People have been using loans as a way of funding large purchases ever since money was invented. There have been times when borrowing money was frowned on as irresponsible, because it made borrowers look as if they were bad at financial planning, or impatient to own things they could not afford. Being in debt was considered to be a very bad thing and was often looked on very harshly by the law, especially if borrowers fell behind in their payments. This attitude was perfectly illustrated in the existence throughout Victorian Britain of debtors’ prisons.
We live in more enlightened times today. In the same way that businesses throughout the ages have borrowed to fund their growth and individuals have bought homes with mortgage loans, we now tend to accept that it can be hard to live without some form of debt. After the second world war the credit card was invented in the USA and soon reached these shores. With one stroke personal debt became acceptable and since then the availability of credit in the form of loans has become widespread and easily accessible.
Here are some figures to illustrate the size of the loan market
Borrowing is not just a matter of what individuals need, it is a massive business.
Although there are more lenders around than ever before offering all kinds of different amounts, terms and conditions there are essentially two types of loan, secured and unsecured. They both have advantages and disadvantages so if you’re thinking of applying for a loan, we hope this brief guide will help you to decide which is the best option for you.
It’s important to understand this description because people often misunderstand its meaning. It sounds very reassuring, the word ‘secured’ making it appear to be a particularly safe way of borrowing. Unfortunately this isn’t the meaning at all.
A secured loan is a loan that is secured on something valuable. ‘Secured’ here means that the lender is guaranteed to get their money back because if the borrower stops making repayments the lender can take the valuable asset instead and sell it. This is how mortgages work and why secured loans are often called homeowner loans. When you agree a mortgage loan with a bank or building society to buy a property, you are giving them a right to take ownership of that property if you stop paying them back. That’s why the lender needs to be included in the paperwork and why they will insist that you take out insurance to protect the building: if it burns down uninsured then you are not the only person who loses out.
Secured loans aren’t confined to property purchases. It’s very common in business for a company to borrow in order to buy expensive equipment, which is mortgaged to the lender. In the same way, if the company defaults on the loan, the lender can seize, or repossess the equipment, or whichever asset was used to secure the loan.
The security for the loan is also known as collateral and even for consumer borrowing it doesn’t have to be a house that is offered as collateral. Any possession of significant value can be used. Secured loans are the only realistic way for individuals to borrow very large amounts. Because the lender has the security of knowing that their money is safe, they are able to offer relatively low interest rates. Even so, the lender will take into account your financial circumstances, your credit rating and, thanks to relatively recent developments in banking guidelines, how affordable the repayments will be for you.
These are most commonly known as personal loans and they are very popular with consumers who need to borrow smaller amounts. Most unsecured loans are for between £1,000 and £25,000, although you’ll tend to get the lowest interest rates if you borrow between £7,500 and £15,000.
As the name suggests, these are loans that are given without any kind of collateral. People can borrow for all kinds of reasons: to buy a car, carry out home improvements, pay for a wedding – anything that falls into this price range. The fact that they are unsecured means that lenders will probably lend only to people who have a good or fair credit rating, because the lack of security makes the loan riskier than a secured one. Because you don’t have to put anything up for security, they are much more straightforward although interest rates will be higher.
These are the main advantages of a secured loan. Firstly, if you need to borrow a substantial sum of money a secured loan is really the only way of doing this.
Secondly, the security aspect means that lenders are more relaxed about whom they lend to, which means even people with a poor credit history can take out a secured loan. Their history is outweighed by the value of the asset which the lender can take in the event of payment default.
Thirdly, most secured loans offer a much longer repayment period. This means you can spread the cost over decades rather than years, which relieves a lot of the pressure of borrowing and enables you to fit your repayments into a long-established routine. Mortgage loans used to last for about 25 years on average but lenders have extended their maximum periods so that it is now possible to get a mortgage terms of 40 years. Increasing life expectancy and longer working lives have made this not only possible but also necessary.
Fourthly, the combination of the security and the repayment term means that secured loans tend to be offered at low rates of interest. Since 2009, the Bank of England base rate has been lower than at any time in its history. Lenders are independent of the Bank of England but they generally peg their secured loan interest rates only a couple of percentage points above the base rate. For years, borrowers have been paying back their loans at little more than 2% a year. Of course, when the base rate rises, it will increase everyone’s repayments, but secured loan rates will always stay lower than those of unsecured loans.
As for unsecured loans, perhaps the most obvious advantage is that you don’t have to put up any security or collateral. Your lender has no claim over anything you own and nothing is at risk. Another benefit is flexibility. With a personal loan you can usually choose the repayment term within the limits which the lender offers. Secured loans tend to be for a minimum of five years. In contrast, most unsecured loans will last for up to five years but can be as short as one, if you choose. Because every repayment includes interest, the longer you take to repay the loan, the more you will pay overall. However, a longer repayment period means each payment will be that much smaller.
You will usually be able to pay off an unsecured loan early without significant penalties for early settlement. If you suddenly find your finances have improved, you may decide to cut the loan short and avoid paying any more interest by paying the full amount outstanding. If you do this very early in the term, you might have to pay something for the privilege, but after a fairly short time you should be able to clear the debt without incurring extra costs.
As the advertisements always say: ‘your home is at risk if you do not keep up repayments on a mortgage or other loan secured on it’. Lenders don’t want to repossess your home, partly because it is more complicated for them to get their money back if they then have to sell your home themselves. However, if you fall seriously behind with payments – perhaps six months or more – they may decide that the risk is getting too great and they have no option.
Repossession is a terrible experience which everyone would rather avoid, and many people decide to sell before the decision is taken out of their hands. Even if the lender does repossess and sell your home, they are only entitled to take from the proceeds the amount you still owe plus any costs they’ve incurred in the repossession and sale. Unless your outstanding debt was huge you will at least see something back. This is small comfort of course, but is worth remembering.
The other main disadvantage of a secured loan is that it can only be used for a specified purpose. Your lender will want to know exactly where the money is going and will need proof and guarantees. If they discover that you have used even some of the borrowed money for some other purpose, they will be entitled to end the agreement on the grounds that you re in breach of its terms. That’s a sure route to repossession.
As we’ve already seen, an unsecured loan tends to be for relatively small amounts, which is fine unless you want to buy a house or a yacht. The interest rates will tend to be higher than those of secured loans. Even when the Bank of England’s base rate was 0.1 % the average personal loan rate was 7.4%  and as the base rate rises this will quickly reach double figures.
Although personal loans are flexible when you set them up, allowing you to choose the repayment term, once they are in force there is very little opportunity to vary any of the terms. With a long-term secured loan many lenders will be prepared to renegotiate certain terms and even offer payment holidays. This is unlikely in the case of an unsecured loan.
These are matters that you will probably have had time to think about before committing to a loan but there is one issue that is not often talked about, and that is what happens if you fail to keep up repayments on a personal loan. There is no security so you have nothing to lose, right?
Unfortunately this is not true. Say for example you used a personal loan to buy a car and it turns out you were sold an unsafe second-hand vehicle that you have to write off. You must still pay off the loan. The lender has no interest in what you used the money for so the debt survives the loss of the car. Although the lender has no security, there is a series of legal steps they can take to recover the money, none of which are pleasant for the borrower.
Your debt may be handed or sold to a debt collection agency who will be very energetic in their attempts to get the money you owe. Court action can follow with a possible county court judgment against you which could end up with an attachment of earnings order, whereby money is taken at source from your salary to pay off the debt. Your credit rating will be badly affected and the consequences of default could stay with you for many years.
We hope we’ve made clear the differences between the two types of loan and the upsides and downsides of each. The fact is that borrowing money is a serious business that always entails some level of risk. But if you understand what you are taking on, and what could happen if things go wrong, then there is absolutely no reason why you should not safely use a loan to bring the otherwise unaffordable within your reach.
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