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Don't get caught out by an early loan repayment charge

Paying off a personal loan early can often bring with it the unwelcome surprise of a huge unexpected charge. The size of the charge will depend on how the lender calculates the interest over the period of the loan, in order to work out how much you still owe, and on whether the lender imposes an early redemption fee.

Before you borrow, if you think there's any chance you might be able to pay off your loan early, consider choosing a loan from a lender who doesn't ask for an early resettlement charge. There are plenty about, including Northern Rock, Nationwide, Virgin Money, Goldfish and even the Post Office.

For anyone locked into an existing loan and considering paying it off, it's worth checking the small print of your agreement, to see exactly what you have signed up for. It has been estimated by research specialists Datamonitor that around 70% of credit agreements are settled early, and many borrowers are trapped in deals that will charge them a disproportionate penalty for settling early.

A report by internet bank Egg estimated that consumers were paying hundreds of millions a year above a fair solution: UK borrowers will collectively pay £332 million in early repayment penalties as a reward for being financially conscientious, it told the Department of Trade and Industry last year.

Excessive settlement fees can be used either to discourage borrowers from paying their loan off early, or from switching to a more competitive lender.

Most loans for sums under £25,000 are regulated by the Consumer Credit Act of 1974. A new Act was in the process of going through Parliament last year, but was halted by the General Election, and will have to begin its progress again. In the meantime, the 1974 Act still applies, although there have been a number of amendments implemented by statutory instrument.

New repayment rules for new loans

The main change concerns how much lenders can charge for early settlement.

Since 31 May this year new loans for a period of more than one year, but less than ten years, have been covered by the Consumer Credit Early Settlement Regulations 2004. This replaced the Consumer Credit Rebate on Early Settlement Regulations 1983 with an actuarial approach to determining an early settlement figure, and created a limit on charges that may be applied by lenders.

The regulations, which cover only fixed-rate loans and not running-account credit, such as credit cards, mean that as long as the borrower follows certain procedures and meets certain conditions, he can only be asked to pay a maximum of two months' interest if he wants to repay early.

The conditions the borrower has to comply with in order to benefit from the new rules include: notifying the lender that he wishes to repay early and has requested an Early Resettlement Figure; paying the amount owing in full part payments do not qualify for a rebate; and taking the loan out as a lump sum and not as a drawdown facility, or arranging for it to be paid out in instalments.

Borrowers with older loans must wait

Unfortunately for existing borrowers, those who have loans for terms of 10 years or less will not benefit from the new rules until 31 May 2007. Those with loans for longer than 10 years won't be covered until the end of May 2010.

Farewell "Rule of 78"

The change in the rules means the end of the discredited Rule of 78.

This arcane formula is still widely used to work out how much interest a borrower should have paid at any time during the repayment period of a loan. However, interest isn't spread evenly throughout the term of the loan. Under the Rule of 78, since each monthly instalment is the same, you pay more interest at the beginning of the period and only start paying off the capital as the loan period progresses.

The name of the rule is based on the sum of 12 months added together 121110987654321, which comes to 78. Thus, for a loan for one year, the lender expects you to pay 12/78ths of the interest in month one, 11/78ths in month two and so on down to 1/78th in month 12.

For a loan for five years - 60 months - you would pay 60/1830ths in the first month down to 1/1830th in the last. Since the monthly payments are equal, it is easy to see that at the beginning barely any capital is being repaid and that, even after several months of making payments, a sum close to full amount borrowed might still remain outstanding.

While this method was a useful rule of thumb in working out interest in the days before computers and calculators, it is a very blunt instrument, because it particularly penalises anyone wanting to repay early a loan that has been taken out over a long period at a high rate of interest.

Now that it's easy to smooth interest payments over the period of the loan there is no reason to make the penal charges, and the new rules mean that lenders can only make a reasonable charge to cover their administration costs and leave them a profit, rather than make a charge that leaves them open to accusations of profiteering.

Earlier this year, Blemain Finance, an associate company of Ocean Finance, Britain's biggest loans broker, was forced to agree not to impose charges on its unregulated mortgage loans, in accordance with the Rule of 78, after an intervention by the Financial Services Authority. The FSA said: A term may be unfair if a consumer is required to fulfil his obligation or pay a disproportionate sum in compensation. The use of the Rule of 78 calculation method is not an appropriate calculation method as it effectively overstates the costs to the mortgage lender.

Blemain's loans taken out before 1997 not only charged the full rate of interest in accordance with Rule of 78, but also reserved the right to add another six months interest-rate charges on loans of between £15,000 and £60,000 .

Check your redemption figure

If you have an older loan it might be worth checking your redemption figure if you want to repay early. If you are going to have to pay a huge penalty, it might be worth keeping the loan going and saving the capital you were going to use to repay it in a high-interest account and get the benefit of it that way.

It will always be a personal decision to get rid of a loan early if you are fortunate enough to be able to afford to do so. In any case you should always check the figure you are being asked to pay. If you feel the figure is wrong, you can ask your local trading standards office to check the statement and give the correct figure.

You can then contact the creditor and dispute the figure. If the lender refuses to correct it, you can take further action via the trading standards department.

Moneyextra.com recommends you take independent financial advice before acting on any article

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2005-11-01 10:44:51 © Moneyextra.com