Watch out for misleading `best buy' loans

Taking out a loan? Been offered one with a low rate and a `payment holiday'? Read this before you go any further.

As you may have guessed, payment holidays allow you to take a holiday from your loan repayments. Sounds great, in theory, doesn't? But watch out.

There are about a dozen unsecured personal loans that currently offer payment holidays at the start, usually lasting three months. Whether these holidays are compulsory or optional, they're all sold as a benefit. However:

Optional holidays are only a potential benefit for a very small number of people.
Compulsory ones are certainly not a benefit for most.

It may make sense to have a holiday in some instances, but most people should just get on with repaying. During the holiday, interest is charged. So, whilst your monthly repayment does remain at the level you were initially quoted, the holiday has several nasty effects:

The interest you end up paying over the course of the loan will be significantly higher than if you hadn't taken a holiday.
The length of your loan increases. If you agreed a 60-month loan, this will typically become a 65-month loan, and you'll make repayments in 62 of them.
The APR increases. You were sold the loan at, say, 8% APR, but this dodgy trick actually pushes your real APR above 9%. You will never be told this.

I do not know a single provider offering payment holidays that reveals any of this to you before you've received the actual contract (even then it's buried in the confusing small print), and none of them ever reveal the real APR.

Let's take a look at some rough figures. You ask for a £10,000 loan to be repaid over 60 months at around 8% APR. The lender's own loan calculator says this'll cost you about £201pm for 60 months, at a total cost of approximately £12,100. But this loan has a compulsory three-month payment holiday.

As a result, the interest rate will actually be more like 9.2% APR, although this'll never be revealed to you. During your short holiday, another £200 will be accrued in interest. Your loan will then take 62 months to pay off and during this time more interest will be added on top of the payment-holiday interest. Your total bill will be around £12,400, £300 more than the lender quoted when you did your online application.

Here are some more figures (which I keep rough, as the actual amount can vary slightly depending on other factors, for example, how interest is calculated):

How a payment holiday affects your loan

Amount	Length	Monthly repayment	*Lender's total repayment figure*	*Real total repayment figure*	*Lender's APR*	*Real APR*
£10,000	60mths	£201	£12,090	£12,400	8%	9.2%
£10,000	60mths	£210	£12,620	£13,020	10%	11.5%
£8,000	60mths	£161	£9,670	£9,920	8%	9.2%
£8,000	60mths	£168	£10,100	£10,410	10%	11.5%
£5,000	60mths	£101	£6,040	£6,200	8%	9.2%
£5,000	60mths	£105	£6,310	£6,510	10%	11.5%
£5,000	36mths	£156	£5,620	£5,730	8%	9.5%
£5,000	36mths	£160	£5,770	£5,920	10%	11.9%

There'll be discrepancies due to rounding, but these are slightly rough figures anyway.

The length of the loans in the table is the one according to the lender. The 60-month loans will actually be 62 months and the 36-month loans will actually be 37 months (excluding the three-month payment holiday). The last repayment will be smaller than shown in the monthly repayment column.

As you can hopefully see, this sneaky trick adds £100 to £400 to a typical loan. The higher the APR your lender claims you'll be paying, the bigger the discrepancy will be. If the loan is shorter, the real APR is even higher than longer loans. However, I'm not recommending you increase your loan on that basis: shorter is better normally, as you'll pay less overall.

Should you ever take a payment holiday?

There's nothing inherently wrong with taking a payment holiday if you're fully aware that it will cost you hundreds of pounds extra. If you desperately need the money today and cannot afford to make any repayments for the next three months, then it may be your only option. But otherwise, I'd steer clear.

Best buys are being affected

The number of lenders doing this trick has crept up on me slowly and caught me unawares. I'll have to reconsider how I write about loans in future. Many of the cheapest loans (so called 'best buys') come with payment holidays, so always check to see if they do, and whether they are compulsory. Whether they're compulsory changes at short notice surprisingly often, so ensure you read the small print of the actual contract to find out if any holiday is optional.

The good news is that the cheapest personal loan that is available to both new and existing customers remains at the top of the best-buy tables, because it doesn't have a payment holiday. This is Alliance & Leicester with an APR of 8%. (It's more expensive if you go direct, at 8.9%.) However, you should always compare loans as normal, as depending on your circumstances and requirements another deal may be cheaper or more suitable. Now, though, I expect you to bear in mind the extra cost of payment holidays by adding a few hundred to the total cost of loans that force this 'benefit' on you.

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