Loan definition

Loan definition

According to The Money Charity, the average UK adult has a debt of £30,832, which constitutes around 112 percent of the average salary. University students on average hold around £32,000 of debt. For those who choose to borrow money using credit cards, making the minimum monthly payment, it will take 26.5 years to pay off the loan.

In a time of considerable financial uncertainty, where the cost of living continues to rise, more and more people turn to bank loans to cover their expenses or pay off their debts.

With so many different types of loan on offer, it can be confusing to begin the process of borrowing money. Lets take a look at some of the most common types of loan.

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What is a Bank Loan?

A bank loan is most commonly utilised by businesses to finance the acquisition of fixed assets like land, infrastructure and machinery. It is more sensible to use a bank loan for one-off payments and purchases, rather than ongoing expenses.

There are several different types of bank loan, including:

  • Working capital loans - for short-term or emergency payments
  • Fixed asset loans - for financing a companys assets, which then secure the loan
  • Hire purchase loans - for purchasing assets such as vehicles or machinery

Advantages of a Bank Loan

The bank cannot demand that the amount is paid back before the end of the agreed loan period

  • Interest rates can be fixed so borrowers can rest assured that their payments will not increase

Disadvantages of a Bank Loan

Start-ups or businesses with a bad financial track record often struggle to be accepted for a bank loan

  • If the borrower owns a business where customers or clients can delay their payments, it could be difficult to keep up the bank loan repayments, causing cashflow issues
  • If the borrower fails to maintain the repayments, the bank could put their business into insolvency
  • Sometimes, as with fixed asset loans, the loan is secured against the business assets or the borrowers home, meaning that if repayments are not made promptly, the business or assets could be taken away by the bank
  • If, on the other hand, the borrower would like to repay the loan in full before the end of the agreed repayment period, the bank may charge a penalty fee

Secured Loan Definition

This is a loan which is secured against the borrowers fixed assets, most commonly their home. Therefore, it is usually only taken out by homeowners or those with a mortgage. If the borrower cannot keep up with the loan repayments, the bank or lender has the right to force borrowers to sell their home in order to make back their money. A secured loan is much riskier than other types of loan and is often discouraged by finance experts as it could see the borrower lose their home and end up in serious financial trouble.

Advantages of a Secured Loan

  • These loans enable borrowers to take out higher sums of money, from £3,000 to over £10,000, and pay them back over longer time periods
  • Because the loan is secured against the borrowers fixed assets, the interest rates are lower than with unsecured loans

Disadvantages of a Secured Loan

  • The interest rates might increase or decrease
  • Borrowers can lose their fixed assets/home if they cannot keep up with repayments

Personal Loan Definition / Unsecured Loan Definition

Also known as unsecured loans, personal loans are those that are not secured against ones fixed assets such as their home. Borrowers can pay back a specified amount of money every month. Interest rates on personal/unsecured loans can be fixed or variable, depending on the Bank of England base rate.

It is thought that in the UK, one in ten people have taken out a personal loan, while the average loan works out to be around £10,000 to be paid back over four years. It should be noted, however, that those already in debt should avoid taking out a loan, as this could exacerbate the situation.

Advantages of a Personal / Unsecured Loan

  • These loans allow users to borrow more than they could with a credit card
  • Borrowers can select their own repayment period, potentially increasing or decreasing the final amount of interest paid
  • Borrowers can fully or partially pay off the loan at any time (but note that repaying more than £8,000 in one year may incur a penalty charge)

Disadvantages of a Personal / Unsecured Loan

  • The majority of banks will not loan less than £1,000 or accept repayment periods of less than a year, causing borrowers to take on a larger loan than they can afford
  • Because these loans arent secured with the borrowers fixed assets, they have higher interest rates
  • Borrowers are not guaranteed the interest rate advertised - just over half of those accepted for a loan get the advertised rate or lower
  • The interest rate might decrease, tempting borrowers to borrow more
  • The interest rate might increase, forcing borrowers to pay more than they can afford
  • Borrowers with a poor credit score could be accepted for a loan with the condition of a higher interest rate
  • If borrowers cannot keep up with the repayments, the bank could charge a penalty fee, or even go to court or apply for a charging order on the borrowers home

Other Factors to Bear in Mind

Credit Score

According to TSB, 61 percent of mainstream loan providers carry out a hard credit check before granting borrowers their final loan interest rate. This hard check impacts negatively on the applicants credit score.

There is a way to get around this, however. Some lenders, including TSB, carry out a soft search, which enables them to provide applicants with a no-obligation quote and doesnt change their credit score. This allows borrowers to shop around before deciding on their preferred loan.

If a borrower is informed that the lender will carry out a credit check, they should ask that they do a quotation search rather than an application search, to avoid negatively impacting their credit score.

Cooling Off Period

Most loans will have a cooling off period, granting borrowers a few days grace if they change their mind. This period is usually 14 days after the contract is signed, and gives the borrower 30 days to return the loan amount to the lender.

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