How to choose a loan

While most of the headlines during the global economic crisis have centred on the difficulties borrowers have in obtaining mortgages, what has often been overlooked is how hard it has become to obtain smaller loans.

Interest rates on loans have been rising and the cheapest deals are only available to those with the best credit histories.

With lenders tightening their criteria it is now much harder to be accepted for a loan – and even if you are, you may find there are hidden charges that bump up the amount you repay.

Here we look at the main factors to bear in mind when shopping for a loan.

Secured or unsecured?

The difference between a “secured loan” (also known as a “homeowner loan”, because they are only available to those who own a property) and an “unsecured loan” (also known as a “personal loan”) is that with a secured loan you are offering the lender some form of security against the debt – usually your house. This means that if you’re unable to meet the repayments, the lender can repossess your home.

Due to that added risk, it’s fair to say that if everything else is equal an unsecured loan is always a better option than a secured loan. However, secured loans often have more attractive rates and providers are more likely to take a risk on a customer with a less than perfect credit score if they have some form of equity to fall back on.

This makes them easier to obtain and larger borrowing is possible. The maximum you can borrow with an unsecured loan is £25,000. However, secured loans tend to be available up to £75,000 or even £100,000. Longer repayment terms are also available – up to 20 years compared with maximum terms of seven, maybe 10 years, with standard unsecured products. Of course the longer the repayment term, the more interest you’ll pay so you should always try and opt for the shortest repayment term you can afford (the shorter the term, the higher the monthly payments).

Here are some questions to ask when choosing the right loan option:

  • How much do you want to borrow and for how long?
  • Do you own a property?
  • Are you sure you can meet repayments?
  • How good is your credit history?
  • Are you likely to repay the loan early?

What to look for with a secured loan

If you opt for a secured loan your primary concern will be the interest rate – the lower the interest rate, the less you should repay.

At the moment the lowest secured loan rates in the UK are both available exclusively through moneysupermarket.com. The Platinum Exclusive Loan has a headline rate of 7.8% and the Blackhorse Personal Finance Loan, which is from the Lloyds Banking Group, is available at 7.9%.

However, before applying for these or any other deals there are some important factors to bear in mind:

You may not get the headline rate: Headline rates are only available to a small proportion of customers with excellent credit scores – this is known as “risk-based pricing”. The majority of borrowers should pay closer attention to the typical rate – this rate must be offered to 66% of all successful applicants. For example, the Platinum Loan and Blackhorse Personal Finance Loan have much higher typical rates than their headline rates at 11.4% and 11.9% respectively.

Is the rate fixed or variable: Most secured loans have variable rates meaning that the lender can effectively increase your payments when it chooses. This has hit many borrowers hard during the credit crunch with some lenders even doubling their rates. This could affect your budget so look for fixed payments – the Blackhorse deal for example, offers fixed rates.

Are there early repayment charges: Secured loans often penalise those who can repay early through redemption charges. Thankfully, for new loans of less than £25,000, these are restricted to only two months’ worth of interest. However, if you borrow larger amounts, be careful as there is no maximum limit and penalties can be sizeable.

What to bear in mind before you apply:

  • Your home may be repossessed if you don’t meet repayments.
  • Do you qualify for the headline rate?
  • Is the rate fixed or variable?
  • Will you be charged a penalty if you repay the loan early?

What to look for with an unsecured loan

With unsecured loans there are fewer traps to fall into – rates are always fixed and not variable; and if early repayment charges do apply they are limited to a maximum of two months’ interest. Consequently, the primary concern for anyone applying for an unsecured loan should be the interest rate.

The lowest unsecured loan rate in the UK is offered by the Alliance & Leicester Personal Loan at 8%. This means that if you borrowed £10,000 over five years you’d repay a total of £12,086 with monthly payments of £201.43. By contrast, if you took out a higher rate loan you’d repay significantly more. For example the same loan amount over the same period at a rate of 15.9% would cost borrowers an extra £2,140 in interest over the lifetime of the loan, so it would cost a total of £14,226.

Nevertheless, the best loan rates are only available to those with excellent credit scores.

What if you don’t have a good credit score?

Applying for the leading loan rates, whether secured or unsecured, is pointless if you have a poor credit rating. With lenders tightening their criteria your chances of acceptance are slim – and having loan applications rejected will only further harm your credit score.

If you are unsure about your credit rating then you can apply for a copy of your credit profile through agencies such as Equifax and Experian. Once you have a copy of your profile, correct any errors as it may make all the difference to your score. If your credit rating is poor look for ways to improve it such as by paying bills and credit cards on time; establishing a fixed address; and getting on the electoral roll.

To compare loan rates when your credit score is less than excellent use our SmartSearch tool. It asks a brief set of questions to get a snapshot of your profile and then returns loan rates you’re more likely to be accepted for.

Is there anything else to watch out for?

There are plenty of other hidden traps with loans that could cost you money unless you’re savvy, including:

Other hidden fees: Several providers impose arrangement or administration costs during the set-up of the loan. Lenders may also charge late payment fees. Check the terms and conditions of a policy carefully.

Deferred repayments: See if it is possible to defer payments or take a payment holiday in case finances are tight.

Payment by direct debit: To ensure you don’t miss payments, ask lenders if it is possible to pay by monthly direct debit.

Payment protection insurance (PPI): Historically lenders have often sold PPI at the same time as a loan is taken out. However, the Financial Services Authority has clamped down on this because of widespread mis-selling and providers must stop selling it in this way by May 29 2009. That said, PPI can be useful because it covers repayments if you suffer an accident, fall ill or are made unemployed. Costs vary hugely though. The cheapest policies tend to be available from stand-alone providers rather than banks and building societies. The level of cover differs so read the small print before you buy – use our PPI comparison tool to compare options.

And finally…

Before applying for a loan ask yourself if you really need to borrow the cash at all. Could you get around any financial problems with some more stringent budgeting for example – such as by cutting out unnecessary spending? Perhaps you could even borrow money from a friend or family member who wouldn’t charge you interest? Check out Clare Francis' interviews with Julie Griffiths from Citizens Advice and Caroline Hamilton from the Consumer Credit Counselling Service for more tips on how to deal with debt problems and visit our debt section for guides that could point you in the right direction.

 

Disclaimer: Please note that any rates or deals mentioned in this article were available at the time of writing.

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