When it comes to borrowing money, one size certainly does not fit all. To avoid being hit by unexpected fees, it’s important to think carefully about the product you choose when you are looking for credit.

Secured or unsecured?

The main difference is whether credit is secured or unsecured. An example of secured credit is your mortgage, where the loan is backed by an asset—usually your house. If you miss payments, your home is at risk and could be repossessed.

The other type of credit is unsecured. This applies to credit cards, overdrafts, personal loans, payday loans and other forms of short-term credit.

These are not attached to assets so are considered riskier by the lender. There’s always the chance that the customer won’t repay, and therefore, interest rates on these types of loans tend to be higher than mortgages, for example.

If you were to get into financial difficulties, you should prioritise your mortgage repayments over credit card debt.

 

Planning ahead

The key to managing your money effectively is that you have a range of options when you need access to money in a hurry. Unfortunately, the quicker you need it, or the more limited your options are, then the more expensive it is likely to be. 

Ideally, to avoid paying high charges for short-term borrowing, you should have the following measures in place:

  1. Three months’ worth of salary as emergency cash
  2. A low-interest or no-interest credit card
  3. A fee-free authorised overdraft which you have arranged in advance with your own bank.

 

Why your credit rating matters

With both secured and unsecured loans, lenders will do background and credit checks on you before they offer you credit. They do this to assess the risk that you won’t pay back. They will then offer you a personalised deal based on your circumstances and credit history.

Most lenders use one of the credit reference agencies like Experian or Equifax. These companies compile data on your borrowing habits—what credit you already have, how much of it you are using, your repayment history, and how and when you pay it back.

They crunch this data to give you a personal credit score, which is based on your historical credit and borrowing behaviour. It's also an estimate of how likely you are to default on an existing or future loan. Based on this score, they make a decision whether or not to offer you a loan, and if they do, what interest rate they will charge you.

You can improve your credit score by demonstrating that you can use credit wisely. If you are on the electoral register, have a mobile phone contract, mortgage, credit card or personal loan, and keep up with instalments, then your credit rating is likely to be good. As a consequence of this, you are more likely to be offered better credit terms, such as a lower interest rate.

If you have never borrowed you may find it more difficult to get a good deal on credit, even if you have managed your personal finances well and never been in debt. That’s because as far as the lender is concerned, there is no track record to show whether you can pay back or not.

If you need to improve your credit rating you could take out a credit card and use it to make small purchases, in order to demonstrate that you are able to pay back.

 

Why interest charges are personalised

When you see an offer for a personal loan or credit card, it will quote a “typical interest rate”, expressed as an APR or Annual Percentage Rate. The APR describes the interest rate for a whole year (annualised), rather than just a monthly fee or rate. It includes any upfront fees charged by the lender.

The typical rate is the rate which a card company might advertise as available, but it is not necessarily the rate that you will pay. This is because lenders set the actual interest rate according to your credit record and personal circumstances. They are only obliged to offer advertised rates to a percentage of their customers.

 

How loan interest works:

Mortgages:

When you pay back your mortgage loan you usually arrange to pay it back over 25 years. You can choose a shorter term and this would mean monthly interest payments would be higher.

Usually, you pay back a portion of the capital you have borrowed, plus interest. The interest rate is decided by the lender although it can change over time depending on what type of mortgage you take out.

Lenders have different ways of calculating interest—monthly, annually or daily, for example. When you are looking for a mortgage deal, watch out for arrangement fees, early repayment fees and other charges, as these will also affect the amount you pay over the long term.

 

Personal loans

Personal loans are not secured against any asset such as your home.

You can choose how much you want to borrow (although there is usually a minimum amount of £1,000) and how long you need in order pay off the loan. The longer the term, the more interest you are likely to pay. The interest rate on personal loans is usually fixed for the duration of the loan, so you do have some certainty over your repayments.

Although they are convenient, the interest rate can be higher than other forms of lending which are secure, for example, mortgages. You might not get the rate that is being advertised.

 

Credit cards

Credit cards can be good for short-term borrowing, or emergency purchases—for example if the washing machine breaks down or you need to replace your car. However, if you don’t manage them carefully the interest and fees can be high.

Store cards are a form of credit card that you can only use with one high street chain or group. The interest rates tend to be higher, and so you need to think carefully about how you are going to pay off the purchase costs.

Credit card interest is expressed as an APR. There are different APRs for different types of transactions on your card – purchases, balance transfers and cash withdrawals are all likely to attract different rates of interest, so you need to read the small print carefully.

With a traditional credit card, at the end of each month you have to pay off a portion of the debt. If you don’t you’ll be charged a late payment fee and potentially extra interest. It will also affect your credit score.

You can avoid this problem by setting up a direct debit to your credit card provider or lender.

If you go over your agreed credit limit on your credit card, you’ll also have to pay a charge. Most cards also charge you for withdrawing cash, and may add on extra fees for using your card abroad.

 

Overdrafts

If you arrange an overdraft in advance, you can borrow money through your current account. This can help with cashflow but needs to be pre-approved. Unauthorised overdrafts are expensive and the charges can mount up quickly. You might request an overdraft from your bank or your bank might automatically offer you an overdraft and renew it each year.

The overdraft limit is set. Although you can request this to be raised, there is no guarantee your bank will agree. Even if you have an agreed overdraft if you borrow more than the agreed amount you could be charged penalties, which includes interest and a daily or weekly fee.

Make sure you stay within your arranged limit. If you need more credit, you can ask your bank to increase the amount available to borrow. This will probably cost extra, so think carefully about whether you actually need it.

 

Payday loans

A payday loan is a type of short-term borrowing at very high rates of interest. You receive a payment into your bank account and you have to repay the capital and interest in full at the end of the month—or up to three months if you have a longer loan deal.

In recent years the amount of interest and penalties you could potentially pay has been capped, after an outcry over the excessive interest charges on loans that were rolled over month by month.

Even so, these are a very expensive way to borrow. They could also affect your credit rating and your ability to get a mortgage in the future. Many lenders are reluctant to lend to someone who has taken out a payday loan in the past, as they regard it as a sign that you are having financial difficulties.

Think very carefully before choosing one. If you are in a situation where you need money quickly, it could be because you are struggling with cash flow. In that case, you could seek debt help from a free charity rather than taking on more expensive debt. You may qualify for benefits or other financial help which would be a better solution than borrowing more money.

 

Help with debt issues

If you are worried about your finances you can take the debt test on the Money Advice Service’s website.

You can also get help with debt from a number of confidential and free counselling services such as StepChange debt charity.

 

Read more advice from Marianne Curphey

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