The Beginner’s Guide to Borrowing Money
Paying for university in cash? Buying a car or home outright? If you’re like most people in the UK, you’ll likely have to borrow money at some point in your life. Borrowing money often coincides with exciting moments in your life—starting university, buying your first car, moving into your first flat, or even looking into buying a home. However, it can also be associated with stressful periods, like unexpected medical expenses or car repairs.
As you start to look into borrowing money, understanding your options and the benefits and drawbacks of each method is vital for having a positive borrowing experience, regardless of what you need the money for. The truth is, there are as many different options for borrowing money as there are reasons for borrowing money, and it’s easy to get overwhelmed by it all. Here, we’ll cover everything you need to know to get started borrowing while making sure that your finances aren’t damaged along the way.
How Does Borrowing Money Impact Your Credit Score?
Before we get into methods for borrowing money, it’s vital to understand how borrowing money will impact you and your credit score. A good credit score makes the process of borrowing money, making major purchases in life, and accessing the best interest rates and borrowing terms much easier.
Borrowing money can affect your credit score in a positive or negative way depending on how you manage the entire process. Let’s take a look at how this happens:
Can Borrowing Money Help Your Credit Score?
Yes! Borrowing money and managing the process in a responsible manner can give your credit score a lift by:
- Improving your payment history: Payment history is one of the largest factors impacting your credit score. Lenders and credit agencies will look at how you’ve managed debt and bills in the past to assess your trustworthiness. Borrowing money and making payments on time and in full helps your credit score increase over time.
- Reducing your credit utilisation ratio: Maintaining a low credit utilisation ratio will help you improve your credit score. Your credit utilisation ratio is a percentage of how much of your available credit you are currently using, and it’s best to use 30% or less of the credit that’s available to you. For example, if you have a credit card with a credit limit of £1,500, try to use no more than 30% (or £450) before paying it off. When you open a new credit line, you increase the total amount of credit available to you, and if you maintain a low use of that credit, you can reduce your utilisation ratio.
Can Borrowing Money Harm Your Credit Score?
Yes. Borrowing money without responsible financial habits can harm your credit score by:
- Pushing you deeper into debt: Borrowing more money than you’re able to repay and taking out multiple loans means taking on more debt. Missing payments, defaulting on accounts and applying for multiple lines of credit too quickly can impact your credit score negatively.
- Recording a hard credit check on your credit report: When you apply for a loan, credit card, or other types of financial products, lenders sometimes pull a hard credit check to assess your creditworthiness. This has a small, yet negative impact on your credit score. While your credit score will recover in time from a single hard credit check, pulling multiple hard checks in a short space of time signals to lenders that you may be in urgent need of credit, and therefore in financial distress. This can lower your credit score and make it more difficult for you to access financial products.
What Are The Most Common Types of Borrowing?
With so many different types of financial products, determining the right way to borrow has never been more important. Finding the right type of loan or credit card depends on factors such as:
- How much money you need
- Your financial history and credit score
- How long you’ll need before repaying the money
- When you can start repayments
Let’s take a look at some of the most common types of loans, along with the benefits and disadvantages of each.
Unsecured Personal Loans
An unsecured personal loan is a loan for a fixed amount, usually between £1,000 and £25,000, which you repay in instalments over a set period of time. This allows you to develop a proper plan and map out how you will make repayments.
- Advantages of a personal loan:
- Unsecured personal loans allow you to borrow money without putting up any collateral as security against the loan
- Repayment terms for unsecured personal loans are more advantageous for the borrower. You can pay the loan back over the course of a year or terms as long as 60 months.
- Disadvantages of personal loans:
- The interest rates tend to be higher, and more advantageous interest rates are reserved for borrowers with high credit scores.
- The repayment term needs to be balanced for your particular needs. If it’s too short, you could burden yourself with high monthly payments, but if it’s too long, you could end up paying more due to excessive interest on the loan.
Credit Builder Loans
Credit builder loans are designed for people who want to build their credit score up from scratch or repair a damaged credit score. A credit builder loan is quite different from a typical personal loan. Once approved for a credit builder loan, the lender puts the borrowed funds into a lender held bank account. It’s not possible to access this account until you have repaid the loan and any interest charged because it’s for the sole purpose of building credit. At the same time, your payments will be reported to credit reference agencies, building your credit score. Once the loan is paid in full, you receive your money back in a lump sum.
- Benefits of credit builder loans:
- The lender will ideally report your payments to the three major credit bureaus, helping to improve your credit score (although this can vary by lender, so make sure to verify this when applying)
- Lenders return the total balance (sometimes including the interest paid) at the end of the term
- If you deposit the sum to your savings account after you’ve repaid it, you can use credit builder loans to build your savings and credit score simultaneously.
- Drawbacks of credit builder loans:
- In some cases, you will owe the lender interest on the loan and certain lenders may require a fee to open an account
- You may be charged fees and have penalties applied if you want to stop payments early
- Because a credit builder loan’s primary purpose is to build your credit, it doesn’t give you quick access to funds the way other types of borrowing can
A credit card is a revolving line of credit that you can use to effectively borrow money at any time, up to the credit limit. Credit cards can be unsecured or secured, but unsecured credit cards are more common.
- Credit card advantages:
- Credit cards are ideal for quickly borrowing
- They offer the flexibility to be repaid over the course of several months (although paying your balance in full each period is best for your credit score)
- Making timely payments will positively contribute to your credit score
- Credit card disadvantages:
- Missing multiple payments or using too much of your credit limit can be detrimental to your credit score—penalties and fees for these errors can be more costly than you’d suspect.
- While there are numerous credit card options available regardless of your credit score or history, the interest rate and the amount you are approved for will depend on your credit history and can vary from lender to lender.
Where Should You Borrow Money From?
With so many borrowing options available, it’s natural to not know where to turn. However, some of the best and most reputable lending institutions are high street banks and credit unions, so let’s take a closer look at what each offers, alternatives, and other financial products that are best to keep a safe distance from.
High Street Banks
When you’re looking to borrow money for the first time, weighing your options with the most prominent national banks in the UK is a great place to begin. Start by comparing borrowing options with HSBC, Lloyds Banking Group, Barclays, and Royal Bank of Scotland.
If you’ve just wrapped up university and you’re borrowing money for the first time, the process can definitely be intimidating, as you might not be familiar with all the terms and services available. If you’ve had a savings account with a bank, looking into borrowing options with that institution can also be a good place to start. Consider scheduling time with a loan officer at your bank who can get a better feeling for what your needs are and what type of borrowing product would be the best fit for your situation and needs.
Common ways to borrow money at big banks include:
- Credit cards
- Personal loans
- Arranged overdrafts
If you’re just starting out building your credit or don’t have a long credit history, try not to get discouraged if you don’t qualify for a big bank’s loan products right away. Building credit takes time, but putting in the work and building credit the right way will make borrowing money easier in the future.
Credit unions are a fantastic source to borrow money from if you are just starting out building credit or want to repair your credit. Credit unions are financial cooperative organisations that serve local communities and run on a ‘not for profit’ basis. Simply put, credit unions are owned and operated by their members. As they’re not incentivized by profit like traditional banks, credit unions are able to offer their members in the form of lower interest rates and personal services. Credit unions also operate in the interests of their members by ensuring that their members don’t take out loans they can’t afford, and generally being advocates for financial wellness.
Credit unions offer similar services to the big banks when it comes to borrowing money:
- Auto loans
- Revolving credit lines
- Credit cards
One of the major benefits of credit unions is that they’re often willing to take your personal circumstances into account when evaluating your eligibility for a loan or credit card. This means that if you’re just starting to build your credit, a credit union might be a better place to begin than a bank.
To learn more about credit unions, visit the Association of British Credit Unions.
Alternative Methods of Borrowing Money
While high street banks and credit unions are some of the more well-known sources for borrowing, they’re not the only ones. Here, we’ll look at two other options—and their respective benefits and drawbacks.
Using Your Overdraft Account
Overdrafts allow you to borrow money from your bank or building society, giving you access to more funds than you have in your current account. There are two types of overdrafts: arranged (authorised) overdrafts and unarranged (unauthorised) overdrafts. An arranged overdraft occurs when your bank or building society has agreed to let you overdraw your account to a certain limit, and an unarranged overdraft occurs when you haven’t made that agreement with your bank, but overdraw your account anyway. Here, we’re referring only to arranged overdrafts.
Arranged overdrafts allow you to cover expenses if you’re tight on money at the end of a month, but it’s important to remember that overdrafts are a form of credit, and you should always borrow with caution. With interest rates for overdrafts sitting around 40%, it’s vital that you pay your overdraft back as soon as possible because interest can accrue quickly, leaving you to pay back much more than you borrowed.
Overdrafts are definitely a type of borrowing that has a mix of benefits and disadvantages. It’s worth understanding these differences so you can fully consider whether to use your overdraft to borrow money.
Arranged overdraft accounts have benefits such as:
- Flexibility to quickly use additional funds in an emergency or between paychecks.
- Immediate access to funds
- Potentially improving your credit score if you use it sparingly, stay within your overdraft limits, and make timely repayments
But overdrafts also have their disadvantages including:
- Higher interest rates compared to many other forms of credit, such as credit cards or personal loans
- Not being universally offered by all banks resulting in,frozen current accounts or unnecessary fees
- Harming your credit score due to missing repayments
If you haven’t established an arranged overdraft with your bank, it’s worth doing, as it can help you out in a pinch and even has the potential to help build your credit score.
Borrowing Money From Friends or Family
Although you might not think of it as such, borrowing money from friends or family is one of the most common forms of borrowing, with a third of Brits claiming to lend to their relatives.
However, when money and family or friends are mixed, it can lead to strained relationships. Therefore, it’s wise to go beyond a handshake and a verbal agreement when borrowing from family or friends and take the time to set up formal agreements and expectations.
If you’re borrowing from a friend or family member, a good way to put their mind at ease is to draw up an agreement to make the loan terms legally binding. By filling out a free loan template, you can give your friend or loved one a sense of security, demonstrate your respect and appreciation for their generosity, and show that you're serious about paying them back.
Done properly, borrowing money from friends or family can have some benefits such as:
- No eligibility checks or requirements
- Flexible repayment periods
- No or extremely-low interest rates
However, borrowing money from the people you know and love also has drawbacks:
- Because your repayments aren’t being reported to a credit reference agency, your credit score won’t benefit from timely payments and won’t show a payment history for the borrowed money
- Borrowing money from people who are close to you could damage the relationship if things don’t work out as you hoped
- If your relative or friend charges interest, it can lead to tax complications for them
Types of Borrowing You Should Avoid
Finally, it’s important to understand that not all borrowing is created equally, and some methods of borrowing money can be full of risk. Let’s take a quick look at two of these methods:
Payday loans are small loans with the purpose of filling financial gaps ahead of your next paycheck. They’re meant to be paid off immediately, but it can be difficult to do so because these predatory loans have astonishingly high interest rates, with the median interest rate sitting around 1,300%.
These interest rates make payday loans an incredibly expensive way to borrow money, as you usually end up paying back over 1.5 times the amount you borrowed to begin with. This means that if you’re borrowing money to tide yourself over until your next paycheck, you could be doing yourself a disservice, as a significant part of your next paycheck will have to be spent repaying the loan.
Buy Now, Pay Later Services
Buy now, pay later (BNPL) services have become increasingly popular over the last half decade. These point-of-sale loan providers allow consumers to purchase items like clothing and delay payments or break payments into smaller pieces. However, they come with their fair share of risks:
- BNPL service can make your budget inflexible: With so many payments to keep track of each month, buy now, pay later services can make it difficult to adjust to unexpected expenses
- Potential to impact your borrowing ability: Some BNPL services like Klarna have begun reporting customer payments and borrowing to credit reference agencies. If a lender checks your credit report and sees that you have outstanding payments for a BNPL service, it could impact their decision on whether to lend to you
- Missed payments can have serious consequences: While some BNPL services advertise no interest or late fees, there can still be serious consequences for missed payments. In fact, delinquent payments could lead to a collections account being placed on your credit report—a negative mark that will stay there for seven years
Frequently Asked Questions About Borrowing Money
Borrowing money is a complex topic, and even an in-depth guide like this can leave you with valid questions about the borrowing process. Let’s dig deeper into a couple common questions about borrowing money.
Can You Borrow Money Interest-Free?
Yes, there are options available to borrow money interest-free, but many of these options are temporary. This is because interest payments are the main source of revenue for banks or lenders.
The most common way to borrow money interest-free is by taking advantage of an interest-free introductory period with a credit card or 0% balance-transfer card. These short-term introductory offers are tied to some credit card offerings, and can allow you to borrow on the credit card interest free for a certain period of time.
However, keep in mind that like we mentioned, interest is the main source of revenue for banks. Therefore, these interest-free periods are only offered because banks and lenders assume that you won’t pay off your balance before the interest-free period expires. Therefore, be as careful as ever before you begin borrowing using one of these interest-free methods, and establish a concrete plan for making payments so you don’t find yourself stuck paying off expensive interest.
How Long Does it Take to Complete a Loan Application?
Most loan applications take around 15-60 minutes to complete, depending on the type of documentation you need to provide. Once you’re approved for a loan, here's how long you'll have to wait to see the funds in your account:
- Big Bank Loans: Usually funded within two business days for existing customers and two to five days for new customers. Being an existing customer is very helpful because you have already gone through the longer processes including background and credit checks. Keep in mind that traditional banks will generally have higher interest rates than credit unions.
- Credit Union Loans: Turnaround at a credit union usually takes one to five business days, but this assumes that you’re already a member of the credit union. Most credit unions in the UK require you to be a member before applying for a loan.
How Long Does it Take to Get Approved for a Loan?
Loan approvals have largely been automated in today's world. Most banks will use an algorithm to determine whether you're a suitable borrower, making the loan approval process much quicker. Most loans only take a few hours to a few days to get approved, but the type of loan and lender can impact approval times.
Unsecured loans can be approved in hours, whereas secured loans or mortgage loans can take up to a few weeks, since the loan is secured against your asset(s), meaning more time is needed to determine the value of the assets.
While the efficiency of the modern loan approval process can be helpful for people with established credit, it can make things difficult if you’re still building and establishing your credit. If this sounds like you, consider looking into a credit union, where you may be able to have an individual review your circumstances and application before making an approval decision.
Build Your Credit to Qualify for Better Borrowing Options
There’s no shortage of choices when it comes to borrowing money. It’s easy to become overwhelmed when reviewing the numerous options available, especially if it’s your first time borrowing, but despite all that, our final piece of advice remains the same: take a deep breath and focus on the long-term. Building credit, borrowing money, and achieving your goals won’t happen overnight, but with persistence, you can get there in time.
Finally, don’t forget that you’re not alone in your journey to borrow money and build your credit score. If you get stuck or aren’t sure what steps to take next, don’t hesitate to ask for help. Most banks and credit unions have resources and staff available to offer expert financial advice specific to your unique circumstances. Plus, there are numerous government resources at your disposal and many other tools to help you reach your goals.
One of the best tools for reaching your financial tools is Pave—an app that helps you build your credit, giving you the assistance you need to qualify for better financial products and borrowing options. By reporting your payments to credit reference agencies, monitoring your bills and bank accounts, and delivering personalised credit fixes, Pave offers a fresh way to improve your credit and financial literacy without taking on any debt. To see Pave in action, download the app from the App Store or Google Play today.