For many borrowers obtaining credit can be a confusing process: they can be unsure of both the options available and which particular credit product may be the right one for them. This website aims to help borrowers by explaining the different types of credit available, the types of lender that offer credit, and some of the principle that underlie borrowing and lending.
Basic Credit Concepts
There are a number of basic credit concepts that must be understood by anyone attempting to acquire consumer credit. When a person or organisation takes on credit, they are known as a borrower, and they acquire debt: this is the amount of money they owe, which in most circumstances must be repaid. This debt does not always stay the same: interest is often added as a charge for borrowing, which means the debt taken on increases over time.
The person or organisation that offers credit is known as a lender; when offering money, each lender will decide on whether to lend, and on the interest rate they will offer, by looking at the borrower’s credit rating: this is a measure that judges how reliable the borrower might be by assessing their past credit history. They may also offer payment protection insurance which can help borrowers maintain payments during periods of unemployment or illness.
Once credit has been gained, it is usually paid into one or more of the borrower’s bank accounts; a good knowledge of how they work is vital if the borrower is to manage their debt effectively.
There are a wide variety of lenders that offer credit to consumers. Banks and building societies are traditional lenders that provide a wide variety of products, but there are also a number of specialist lenders. Credit unions, for instance, are local organisations owned by members that offer savings accounts and loans to people in their area. Peer to peer lenders and payday loan companies are both online lenders, but there are big differences between them: the former bypass financial institutions by allowing individuals to lend to each other, while the latter offer very high interest rate loans over short periods to those that might have difficulty getting credit from other sources. There are also a number of traditional money lenders such as pawnbrokers, doorstep lenders and loan sharks still in existence, but the latter especially should be avoided as they are illegal, and are known to treat clients badly.
Loans are one of the most popular types of credit, and there is a wide range available. Personal loans are those aimed at private individuals, and they can be split into two types: secured loans (which are secured by collateral such as property) and unsecured loans.
However, there are many sub-types of personal loans. Those needing quick credit can apply for payday loans, same day loans or short term loans, while those needing to build up their credit rating can apply for bad credit loans; if they are really struggling with debt they can apply for debt consolidation loans. Many of these are available on the World Wide Web as online loans, as are peer to peer loans: these are loans that are offered by other individuals rather than financial institutions.
There are also loans offered for specific reasons. Car loans are used for buying motor vehicles, while logbook loans are a way of obtaining credit by using vehicles as collateral. Student loans, on the other hand, are for students wishing to study at university, and business loans are targeted at the business community.
Whichever loan a borrower takes up, it is important they take account of any attached loan charges, as these will give an idea of the total cost of the loan. Using a loan calculator is a good way of finding how much a loan will cost.
Credit cards are another popular means of obtaining credit; they allow users to buy goods and services and pay for them later, as well as withdraw money via cash advances and pay for goods over the phone or the Internet via card not present transactions.
Holders of credit cards receive monthly credit card statements that allow them to keep track of their accounts (including any credit card charges levied) and then make payments to ensure the debt is paid off or does not get out of control. Credit card users can also use balance transfers to switch money between cards: this is usually done when interest free credit cards become available as without interest being charged the cardholder can pay off their debt more quickly.
Aside from standard credit cards, there are various specialist types available. Store cards, for instance, are issued by shops to allow customers to obtain goods on credit from them alone. Cash back credit cards give cash rewards to their users, while prepaid credit cards allow people to make credit card payments using money they have already paid onto the card (thus avoiding any possibility of late payment charges). There are also credit cards for bad credit, which have high interest rates but allow customers that run their accounts well to build up their credit rating.
If a borrower wishes to buy a house, a mortgage is essential unless they can pay cash up front.
There are two basic mortgages: repayment mortgages, in which the borrower pays off the loan and interest at the same time, and interest only mortgages, in which borrower pays the interest on the mortgage but must find a separate way to pay the loan at the end of the mortgage if he or she wishes to own the property. The latter type is often linked with endowment mortgages, which involve the buyer paying into an investment plan that will hopefully pay off the mortgage when it matures.
Other mortgages are generally variations of repayment mortgages. Fixed rate mortgages have a fixed, unmoving mortgage rate for at least a part of the mortgage, while the interest rate in variable rate mortgages moves depending on a number of variables. Tracker mortgages closely track the Bank of England base rate, but capped rate mortgages cannot go above a certain level. Offset mortgages are slightly different than the previous examples: they work in conjunction with savings accounts, with mortgage payments being lessened by a sum related to the amount saved.
In addition, there are a number of mortgages aimed at specific sections of the market. Buy to let mortgages are aimed at landlords that wish to rent out properties, while first time buyer mortgages are for those just climbing onto the property ladder. Self build mortgages, on the other hand, are targeted at those wishing to build their own home, and commercial mortgages are for those buying property for their business.
For those wishing to buy property with others, joint mortgages are appropriate; if, however, a person doesn’t have the funds for home buying but also doesn’t have anyone to buy with then one of the shared ownership mortgages available may be suitable: they allow people to buy in conjunction with housing associations or similar organisations.
Mortgages can also serve as a way of refinancing. Remortgaging, for example, involves replacing the borrower’s current mortgage with a new one, hopefully one that has lower repayments. Second mortgages, on the other hand, allow people to take out loans against their property while the first mortgage is being repaid, while reverse mortgages allow those that have paid for their properties to borrow against them to give a regular income. This can be especially useful for pensioners.
Whatever type of mortgage a person has, they will have to pay attention to a number of factors. Mortgage rates represent the interest paid on any mortgage, with mortgage fees being the additional charges mortgage lenders or mortgage brokers may add to any deal to cover necessary overheads. Sometimes it is difficult to determine how much a mortgage will cost after all these costs are added together, in which case it is a good idea to use a mortgage calculator to find a total.
If the borrower gets through all this and pays off their mortgage they will have reached mortgage redemption, when they should finally own their property outright. If they have had difficulties, however, they could suffer mortgage repossession: this is when the lender cancels the mortgage and takes back the property, however much has been paid on it.
If they need short term credit, holders of bank accounts may apply for an overdraft, which allows them to take money out of their account after the balance has reached zero, up to any agreed overdraft limit.
Overdrafts may be split into two types: authorised overdrafts and unauthorised overdrafts. Both come with overdraft charges, but the ones for the latter will be greater as the overdraft will not have been agreed with the credit provider. Overdraft rates – the amount of interest charged on the overdraft – will be greater for the latter type also.
In addition to standard overdrafts, there are ones targeted at certain sectors of the market: student overdrafts are for those studying at university, while business overdrafts are for companies and small businesses.
It is essential that anyone thinking of taking on credit becomes familiar with the best principles of debt management; if they do not they may get into financial difficulty. Those with relatively mild debt problems may benefit from debt consolidation, a reorganisation that merges debts so that there are fewer payments to keep track of. If things are more serious, however, borrowers should seek free debt advice from one of the many charities or government bodies that offer it: they have a long record of formulating effective debt management plans for their clients, and do not charge for the service unlike profit-seeking debt management companies.
For those in real trouble, however, a more serious option may be called for. Individual Voluntary Agreements and Debt Relief Orders are respectively semi-formal and formal ways of keeping creditors at bay, but if no solution can be found then bankruptcy may have to be considered. Here, debts are wiped after a given period, but the debtor will find it extremely difficult to obtain credit in the future.