What is a personal loan and how does it work?

What is a personal loan?

A personal loan is a form of consumer credit: a loan with a fixed amount and term repaid in equal monthly instalments¹. It usually carries a fixed rate, so the payment is the same from the first month to the last. People use it to finance things like home improvements, a car, equipment, education, or to consolidate several debts into one.

Unlike a mortgage, a personal loan is not secured on a property. Because the bank takes on more risk, the interest rates are higher and the terms are shorter (typically 1 to 7 years).

How the payment is calculated

The payment is constant and follows the French amortisation system: each month, part of the payment covers the interest on the outstanding balance and the rest repays capital. The formula is:

payment = principal × i / (1 − (1 + i)^−n)

where i is the monthly rate (the TAN divided by 12) and n is the number of months in the term. Early on, most of the payment is interest; over time more and more of it repays capital.

There is a rule of thumb worth keeping: a longer term lowers the payment but increases total interest. A longer term spreads the capital over more months, but also leaves it accruing interest for longer.

TAN, TAEG and the real cost of the credit

These are two different rates, and confusing them is the most common mistake:

• The TAN (nominal annual rate) is the interest rate that drives the payment. It is the one that goes into the formula above.
• The TAEG (the APR) is the one that measures the real cost: it bundles the interest with every charge of the credit, such as the arrangement fee, the monthly processing commissions, the associated insurance and stamp duty².

That is why the TAEG is always higher than the TAN. Even with no fees at all, the TAEG sits a little above the TAN, because interest compounds month by month: it equals the TAN compounded, (1 + TAN/12)^12 − 1. It is the TAEG, not the TAN, you should use to compare offers from different banks. For a deeper look at what the TAEG includes, see what is the TAEG.

How much does it cost? (worked example)

Picture a personal loan of €10,000 over 60 months (5 years), with a 7.9% TAN and no fees:

• The payment is about €202.29 a month.
• Over the 5 years you would pay around €12,137, of which about €2,137 is interest.
• The TAEG would be 8.19% (the TAN compounded monthly).

With a €250 arrangement fee the payment would not change, but the TAEG would rise, because it now reflects that charge. Run the numbers with your own figures in the personal loan calculator, which shows the payment, the TAEG and the total cost, or compare the cost of several offers in the TAEG calculator.

What to check before you sign

Before you sign, the bank gives you a standardised information sheet, which gathers the TAN, the TAEG, the fees, the insurance and the total amount payable (everything you will pay). Use it to compare, and bear in mind that:

• Banco de Portugal publishes, each quarter, the maximum rates (TAEG) that may be charged for each type of consumer credit¹. An offer above that cap is illegal.
• You have 14 days to withdraw from the contract (the right of withdrawal), with no need to give a reason.
• You can repay early, with a fee capped by law (typically 0.5% or 0.25% of the capital repaid, depending on the remaining term).

A personal loan is a useful tool when the expense is necessary and the payment fits comfortably in your budget. Always compare by the TAEG and choose the shortest term you can repay without straining your finances.