Why borrowers are winners in the loan-providers' price war

As lenders compete to offer the best deals, now's the time to take out or switch loans, says David Prosser

he best bargains from the sales may now be long gone, but the savings on offer from leading loan providers keep on getting better. Banking experts say that a January price war has broken out between providers of unsecured loans. As a result, more than 10 lenders now offer unsecured loans - which do not require borrowers to offer collateral - at interest rates below 6 per cent a year. That's only marginally more expensive than the cheapest mortgages, where borrowers risk losing their homes if unable to keep up with repayments.

Currently, the cheapest lender in the market is Moneyback Bank, an internet-based subsidiary of Alliance & Leicester. Last week, it cut its rate from 5.7 to 5.5 per cent, in order to stay ahead of rivals such as Halifax, Bank of Scotland, Cahoot and the AA, which have all cut prices since the beginning of the year.

In part, the reductions reflect expectations that the Bank of England's Monetary Policy Committee will cut base rates in the months ahead. But lenders are also keen to steal a march on one another as early in 2006 as possible.

The cuts are good news for borrowers - and not just people who currently need to take out a new loan. Existing borrowers can use new loans from the cheap lenders to pay off other debts and reduce their monthly repayments. The savings can be considerable. Borrowing £5,000 at 5.5 per cent over five years, say, would cost a total of £5,717, or £95 a month. The same loan from Barclays, where the typical interest rate is currently 15.9 per cent, would cost £7,133, or £119 a month.

Working out whether it will cost money to switch loans is relatively straightforward, as long as you check what it will cost you to get out of your existing deal. Many lenders charge penalties if you pay off your loan ahead of schedule, so check the figures carefully. Typically, you'll pay a month of interest charges as the penalty fee, though some lenders still use other formulas. "Your lender should be able to give you a precise figure for what paying your loan off early will cost, including any repayment penalties," says Andrew Haggers of the analyst Moneyfacts.

Then you should ask potential new lenders for the total cost of borrowing from them and compare the two numbers. Don't be distracted by the monthly cost of loans. It's only a fair comparison if you would be paying both off over the same term. A five-year loan, for example, may still be more expensive than a three-year product, even if the monthly repayments are smaller.

There are two other traps to watch out for. "Only those with an excellent credit profile will benefit from the price war," says Stuart Glendinning, director of personal loans at the price-comparison service Moneysupermarket. "Most borrowers will find it more difficult to achieve the most competitive deals."

By law, lenders must advertise their typical rate - the interest rate at which they lend to most customers. However, borrowers with less-than-perfect credit ratings may be offered more expensive loans.

The second pitfall is that lenders selling cut-price loans are anxious to make money wherever they can. "These low rates are only sustainable if the lenders can make up profits by selling payment-protection insurance," says Andy Smith, personal-finance product manager at the price-comparison service Uswitch. "Yet not only is this insurance often overpriced when bought from the lender, but there is growing concern over the suitability of this product for many borrowers."

Roger Mills, 36, (above) had been concerned about the cost of his Lloyds TSB bank loan for some time. He was paying close to 10 per cent a year for the loan, as well as premiums for a payment-protection insurance policy that he didn't really need.

"Like lots of people, I just took out the loan on offer at my bank, without shopping around," Roger says. "Later on, I realised that I was paying over the odds, especially as the insurance policy I was sold didn't appear to be much use."

Determined to save money, Roger looked at internet-based lenders. He was amazed to discover that, as an existing customer, Lloyds would lend him the same amount of money at 6.5 per cent a year. He used a new Lloyds loan to repay the old debt, and also borrowed a little extra. "Even though I've taken on a bigger debt and I'm paying it back over the same term, I'm saving money each month, especially as I no longer have to pay the insurance premiums," he says.