Switching to a cheaper personal loan certainly isnâ€™t as popular as remortgaging or taking out a 0% balance transfer credit card. Although the principle is the same, the savings are sometimes less than you expect. Nevertheless itâ€™s still worth investigating as in some circumstances you could save a respectable bundle of cash.
For example, if youâ€™ve taken out a personal loan via a bank branch, you could be paying a much higher rate of interest than is currently available on the market. As you might expect, the saving you could make will be greater for larger loan amounts and if the loan still has several years to run. Many companies allow you to use their personal loans for debt consolidation so you may be able to combine two or more expensive personal loans into one cheaper one.
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Whatâ€™s the penalty?
The first step is to establish what sort of early repayment penalty applies to your loan. Each company has a different policy and recent loans tend to have lower penalties due to a rule change that came into force in 2005.
Any fixed-rate loan taken out on or after 31 May 2005 can only have an early repayment penalty of up to two monthsâ€™ interest. Additionally, any loan taken out before this date and that was due to last for 10 years or less, now also has a maximum penalty of two monthsâ€™ interest. So, if you have an old loan, youâ€™ll find that the exorbitant repayment penalty that was specified in the original agreement now no longer applies. Unfortunately, if your loan was for greater than 10 years, then the original penalty charges do still apply for a little while longer (the two month maximum for loans of this length does not come into force until 31 May 2010).
There is one additional complication for loans taken out before 31 May 2005. The way the outstanding amount is calculated on these loans may be based on an archaic method called the â€śRule of 78â€ť. Thereâ€™s no need to go into details here and not all lenders use it. Suffice to say the rule works in the lendersâ€™ favour so it can add a little extra to the amount you have to repay.
The next step is to request an early resettlement figure from your lender. This will tell exactly what you have to pay to settle the loan in full. You can then use this figure to see what a replacement personal loan would cost and compare the two.
Comparing your new loan
The easiest way to compare the old and new loan is to assume your new loan runs for exactly the same time as your old one would have. You can then simply compare the total of remaining instalments for your old loan against the total of the installments youâ€™re required to pay for the new one.
Say you took out a £5,000 loan for five years, youâ€™re paying £109 a month, and it has three years left to run. Youâ€™ve been quoted an early resettlement figure of £3,250, and you discover a new loan for this amount will cost you £100 a month. The total amount you have to repay for the old loan would be £3,924 (36 times 109) and for the new one would be £3,600 (36 times 100). So in this case you would save £324.
Saving even more money
You may have some spare cash which you can use to pay off part of your loan. In this case your new loan would be less than your early resettlement figure, so youâ€™ll save a little bit of interest. The rate of interest you can get on a savings account will normally be less than a personal loan, especially once youâ€™ve taken tax into account. So itâ€™s usually worth using savings to pay off your debts.
You may also be able to pay back your new loan over a shorter time period than your existing one. For example, you might have had a pay rise or paid off other debts meaning you have more spare cash each month. A shorter repayment period will mean higher monthly repayments of course, but it will save you interest overall. You can still compare your existing and new loan by looking at the total amount you repay under each scenario. Using our previous example, reducing the term of your new £3,250 loan from 3 years to 2 years would save you an additional £100
It might be tempting to pay off your loan over a longer period of time. However, this is something best avoided if at all possible. You will pay less each month but a lot more interest in the long run. Still, itâ€™s an option if your finances are tight.
One thing to be aware of is that the interest rates for personal loans tend to get more expensive for lower amounts. So if youâ€™re looking for a loan of less than £3,000 youâ€™ll have to pay a higher rate and may find that you only have a choice of a few lenders. Rates tend to get cheaper at £5,000 and £7,500 so, if youâ€™re refinancing a loan above these levels, itâ€™s more likely that youâ€™ll be able to save a worthwhile amount. If youâ€™re looking to replace a loan of under £3,000 with two years or less to run, itâ€™s unlikely youâ€™ll save that much money.
What about payment protection insurance?
One final point to consider is what happens if you have a payment protection policy on your old loan.
The way refunds for these policies are calculated has been scrutinised by the FSA, in particular for what is known as single premium policies where the entire cost was added to the loan upfront.
You should now be able to get a partial refund for the cost of any policy but if your lender plays hardball then itâ€™s worth speaking to the FSA or the Financial Ombudsman to bring them into line. In some circumstances you may even be able to reclaim the entire cost of the policy on the grounds it was mis-sold.