Taking out a loan is a big commitment. And as they vary in their interest rates and repayment schedules, it's important to know which type of loan is best for you.
Most loans are either secured or unsecured. A secured loan is tied to collateral, something that can be reclaimed by the lender if repayments are not kept. Whereas an unsecured loan is not tied to anything. Here's a rundown of the different loans and what you can use them for.
There are 6 types of loans
Most banks offer a personal loan, which can be used for almost anything. Interest rates and repayment amounts can be fixed or varied, and although most banks advertise a representative annual percentage rate (APR), this only has to be offered to 51% of customers.
Personal loans generally have higher interest rates than other loans, particularly with smaller amounts of money, and a poor credit rating can increase the interest rate even further. Longer deals generally have lower interest rates, but it will cost extra to pay off the loan quicker.
Car finance can come in 4 forms. The first is a type of personal loan, which we mentioned above. The other 3 are specifically for vehicles.
- Hire purchase – Here the loan is secured against the car, which means you can use it while paying the monthly instalments, but you don't own the car until the last payment. If you miss any payments then the car could be repossessed. Some hire purchase plans may require a deposit, and the rest of the cost is covered by monthly payments.
- Personal Contract Plan – A PCP may also require a deposit, and at the end of the deal you can either pay a lump sum to own the car, return the car, or trade it in for another car. As you never own the car during the deal, you won't be able to modify it or sell it, and you have to stick to a mileage limit.
- Lease – A lease involves paying a fixed amount every month to use a car within an agreed mileage, and ends with you returning the car. The monthly cost usually includes maintenance, and the amount will depend on the vehicle.
For more help, have a look at our article on car finance.
A mortgage is a loan normally taken out when you buy a house. It can come from a bank or building society, or else a mortgage broker who finds the best deal for you.
When you apply for a mortgage, the lender will take your credit score, income and expenditure into account, as well as your deposit and the value of the property. They can then decide the terms of the loan – the interest rate you make repayments at, and the length of time you have to repay the mortgage.
A home equity loan is similar to a mortgage in that the equity in your home is used as security or collateral for the loan. They are often referred to as a second mortgage. The equity is the current market value of the property minus your remaining mortgage payments.
The terms generally require good to excellent credit history, and the loan itself normally includes a fixed interest rate and a set repayment period.
A credit card is a way of borrowing money that you repay every month. You are normally charged interest for borrowing the money, but some credit card companies and lenders do promote zero-interest periods. Your credit score and rating can determine what type of credit you can apply for.
Credit cards can also come with various benefits. For example, they offer protection for purchases made with the card, and some cards have the option to consolidate any other debt into one single payment.
A payday loan is a short-term loan, normally with a very high interest rate, that is intended to tide you over until payday. It's important to remember the following points.
- The full amount of the loan owed is taken from the borrower's bank account on repayment day no matter what, which can be dangerous if you require the money for other things.
- Due to the high interest rates, payday loans can lead to even more debt if the balance isn't paid, which can heavily damage your credit rating.
Which loan should I choose?
Whether you're planning to buy a new sofa, a car or a house, with smart shopping around you can find a loan that suits you perfectly. But if you apply without being fully aware of the terms, then you could end up in a debt spiral.
Author: The AA. Published 28 June 2019. Updated 9 November 2023.