Loans Guides

Understanding your loan

Updated: Tuesday 22nd November 2011

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Thinking about getting a loan? To get the best deal it's crucial that you understand a few key terms, and we're here to help.

Understanding your loan deal before you commit to anything could save a lot of hassle and expense after you’ve signed on the dotted line.

In this guide we explain the key loan terms you need to know, as well as showing you what to look out for when choosing a loan.

Loans terms you need to know:

APR: Annual percentage rate is the amount of interest you’ll pay over the life of the loan and includes all fees and charges. If a lender advertises its monthly interest rate, ask for the APR so that you can better compare it to other loans.
Early redemption fee/settlement penalty: The amount some lenders will ask you to pay if you decide to settle your debt before the end of the loan term.
Loan term: The length of time you’ll be borrowing the money for. For unsecured loans, this is usually between one and 10 years.
Credit rating: Lenders will check your credit rating before deciding whether to give you a loan. It’s a measure of how big a risk you represent, so it’s based on how well you’ve managed to repay debts in the past, among other things.

About APRs

Looking at the APR is the best way to compare different loans - it’s a good measure of how competitive a loan is relative to another.

The APR is the most accurate way to compare interest rates for borrowing because it’s the total (or “gross”) interest you’ll pay over the life of a loan including any charges and fees. As a loan is over a number of years, the APR also includes a “compounding” effect (paying interest on interest).

One tip when comparing loans over periods longer than a year is, if you see a loan advertised and the headline rate (the interest paid over 12 months) and the APR (the interest paid over the entire term of the loan including fees and charges) is the same, then this means the lender is not imposing charges or fees to the headline rate, and it is a true reflection of the interest rate you’ll pay. As we’ll see, no charges make the loan cheaper.

For example, borrowing £7,500 over three years from a lender that doesn’t levy any extra charges on the loan, an annual interest rate (the headline rate) of 6.7% (the lowest personal loan rate on the market at the time of writing) will also translate to an APR of 6.7%. At this APR, you borrow £7,500 over three years, the repayments are £229.88 a month and, over the three year term, you’ll actually pay back £8,276 - £776 more than you originally borrowed.

Now, let’s say the lender hits you with extra charges of £150. The headline interest rate is still 6.7% but, factoring in the £150 fee means the APR rises to 8.13%, the monthly payments are £234.47 and, over the three-year term, you’ll actually pay back £8,441 (£941 more than you originally borrowed). The £150 charges cost you dear - an extra £165 over the life of the loan, more than ten times the charges.

Early redemption fee/settlement penalty

You may think a lender would be grateful to you for paying off your debts early. Alas, no. Personal loans (and mortgages) levy early redemption or repayment fees (ERF, also called exit fees) because the profitability of your loan to the lender is calculated on the basis that you’ll pay monthly charges over the entire life of the loan.

To pay the loan off early means the lender will make less profit and so will look to claw back potential lost profit with an ERF. This could cost the same as up to three months’ interest and the earlier in the term you repay the loan, the higher the ERF might be. If feel you may be able to pay the loan off early, always check how much the ERF will cost if you do this before you sign-up for the loan.

Loan term

The period of time you borrow the money over will not only affect the interest rate charged but also the total charge for the credit. The basic rule of thumb for loan terms is the longer the loan term, the lower the monthly repayments. However, because of the extended term, you’ll actually pay a higher total charge for borrowing the money.

Let’s look again at our example using exactly the same figures, but extending the loan period. Borrowing £7,500 at an APR rate of 6.7% (no fees or charges added) over five years your monthly payment would be £172.23 and the total amount you’d pay back is £8,616, paying a total interest charge of £1,116, which is £340 more than the £776 charged had you borrowed the money over three years. The reason? The APR is calculated over two extra years.

So, as well as comparing APRs, also get the potential lender to give you a breakdown of the amount you want to borrow, the APR you’ll be charged and the monthly payment, which will help you calculate not only the total credit charges, but also the total interest you’ll pay on the sum borrowed.

Credit rating

Every person in the UK who has ever obtained credit, be it a hire purchase agreement, credit card, loan or mortgage, will have a credit rating based on their credit history which is formulated into a “credit score” by a credit reference agency and is used by a lender to assess your suitability as a potential borrower.

Your credit report contains detailed information on your credit history, a record of your past borrowing and repaying, including information about late payments and bankruptcy. It also includes all applications you’ve made for financial products and whether they were rejected or accepted.

From the information on your credit report, a credit referencing agency (such as Equifax and Experian) will calculate your credit score - a three-digit number (ranging from a low of 300 to a high of 850). Your credit score enables lenders to determine how much of a credit risk you are.

Basically, a low credit score indicates you present a higher risk of defaulting on your debt obligations than someone with a high score and any products you successfully apply for with a low credit score will carry a higher rate of interest matching this risk.

What to look out for when choosing a loan

As well as the APR, there are several other costs you need watch out for when choosing the right loan for you circumstances, including the following:

Payment holidays – Some lenders may offer to defer your repayments for a few months at the start of the loan. However, you will still be being charged interest during this time and your future repayments will be larger to compensate. Your total amount repayable will be larger too, so avoid this if possible.

PPI – Payment protection insurance (PPI) is the latest scandal to affect the banking industry. Sold on the back of loans (and credit cards), the idea behind PPI is that in the event of job loss, accident or injury, the PPI would cover your payments if you couldn’t

PPI is riddled with exclusions - it doesn’t cover the self-employed, contract workers or pre-existing medical conditions that might prevent you from working. Many policies were even sold to people who were unemployed or retired and therefore didn’t have an income to protect

If your loan provider asks if you’d like to add PPI to the loan, politely decline and don’t be persuaded to change your mind.

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