What an early repayment charge actually is

When you take out a personal loan, the lender sets your monthly payment on the assumption that you will pay every instalment on time for the full term. If you clear the balance in one go, that plan changes, and the lender may look to recover some of the interest it expected to earn. That is what an early repayment charge — sometimes called an early settlement fee or redemption penalty — is designed to do.

The charge usually turns up in one of three shapes:

• A set number of days' or months' interest on the outstanding balance, which is by far the most common approach.
• A percentage of the amount you are settling, which appears less often on standard personal loans but does exist.
• A flat administration fee, often somewhere between £50 and £100, sometimes charged on top of an interest-based penalty.

Not every lender charges one. Plenty of UK personal loans can be settled early with no penalty at all, which is one good reason to read the terms before you sign rather than after.

What the rules say about settling early

Most personal loans taken out by UK consumers are regulated credit agreements, and that gives you a layer of protection. In practice:

• The extra charge a lender can apply when you settle a regulated loan early is capped at 28 days' interest on the amount you repay.
• The old "rule of 78" method of calculating rebates, which was notoriously unfavourable to borrowers, was banned for agreements taken out from 31 May 2005.
• Lenders must work out the interest you still owe on an actuarial basis, so you get a fair rebate for interest you have not used.
• You can ask for a written settlement figure, and that figure is normally held for a set period, often 28 days, so you know exactly what to pay and by when.
• If your borrowing falls outside the regulated regime — larger or business-purpose loans, for instance — the lender's own terms apply, so read them carefully.

One further right is worth knowing. You have 14 days from signing a credit agreement to withdraw from it. Within that window you repay the credit plus interest accrued to that date, with no early settlement charge. It is useful if you spot a much better deal straight after signing.

Doing the sums: will settling early really save you money?

The only question that matters is whether the interest you would save is bigger than the fee you would pay. Usually it is, but not always.

Picture a loan of £8,000 over five years at 7.9% APR. The monthly payment is roughly £162, and total interest over the full term comes to about £1,710. If you settle after two years, the outstanding balance is around £5,170. The 36 remaining payments would have cost you about £5,826, so settling saves roughly £650 in interest. A penalty of 28 days' interest on that balance works out at about £31 — so you would still be around £620 better off.

Two warnings, though. First, the later you are in the term, the smaller the prize. Settle with only three months to run and you might save £20 in interest while paying a £30 fee, which is a losing trade. Second, some loans are structured so that interest and charges are loaded at the start; where that is the case there may be very little interest left to rebate, so check the breakdown in your agreement rather than assuming.

Overpaying in instalments instead of settling in full

Often the smarter route. Many lenders allow regular overpayments, and a partial overpayment is not normally treated as a settlement, so no early repayment charge is triggered. Look for two things in your agreement: any annual overpayment limit (commonly 10% of the balance or the original amount before a fee applies), and how the lender applies extra money. Most apply it to reduce the term, which saves you more interest than simply lowering your monthly payment.

If your penalty is a flat fee, spreading overpayments over several months can dodge it altogether. If it is a percentage of the balance, clearing the loan sooner still reduces the fee, because the balance is smaller.

Traps worth avoiding

• Borrowing to repay borrowing. Taking a new loan to clear an old one can raise your total cost once arrangement fees and a fresh term are counted.
• Letting the quote expire. Interest accrues daily. If you pay after the settlement figure lapses, you will owe a little more.
• Paying the wrong amount. Your settlement figure includes interest since your last payment, so paying the balance shown on your statement will not clear the loan.
• Assuming your credit score jumps. Clearing a loan lowers your overall debt, which helps, but a short account history is neutral at best.
• Emptying your savings. Clearing a loan and leaving yourself with no buffer rarely ends well.

A quick checklist before you pay a lump sum

• Ask for a written settlement figure and note the date it expires.
• Check your agreement for the early settlement charge, any admin fee, and any overpayment limit.
• Add up the interest you would save over the remaining term and compare it with the total penalty.
• If the numbers are close, run the figures for regular overpayments instead.
• Keep an emergency fund intact before parting with a lump sum.
• Once you have paid, confirm in writing that the account is closed and no further payments will be taken.