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Home / Finance / Providing Some Clarity and Understanding About Loans

Providing Some Clarity and Understanding About Loans

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“Consumer spending reaches record levels!” – a not unfamiliar news headline. However, if you take a look at the year-on-year rise in consumer spending figures and then compare those figures with the year-on-year rise in wages, you’ll immediately notice a disparity. Lately, rises in consumer spending have far outstripped rises in wages. So, how is this happening? The answer: record rises in the levels of debt financing.

Debt financing can come in many forms: credit cards, hire-purchase and store cards being principal among them. However, probably the biggest form of debt financing is the loan. However, the various different types of loans available can leave those unfamiliar with loans confused. The following is a brief explanation of loans to try to help you here.

Loan Types

Simply put, a loan is something you borrow from someone willing to lend it. However, in the highly regulated world of financial markets, things are not that easy. As a result, “loans” involving money have a variety of names, depending on the intended use of the proceeds (money).

 

* Personal Unsecured Loans:

Probably the mainstay of loans is the personal unsecured loan. As it name suggests, a personal unsecured loan is money that you borrow from a bank or building society. As part of the loan agreement you agree to repay the principal of the loan (the amount borrowed) plus interest (the lender’s profit). In most cases you’ll agree to repay the loan in equal [monthly] repayments. However, you do not agree to provide any security (or collateral), in the case that you default on your repayment.

The upside of an unsecured loan is that the lender cannot repossess the item that you have bought with the proceeds of the loan, nor can they enforce against any of your other assets.

The downside of an unsecured loan is that, in return for the lender’s greater risk factor, you’ll likely be paying a higher level of interest than is the case with a secured loan. You also need to be a little careful: the concept of an “unsecured” loan is a misnomer. In fact, in most cases, you’ll need to declare what the loan is for, and if you do happen to default the lender will likely bring an action against you to seize the assets. Consequently, if you think it is unlikely that you’re likely to default, to reduce the costs of the loan, it’s probably just as well that you take out a secured loan.

* Personal Secured Loans:

Obtained in the same way as a personal unsecured loan, the main difference being that you agree to provide the lender with security, in the case that you default. “Security” can come in many forms (for example, share certificates, car, boat, plane, even cash bank accounts); however, these days banks prefer this security to be a charge over your house.

The upside of a secured loan is that interest rates and costs are usually lower – as the lender still has recourse to funds in a worst case scenario.

The downside to a secured loan is that you run the risk of losing the asset if you cannot repay the loan.

* Other types of loans

Depending on your needs, you may also come across the following types of loans, which are more specific to the application of the proceeds of the loan: car loans, student loans, home improvement loans, holiday loans, bridging loans, debt consolidation loans. Essentially, all of these work in the same way as a secured or unsecured loan.

INTEREST RATES ON LOANS

Once you’ve decided whether you’re going to have a secured or unsecured loan, the rate of interest that will accrue against the loan will be determined.

* Fixed Rate Interest

Fixed rate interest is exactly as its name suggests – interest fixed throughout the period of the loan. The advantage of having a fixed rate interest is that it is easy to calculate the exact figure you need to repay. Your budgeting can then reflect this. The downside is that there is usually a breakage fee (cost of funds) if you want to repay the loan early.

*Floating Rate Interest

Floating rate interest can work in a number of ways. Usually, however, you’ll see this described as being: Base Rate plus basis points. Although the basis points (which is a percentage figure) are fixed, Base Rate is a floating rate set by the Bank of England from time-to-time; hence the overall interest rate floats. The upside to a floating rate interest is that there is rarely a breakage fee – if you make early repayment. The downside is that the rate can swing very quickly against you – as happened in the early 1990s when the Bank of England was raising Base Rate almost weekly.

The best way to try to calculate whether to use fixed rate interest or floating rate interest is to ask the lender to do an Annual Percentage Rate (APR) calculation for you. APR calculations are adjusters, and so this should help you to determine the real rate of annual interest you’ll need to pay on the loan.

THINGS TO THINK ABOUT LOANS

Finally, here are some things to think about if you’re considering a loan:

  1. is it absolutely necessary for you to fund the purchase through a loan. Sometimes dipping into your saving will mean you save in the end;
  2. look around for the cheapest (cost) loan;
  3. when looking at interest rates, always ask an APR calculation;
  4. make sure you fully understand the security issue;
  5. don’t agree to any add-ons, like insurance, unless you believe you’ll need them;
  6. if you’re going to need to fund the purchase for a period over one year, a loan will nearly always be cheaper than other forms of short-term debt financing – like a credit cards;
  7. don’t sign any loan agreement unless you’re completely satisfied you understand what’s being asked of you. All too often, we are in a hurry to buy the product and don’t read the small print. Remember, “buy in haste, resent at leisure.”
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