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Thursday 28th July 2022
What it's all about?
This article's designed to help you:
There’s a fair bit of confusion over the subject of credit and loans. When you’re in need of some extra cash, it’s tempting to lump all your various options together – but it’s usually a mistake not to think your choice through carefully. Let’s start by talking about what we mean by ‘credit’. Credit actually comes in 8 basic flavours, so we’ll take them one at a time.
Trade credit is what you’ll tend to see when businesses deal with each other. The ‘customer’ business agrees to pay later for goods or services the ‘supplier’ business provides now. The credit terms offered will usually depend on the relationship between the firms. So, for instance, the agreement might be based on the financial situation of the borrower. If the businesses know each other pretty well, then the rules might factor that in too, although larger companies will often have set credit terms they offer to pretty much all their customers.
With consumer credit, we’re talking about the kind of thing you’re most likely to run into on the average high street. This is where the customer is allowed to delay the cost until a later date for any goods, services or even money they’re given now. There’s typically some kind of charge for this.
Consumer credit deals are the kind of thing you tend to see with ‘hire purchase’ agreements, vehicle finance, credit insurance or personal loans. The consumer can be offered the deal based on how ‘credit-worthy’ they are – basically just meaning how likely the business thinks they are to be able to afford the repayments. The rules are usually pretty much standardised for those who qualify. A fairly typical example of a consumer credit deal is an ‘equated monthly instalment’ agreement, where you pay back a set monthly amount to cover the overall cost (plus interest). Another common example is an overdraft facility on a bank account.
Bank credit is similar to consumer credit in a lot of ways. The bank offers the chance to pay back what you owe in stages, with terms depending on your financial position. The bank will look at things like your statements and the value of any assets you own, which are often used as ‘security’ in the agreement.
As for what you actually get with a bank credit deal, we’re talking about anything from a mortgage or housing loan to a cash credit facility. Letters of credit (where a bank backs your payment to a seller), bank guarantees and discounted bills of exchange (where a bank basically buys a debt at a discounted rate) are also broadly lumped under the bank credit category.
Revolving credit includes things like standard credit card arrangements. You can keep borrowing cash on an ongoing basis, up to an agreed limit, making repayments as you go to bring down the overall amount. Along the way, the debt will tend to stack up interest, which you’ll obviously need to keep on top of to avoid hitting your overall limit even if you don’t keep borrowing more. As long as the customer keeps their end up, the deal basically continues until it gets closed.
Instalment credit is another system where you make fixed, regular repayments against the amount you’ve borrowed. Your bank or finance company sets the terms and lays out the kind of interest you’ll be racking up on what you owe. You’ll probably find yourself facing penalty charges if you don’t keep up the agreed repayments, but unlike a revolving credit deal you’ll have a clear plan in front of you for paying up. In fact, many people use instalment credit agreement as a way of ‘consolidating’ other debts into a single, simple repayment plan.
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The open credit system’s kind of a mixture of instalment and revolving credit plans. They’re broadly grouped under the good old ‘buy now pay later’ category. The borrower gets to make multiple withdrawals up to a predetermined limit, only stacking up interest on the amount they’ve actually borrowed. On a monthly schedule, the borrower gets a statement of what they owe, paying it off to keep the scheme going. You often see this kind of credit arrangement with things like phone and energy bills. You use what you need now, then pay up later.
This is where things can get a little sticky. In a mutual credit agreement, borrowers and lenders can trade with each other without any actual money changing hands. It’s like a network where people or businesses can work together without needing to keep a lot of cash on hand. Confused yet? Picture this: Business A offers its products or services to a trusted network. Instead of money, it gets ‘credit’ within that network, which it can use to buy things from other members without using conventional money. Unlike other kinds of credit or loans, any ‘debts’ within the network don’t get fattened up by interest. Also, since the value of the credits in your account is agreed across the whole network, any debts can be settled in cash or other equivalent means.
Lawyers and accountants are pretty good examples of service credit, when they only charge once the case is over or the paperwork’s finished. By doing the work up-front, they’re essentially offering their customers a line of credit for the duration of the job. Sometimes that means paying up what’s owed at fixed intervals, if the work is ongoing. If you don’t keep up the payments, though, the service gets cut off.
There are actually a lot of commonplace service credit deals that we don’t tend to think about. Again, telephone and utility bills can be put into this category if you’re on a scheme where you pay in arrears for what you’ve actually used.
Now we'll take a look at the 8 main kinds of loan.
Personal loans are your general, all-purpose deals where the lender doesn’t care all that much what you need the cash for. They’re useful for handling expensive one-off costs like improvements around your home or blow-out weddings. Depending on your situation and how much you’re borrowing, you’ll often find you don’t need to ‘secure’ your loan against big things like your house. You’ll still need to keep up your agreed repayments, though, and factor in the interest rate you’re ramping up. This kind of loan can take months or even years to pay off, so you really do have to keep both eyes open when you dive into one.
Again, this is a very common type of loan that most people have at least heard of. Unlike a personal loan, the cash you’re borrowing is earmarked for a specific purchase, so you’ll find yourself dealing with some extra rules and considerations. For one thing, your vehicle loan will almost certainly be secured against the vehicle you’re buying. That means if you don’t keep up your end of the deal, you’ll stand to lose the car itself. You might not have to borrow the full amount the vehicle costs, of course. If you’ve already made any down payments against the value, those will bring down the loan amount you need.
As with other types of loan, you’ll probably be making repayments for years to come. In fact, as car prices continue to grow, vehicle loan terms are extending along with them.
Student loans can either come from the main Student Loans Company or a separate, private lender. In fact, it’s perfectly possible to have both at once, if you qualify for them. Agreements from the Student Loans Company tend to be more common, though, since they’ve got specialised features like income-dependent repayment plans and even ‘forgiveness’ in certain circumstances. Like other types of lending, student loans from a private lender will usually involve getting credit-checked to make sure you’re a safe bet for the company, and the terms you’re offered (repayment plans, interest rates, fees, etc.) will depend on the lender.
Like a vehicle loan, a mortgage agreement is designed to cover the cost of the place you’re buying, minus any down payments or deposits you’ve already paid out. Another thing a mortgage shares with a vehicle loan is that the property itself is considered ‘collateral’ for the deal. If you can’t keep up the payments, you’ll lose your home to ‘foreclosure’ proceedings.
A mortgage is probably the single biggest debt you’ll ever shoulder in your life, with common payment terms easily hitting anything from 10 to 30 years. As with other loan varieties, you’ll be making regular interest payments along the way, which may be fixed throughout the mortgage’s entire lifespan or vary up or down over time.
Home equity loans and home equity lines of credit (HELOCs) are another kind of general agreement where you don’t need to use the cash for any pre-arranged purpose. The twist with these ‘second mortgage’ types of deal is that they let you borrow up to a given percentage of your ‘equity’ in your own home (meaning how much of its cost you’ve paid off).
A basic home equity loan comes as a lump sum, which you pay back like a normal instalment loan. The terms will probably stretch out over 5 to 30 years, depending on what you’re borrowing. With a HELOC agreement, on the other hand, you’re signing up to more of a revolving credit arrangement. You can draw cash out up to a set limit as you need it, and only pay interest on what you’ve actually taken out. 20 years is standard for a HELOC plan. While a home equity loan will have a predetermined interest rate, HELOCs generally have variable ones.
Of course, all these different kinds of loan aren’t much use if you don’t have a strong credit history to fall back on. That’s where credit builder loans come in. These agreements are built to put much-needed financing within the reach of people who couldn’t otherwise access them. The system works by the lender paying the amount to be borrowed into a savings account. The borrower then makes monthly repayments at a fixed rate for anything between 6 months and 2 years. Once the loan’s repaid, the borrower gets the cash back, possibly with some interest on top.
Why is this useful? Well, a credit builder loan is less about getting some up-front cash than it is about building up your overall credit rating. If you’ve only got a limited credit history, signing up to this kind of deal is a decent way to boost your score and make other lenders take you seriously, by establishing a track record of sticking to a repayment schedule. Of course, to make this work you need to be sure your lender’s reporting the deal to the organisations that track your credit score.
We talked a bit about these earlier, but at heart a debt consolidation loan is just a way of getting other high-interest debts under control. Instead of making monthly payments to a collection of lenders, you take out a single loan to pay them all off at once. Once those other debts are settled, you’ll be left with only a single loan to clear – hopefully at a lower interest rate than you were paying before.
Debt consolidation loans can be great for people struggling with expensive debts like credit card balances. Depending on your situation and lender, you might end up with a fixed or variable interest rate to deal with, but clearing credit cards and other loans can seriously boost your credit score, simplify your monthly finances and potentially save you a lot of cash overall.
Sitting at the opposite end of the scale from decades-spanning deals like mortgages, payday loans are short-term agreements for much smaller amounts of money (usually £1,000 or less). You can get them from specialised websites or high street firms, and they do a good job of making it easy to get the emergency cash you need right now. The interest rates are eye-watering, though, despite the various safeguards that have been set up to protect you. You should never have to pay back more than twice what you borrowed, for instance.
Before taking out a payday loan, it really is worth considering your other options. They might seem like an easy way to get you through a tight financial pinch, but they can throw up a few red flags in terms of the actual value they offer.
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