You're punished for being good

Sam Dunn reports on why banks penalise virtuous borrowers who clear their debts ahead of schedule

Clearing your debts as soon as you are in a position to do so would seem sound financial planning. But it might not work to your advantage if you have taken out a personal loan from a lender that charges a penalty for early repayment.

Research from the internet bank Egg, using figures from data provider Moneyfacts, reveals that most of the 70 per cent of borrowers who pay off their unsecured loans early gain nothing by doing so. Last year, borrowers were penalised to the tune of £332m for repayments made ahead of schedule.

In its report, Egg is fiercely critical of Royal Bank of Scotland (RBS), Lloyds TSB, NatWest and Yorkshire Bank for imposing a fine of two months' interest on customers paying off their loans ahead of schedule, on top of the standard charge for early settlement. These fines have been introduced during the past five years. However, such penalties are avoidable because not all lenders impose them. Those that don't include Nationwide, Barclays, Virgin Money and Egg.

This confused picture isn't helping the Government as it tries to persuade us to save more instead of saddling ourselves with borrowings. The level of debt we are taking on makes worrying reading: recent research from the Banking Code Standards Board shows that the average adult in Britain has £5,000 of unsecured debt, with one sixth of the population having trouble meeting repayments.

Mark Nancarrow, Egg's chief executive, hopes the survey's findings will put pressure on the Government to force banks to drop penalty charges when the Department of Trade and Industry (DTI) announces the conclusions of its investigation into the personal loan market, expected in the next few weeks.

Egg wants all such fines to be abolished and lenders to absorb the loss of interest into their overall costs. This will make it easier for consumers to compare personal loans from different providers, since early repayment fines are not currently being made clear at the outset.

"You shouldn't be penalised for settling early," says Melanie Green, head of money research for the Consumers' Association (CA). The key thing is the lack of trans-parency in personal loans ... People should be told how much it would cost to settle early."

David Bitner, head of products at independent financial adviser (IFA) The MarketPlace at Bradford & Bingley, warns those looking for a loan not to opt automatically for a product from their own bank simply because they trust a high-street brand.

"The choice of deals is limited, and it can be hit and miss whether the loan's full terms and conditions - such as early repayment penalties - are adequately highlighted," says Mr Bitner.

For years, banks have used a complicated calculation called the Rule of 78 as a yardstick when setting interest rates and early repayment charges on loans. Under the rule, the interest you pay on the loan is, in effect, fixed at the outset. If you decide to repay the loan early, the bank will levy the charge to cover the interest it has lost.

The DTI has been looking at the Rule of 78 in particular, as part of its investigation, and some banks have already changed the way they set interest charges, using daily calculations instead of fixing rates from the start.

Those banks that impose additional fines for early repayment argue that these penalties also cover the cost of "loan service" and closure. Lloyds TSB claims Egg's research paints an unfair picture. A spokesman says customers who want to reduce their monthly repayments can refinance their loan with the bank, incurring no fees. Lloyds TSB introduced an exit charge 18 months ago because it wanted to satisfy its shareholders that it was "staying competitive in the banking market".

If you are in a position to pay off your personal loan ahead of schedule, check first to see how much it will cost to do so. It might be worth switching to a chea-per loan - but, again, watch out for charges.

"It's a question of looking at the total cost of moving. It might be that you can move across to a new loan, but the benefits of being on a better rate might be cancelled out by the cost of leaving [your old deal]," warns Ms Green at the CA.

"[On the other hand,] it might be that you are paying at the top end and, even with a redemption payment, that it will be in your interest."

Deals and terms on personal loans vary wildly, so it is essential to do your research before taking out a loan. Personal finance websites such as those operated by The Market Place at Bradford & Bingley and IFA Chase de Vere will allow you to compare loans and check which lenders are charging a penalty for early repayment.

Moneysupermarket.com, another website comparing the cost of financial products, also has a "bestbuy" list of personal loans, with information on each product.

Contacts: Chase de Vere, www. moneyextra.com; The Marketplace at Bradford & Bingley, www.marketplace.co.uk; Moneysupermarket, www.moneysupermarket.com