Borrowing money can be a confusing jumble of jargon and terms. It can often feel that everyone else knows what this all means, except for us. But that's not the case. This article will tell you everything you wanted to know about how loans and credit work, what an APR is, and why you should care about your credit score.
Credit and Loans
What's the difference between credit and loans?
Credit is the ability to borrow money - ie. someone has said that you can borrow up to a certain limit.
In contrast, having debt or having a loan is when you have borrowed.
So, think about your credit card or overdraft. You have a credit limit but once you've spent the money on credit, the outstanding amount would count as a debt.
The big difference between a loan, and a credit product is that a loan is a fixed amount that you borrow from a lender and pay back over a set period of time. However, with credit products, you can dip in and out as you need. It does have a limit, but you don’t have to borrow it all at once.
|Credit products||Loan products|
|Credit cards||Personal Loan|
|Line of credit||Mortgage|
|Store cards||Student Loan|
Let's talk about the pros & cons of loan products
- You borrow a fixed amount, and this can often be a larger amount than what you could get on credit.
- Usually a lower APR (unless there’s a special 0% rate on a credit card, or you’re using a payday lender)
- You’re forced into the discipline of fixed, regular repayments to pay off the debt on a set schedule
- You can’t re-use the loan (if you pay off part of it, you can’t then borrow the same amount again automatically).
And, pros & cons of credit products
- Usually a higher APR than with loans
- You can get special rates of 0% credit cards
- Sometimes comes free with your account (e.g. a certain limit of overdraft)
- Can have it ready in case of emergency
- More flexible repayment options
- You can re-use it (e.g. pay it off, then start spending on credit again)
- Harder to get rid of once and for all - you need to the disciplined one!
Extra for Experts:
This is the fancy term for when you bundle all your loans together into a new one. Rather than having lots of different payments to different lenders at different rates, you move them all into one big loan with one lender. This can be a good option if you want to reduce the confusion, and if you can get a lower rate by consolidating. Make sure you still keep the same loan term, otherwise although your monthly repayment could be less, your overall repayment for the whole loan will be more because there’s more time for interest to get charged.
Secured and unsecured loans
A secured loan is money you borrow that is secured against an asset you own, usually your home (sometimes a car). Secured loans are less risky for lenders, which is why they are usually cheaper than unsecured loans, and let you borrow more . But they are much more risky for you as a borrower because the lender can repossess your home or car if you do not keep up repayments. They are sometimes also called home equity loans, second mortgages, homeowner loans.
Unsecured loans are probably what we think of most of the time – we borrow money from a bank or another lender and agree to make regular payments until it’s paid in full. Because the loan isn’t secured on your home, the interest rates tend to be higher.
APR and interest
Interest is what you get charged to borrow money. Unlike your mate, the lender doesn’t loan you money to do you a favour, they ultimately want to make a profit. They do this by charging you a percentage of what you borrow - for example a 10% interest rate would mean that for every £100 you borrow, you need to pay back £110.
Your interest rate could be fixed (it will always be the rate you start with for the whole loan), or variable (it could change if the lender decides to change it). Always know what type of interest you’ll be charged before you sign the dotted line.
What is an APR and how does it work?
Annual Percentage Rate is the amount of interest and fees and charges that you’ll pay to borrow money from a lender.
Take a look at this example - you can see how the interest rate is different to the APR, unless there are no additional fees or charges. The higher the APR, the more you end up paying:
|Borrowing type||Amount borrowed for 2 years||Interest rate||Fees & Charges||APR||How much you pay back over 2 years|
|Credit card||£2,000||21.95%||£0||21.95%||Around £2,489 - £104 per month|
|Loan A||£2,000||19.95%||£90||24.58%||Around £2,551 - £106 per month|
|Loan B||£2,000||8.9%||£0||8.9%||£2,191 - £91 per month|
What is a “Representative APR”?
This just means that this is what the average customer will get as an APR when borrowing. Most lenders advertise their representative APR to try and entice you in.
In reality, the exact APR you get will depend on your credit score, but UK law says that at least 51% of a lender’s customers must get that APR in order for them to advertise it as “representative”.
What are the other fees that could be charged?
Some companies charge an application or arrangement fee - this is the amount that is charged to get the loan set up. Others might have a yearly charge - an annual fee.
Why does the APR matter?
It’s the quickest and easiest way to compare the cost of borrowing from different lenders before you commit to one. The lower the APR, the less you’re going to pay for borrowing that money.
Remember, make sure you know what your APR would be, and not just the representative APR. If you look at your credit report, you will be able to get a sense of whether you would get a good APR, or not. High credit score = low APR = good for your bank balance.
Credit Scores 101
What is a credit score?
Your credit score is a number that tells companies how credit worthy you are - how likely you are to pay them money on time.
You won’t just have one score - different credit reference agencies have different ways of calculating it. The main ones are Experian, Equifax, and TransUnion UK (formerly Callcredit). All of them offer a free service that will let you get your score.
How does it work?
Your credit score is based on the information in your credit report.
A credit report shows information about your financial footprint, such as if you pay your bills on time, if you have overdrafted your account, if you’ve paid previous loans off on time, who you have joint accounts or credit with (and how good they are with their money), how many loans you have applied for recently, and more. It also provides details to verify you are who you say you are, such as showing whether you’re on the electoral roll or not.
If you have previously have made bad financial decisions (or you’re young or new to the UK and don’t have much history), then it becomes harder for companies to know if you’re a safe bet to loan money to, and so you have a lower credit score.
You can request to see your credit score and credit report - it’s a good idea to check regularly to make sure there is no incorrect information. Looking up your own score won’t impact it.
Why does it matter?
Having a good credit score can make a big difference. With a low score, you may be charged a higher APR for loans and credit, be given smaller limits, or be rejected for a certain product. This could mean needing to take on more expensive borrowing! Taking the time to build up your credit score could save you thousands of pounds in interest and fees over your lifetime.