How to budget for a personal loan

julia kukiewicz
By Julia Kukiewicz

personal loans interest rates

Personal loans can be one of the cheapest ways to borrow: currently the top deals' interest rates hover around just 4% APR.

But getting the best rate is just one aspect of planning for a personal loan deciding on the amount to borrow and the repayment period means really budgeting for the borrowing.

In this guide, we take a look at how to do that.

How much should you borrow?

Those looking for a personal loan face two initial questions:

The more quickly the loan can be repaid in full and the smaller the amount to be borrowed, the cheaper the borrowing is likely to be.

Right from the start, then, looking for a loan means it's time to get the spreadsheet out and decide on a realistic repayment plan.

Only with the amount and the time period more or less sorted can those looking for personal loans begin to delve into interest rates.

Rates: more is less

In general, the largest loan amounts will attract the lowest interest rates; the banks want to entice consumers to borrow larger sums so that they'll get a larger return from their investment.

However, it's not quite as simple as that.

Rather than increasing in logical steps, there's a big leap from the smallest loans to the sector of the market that runs from £7,000 to £15,000 and then a smaller interest rate increase on loans of more than £15,000.

These amounts represent the loan market's most popular products and, therefore, the area where we see the greatest competition between providers.

For those looking to borrow just under £7,000, that jump from mid-market to market leading can make a big difference.

An example

Amount Interest rate Total cost of borrowing
Loan A £6,000 16.9% APR £1,112 over 24 months
Loan B £7,000 6.9% APR £514 over 24 months

Similarly, those looking to borrow just over about £15,000 could benefit from borrowing slightly less, if possible.

Another example

Amount Interest rate Total cost of borrowing
Loan A £14,000 6.9% APR £996.64 over 24 months
Loan B £15,000 6.9% APR £1,525.44 over 24 months

There are two conclusions we can draw from this.

First, sometimes it actually makes sense to borrow a little more, or save a little more and borrow a little less, in order to take advantage of lower APRs.

Second, for those that only need to borrow a small amount, personal loans actually don't offer the best deals.

Credit cards offer revolving credit which is far more flexible for small amounts and low rate or 0% purchases deals, cardholders can borrow for over a year interest free or at low cost.

Find out more about these deals here.

Budgeting for 'representative' rates

Up until now, we've been talking about advertised interest rates, the ones we look at when comparing personal loans, as if we could satisfactorily know how much will be due in interest.

However, that's not the case because the advertised rates are just representative interest rates.

The actual interest rates that people pay can be a bit different.

In February 2011 the EU's Consumer Credit Directive came into force. Under the legislation, advertised or 'representative' must be available to at least 51% of applicants.

Coupled with the effect of the banking crisis, which has made lenders generally much more risk averse, it means that many applicants will be offered an interest rate higher than the representative rate.

Faced with a higher than expected rate those looking for a personal loan have two options: take on the extra costs or choose not to use the loan and look to borrow elsewhere.

Neither is ideal. Those that make credit agreements at a distance (online, by phone or by post) have a 14-day cooling off period during which time they can cancel the loan after receiving an interest rate that was too high.

However, choosing to do so in order to apply for a new deal can prove a problem because making the first application means that the lender will make a full search of the applicant's file.

Full searches can damage an applicant's standing in the eyes of a creditor while they remain on file.

There is an exception to this: some lenders offer a quotation search service which allows applicants to gauge an idea of the interest rate they'll be offered without having a full search show up on file.

RateSetter are another loan provider who offer a "SmartQuote" service, a loan quote using only a 'soft search' that won't impact a credit score. RateSetter is a peer to peer lender however, meaning you're borrowing from individual savers instead of a bank or building society. Find more on peer to peer in this guide.

Some providers offer another solution: 'rate guarantees'. But beware, these are rarely what they seem.

Overall, then, planning ahead is far preferable.

Taking the fact that rates are representative into account when looking into the market is ideal.

Find more information on budgeting in general in our full guide.

Looking for a loan: the options

Once it's time to start searching, there are a number of options.

Banks and building societies

The obvious answer is also often the cheapest: competition among banks and building societies for new customers means that they offer some of the cheapest borrowing rates around.

Away from the mainstream

Away from the mainstream, local credit unions are also worth checking out, particularly for those who have poor credit.

You can find the unions you're eligible to join through this credit union search and read more in our introduction to credit unions.

Peer to peer lenders also offer personal loans away from the mainstream.

Sites such as Zopa and RateSetter work by hooking up those looking to borrow with lenders, other ordinary consumers looking to make money from interest just as they would with a savings account.

In other words, they're like informal loans between friends and family except that in return for their middleman role they take a fee, though this is sometimes waived or lowered for first time borrowers.

Note that it's particularly worthwhile researching online lenders thoroughly to avoid loan fraud and because of general risks of peer to peer platforms, more details here).

'Consolidation' loan providers

Also away from the mainstream slightly, but in a less good way, is the burgeoning market in loans which combine several debts.

These providers promise those with a number of debts that they can pool them and end up with a "simple, single monthly payment" at a lower interest rate.

However, consolidation providers should be approached with caution since the loan amount, albeit at the low rate, often comes with a fixed number of repayments spread over a very long period.

That can end up being much more expensive overall.

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