FOOL'S EYE VIEW
Save Money On Your Personal Loan

By Jane Mack (TMFJane)
June 12, 2002

Many people who take out loans are often persuaded to take out payment protection insurance. For some, this is absolutely the right thing to do, particularly if you think you may be at risk of redundancy (although one might question the wisdom of taking out a loan in the first place if this is the case!)

However, such insurance is often a waste of money if you feel fairly secure in your job and in good health. It's true, no job is ever totally safe, and neither is one's health. However, since these insurance policies only cover your monthly payments until you can get another job or become fit again, you should think about whether you could afford to make those payments for a couple of months yourself. In other words, it's a risk not taking out the insurance, but it might be a risk worth taking.

There are several other reasons for not taking out payment protection insurance, an important one being that it can add a disproportionate amount to your total repayments. For example, a quick check on three different lenders' websites indicated that I could expect to pay about 10% extra if I took out the insurance. If you add that to the interest rate, you could end up paying humungous amounts over and above the amount you actually borrowed. Would you want to borrow the money if you realised that you'd effectively be paying back an extra 25% or so for the privilege?

Another point to bear in mind is that many people actually pay off their loans early. This is fine with flexible loans where you can do that without penalty. But with some loans and with most payment protection policies, you're very likely to be caught out by something called the 'Rule of 78'.

The Rule of 78 is where the interest on your loan or the insurance premiums is 'front-loaded'. The way it works is very similar to a repayment mortgage. The moment you take out the loan, you are immediately obliged to pay back the entire capital sum and all of the interest that will accrue over the agreed term of the loan. The same goes for the insurance protection premiums.

So the lender will work out the total amount you need to pay, split it into monthly payments and then use a higher proportion of your initial payments to pay the interest or protection premiums before applying the remainder to the capital.  It works on a sliding scale throughout the term of the loan or policy. The rationale is that at the start, you had a higher balance -- therefore the interest or the insurance premiums would need to have been higher to cover it.

Many personal loans work on a simple interest basis and if you settle up early, this will usually reflect the fact that you've had the loan for a shorter time period -- although you may have to pay a penalty of one or two months' interest. However, with the payment protection premiums, the Rule of 78 is still a firm favourite in the industry and when you think about, it's not hard to see why.

It all comes into play when you want to pay off your loan early and the insurer has to calculate how much you've paid in insurance premiums up to that point. It's a complicated mathematical formula but, effectively, since you've paid much of it up front, there won't be a lot left to refund to you. It usually comes as a bit of shock to people who haven't read the small print in the contract.

This shouldn't deter you from disputing the matter either directly with the insurer or the loan company who sold you the policy in the first place. About four years ago, the then version of the Financial Ombudsman expressed concern to the Association of British Insurers about their use of the Rule of 78 and, unhappy with their response, stated:

"...in considering such complaints, we now endeavour to establish whether the borrower had the opportunity to understand at the outset that, if the insurance were to be cancelled before the end of the loan term, a pro rata refund would not be given and how the calculation would be made. If this was not explained clearly, then we may take the view that the insurer should give a pro rata refund."

That's a pretty clear indication of how any complaints might be handled should you need to take it that far.

It's quite likely that the use of the Rule of 78 will be regulated soon. The Consumer Credit Act is currently under review and the ABI is expecting a directive on the subject telling them in what circumstances it can and can't be used. So, hopefully, we can look forward to rebates that are calculated rather more fairly in the future.

By the way, the Rule of 78 comes from the sum of the numbers 1 through to 12, there being 12 months in a year. If you want to know more, there's an excellent step-by-step explanation of how the formula works on this American website.

More: Visit the Motley Fool's Personal Loan and Insurance centres.