Understanding early loan repayment charges

Unsecured personal loans can be a useful way to borrow money for all kinds of things, from a car to a home renovation project, but you have to commit to making monthly repayments until you pay off the loan.

However, if you’re lucky enough to have some spare cash, you could consider paying off your loan early to save on interest. This certainly has the potential to save you money, but you need to understand what early repayment charges you will have to pay to know whether it’s cost-effective. 

Alternatively, you may not be bothered about whether an early loan repayment can save you money – you may simply want to clear your debt. However, it’s still worth knowing the costs involved.

Is it a good idea to make an early repayment on my loan?

Paying off a loan early can save you money and make good financial sense. You may save on interest charges and free up money that you can use to pay off other debts, or build up rainy-day savings.

However, you should check whether the small print of your loan contract includes charges or repayment fees. Otherwise, it could be expensive when you make an early repayment of a loan.

Why might I need to pay redemption fees?

Where you take out a loan, it's for a set term. Personal loans are usually between one and seven years, but may be longer. Mortgages, which are also loans, can be for very long periods. Written into the contract is the amount of interest you will pay over the term, and the monthly repayments you will make. These repayments may be part payment of the loan and partly interest.

Some loans allow you to pay off your loan early without any penalties or to overpay by a fixed amount. If this is the case then it's a good idea to make an early repayment on your loan if you can afford to do so.

You will save money on interest charges and you will also improve your credit rating because you will be able to show that you were able to borrow money responsibly and pay it back.

If you are thinking of taking out a loan, have a good look at the small print before you sign up. If you think you might want to pay a loan back early then look for personal loans that allow you to repay your loan before the end of the term. You will need to weigh up whether here is an added cost of having a flexible repayment loan with the advantage of being able to clear your debt early.

When is it not a good idea to pay off a loan early?

Some loan agreements have clauses in the small print that penalise early repayments with fees, such as early redemption fees and early repayment charges.

The small print differs between loans and between lenders, so the only way to tell whether you are likely to be hit by an early repayment charge is to check your loan agreement or get in contact with your lender and ask them.

You can compare loans with no early repayment charges or fees using our comparison tables and find the best loan for your needs.

Paying off your loan early

Under Section 94 of the Consumer Credit Act 1974, which governs all UK consumer credit arrangements, including loans, you have the right to repay your loan early. The Act contains regulations on how loan providers must calculate any early repayment fee borrowers have to pay when ending a credit arrangement prematurely. This fee is known as the ‘settlement figure’.

When you first take out a personal loan, the lender creates a repayment schedule, determining how many months the loan will last and how much you must pay each month. The fixed monthly amount is calculated based on the amount you’ve borrowed plus the interest the lender will charge for the loan, divided by the number of months the loan will last.

For example, if you borrowed £3,000 over three years at an interest rate of 14.3% APR, you would have to pay around £662 in interest as well as the original amount you borrowed (the capital). Overall, you would have to repay a total of around £3,662. If you divide this figure by 36 (the number of months the loan arrangement lasts), you get 101.72. Hence, you might expect to make monthly repayments of £101.72 for 36 months.

However, while the monthly repayment remains the same throughout the loan period, you don’t pay off the same amount of interest each month. This is because lenders base the interest you pay on how much capital you owe. Over time, the proportion of your repayment that goes towards paying off interest gets smaller. This way of calculating loan repayments has an impact on early repayment fees. Exiting your loan arrangement early may save on the interest you would have paid if you’d kept the loan until the end of its term, but working out how much interest isn’t straightforward. Lenders use a detailed formula to do this.

Early loan repayment charges

As the lender will be missing out on the interest they would have received had you kept the loan for the full term, most apply an early repayment charge to partially compensate for this loss of income.

They can add up to 28 days’ worth of interest if the original loan term was under 12 months and 58 days’ worth if it was over 12 months (different lenders apply different conditions when fewer than a certain number of days remain on the loan).

If this sounds unfair, consider it from the lender’s viewpoint – longer-term loans tend to attract lower interest rates. So, if you seek to repay early, you’re benefiting from an attractive rate designed for people who are borrowing for longer periods.

You can also often make overpayments on your loan – in other words, make partial early repayments. In this case, the early repayment charge would be based on the overpayment amount.

As working out your settlement figure is complex, you won’t usually know what it is until the lender sends it to you.

It will effectively be the remaining capital you owe, plus the interest due on the loan up to the settlement date.

Your settlement date may be 28 days after you ask to pay off your loan in full, but your loan provider can add an additional 30 days of interest if your original loan term was over 12 months or give you a settlement date of 58 days after you ask to pay off the loan. This means your early repayment charge could be equivalent to 58 days’ worth of interest.

And if you borrowed more than £8,000 in total over a 12-month period, the lender may charge you even more.

Is it a good idea to pay off my loan early?

Paying off your loan early could save you a significant amount of money in interest, so it can be well worth doing. Exactly how much you would save depends on the amount of the original loan, the interest rate charged on it, and when you pay it off.

For example, if you paid off a five-year loan for £5,000 with an interest rate of 9.9% APR halfway through the term, you could save around £333 in interest after paying an early repayment charge of around £41. If you paid off a five-year loan for £10,000 with a rate of 6.6% APR halfway through the term, you could save around £430 in interest after paying an early repayment charge of around £53.

Other plus points are that you would no longer have the repayments coming out of your account each month, and you would reduce your overall level of debt.

However, if you have other credit arrangements that charge a higher interest rate than your loan, you may be better off repaying those first as you could save even more in interest.

Does paying off a loan early hurt your credit score?

Paying off your loan early might temporarily cause a slight decrease in your credit score. This occurs because you will no longer receive boosts from consistently paying off the debt each month, which demonstrates your reliability as a lender.

Paying off your loan early will also reduce the range of credit types you use. Your credit score increases when you effectively manage different forms of credit, such as an overdraft, credit card, mortgage and personal loan. This also helps lenders see you in a positive light. If you don’t have the loan anymore, you’ll be reducing the diversity of your credit.

However, the advantages of paying off your loan will likely outweigh these negative effects.

Can I cancel a loan once I’ve borrowed the money?

In addition to giving you the right to pay off your loan early, the Consumer Credit Act provides a 14-day ‘cooling-off’ period after you’ve signed a credit agreement. You can cancel the loan during this time without paying any interest. If you’ve already received the money when you cancel, you’ll have 30 days to return it.

Read more …

• Loans explained: all you need to know

• What are personal loans and which one is best for me?

• Unsecured Personal Loans Calculator and Comparisons