How to budget for a personal loan

higher interest rates ahead

Personal loans can be one of the cheapest ways to borrow, especially for those who need to borrow large amounts.

But there are a number of things that anyone thinking of taking out a personal loan must consider, from getting the best possible interest rate to carefully deciding the amount to borrow and the repayment period.

Taking all of these things into consideration can help us to budget carefully for borrowing.

In this guide we take a look at how to budget, explain what to check when looking at interest rates and take readers through some of the borrowing options available to them.

Budgeting to borrow

When budgeting to borrow remember that the amount to be repaid comprises both the value of the initial loan and the interest rate applied by the lender to this value.

So those looking for a personal loan face two initial questions:

The smaller the amount borrowed and the shorter the repayment period the cheaper the borrowing is likely to be, because less interest will be incurred.

Interestingly, although interest rates are incredibly low at the moment, July 2017 saw the biggest slow down in consumer borrowing (personal loans, credit cards and overdrafts) since April 2016.

Consumers are facing pressure to budget due to continued negative earnings growth, with inflation continually higher than wage growth, meaning that the average household has less to spend.

This squeeze on our budgets makes it even more important to carefully work out a realistic budget to repay any personal loan.

Interest rates explained

Once the amount to be borrowed has been decided, it's then important to fully understand the interest rate that will be applied to the loan to work out how much will need to be repaid.

In general, the largest loan amounts attract the lowest interest rates - with banks lending up to £50,000. The banks want to entice consumers to borrow larger sums so that they'll get more return from their investment.

However, be aware that finance providers set loan value boundaries that affect the interest rate that is offered.

For example, there's a high rate for small loans of up to £7,000, a slightly lower rate for loans that run 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 interest rate competition between providers.

Below are a couple of examples to illustrate this point. These examples use APR interest rates.

An APR - which stands for annual percentage rate - is the total annual amount that will be paid on top of the original loan value. As such it covers the interest rate applied and any other charges and fees.

Example one

For those looking to borrow just under £7,000, it could actually be worth borrowing just over £7,000 to benefit from the lower interest rate.

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

Example two

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

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 a few conclusions we can draw from this:

For anyone who wants to borrow less than £5,000, credit cards are often a better option than a personal loan.

Unlike personal loans, which have a fixed repayment period, credit cards offer revolving credit - there are not a fixed number of payments in which the credit must be repaid - which is far more flexible for low value borrowing.

There are also lots of low rate or 0% purchase deals that cardholders can use to borrow relatively small amounts, usually for over a year.

For example, the cards below allow interest free borrowing for several months:

0% on PurchasesRewards
post office money matchedPost Office Money Matched
0% for 30 mths
None
Representative example: When you spend £1,200 at a purchase rate of 18.9% p.a. (variable), your representative APR will be 18.9% APR (variable).
Post Office Credit Cards are provided by Bank of Ireland UK. Post Office Limited is a credit broker and not a lender.
post office money platinumPost Office Money Platinum
0% for 28 mths
None
Representative example: When you spend £1,200 at a purchase rate of 18.9% p.a. (variable), your representative APR will be 18.9% APR (variable).
Post Office Credit Cards are provided by Bank of Ireland UK. Post Office Limited is a credit broker and not a lender.
tsb platinum purchaseTSB Platinum Purchase
0% for 20 mths
Get 1% cashback on the first £500 eligible spend per month
Representative example: When you spend £1,200 at a purchase rate of 18.94% p.a. (variable), your representative APR will be 18.9% APR (variable).

While these cards offer low interest rates for sustained periods of time:

Balance TransferTransfer Fee
lloyds bank platinum low rate credit cardLloyds Bank Platinum Low Rate Credit Card5.69% p.a. life of balance
0%
Representative example: When you spend £1,200 at a purchase rate of 5.69% p.a. (variable), your representative APR will be 5.7% APR (variable).
low rateLow Rate6.45% p.a. life of balance
0%
Representative example: When you spend £1,200 at a purchase rate of 6.45% p.a. (variable), your representative APR will be 6.4% APR (variable).
clear rate platinumClear Rate Platinum6.9% p.a. life of balance
No fee
Representative example: When you spend £1,200 at a purchase rate of 6.9% p.a. (variable), with a £24 annual fee, your representative APR will be 11.1% APR (variable).

For more deals like these visit here. There's also more information on the cheapest credit card deals in this guide.

Budget for representative rates

When lenders advertise an interest rate we use this as a basis to compare personal loans.

However, it's important to remember that advertised rates are just representative interest rates; the actual interest rate that people pay can be a different amount.

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

This means that, based on an assessment of an individual applicant by the lender, they may decide to offer the applicant a personal loan but not at the advertised or representative rate.

Higher risk applicants will usually be offered the loan at a higher rate of interest than the representative figure.

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

Neither option is ideal. Anyone who takes out a personal loan has a 14-day cooling off period during which they can decide to cancel the loan if they receive an interest rate that is too high. They can then decide to apply for a different loan.

However, each application requires a full credit search on an applicant's file, and applying for two loans in quick succession is damaging. There's more on credit ratings in this guide.

There is an exception to this: some lenders offer a quotation search service that applies a soft search. These searches allow applicants to gauge an idea of the interest rate they'll be offered without having a full application search show up on their file.

For example, RateSetter is a loan provider that offers a "SmartQuote" service which only applies a soft search on an applicant's credit file. RateSetter is a peer-to-peer lender - there's more on this kind of lending below.

Some providers offer another solution in the form of 'rate guarantees'. This is a tool used by some lenders to attract borrowers with a promise that their rate cannot be beaten. But beware; these are rarely what they seem.

All in all, it's vital to take into account the vagaries involved in personal loan interest rates, remembering that interest rates are representative and are not a guaranteed figure for everyone.

It's important to budget for the interest rate applied to a personal loan, as well as repaying the capital. Find more information on budgeting in general in our full guide.

Looking for a loan: the options

For anyone who has decided to take out a personal loan and has worked out how much they need to borrow and over what period they want to repay it, it's time to start searching.

There are a number of options available in the personal loan market.

Banks and building societies

The obvious answer is to apply for a personal loan at a bank or building society.

This option 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.

Find out more information on banks and building societies here.

Credit unions

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

Local credit unions can be found through this credit union search and there's lots of information available in our introduction to credit unions.

Peer-to-peer lenders

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

Peer-to-peer lenders operate on websites such as Zopa and RateSetter. They match those wishing to borrow with savers who are willing to put money aside for the long-term. The savers' money is used as loans for those who wish to borrow.

By cutting out the middleman - the bank or building society - the savers get a better interest rate than the mainstream can offer and borrowers get a lower rate of interest on their loans.

The websites themselves usually take a fee, although this is sometimes waived or reduced for first time borrowers.

There's more on peer-to-peer lending in this guide.

It's worth knowing about the risks involved in this kind of lending - more details here. Also, it's worthwhile to research online lenders thoroughly to avoid loan fraud.

'Consolidation' loan providers

For people who have a number of different debts that they wish to pay off, there is the option to consolidate.

Here providers combine each individual debt a person has through a loan that covers the total amount. This allows them to treat all of the different debts as one large debt that can be paid off with a single monthly payment at a low interest rate.

This is appealing to some people because rather than paying off lots of different debts with lots of different interest rates - which can be confusing - the debt is simplified to one amount with one interest rate.

However, this only makes sense if the total consolidated loan amount being repaid isn't actually more than the original repayment amount of all the individual debt - no matter how confusing paying for a number of different debts can be.

This can trip people up because consolidation providers often offer loans with a fixed number of repayments spread over a very long period of time.

Spreading repayments over a long period means that people pay more interest on the value of the loan and therefore end up spending more.

Ideally, for people with multiple debts, taking out a new loan is not always the best option - even if it is taken out solely to pay off existing debts.


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