What is a Loan?

What is a loan? A loan is a sum of money that is borrowed and paid back over time. Loans are typically repaid to the creditor in monthly instalments over an agreed period. As well as paying back the principal, monthly instalments will also contain interest at a predetermined rate. Depending on the size of the principal, a borrower may need to provide some form of security such as a guarantor and/or evidence of assets.

Examples of loans

In the UK, loans generally come in two main forms. These are personal loans and business loans. Both loans can be further subdivided into smaller categories. For example, the category of personal loans includes student loans, car loans and mortgages.

The category of business loans includes working-capital loans, asset financing and invoice financing. Bonds are also, effectively, business loans. The mechanics of bonds, however, work differently from the mechanics of regular loans.

Why are loans used?

In the consumer world, personal loans are generally used to finance purchases a consumer would not otherwise have been able to afford, such as a house or car.

Loans may also be used to pay for:

• household repairs or home improvements
• vehicle repairs
• weddings
• holidays

Personal loans can also be used for debt consolidation.

Business loans

In the business world, loans tend to be used to finance growth. This allows a company to grow more quickly than it could have done just using its own income. Company owners may prefer borrowing to getting investment as it allows them to retain full control over their company.

Some businesses may also use loans simply to establish a credit history. As they repay the loan, they improve their credit rating. Over time, their credit score will increase. This will make it easier for them to get financing at a decent interest rate if they ever actually need it.

Should I take out a loan?

A loan is a relatively long-term commitment that will have an ongoing effect on your household or business finances. Furthermore, the act of applying for a loan can have a significant short-term impact on your credit score. Before applying for a loan, you should consider:

• Whether you can comfortably afford the repayments

• Whether you can improve your credit score to access the best interest rates

• Your likelihood of being accepted the first time around. Because a loan application involves a hard credit check, multiple applications can negatively impact your credit score

Loans versus other forms of credit

Loans are one of several forms of credit available to consumers and businesses alike. Here, we compare loans to similar forms of credit.

Revolving credit

A loan is a specific sum of money lent for an agreed period of time. Most loans have a regular repayment schedule. In the UK, monthly repayments are standard.

Revolving credit is an agreement that a creditor will make a certain amount of credit available to a borrower. The borrower may or may not access this credit. If they do access the credit, they can borrow as little or as much as they wish up to their credit limit.

The borrower’s monthly payments depend on the amount borrowed in that particular month (and the interest rate). They will go on indefinitely unless the borrower or the creditor decides to cancel the arrangement.

Two common examples of revolving lines of credit are overdrafts and credit cards. Both are available to consumers and businesses. Businesses may also be able to access business lines of credit.

Instalment plans

Instalment plans are loans that meet specific criteria defined by the FCA. In particular, they can only be for a maximum of 12 instalments over a maximum of 12 months. They can be shortened but not extended (or renewed) and they cannot include any interest or charges.

As long as these criteria are met, instalment plans can be offered without explicit FCA authorisation. The main implication of this is that businesses can offer their customers the option to pay for goods/services by instalment. This includes business customers (i.e. B2B transactions).

Bonds

Bonds are essentially a form of peer-to-peer lending. They work very similarly to crowdfunding. Businesses define how much money they need and for how long. They set out the interest rate they are willing to pay. They may also set out minimum and maximum limits for creditors.

As with loan rates, the interest rates for bonds will reflect the going market rates for that type of debt. The business’ perceived reliability will also be taken into consideration. For example, potential creditors will probably want to know the company’s credit score and income.

Find out more about business credit vs. personal credit.

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Loans FAQs

What is early settlement?

Early settlement is when a borrower exceeds their monthly repayments and pays off the loan earlier than the agreed final repayment date. They may make monthly overpayments or make a single lump sum payment. This means that the borrower pays less interest, although creditors will often charge a fee for early settlement.

How do I apply for a loan?

Most creditors will allow you to apply for a loan in-branch, over the phone or online, and a decision can be made almost instantaneously. In order to increase your chances of a successful outcome, you should have the following documentation to support your application:

• Proof of current and previous addresses
• Proof of employment or earnings
• Your bank details
• Personal information and ID

What happens if I can’t repay my loan?

If you are unable to cover the cost of a loan repayment, this may result in your account falling into arrears. This may result in your having to pay more interest and/or make larger monthly repayments in the future. Furthermore, your credit score may be negatively affected. If multiple repayments are missed, this may result in the debt being transferred to a collection agency which will result in additional fees and charges.

This is why it is so important to ensure that your budget will allow for your monthly repayments. If you are unable to cover this cost, inform your creditor as soon as possible as they may be able to help you find an outcome with minimal damage to your finances and credit score.