Why it's important to understand what you're borrowing

Whenever you borrow money, whether it’s a loan, credit card, or any other form of credit, it’s really important that you make sure you only borrow an amount that you can comfortably afford to pay back.

When you take out any form of credit, you’ll sign a credit agreement with the lender which sets out the repayments you’ll need to make on time and in full. But if you borrow more than you can afford, you might not be able to stick to the terms of the agreement - which can have serious, negative consequences.

You might not be able to pay the full amount on the date it’s due, or even miss a payment altogether. Late fees and extra interest may be charged, meaning that your debt grows. It’s a dangerous situation to get into and can cause you stress as well as increasing the time it takes to clear your borrowing as well as the cost.

What’s more, a string of missed payments or even defaults will damage your credit score, making it difficult to borrow any money for years to come. Bad credit can remain on your credit file for six years, telling anyone who searches your credit file that you’ve struggled with your finances, and they may be reluctant to lend to you as a result.

How lending works

When you borrow money, you need to pay it all back plus interest. With any form of credit, the lender must tell you the rate of interest, typically as an APR.

APR stands for Annual Percentage Rate, and it gives you an at-a-glance view of how much the debt will cost overall, taking into account the interest and any additional charges that you might have to pay. The APR can also allow you to compare credit from different lenders and of different types.

For example mortgages may have APR’s of 5% or similar, whilst credit cards can have APR’s in excess of 30%. This is because mortgages are secured, reducing the lenders risk and are designed to be repaid over a very long period. Credit cards, on the other hand, are designed to be paid off in full each month.

Most credit will be repaid gradually over a “term”, typically in monthly instalments of an amount that you agree with the lender. The ‘term’ is the amount of time that you agreed to pay the money back over. This varies depending on the type of credit you borrow, and can range from weeks to years.

There are quite a few different types of lending which all work in different ways, but the basics don’t vary too much between them. You borrow money, then repay it over a term along with the interest the lender charges.

Interest is the lenders “reward” for the risk they are taking in making the loan. The higher the risk, the higher the rate of interest the lender will charge. The risk involved can depend upon a number of factors, including your credit score and the type of credit involved.

For instance, a second mortgage uses your property as collateral, so if you are unable to repay the loan the lender can repossess the property to recover the costs. A credit card is unsecured and the rate will be much higher as a result. The loan term for a second mortgage can also be much longer than for an unsecond mortgage, for example, and can range from 5 to 25 years.

The interest that you’ll have to pay on a loan or credit card also varies and different lenders have their own rates that they charge. There isn’t one single rate of borrowing, and how much it costs will depend on the type of credit you take out and the lender you borrow from.

The consequences of not keeping up with repayments

If you borrow money, you need to make sure that you’ll be able to pay it all back, plus any interest or charges that might be applied. Any responsible lender will work with you to decide an affordable amount for you to pay every month, but it’s up to you to keep to this agreement and repay your loan on time.

Missing payments on a loan or credit agreement can have serious consequences. Any lender or company that searches your credit history will see that you’ve had some difficulty making payments on time in the past. This alone could be enough to put a lender off.

A string of defaults and missed payments on your credit file indicates to lenders that your money management might not be quite up to scratch, so your chances of borrowing money are significantly reduced. And it’s not just loans, credit cards and mortgages that are affected. You might also find that getting your hands on a new mobile phone contract is more difficult if you’ve got a low credit score and a bad credit history. A low credit score and bad history can also affect your chances of finding somewhere to live as it can make landlords reluctant to rent you their property, or mortgage lenders think twice about helping you buy.

But more than just a few negative marks on your credit file, missing repayments can also put you at risk of losing control of your debts. If you can’t make a repayment one month, you might need to make two loan payments the next month, meaning you accrue even more interest and extra charges. You might also be charged a late fee by the lender for every month that you default on a payment, adding to your mounting debt and making it more and more difficult to pay back.

If you’re struggling with debt, remember you’re not alone. Contact your lenders and creditors as soon as you can. Any responsible lender will do what they can to avoid loading extra debt on to your shoulders. This can include freezing interest and charges, rescheduling the payments or helping you to budget.

If you need further information or help, there are several sources of free debt advice – these include charities like StepChange or payplan, as well as the government funded Mortgage Advice Service. All can help you get back on track.