William Kay: Rule that penalised good borrowers is scrapped

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The Independent Online

Boomtown Rats, the Jam, sharp suits, brothel-creeper shoes, mohair jumpers and slim-jim ties: I thought the whole 25-years-ago nostalgia kick was thankfully being outlawed at last this week when the Department of Trade said that it was abolishing the Rule of 78.

Sadly, no. Sir Bob Geldof is to be allowed to continue going round with that hangdog expression, proclaiming: "I don't like Mondays." Instead, the DTI is scrapping a cunning little wheeze banks use to sting borrowers if they dare to repay a loan early, as 70 per cent do.

Most borrowers don't realise it, but your first few loan repayments are almost all interest and little of the original sum, or principal. As more of the principal is repaid, the interest element falls until the last instalment is almost entirely principal. Repayment mortgages work the same way.

So if you want to repay the whole loan early, you find you still owe as much as you started with, thanks to the Rule of 78.

Most loans are for multiples of a year, with 12 monthly repayments a year. The figure 78 comes in because that is what you get when you add the numbers one to 12. So the first month's interest is 12/78ths of that month's repayment, the second month's interest is 11/78ths and so on.

This system exaggerates the first few months' interest, so you are not paying off as much of the principal as you should be. That matters little if you keep the loan for its planned life, because it all evens out. But early repayment can be penal, so the DTI has banned it. Instead, lenders will be able to charge one month's instalment.

The official responses have been revealing. The Consumers' Association, as you might expect, howled that it did not go far enough and there should be no penalties at all. The British Bankers Association welcomed the proposal, as long as it did not apply retrospectively to existing loans.

Much as I support the Consumers' Association, its attitude is naïve. Running a loan involves costs in paperwork, staff time, going to the money market and the fact that the money being lent cannot be used elsewhere. And if you have no penalty, lenders are left open to frivolous borrowers who take out a loan one day and repay it the next.

But my suspicions are aroused by the bankers' enthusiasm. They clearly think a month's interest will do nicely as a penalty. That immediately suggests to me it will be too much.

We could start haggling and say the penalty ought to be the equivalent of three weeks' or two weeks' instalments. But I believe a flat-rate penalty is inherently unfair, because it hits the late repayer as hard as the early repayer, and the late repayer will already have contributed a healthy chunk of interest.

So the hated Rule of 78 has something going for it, in that it does taper the interest. What the DTI should do is insist the taper starts at a lower level, so a month's instalment might be fine for an early repayment but this could be reduced as the loan goes on until it is next to nothing towards the end.

The DTI has another chance to ponder these points, because in the autumn it plans to publish a White Paper on consumer credit. This is to sweep up a lot of work being done by the Office of Fair Trading and others about the difficult problem of how to protect borrowers at the bottom of the heap, such as jobless single parents who need money to tide them over until their next benefit cheque. Such folk are the regular prey of the loan sharks, who will think nothing of racking up interest that far exceeds the original loan, and exact summary justice on defaulters.

The trouble is that a licensing system for lenders, which we have at present, drives the real rogues underground. The main banks are trying to think creatively about this conundrum, by looking at ways in which they can reach the high-risk, feckless borrower.

Back about 1978, when The Jam was jamming and the Rats were booming, NatWest experimented with street lenders. Copying a New York idea, they dressed in jeans and T-shirts and moved around the bars and clubs offering loans, mainly to people running small businesses.

The banks should bring back the street lenders with the specific aim of taking on the loan-sharks, undercutting their crippling interest rates and introducing decency and dignity to struggling borrowers.

* One of the revelations of Fidelity's summer party this week was Anthony Bolton, the legendary fund manager whose relentless attention to detail and tireless research enabled him to outstrip his peers in the bull markets of the past 20 years.

At the start of this year Mr Bolton, 53, shed two of his funds to concentrate on Fidelity Special Situations and Fidelity European Investment Trust. The effect has been dramatic.

No doubt the party surroundings of London's Somerset House and the excellent wine had something to do with it, but the years seemed to have fallen away from Mr Bolton and rekindled his appetite for investment. "I'm only dealing with 200 stocks instead of 400," he said happily.

If you are thinking of dipping back into the stock market, you could do a lot worse than tap into Mr Bolton's new-found buoyancy.

w.kay@independent.co.uk

William Kay is Personal Finance Editor of 'The Independent'

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