FOOL SCHOOL
Choosing A Personal Loan

December 15, 2004

As far as financial products go, personal loans are one of the least complicated. But the industry still makes its usual attempt to confuse what should be a relatively simple decision. Here are the factors you need to consider before signing on the dotted line.

Secured or Unsecured?

Personal loans will either be secured over some of the assets you own, usually your property, or unsecured. Secured basically means that the lender has a right to take the asset off you if you don't pay off the loan as you initially agreed. They may settle for a reduced payment plan instead. Consequently, the rates of interest on a secured loan will be lower because the lender is taking on less risk.

But losing your house is not a pleasant thought is it? If you wish to get a lower rate of interest by going the secured route then an extension to your mortgage or a flexible mortgage may be more practical and cost effective.

Interest Rate

The lower the better. The better credit risk you are, the better deal you are likely to get. Some of the 'best buy' deals you see in the papers are only available to those with the best credit records although when lenders promote an enticingly low 'typical APR', they now have to offer it to at least 66% of customers who apply (prior to November 2004 it was only 51%).

But watch out for the small print. Many loans incur penalties if you pay them off early or if you vary your payments. As it happens many of us actually do choose to pay off our loans before their due date so this is a very sneaky little trick. As it's best to pay off your debts (especially high-interest ones) as quickly as possible there is very little reason to choose a loan that penalises you for doing so. If in doubt, don't be afraid to ask.

The good news is that excessive charges for settling an agreement early will eventually be replaced with a new fairer system so lenders can only charge maximum interest of one month and 28 days. The new rules will apply to existing agreements of up to ten years from May 2007 and, for loans over ten years, it will apply from May 2010.

You also need to be wary of the various tricks companies currently use when charging their interest. Some calculate the amounts due in different ways so although the headline interest rate may be the same the monthly payments may differ. From May 2005, lenders will have to use a standard way of calculating the Annual Percentage Rate (APR) so consumers are truly in a position to compare products equally. Until then, compare different loans using the APR and the total monthly payments you will have to make to help remove these distortions. Again don't be ashamed to admit if you're confused by all the figures or ask for further explanation.

Repayment Period

The shorter the better. Although it's tempting to choose a longer period as this will reduce the monthly payment this is often a false economy. In the long run this will cost you more in interest charges. Choose a repayment period that you can meet comfortably and if you find that you have additional spare cash along the way, use that to reduce your debt still further when you can.

Fees, Insurance and Payment Protection

Some lenders charge a fee for application. Most don't, so why bother with those that do? Other companies will offer lower rates if you take out their insurance products as well. However, this fact is often not made clear in their advertisements. In the main, financial products that are bundled together like this are usually more expensive than those bought separately, and best avoided.

As you fill out the application you may be asked if you want to take out payment protection as well. This is intended to ensure that your payments are covered in certain circumstances such as long-term illness. On the whole, these products are very expensive and you may already be covered for such eventualities elsewhere, through a works scheme for example.

You also have to read the small print on such schemes with a great deal of care, as many them exclude a lot of illnesses or other events that you might think you could make a valid claim under. In some cases you have to be practically dying to qualify under loan repayment protection schemes or else be long-term unemployed. And your loan is only likely to be paid off in full if you actually drop dead. But they don't tell you that, of course.

For example, a policy might cover your monthly payments for up to a year until you find a new job. But the small print will probably say that it won't pay out for the first couple of months of unemployment by which time you'll either have found yourself another job, or you'll be two months behind with your payments already.

The same thing will probably apply if you fall ill. Most likely you'll be well again within the non-claimable period but, unless your employer has continued to pay you your salary, again you'll probably find yourself behind with the payments.

If you're taking out a loan that is secured against your home then some form of payment protection might be worth thinking about if you have no other form of insurance against loss of income. After all, you don't want to risk losing your home.

But if you really want some form of protection against being unable to pay your bills, then a 'catch-all' income protection policy would probably be much better value than taking out individual policies for many forms of borrowing. That way you can pay all your bills rather than just one of them. Some savings to cover your monthly payments for the period during which they won't pay out would also be sensible - you could put by the insurance premiums you've saved for a start.

Negotiate

Don't be afraid to negotiate. For example, your own bank may be encouraged to offer you a better deal if you happen to mention what sort of deal you have been offered elsewhere. They can only say no!

> Compare Personal Loans here