Understanding how personal loans work has its financial benefits. Conversely, if you’re not clear about what a personal loan is or how it works before you sign up, it could be a path to financial hardship. Consider this the ultimate beginners guide to short-term personal loan, secured and unsecured personal loans.
Understanding the basics of personal loans
There are a few moving pieces to personal loans that merit some basic explanations. What is a personal loan? How does it work? What is the interest rate offered? What are the different types of loans available and when should you use one? The answers to these questions will aid your understanding of personal loans.
What is a personal loan?
A personal loan is when a person or an organisation, such as a bank (check out African Bank’s Personal Loan offering), lends you a lump sum of money for a small cost (stated in a percentage interest rate). In other words, a personal loan is when a consumer purchases a lump sum of money to make a purchase.
For example, John wishes to do some basic home renovations, but doesn’t have R10 000 saved up to do so. So, he goes and secures a short term personal loan of R10 000 from the bank at the cost of paying back the full amount plus interest over an agreed period of time. The percentage interest is the cost that the bank charges for providing John with the lump sum.
Different types of personal loans and how they work
The term “personal loan” is generic for any type of loan taken out by a consumer. Personal loans are categorised into two different sub-categories, namely secured loans and unsecured loans.
Secured personal loans
A secured personal loan requires a piece of collateral as a form of security in the event that the loan can’t be repaid. In the example above, John takes out a secured loan where an item of considerable value is considered collateral for the R10 000 personal loan. This is an example of a secured loan.
Other types of secured loans include:
- Home loan (bond) – used to purchase real estate
- Any type of motor vehicle loan (car, boat, etc.)
- Home equity loans (aka a second bond) – this is home “refinancing”, using the equity in your home as collateral
- Title loans – used to take out loans against paid off vehicles, i.e. “pawning” your car
Unsecured personal loans
Unsecured personal loans don’t require collateral. Unsecured loans use the consumer’s financial reputation and credit score as proof that the consumer has the financial ability to repay the loan.
A consumer may request an unsecured personal loan from a bank for reasons such as:
- To pay for major life events such as a wedding, a costly vacation, or a funeral
- To pay for home improvements
- To cover education costs
- To consolidate debt into one loan from many smaller loans and credit cards
- To purchase home appliances
- Any other type of larger purchase where the consumer doesn’t have available funds
Personal loans, whether secured or unsecured, have agreed terms set by the money lenders (financial institutions). These terms state the loan repayment amounts, how often these need to be paid and the length of time before the loan is paid back in full. The loan terms also state the interest rates, or cost of the loan, that will be charged.
Steps to consider when taking out a personal loan
When taking out a personal loan, keep in mind the following tips:
- Review your current financial obligations to be sure you can afford the payments
- Compare loans from multiple banks to ensure you obtain the best personal loan interest rate
- Be honest when declaring your income and expenses
- Review the potentially large purchases in the future, which may be affected by the loan, such as a home purchase, wedding, car purchase, etc.
Now you can consider yourself a seasoned expert in the basics of personal loans. Understanding personal loans isn’t rocket science but, as you can see, it helps to know the basics.