Punishment eases for early payers of debt

Being responsible and paying off a personal loan early has rarely rewarded you in the past.

Being responsible and paying off a personal loan early has rarely rewarded you in the past.

Many consumers wanting to do so have run up against the Rule of 78, a complicated formula that levies a charge for clearing your debt before the end of the original loan term.

Interest is disproportionately stacked up at the outset of loan repayments, and so early settlement hits your wallet hard.

Although not all lenders have applied the rule, it has been a way for many banks to profit from customers' willingness to get out of the red.

However, changes to the Consumer Credit Act mean that, on Tuesday, the Rule of 78 will be abolished on all new loans. Providers will now only be able to charge a maximum of two months' interest - as opposed to sums that have sometimes been much higher.

The reform will apply immediately for new borrowers. Existing ones who have loans for terms of 10 years or less, and want to settle early, will not benefit until 2007. Those with loans for longer than 10 years will not be covered until 2010.

"The Rule of 78 is an archaic and confusing calculation that has finally been overhauled," says Richard Mason of the price-comparison website moneysupermarket.com. "Consumers should not be heavily penalised for repaying their loans early and trying to get out of debt."

It's worth looking out for a handful of loan providers that do not levy any early redemption penalty but still offer competitive borrowing rates. Interest on these loans starts at 5.7 per cent at Northern Rock and 5.8 per cent at the Post Office - rising to 6.9 per cent with Cahoot Flexible and Virgin Money.

The Rule of 78's abolition may also encourage consumers to switch between providers, adds Mr Mason - instead of feeling tied to the same one for a long time. "This allows people to benefit from the many low-rate loans that keep joining the market."

When seeking a loan, look beyond the headline rate to see what you will really get; most lenders operate a policy of risk-based pricing where the deal depends on your own credit rating.

That said, they can only advertise "typical" loan rates if at least two-thirds of applicants qualify.

Also, think carefully before signing up to payment protection insurance, as this cover is often expensive and can carry exclusions that make it of little or no value to the buyer.