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Guide to unsecured and secured loans

When deciding to borrow money, it is important to have a broad overview of the market and know what is available, to make the best possible choice dependent on your circumstances. Overdrafts and credit cards might be suitable for smaller amounts, but when a significant amount of capital is needed, a loan is usually more appropriate.

There are so many different types of loans and providers on the market that it can be difficult to know where to start. However, before starting to compare interest rates and term lengths, it's important to know the differences between secured and unsecured loans first, so you know what you are getting yourself into.

Types of personal loans

Lenders are more likely to offer loans if they have reason to believe that the borrower will repay it. This is what a credit score is for, it reflects how likely someone is to pay back what they owe based on previous behaviour. However, some providers require borrowers to back the loan against an asset, typically a house.

This is more common when borrowing large amounts of money, over £25,000. However, the maximum amount available will depend on the value of the asset being put up as collateral and dependent on how much the lender is willing to let borrow.

Unsecured loans have often been preferred to secured loans because they're often cheaper and they don't need to be asset-backed. The lenders will approve the loan based on income and credit history. However, due to the economic climate they have become much harder to obtain for people without a clean credit history.

Pros and cons

There are advantages and disadvantages to both types of loans, but it's important to know which can offer the best terms on an individual basis.

Secured loans are generally easier to obtain than unsecured loans as the lender has the security of it being asset-backed in the event that it's not repaid. They also tend to offer lower rates of interest and higher levels of borrowing.

Secured loans also tend to have complex terms and there's always the risk of losing the asset. They have however, improved over recent years and are a much more viable option than they used to be.

Unsecured loans are the most common type found on the market; personal loans, student loans and payday loans are all unsecured. For people with a positive credit history and reasonable annual income, they are usually the better option, although they do usually come with higher interest rates.

Applying for a loan

It is important that every aspect of a loan is scrutinised and compared before applying. The advertised interest rate will be a "typical" or "representative" APR, meaning that it's the rate that the majority of applicants have been offered.

However, consumers with less-than-perfect credit histories might be handed a higher rate.

Although the rate of interest is important, the value of the monthly repayment also needs to be taken into consideration. It's possible to reduce the payment, but this could mean more interest is paid in the long term. Therefore, when applying for a loan base the term on the maximum that can be paid each month.

Loan applications require lots of personal information, including address history, employment details, income and so on. It's likely that the applicant will need to show proof of ID too, so don't be surprised if online applications take longer than expected. It is possible for the loan to be approved in principle, but it may take a few days for it to go through and the funds to appear in the account.

Alternatives to loans

A loan is not the only option available to people looking to borrow money. For those wanting to borrow anything up to £5,000, it could be worth looking at a credit card. There are a large number of deals on the market, offering 0% on balance transfers and purchases for six months or more, which could work out cheaper than a loan.

Homeowners needing a loan might want to consider raising funds by remortgaging and releasing some equity from the property. This has been a popular choice for some, but it could incur additional depending on the product.

As with everything in personal finance, there is no straight forward answer as to which method of borrowing is best. It will depend on personal circumstances, but in general unsecured loans are a better option for the vast majority of borrowers.