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Last updated on 23rd of February 2022

What Is A Personal Loan?

A personal loan allows you to borrow money to pay for personal expenses and then repay those funds over time.
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Whether you want to borrow money to buy a car, fund home renovations or pay off existing debts, there are lots of reasons you might want to take out a personal loan.

A personal loan can give you fast access to the money you need, but it's important that you understand how they work before taking on this type of debt.

Read on to find out how personal loans work, discover the pros and cons, and learn how to get the best personal loan deal.

How does a personal loan work?

First thing’s first, how does a personal loan work?

Personal loans are a type of credit and you can find them through banks, credit unions and online lenders. 

Personal loans are usually unsecured, meaning you don't have to secure the loan to an asset such as your home or car.

Personal loans can vary from one lender to the next. Each lender has different criteria and terms.

While some are very selective about who they lend money to, others specialise in lending money to people on low incomes or those who've struggled with debt in the past.

What are the different types of personal loans?

So, what are the different types of personal loans and how do they differ? 

While there are many different types of personal loans, they can usually be divided into two categories: secured loans and unsecured loans.

Secured loans

Secured loans are loans that require you to offer up a valuable asset such as your home or car as a security. 

Mortgages and some types of car finance are just two examples of secured loans. If you were to default on a secured loan, this could lead to the repossession of your home, car or whatever asset you attached to the loan.

Unsecured loans

When you take out an unsecured loan, the lender will give you the money you need without the need for security. 

Lenders consider unsecured loans to be riskier than secured loans because if the borrower fails to repay the loan, it may be harder for them to recover the cost. 

For this reason, lenders tend to offer smaller unsecured loans and favour borrowers with good credit scores.

Secured and unsecured loans each have their own pros and cons, so it's wise to compare the two before deciding which is right for you.

What is a personal loan used for?

This type of loan is extremely versatile, but what is a personal loan used for? 

Once you've received your loan, you can usually use the money for anything you wish. 

However, while a personal loan can be a smart financial move in some cases, in others it might not be a wise decision. 

Let's take a look at some of the things you could use your personal loan for, before exploring times it might not be a good idea.

Debt consolidation: If you owe money to a number of creditors and you're spending a lot of money on interest, using a personal loan to consolidate the debt can be a smart move.

Home repairs: Whether your boiler has broken down in the middle of winter or you have a leaky ceiling, a personal loan could help you get the job fixed before the problem escalates. 

Personal loans can be approved fairly quickly, meaning the money could be in your account within a couple of days. 

If you rent, be sure to ask your landlord to fix the problem rather than reaching out to tradespeople yourself. 

It's your landlord's responsibility to repair issues within your home and they'll probably have factored repairs and maintenance costs into the amount they charge you in rent.

If you're a homeowner and have homeowner's insurance, find out if repair costs are covered in these specific circumstances. You may save yourself having to take out a loan.

Home improvements: If you want to have a brand new kitchen fitted or your bathroom is in desperate need of a makeover, a personal loan can help you fund the project. 

For non-essential works, it's a good idea to compare a large number of deals to try and find the best interest rate.

Repaying family or friends: If you've borrowed money from friends or relatives, a personal loan could help you pay them back sooner. 

Before making a loan application, have a conversation with the person who lent you money to find out how quickly they need it back. 

If they don't need the money urgently and can wait a few months, create your own payment plan so they know when they can expect to be repaid. 

This could save you hundreds or even thousands on interest.

Helping a loved one who aren't eligible for credit: If your son is struggling to finance his first car or your mum has had several credit card applications rejected, you may choose to take out a personal loan to help them solve their problem. 

Before doing so, have an honest conversation with your loved one about whether you need the money back or not. 

If non-payment could damage the relationship, avoid getting a loan and help them explore alternatives instead. Avoid putting yourself under unnecessary financial pressure to help someone else.

Weddings: A wedding can be extremely expensive and can take many years to save up for. 

It's no wonder that so many people use personal loans to fund their big day. A personal loan will usually have cheaper interest rates than a credit card, but before going down this route question whether debt will cause stress at the start of your marriage.

Holidays: Some people use personal loans to pay for their holidays, but it's important to be mindful of overspending. 

Just because you have access to a £5,000, £10,000 or even £15,000 loan doesn't mean you should use it to splash out on a luxury holiday. 

Think about how long it'll take to pay back the money and whether those repayments could affect your ability to pay for other holidays in future.

Buying a car: Many people turn to personal loans when looking to buy a car they can't afford to pay for in cash. 

It's worth exploring specialist car finance options before taking out a personal loan. 

You may find that car finance deals offer better interest rates since the debt will be secured against the car. However, car loans tend to require a deposit whereas personal loans don't.

Personal loans can also be used for expensive goods such as computers, jewellery and mattresses.

Some people use them to pay for cosmetic surgery or dental treatment such as braces or Invisalign.

They can also be used to ease the financial burden during difficult periods, for example you could use a loan to cover funeral costs or unexpected vet bills.

What is a personal loan unsuitable for? 

From debt consolidation to home improvements, it’s clear that personal loans can be used for a number of things. But what is a personal loan unsuitable for? 

Avoid using personal loans for the following: 

Student debt: If you live in the UK, using a personal loan to pay off student debt is unlikely to be a smart idea. 

Although student debt can be frustrating, personal loans tend to have higher interest rates and the consequences of non-payment are more severe. UK student loans are designed so that those who cannot afford to repay the debt don't have to. 

Personal loans, however, need to be repaid even if your income falls or you lose your job.

Investing in the stock market: If you're eager to buy stocks with a specific company or you've heard good things about a certain fund, you may feel tempted to use a personal loan to invest. 

However, this is extremely risky and may leave you with nothing. 

The stock market is extremely volatile and there's no guarantee you'll get back what you put in. 

If your stocks were to fall in value (even if it's only temporarily) you may struggle to repay your personal loan on time. 

This could lead to interest, fees and a damaged credit rating. Only invest money you can afford to lose.

How to get the best personal loan deal

So, how can you get the best personal loan deal and save money? Here are a couple of options. 

Compare different deals

To get the best personal loan deal, avoid settling for the first one you see advertised. Instead, make a note of the terms and interest rate before comparing these with alternatives. 

Online comparison tools can be really helpful here. Some will ask for personal details so that their results can be tailored to you.  

Improve your credit score before making an application

Your income and credit history will usually influence the type of loan you have access to. The better your credit score, the more choices you'll have. 

With a good credit score, you'll usually have access to better interest rates too.

Building a good credit score is one of the most effective ways to get the best personal loan deals. 

This isn't an overnight process and it can take months or even years to improve your score, but by managing your existing debts effectively you can prove to lenders that you're a trustworthy borrower.

If you need to borrow money urgently, it might not be possible to improve your score in time.

Avoid any hard credit checks until you’ve found the right loan

Before making an application, look out for lenders willing to carry out a 'soft' credit check to determine your eligibility.

Although you'll be able to see evidence of these soft credit checks when you look at your own credit report, other lenders won't be able to see them. 

If, however, a lender carries out a 'hard' credit check, this will leave a footprint on your file which could deter other lenders who look at your credit report in the near future.

Now you know how to get the best personal loan deal, you can boost your chances of getting accepted and potentially lower the overall cost of your debt.

Next, let’s look at how to qualify for a personal loan.

How to qualify for a personal loan

To qualify for a personal loan, you'll need to be over 18-years-old and a resident of the UK.

You'll need to provide documentation to prove your age and home address. 

Accepted documents usually include a driving licence, passport and recent utility bills.

Lenders will carry out a credit check to assess how effectively you've managed debt in the past. Your credit score is important when applying for a personal loan, but it's not the only thing they're looking for when assessing your eligibility. 

Instead, lenders look at your credit report as a whole. They want reassurance that they'll get their money back.

Lenders will usually have additional criteria and this can vary from one lender to the next. 

While some lenders are very selective when it comes to deciding who to lend money to, others are more flexible and open to providing loans to those who've had difficulties with debt in the past.

If your loan application is rejected, you could approach the three main credit reference agencies (Experian, Equifax, and TransUnion) and ask them for any information which could have caused the lender's decision.

Getting rejected for a personal loan doesn't mean you'll never be able to borrow money. By working hard to improve your credit score and show you can manage debt responsibly, you may be able to get a loan in the future.

What are the pros and cons of personal loans?

Let’s break down the pros and cons of personal loans when compared to other options.

Pros of personal loans

Versatile spending - When you take out a personal loan, you'll usually be able to spend the money on whatever you like.

Lower interest rates than credit cards - If you have a good credit rating, you may be able to access far better interest rates with a personal loan than you would with a credit card.

Higher borrowing limits - If you want to borrow a very large amount of money, a personal loan will probably be more suitable than a credit card. Most lenders offer around £25,000 or less, but some will go higher than this.

No collateral required- If you're applying for an unsecured personal loan, you won't have to use your home, car or another asset as a security. 

If you fail to make repayments, your credit score could be affected and you may have to pay fees/interest, but at least you won't need to worry about losing your home as a direct consequence of your missed payments.

Cons of personal loans

Not always the cheapest option - Although personal loans can be cheaper than credit cards, there are even cheaper options available. 

For example, if you're looking for a way to pay for a new car, some car finance deals can be more cost-effective than unsecured loans. 

Consequences of non-payment can be damaging - If you fail to pay off your loan on time, this can make your finances even harder to manage.

Less payment flexibility - One downside of personal loans is that you cannot change your repayments from one month to the next like you can with credit cards. 

Rather than paying off the minimum and letting the remainder of the balance roll over to the next month, you'll have a fixed amount that needs to be paid each month.

The temptation to spend - As with many other types of debt, personal loans can make it easier to spend money on things we don't really need. 

If you're an overspender or a comfort shopper, a personal loan could lead to a spiral of debt that can be difficult to escape. 

Is a personal loan safe?

Personal loans can be a smart and safe way to borrow money in the right circumstances.

If you've weighed up the pros and cons and a personal loan seems like the best one for you, be sure you can afford the repayments before making an application. Here's what can happen if you default on the loan:

  • You may be charged a fee on missed payments

  • You may be charged interest

  • Your credit score could be affected

If you default on a secured loan, you may lose the possessions that you used as a security.

In severe cases, defaulting on a loan could lead to you being issued with a county court judgement (CCJ) or having to declare yourself bankrupt. 

This is something to be aware of when searching for a personal loan. Specialist services and free debt charities are designed to help you avoid getting to this stage.