What are the different types of loans?

January 14, 2021

Secured, lines of credit, unsecured, guaranteed… there are a whole host of words that are used to describe loans. In this blog we will explain the most common types of loans.

Throughout the blog we will refer to APR, simply put, this is the cost of the loan (the higher the APR the more expensive the loan is),for more details see our blog on APR and interest rates.

Secured Loan

A secured loan is held specifically against something that you own; the item you use to get the loan is called the collateral. You can still make use of the collateral, but if you don’t keep up payments on the loan the lender can take possession of the item and sell it to recover their costs,this is called repossession. No one other than the lender may take ownership of the collateral, even if you go bankrupt and owe lots of companies’ money.

Until they have sold your item you may still have to pay interest on the loan.

Because banks are not experts in selling houses or cars, they may pay a company to sell your item for them. They may also incur legal costs in selling the item.

Once they have sold your item, they will take the money owed to them on the loan and any costs they have incurred. You will receive back any money left, after the lender has recovered the loan and costs. If the sale doesn’t cover the lenders costs, you will have to continue making payments until the loan is paid off.

As there is a higher chance that the lender will get their money back, secured loans are safer for the lender. This means that securedloans often have a lower APRthan non-secured loans.

Often secured loans are used where you take out a loan specifically to buy an expensive item e.g. a car or a house. In fact, a mortgage is a secured loan.

Un-secured loan

Unlike secured loans, unsecured loans are not secured against a specific item. This means that if you don’t pay the loan back the lender can’t just repossess the item to cover the debt. Instead, the lender must take you to court and get the court to order you to pay them back. If you are unable to make repayments, the lender can then appeal to the court to take possession of some of your items. But the lender can’t take any items that you used as collateral in a secured loan, and if you go bankrupt the lender might not get all their money back.

Because un-secured loans are riskier for the lender, they often have a higher APR than secured loans.

Wedding loans, credit cards, holiday loans, and debt consolidation loans are all examples of un-secured loans.

Bad Credit

Bad credit loans are designed for people with poor credit scores. People with poor credit scores are seen by lenders as being at a higher risk of not paying the loan back. Because of this bad credit loans often have a high APR, Uswitch calculates that the average bad credit APR is a whopping 49%! Bad credit loans are often for low values with low monthly repayments.

Bad credit loans can be secured or unsecured.

Pay day loans

People often use credit cards or overdrafts for short term and(relatively) low value borrowing. But people with bad credit scores are often unable to get credit cards or overdrafts, as the lender sees them as being too high risk. As a result, there are companies that specialise in short term low value loans for people with bad credit scores. These loans are often referred to as payday loans, as they are advertised to help you with an unexpected bill until payday comes round.

Because the loan values and terms are short the loan is expensive for the lender to make also because the people are higher risk, there is less chance of the lender getting their money back. As a result they have very high APR’s; the Money Advice Service reports that the Average APR on a payday loan could be up to1,500% compared to 22.8% for the average credit card.

This means that if you borrowed £1,000 and paid it back after a month, you would owe the payday lender a massive £2,250, but if you had used a credit card you would only owe £1,019!

Payday loans are usually unsecured loans.

Guaranteed/co-signed loans

People with bad credit scores often find it hard to get higher value loans for an APR that they can afford. To overcome this, lenders offer a loan where a friend or family member guarantees (or co-signs) the loan.

If the borrower fails to repay the loan the lender can claim back any lost money form the guarantor. In return for the guarantee, the lender will offer the loan at a lower APR than without the guarantor, though still with a higher APR than if the guarantor took out a personal loan.

The borrower is using the guarantors credit score to get abetter APR.

Before acting as a guarantor, you need to be sure that the borrower can afford to make the repayments, or that you are happy to make them if they can’t. You might also want to know what they are using the money for; you might not be happy if you suddenly have to start paying the loan back, but you will be less happy if you found out the loan was spent on something frivolous.

The advantage of this type of loan is that the loan is cheaper for the borrower and if successfully repaid it can help to repair their credit score.

The downsides are:

·        The borrower needs to tell the guarantor about their financial position.

·        The guarantor can become uncontrollably responsible for someone else’s finances.

·        If it goes wrong, it can ruin relationships.

Lines of credit

With most loans you receive the value of the loan in a lumpsum. You then have set monthly payments to make. With a line of credit, the lender authorises you to take money from a pre agreed pot. You pay interest each month on the amount of the pot you have used. You must usually make a minimum payment that covers the interest, and you can then choose how much of the money you have used you want to pay back.

Examples of lines of credit are over drafts and credit cards.

As you only pay interest on the money you have used, lines of credit can be cheap for short term ad hoc items. But due to their flexibility the lender doesn’t know how much you will borrow from one month to the next and because lines of credit are often unsecured, they are often more expensive than personal loans for higher value long term borrowing.

Credit card cash advance

Instead of using your credit card to buy items, you can use it to withdraw money. When you buy an item, lenders assume that you want the item and can afford to pay it back When you borrow money, they wonder why you need the money and if you can afford to pay it back next month. As a result, lenders see this as riskier than when people use their credit card to make purchases and the fee they charge for cash advances is higher than for purchases.

In addition, the lender must pay banking costs to provide you the money and so include an additional charge to cover this.

Finally, interest for cash advances usually starts on day one, whereas for credit cards it usually starts at the end of the billing month.

Pawn shop loans

Pawn shop loans are always secured loans. You provide an item to the pawn shop (electronics, jewellery…) and in return they provide you with a loan. Because second hands goods take time to sell and are not worth as much as new items, the loan they offer will not be the full value of the goods you have pawned.

You will usually have to make monthly payments that at least cover the interest. If you do not keep up the loan payments the pawn shop will sell your goods to cover their costs. Once you have paid back the loan the pawnshop will return your goods to you.

The pro’s of pawn shops are: quick, cheaper loans for bad credit customers (as the loan is secured), and if the item is sold and there is a shortfall you don’t usually have to make further payments.

The con’s of using a porn shop are: the loan won’t equal the full value of the item, and for customers with good credit scores there are cheaper forms of borrowing.