligibility checkers (often called soft searches) to see your likelihood of approval without leaving a hard footprint on your credit file.
What to do if you’re struggling to repay a loanÂ
If you find yourself struggling to meet your loan payments, there are steps you can take to help.
Contact your lender: Explain your situation honestly. Lenders are often required to treat customers fairly and may be able to discuss options like a temporary payment holiday or a reduced payment plan.
Seek free debt advice: There are several UK charities and non-profit organisations that offer free, confidential, and unbiased advice on managing your debts, such as StepChange Debt Charity and National Debtline.
This blog is for informational purposes only and does not constitute financial advice. Please speak to a qualified financial adviser before making financial decisions.