Can I repay my loan early?

I have a little more money to put towards my personal loan repayments than I thought. Can I repay my loan early? And, if I am allowed to, should I?

When looking to borrow it's generally true that the quicker a personal loan can be paid off, the better.

Those that can pay off more quickly benefit from lower total interest charges and, obviously, spend less time in debt.

However, once you have a personal loan it's not quite as simple as the faster the better.

The original conditions of the loan agreement, when the borrowing was taken out and the interest rate will all affect whether a borrower can make early repayments and whether it will be advantageous to do so.

The advantages of early repayment

In most cases, however, the advantage is pretty clear: paying off a debt will almost always be more beneficial than putting extra cash that could have been used for repayments into a savings account.

Charging more money lent than they give out for money saved is how most banks make their profit, after all.

So, for example:

In addition, and perhaps even more importantly, paying off a debt reduces risk: paying off a debt decreases the chance of letting the borrowing linger and continue accruing interest and of defaulting or missing a repayment by 100%.

The exceptions to the rule

However, there are a few cases where this isn't the case.

Those borrowing using with an extremely low APR loan with extra money in a high interest savings account, which will most likely also be an account that it's difficult to access without loss of interest, could be best off sticking to their original payment plan, rather than using savings to pay off the debt.

In addition, it can be worth sticking to the original plan for repayment if there are significant charges attached to paying off the loan early.

We'll look into these penalties below.

The right to overpay

First, though, it's worth noting that every personal loan holder does have the right to overpay on their debt.

The Consumer Credit Directive, which came into force in February 2011, strengthened existing consumer law on overpayment of loans and limited the amount lenders could charge for early repayment.

Under this directive, the early repayment penalty for new loans cannot be over 1% of the amount being repaid early.

If the payment is made in the final year of the credit agreement, the penalty cannot exceed 0.5%.

For older loans, the penalty can be no more than two month's interest.

Early repayment penalties

The penalty attached to early loan repayments goes by many names: early repayment penalty; financial penalty; early redemption fee and redemption charge.

But, in principal, all of these terms amount to the same thing: those with a personal loan will have to pay the provider a certain sum in order to clear the loan early.

There is no set amount for this penalty, but it will usually be around one or two month's interest.

The earlier the repayment is made, then, the higher the penalty will be as the outstanding interest is much greater at this stage.

It is essential that you check the terms carefully and make precise calculations before deciding whether it is worth making an early repayment or not.

Rule of 78

In 2004, Egg, one of the few lenders at the time to offer borrowing without early redemption fees, calculated that UK consumers would pay £332 million in fees for paying loans off early.

That was because of a nasty little law called the 'rule of 78'.

Those that applied for their loan three or more years ago may still be affected by this rule so we'll cover it briefly here. This further hidden penalty was abolished in June 2005, though, so it will only apply to a small minority of loan holders.

Under the rule of 78, borrowers pay a set amount of interest based on both the capital and the set borrowing period throughout the life of a loan.

This is a problem for early repayment since the amount borrowers start paying, which includes interest to cover over the whole planned period, is obviously slightly off-kilter.

In effect, people with these loans will have more left to pay off than they might think.

The rule is named for the sum of 12 months (i.e. 12+11+10+9+8+7+6+5+4+3+2+1) which comes to 78.

On a one year loan, the first payment would include 12/78ths of the interest in month one. Six months in, the payment would include 6/78ths of the interest.

The name is a bit misleading because on a two year loan you'd do the same calculation but the sum of 24 months comes to 300 - so the first payment would include 12/300ths of the interest due. No 78s at all.

We told you it was complicated but please do rest assured that very few people with personal loans have to worry about this any more.

Thinking ahead: early repayment before you apply

But these do not apply for every loan - many are completely free of early repayment charges.

When applying for a loan it might be worth choosing a package free from these charges if you feel you might be in a position to repay early.

There will usually be an 'Early Settlement' clause in the paperwork of your initial loan agreement.

It is here that you will find information on how much you are likely to be charged for repaying early.

Here is an example of an early settlement clause:

'Your settlement quotation is valid for 28 days from the date of your request and includes interest up to and including this date. If your loan term is greater than 12 months you will pay an additional 30 days interest.'