Personal Loan Rate Tricks

Lenders use these three tricks to manipulate interest rates on loans and catch us out...

When you're shopping around for a personal loan, what's the first piece of information that grabs your eye? Whether you're looking at individual advertisements, or studying a table which compares several loans all at once, the thing most likely to catch your eye is the Annual Percentage Rate (APR).

In theory, the APR is supposed to provide you with a true comparison of the cost of borrowing. Thus, the APR factors in charges for credit, including interest and any compulsory fees. However, in the real world, lenders have discovered how to manipulate APRs in order to disguise the true cost of borrowing. Here are three fiddles to watch out for:

1. Misleading 'typical' APRs

Until the late Nineties, personal-loan providers would offer the same standard interest rate to all applicants, regardless of their personal circumstances. However, the arrival of computerised 'risk-based pricing' programmes allowed lenders to tailor their loan rates to suit individuals' personal credit history and ability to repay.

Nowadays, more than eight out of ten personal-loan providers use risk-based pricing to carve up their customer bases. This allows them to offer the lowest rates to the best customers, while charging higher rates to everyone else. This practice is often referred to as 'cherry-picking'.

In theory, when a lender using risk-based pricing advertises a 'typical APR', this rate should be given to two-thirds (67%) of new borrowers. However, some lenders get around this rule simply by rejecting lots of applicants. For example, a lender receiving ten loan applications could reject seven, give its typical rate to two applicants, and offer a higher rate to the remaining applicant. Although the lender has met the 2/3rds rule, only two out of ten applicants got its headline rate!

2. Expensive repayment holidays

When you take out a personal loan, your first repayment will usually be due one month after you draw down your loan. However, if you have chosen a loan which offers an extended initial repayment holiday, then your repayments will normally begin after, say, three to six months.

This extra break from repayments may sound appealing, because you have more time to repay, which reduces the 'official' APR. In fact, it works against you. Thanks to the extra two-month break, you repay your loan over, say, 38 months instead of 36 months. This pushes up your overall interest bill and, therefore, makes loans with repayment holidays more expensive than traditional loans. Gotcha!

3. Rip-off payment protection insurance (PPI)

Here at The Fool, we're no fans of payment protection insurance -- and that's an understatement! PPI is an optional insurance policy which covers your loan repayments if you are unable to work due to an accident, sickness or unemployment, and pays off your loan if you die. Alas, it's hideously overpriced and can add upwards of £1,000 to the cost of a £5,000 loan over three years.

Believe it or not, when a lender adds a hefty PPI premium to your loan, the APR doesn't budge. In other words, although PPI might push up your monthly repayments by a fifth (20%), it won't affect the APR. Thus, a loan with PPI will show the same APR as an unprotected loan, even though the former is massively more expensive. So, be sure to check that you don't have PPI before signing on the dotted line!

In summary, don't put too much faith in APRs. Instead, do what I do: compare loans using the TAR, or total amount repayable. This tots up the loan advance plus all charges for credit in order to produce a figure which more accurately reflects the true cost of a loan.

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