Imagine your family needs a car to get to work, but it costs £6,000 and there isn't £6,000 sitting in the bank today. One answer is to borrow the money now and pay it back a bit each month. That is a loan — and almost every adult uses one at some point, from a phone on contract to a house.
Principal and interest
Every loan has two parts you must keep separate in your head:
- Principal — the amount you actually borrow (the £6,000 for the car).
- Interest — the extra you pay the lender for the use of their money, usually shown as a yearly percentage rate.
The total cost of the loan is the principal plus all the interest. That total is always more than the sum you received — that gap is the price of borrowing.
How a loan repays over months
Most loans are paid off in equal monthly instalments. Each payment does two jobs: it chips away at the principal and it pays that month's interest. Early on, more of your payment is interest; later, more of it clears the principal. Slowly the debt shrinks to zero.
The rate matters enormously. A low, tidy rate on a mortgage is a world away from the eye-watering rate on a payday loan, where a small sum borrowed for a few weeks can balloon alarmingly. Two things drive the total you pay: the rate (how much interest per year) and the length (how many months you are charged). Borrow at a fair rate over a sensible time and a loan is a helpful tool; borrow expensively for a long time and it becomes a heavy weight. Whenever a lender shows you a deal, hunt for two numbers: the rate, and the total amount repayable printed at the bottom.
| Loan type | Usually for | Rough length |
|---|---|---|
| Personal loan | Car, furniture, a wedding | 1 to 5 years |
| Car finance | A vehicle | 3 to 5 years |
| Mortgage | Buying a home | 25 to 35 years |
| Student loan | University fees and living costs | Repaid from your salary later |