Types of borrowing

Start with the basic deal

Borrowing is a simple trade. A lender gives you money now, and you promise to pay it back over time. In return for waiting, and for the risk that you might not pay, the lender charges interest. Interest is the cost of borrowing. It is why £1,000 borrowed almost never means £1,000 repaid.

Say you borrow £1,000 and the interest comes to £120 over the year. You pay back £1,120, and that £120 is what the loan cost you. Borrow the same £1,000 somewhere cheaper and you might pay back £1,060. Same £1,000 in your pocket, very different price.

One rule comes before everything else: you have to be at least 18 to borrow in the UK. Lenders will also check whether they think you will pay them back, which we come to below.

Short-term or long-term

Borrowing is split by how long you take to clear it.

Short-term borrowing is for a year or less. It covers things like credit cards, an arranged overdraft, a small personal loan, and buy now pay later.

Long-term borrowing runs for more than a year, sometimes for decades. It covers hire purchase and PCP for a car, larger personal loans, student loans, and the biggest one most people ever take on: a mortgage for a home.

The longer you borrow for, the smaller each repayment tends to be, because you are spreading the cost. But spreading it out usually means paying more interest in total. Cheaper each month is not the same as cheaper overall.

The price tag: APR

Every borrowing product has a headline price called the APR, the annual percentage rate. It rolls the interest and some of the fees into a single yearly figure, so you can compare two deals fairly. A higher APR means more expensive borrowing.

Here is why the rate matters more than the amount. Put £2,000 on a credit card at a high APR and drag out the repayments, and it can quietly cost you hundreds of pounds. Borrow the same £2,000 as a personal loan at a lower APR over a set term, and it can cost far less. The sum you borrow is only half the story; the rate and the time decide the rest.

You will also see AER, the annual equivalent rate. That is the mirror image, used for savings, where a higher number is good news because it is what they pay you. Interest can be fixed, so it stays the same, or variable, so it can move. Variable rates are influenced by Bank Rate, the rate set by the Bank of England.

Good debt, bad debt (handle with care)

You will hear borrowing split into 'good debt' and 'bad debt'. It is a useful idea, but treat the labels loosely, because no debt is automatically one or the other.

Borrowing tends to look sensible when it is affordable and it pays for something worthwhile that lasts, like training that lifts your earnings, or a home. It tends to cause trouble when it is expensive and it pays for things that are gone almost straight away, like a weekend you are still paying off months later.

The honest test is not the label, it is two questions: can I afford the repayments without struggling, and is this worth paying extra for? The same £500 loan can be a smart move for one person and a millstone for another.

How a lender decides to say yes

A lender is really asking one thing: how likely is it that I get my money back? To judge that, they look at your income (can you afford it), any deposit you are putting down, your credit history (how you have handled borrowing before), how steady your job is, and how much you want to borrow.

If they see you as lower risk, they are more likely to lend, and often at a better rate. If they see you as higher risk, they may say no, or charge more to cover the chance that you do not pay.

Comparing your options

When you choose how to borrow, the headline rate is not the only thing to weigh up. Look at the interest, any fees, the monthly repayment, the length of the term, whether you actually qualify, and whether the loan is secured against something you own.

That last word matters. Secured borrowing is tied to an asset, and if you stop paying, the lender can take it: a mortgage is secured on your home, and a car on finance can be repossessed. Unsecured borrowing is not tied to a specific item, but missing payments still does you real damage.

When it goes wrong

Miss a repayment and several things happen at once. You will usually be charged extra. Your credit history takes a knock, which makes borrowing harder and dearer next time. Keep missing them and, with secured borrowing, you can lose the thing the loan was for: a car repossessed, or in the worst case a home. Rent works the same way; fall far enough behind and you can be evicted.

None of this is meant to scare you off borrowing. It is the reason the affordability question at the start matters so much.

Mortgages up close

Because a mortgage is the biggest loan most people ever take, it is worth understanding a little more.

First, how you pay it back. With a repayment mortgage, each monthly payment chips away at both the interest and the amount you borrowed, so the balance falls over the years and should reach zero by the end of the term. With an interest-only mortgage, you pay just the interest each month, which makes the payments smaller, but the amount you borrowed is still sitting there at the end and has to be repaid some other way.

Then, the type of interest deal. There are four names worth knowing:

When Bank Rate changes, it feeds through to tracker, variable and Standard Variable Rate deals, so those payments can rise or fall. A fixed rate does not move while the fixed period lasts, which is the whole point of it. Two more things shape the deal you are offered: your loan-to-value (the size of the loan compared with the property's value) and the lender's Standard Variable Rate.