What are Personal Loans and how do they work?

2 January 2017

What are Personal Loans and how do they work?

personal finance

What is a personal loan and how does it work? If you’re considering applying for a personal loan, here’s a quick summary of the key things you need to know.

Why take a personal loan?

When you take out a personal loan, you’re effectively borrowing money from a lender, such as AA Finance. There are a number of reasons you may need access to cash. They range from planned costs like weddings, holidays and debt consolidation, through to unexpected expenses like medical bills and household repairs.

Your application for a personal loan will usually be successful if you have a good credit history and can demonstrate your ability to repay your loan.

Credit history

Your credit history demonstrates whether you’re able to borrow money responsibly and keep to the terms of a financial agreement. A good credit history gives a finance provider confidence that you will stick to the terms of the personal loan contract. A poor credit history, or no credit history (if you haven’t borrowed money before) can make it more challenging to borrow.

Debt-to-income ratio

You can demonstrate your ability to repay your personal loan by sharing information about your income and expenses. This information allows a personal loan provider to review your debt-to-income ratio. Effectively this is how much money you have left to repay your debt after taking living expenses and existing debt payments off your income.

The personal loan agreement

When you enter into a personal loan agreement you commit to repaying the loan as agreed by yourself and the finance provider. Your personal loan contract will include details about the interest rate you will be charged, the value of your repayments and their frequency, and the term of the contract (i.e. how long you’ll be making payments for).

Interest rates

The interest rate is how the loan provider charges you for borrowing their money. Most personal loans have a fixed interest rate that is agreed before the loan contract is signed.

Interest is calculated based on how much money you owe at a given time. This means the faster you pay off the loan, the less you pay in interest. Interest rates can vary from provider to provider but are not the only way that lenders can charge. Try out our loan repayments calculator to estimate repayments on Personal Loans from AA Finance based on current interest rates.

Borrowers are also often charged documentation or loan set-up fees. It’s definitely worthwhile exploring all the fees associated with your personal loan before you sign on the dotted line.

Repayment rates

You can choose to repay a personal loan quickly in higher instalments, or you can spread the debt over a longer period with smaller individual repayments. How you structure the length of your loan and repayment level will depend on your preference and what the personal loan provider will allow. Remember the longer you take to pay off your loan, the more you’ll be charged in interest.

Your financial position

It’s not uncommon for your financial situation to change before you’ve paid your loan off in full. Especially if your loan has a longer term, i.e. over more than a year. With more funds available you might want to increase your repayment rate or pay the loan off in full before the end of the loan agreement. That’s why it’s important to be aware of whether your provider charges you for that flexibility before you commit to a loan. Many loan providers include early repayment fees and charges in their loan agreements.

Similarly, it’s worthwhile understanding what you’ll do if you experience a financial setback that could stop you being able to make a payment. If you lose your job or experience a drop in income, it’s important to contact your loan provider straight away. Failure to meet your repayment obligations can affect your credit record and your ability to borrow in the future.

Loan security

In many cases, personal loans offer unsecured debt. That means the provider has no specified way of recovering the money you borrow if you fail to repay it. If security is applied to a loan, it’s usually in the form of a single item or a group of items that are worth the same amount as the loan and can be sold if you consistently fail to make repayments. Security simply gives the lender a way of recovering their funds should you fail to keep to the loan agreement.

Choosing a personal loan that works for you is about finding a balance between convenience and cost, and being clear what’s important to you. Remember the interest rate level is not the only deciding factor; you also need to review the provider’s flexibility around repayment levels, their loan charges and fees, and understand how quickly they will let you pay off your loan.

If you would like to know more about personal loans, contact the team at AA Finance on 0800 600 888 or visit our Personal Loans page for general info.

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Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure the content is correct, the information provided is subject to continuous change. Please use your discretion and seek independent guidance before making any decisions based on the information provided in this article.

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