What if I want to pay off my loan early?
If, after having taken out a loan, your circumstances change and you wish to repay your loan early you will have to ask the lending company for a “redemption” or “settlement” statement- this will detail how much you have to pay to redeem the loan. The lending company will permit you to repay the loan early. You will not ( unless the loan only has only a few months to run) be required to pay all of the interest due over the remaining term of the agreement. The lending company may require you to pay part of the interest you would have paid had the loan run its full term.
The method of calculating the amount payable on early redemption varies between lending companies and even between different loan agreements issued by the same lending company for example, some loan agreements will state that if the borrower wishes to pay the loan off early a number of months interest will be added to the balance at the time of redemption. This is very common particularly on loans or mortgages for larger amounts, it is also very common for companies offering special offers for new borrowers, to include a requirement that in the event of early redemption a charge of a number of months interest will be added to the outstanding balance on the mortgage.
The consumer credit act (which governs loans up to £25,000) prescribes a calculation which determines the maximum amount of money to be paid in the event of early redemption.
On loans or mortgages of up to £25,000 it is more common for the redemption calculation to be more complex. The wording used on many agreements will say something like “ in the event of early redemption a rebate will be given in accordance with Rule of 78” (sometimes the Rule of 78 is referred to as “the sum of the digits or Regulations made under the Consumer Credit Act 1974”).
The word rebate can cause confusion. You should remember the rule calculates a rebate on the total charges you would have paid over the full lifetime of the loan. It will produce a figure greater than the capital element of the loan balance.
The mathematical formula, prescribed in law, assumes that during the lifetime of a loan the debt decreases from the opening balance to the amount of the last payment, it also assumes that the amount of interest applicable to any particular month is proportionate to the balance outstanding in that month. This creates the effect that a larger amount of interest is attributed to the early months of the agreement than to the later months.
Using a 12 month loan period as an example, the rule divides the total interest payable in to equal units. It then assumes that the amount of interest for month 1 is 12 units, the amount for month 2 is 11 units and so on, the amount of interest for the last month would be 1 unit. The rebate calculation is known as Rule of 78, because when applying this principle to a loan of 12 months duration the digits add up to 78, ie; 12+11+10+9+8+7+6+5+4+3+2+1=78.
In recognition of the lender incurring costs when granting a loan the Consumer Credit Act permits the date used to work out the amount due to be deferred beyond the actual payment date. The deferral period is 2 months on loans of up to 5 years duration and 1 month on loans of more than 5 years.
If a 12 month loan is settled early at month 6 the settlement date would be deferred by two months to month 8. The amount of interest attributable to the remaining period would be 4+3+2+1=10. This would result in a rebate of 10/78 of the total interst charged. This requires that a total of 68/78 of the interest will be payable on the loan. The principle is applied to loans of longer and shorter time periods, the figures varying depending on the number of instalments involved.
Although the Rule of 78 calculation delivers a rebate of charges it can, particularly when redemption takes place very early in the life of the loan, produce a redemption figure greater than the original loan amount.
The example below will help to explain the effect of the rule of 78 calculation.
Example; If you borrowed £1000 over 180 months at 14% APR and wanted to pay it off at month 120 the amount required to pay off the loan would be £637.87. If you wanted to redeem the loan at month 40 the redemption figure would be £1024.92.
It should be remembered that the balance of the loan will not affect the redemption figure. A loan balance will increase or not decrease as it should, if you do not make the payments on time or if you miss payments. It will also increase if the lender makes a charge for correspondence informing you of things like missed payments, unpaid direct debits, or returned cheques. The lender is likely to charge fees for supplying items like a deed of postponement, or a transfer of security. The lender will provide you with a tariff of these charges, charging fees of this nature is common amongst banks, building societies and finance companies.
If you have authorised it ,the loan balance may also include items like the premium cost of any insurance and any credit brokers fee. These will all attract interest and influence any redemption calculation.