Everything You Need to Know About Small Loans (A Complete Guide)
Borrowing money in the form of a small loan can be used for almost anything: emergencies, healthcare, home improvements, debt consolidation, big one-off purchases, unexpected bills.
Before you take out a loan, first read how they work, what they cost and what borrowers should consider before they apply for a loan.
In this guide, we’ll cover:
- How loans work and what type of loans are available
- What the costs are for borrowing and understanding APR
- How to repay your loan and the impact a loan has on credit scores
Let’s get started!
How do small loans work?
If a borrower applies for a loan and is approved by the lender, they will transfer the money directly into the applying borrower’s bank account.
Borrower’s then pay back the loan, usually every month, until the balance is cleared. Borrowers should decide how long they need to repay the loan before they apply.
With the majority of loans, borrowers can decide to spread their payments over one month to five years, with some allowing borrowers to repay more quickly to save them money, or spread their payments over a more extended period. Loans that are repaid lower than one year are generally known as short-term loans. More than a year are long-term loans or personal loans.
What types of small loans are there?
There are several different types of loan, so which loan is best?
Well, they all fall into one of two categories:
- Secured loans are tied to an asset a borrower owns like their property (house, car, business). They usually are far more considerable sums and repaid over longer periods
- Unsecured loans are not directly tied to any of the borrower’s belongings. They are used when people wish to borrow smaller amounts and generally last between one and five years
Unsecured loans can also be broken down into various types, most notably short-term loans, payday loans and personal loans. Other terminology borrowers will hear are the following:
- Payday loans are loans with extremely high-interest payments. It is a short-term loan that is offered through a business and not a bank
- Short-term loans are scheduled to be repaid in less than a year. Typically with a high-interest rate
- Debt consolidation loans are a new loan to pay off existing debts. Effectively multiple debts are combined into a single, larger debt, usually with better repayment terms like lower monthly repayments and a lower interest rate
- Instalment loans are a loan that is repaid over time with a set number of scheduled payments; until the loan is repaid in full
- Same day loans is a loan where an applicant applies for a loan, receive a decision and if approved receives the money transfer all on the same day
- Fast cash loans are a loan that applicants can apply to receive funds into their account directly and quickly, being typically processed within one hour.
Where can you get a loan?
Loans are not only available at major banks or high street financial institutions. People can apply for small loans everywhere, including:
- banks & building societies
- credit unions
- peer to peer borrowing websites
- short-term lenders (payday loan companies)
Who can borrow a loan?
Borrowers must be 18 or over to apply for a loan in the UK because this is the minimum age people are legally permitted to borrow money. Plus, borrowers must be:
- a UK resident
- proof of their address
- have a regular income
- accept to having their credit report checked
- able to repay a loan
How much can people borrow in a loan?
With most loan types, borrowers could borrow between £100 and £25,000, however, some do offer smaller amounts or much more substantial sums (like a homeowner loan or mortgage).
- smaller loans tend to be over shorter periods, usually a year or less
- larger loans typically last at least three years but can be anywhere up to 25 years
The best rates for personal loans are in the £7,500 to £15,000 range, with loan costs being around 3-9%. Anything over that amount tends to command interest rates of around 10%.
For smaller loans, the average interest rate is typically classified by the Financial Conduct Authority of being over 100%. Although many exceed this amount.
UK consumer debt is estimated at £200 billion according to the ratings agency Standard & Poor’s. Yet this amount contains mortgage debt which will always be a substantially high amount.
- The average debt of a Briton without mortgage debt (loans and credit) is £8,000 per person.
- First-time mortgage buyers were aged 30
- 5.4 million short-term loans were made in 2018
- The average payday loan amount was £250, with £100 the most borrowed amount
- The average age of those taking a payday loan is 25-30
What’s the cost of taking out a loan?
Interest in the form of a percentage is how lenders determine the cost of borrowing money, and this amount is added to the loan a borrower repays in addition to the initial loan amount. The interest is typically calculated as an annual percentage as if the borrower repaid the amount over one year.
Interest rates are either variable or fixed. Fixed rates remain static during the loan agreement, whereas variable interest rates move both up and down, being tied to a benchmark rate; thus can fluctuate.
Lenders must display their interest rates annually, and this is known as the Annual Percentage Rate (APR). The APR must include all the regular costs of obtaining a loan, including any other applicable fees charged by the lender.
Lenders then display a representative APR before people apply for one of their loans. Representative APR is the interest rate that at least 51% of successful applicants must receive when they apply for a loan from the lender.
The lender could offer the remaining applicants a higher interest rate. Meaning that borrowers may not receive the advertised representative APR when they applied for a loan.
What other fees are included?
Most lenders charge borrowers interest (APR) when borrowers take out a loan and is the amount of money a borrower owes for the duration of their loan.
Some lenders, however, also charge additional fees to the interest rate, including but not exclusively to:
- broker fees
- additional fees for transferring funds faster
- missed or late payment fees
- payment protection insurance
How are loans repaid?
With most loans, borrowers pay back the same amount each month because the interest rate is usually fixed for the loan’s duration. Repayments generally are the agreed amount (depending on the lending term and amount borrowed) and the accrued interest as per the interest rate offered by the lender in the borrower’s application.
Most payments are made by either standing orders or direct debits that promise to repay the lender on a specific day each month.
Short-term loans are also usually repaid through monthly instalments, though some can be paid back on a weekly basis or in bulk at the end of the month after a borrower’s salary has been paid to them.
Repayments are managed through direct debits, standing orders or what is known as a Continuous Payment Authority (CPA). CPAs permit lenders to automatically collect the monies they are owed on scheduled repayment dates from a specified account as listed in the borrower’s application.
How do loans impact credit scores?
Another critical element in a creditworthiness assessment (especially when taking out short-term loans) is an affordability risk. An affordability risk is characterised as whether the borrower will not only fail to make repayments but will borrowing from the lender cause them to sink into significant further financial debt. In other words, will borrowing from the lender make their financial situation worse.
Whenever a borrower applies for credit, a lender will examine the applicant’s credit report to receive an overview of his or her credit history. Customer credit reports contain their payment history, current accounts, outstanding debts, credit inquiries, name, addresses, date of birth, any bankruptcies or county court judgements, and other details like whether the applicant is on the electoral register.
All this information is utilised by lenders to assess a borrower’s loan suitability, and whether there is a likelihood that they will default on repaying a loan – their creditworthiness.
Taking a small loan, or any form of credit should never be a quick and unresearched decision. Failure to repay an unsecured loan, will result in additional interest and late fees added to the loan, and worse, make it harder to repay the balance owed. Should borrowers fail to repay the amount, then the lender can apply to have a county court judgement or bankruptcy made against the borrower.