An unsecured loan is one of the simplest types of debt.
This is where a bank, building society or other lender gives you up to £25,000 which must be paid back over a set period of time with a fixed interest rate.
Unsecured loans are usually available to repay for between three and ten years, with payments made once a month.
The term ‘unsecured’ refers to the fact the lender usually cannot use your home as its security if you miss payments.
In other words, you won’t lose your home in most cases if you fall behind. This is very different to a mortgage or secured loan where your property is at risk.
An unsecured loan does not provide a cast-iron guarantee, however. In exceptional circumstances, banks and building societies have been known to ask a court to force you to sell your home to free up cash to repay a debt, but this is very rare.
When choosing an unsecured loan, don’t just consider the rate itself as this won’t tell you the cost in pounds and pence.
Ensure you weigh up exactly how much the loan will cost by asking for the total cost of credit, which is the cost of the interest. Even on the same rate, the total cost can rise dramatically when paid off over a longer period.
To highlight the real cost of a typical rate, say you borrow £5,000 at 10% annual interest over three years, it will cost roughly £808 in interest, meaning you pay back £5,808, at £161 a month. Over five years it will cost £1,307 in interest, at £106 a month.
When choosing a loan, the advertised rates are only “typical”, which means lenders only need to offer them to two thirds of those accepted. By definition, one third will pay more, so be prepared, especially if you don’t have the best credit history.
To get the lowest rate you often need to have a decent credit score. Therefore, those who have missed debt repayments or have excessive amounts of debt may not qualify for the best rates.
An unsecured loan, when rates are low, is usually the cheapest way to borrow money from a mainstream lender over a three to ten year period. However, it is not necessarily the cheapest type of borrowing over shorter periods.
It is possible to use a credit card to borrow money cheaply as many offer 0% interest on purchases or balance transfers (plus a one-off 3% fee of the amount transferred) for between a year and 18 months.
If you spend £3,000 on a 0% purchase card then the interest cost is nothing for the length of the offer. If you transfer the same amount the fee will be up to £90, still much cheaper than the interest on any unsecured loan during the offer period.
However, the risk is you do not get the available credit required on a credit card as criteria is often a lot stricter than on an unsecured loan.
Over a longer period, loans are generally a better option because even those with good credit scores can get rejected for credit cards or not get the desired limit which could leave you stuck once your 0% period ends and the debt reverts to standard rates of up to 20%.
Some people borrow extra on their mortgage, though this usually has to be paid over a much longer period meaning interest costs can be high.