The five cheapest ways to borrow

Personal loans rates are still enormous compared with the base rate. Find out how you can borrow more cheaply.

Why are personal loan rates so much higher than mortgages? The quick answer is risk. Mortgage lending is secured on collateral - i.e. the lenders can repossess your home if you fail to pay them back. Personal loans are unsecured, making them a far more risky proposition to lenders.

Unfortunately for borrowers, while the financial crisis led to sharp reductions in the base rate, interest rates on new personal loans didn’t fall by an equivalent amount, and in some cases rates actually stepped up.

In fact, according to Defaqto, average loan rates in 2007 - before the credit crunch took hold - were 8.8% while the base rate was 5.25%. But this year, average rates are approaching 13% while the base rate remains at an all time low of 0.5%.

Something isn’t right here.

What went wrong?

Why is the margin between the base rate and personal loan rates so much higher now than it was before the financial crisis?

There are many reasons but part of the blame can be laid at the door of higher funding costs. Lenders found that the cost of securing new long-term funds through the wholesale markets (i.e. through other lenders and institutional investors) rose once the strength of banking sector had been called into question.

Before the credit crunch, funding could be found at rates reasonably close to the base rate, but the margins have since widened. And, although the capital position of the banks has since improved, the cost of funding loans remains high relative to the base rate.

John Fitzsimons looks at the crucial things to remember before you apply for a loan

But this doesn’t tell the full story since the mark-up applied by lenders has increased above and beyond greater funding costs. Today’s higher loan rates may be partially explained by lenders’ need to rebuild balance sheets and increase capital reserves.

Profits have surely been forced downward since lenders have been prevented from cross-selling payment protection insurance (PPI) alongside loans since early 2009, and this has had an adverse effect on rates.

All this is pretty bad news if you need to borrow, but luckily personal loans aren’t your only option. Here are five other ways to get good value:

1) Get a 0% credit card

As you’ll already know, credit cards have long been a great way to borrow interest-free. But which lenders are offering the best 0% on purchases deals? Right now you can enjoy 13 months interest-free credit on all your spending with the fantastic Tesco Clubcard Credit Card. Even better your card doubles as a Tesco Clubcard so you can earn Clubcard points on everything you purchase in Tesco stores and at all other retailers.

2) Do a 0% money transfer

A second option here is interest-free money transfers. A select few lenders will allow cash to be transferred into your current account which is funded by your card. You then have a temporary period in which to clear your balance without paying an interest.

Cards which offer this option include the MBNA Platinum 16 Month Card where you’ll get a market-leading 16 months grace to repay your money transfer, interest-free. The transaction must be made within 60 days of opening the account, and you’ll be charged 4% as a handling fee.

In fact, many of the credit cards issued by MBNA allow 0% money transfers. The Virgin Money Mastercard offers an interest-free window which lasts for 14 and the MBNA Platinum card allows 13 months. But again, a 4% handling fee applies.

3) Get a 0% overdraft

Large interest-free overdrafts are becoming scarce, but it’s still possible to arrange an overdraft which is completely free for a year using the Santander Preferred Overdraft Rate account. Just be aware you must pay in at least £1,000 a month to qualify. If you already have an overdraft on your existing account, you can switch it to Santander where it will be matched up to £5,000 (depending on your circumstances).

Once the year is up, the standard rate of 12.9% will kick. This rate is very similar to the average rates charged on personal loans, so you may need to rethink your borrowing options at this time.

Credit cards and overdrafts are only really suitable for short-term borrowing of a year or so. If you need to borrow over a longer period, consider the next option…

4) Borrow via Zopa

We really like Zopa because it cuts the banks out of the lending loop completely. Instead Zopa is an online service which brings together people who want to borrow at reasonable rates, and people who have capital available to lend and want to earn a better return on their cash.

Lending rates through Zopa are pretty competitive, and should be lower than average personal loan rates if you have a decent credit rating. For example, if you borrowed £5,000 over 36 months, Zopa quotes a typical APR of 9.4%, and you can repay your loan early with no penalties or admin charges.

5) Get a best buy loan

I’ve certainly complained about rip-off loan rates, but in fairness not all deals are bad, particularly for medium to large loans. The best buys may still be worth looking at. Alliance & Leicester Personal Loans, for example, offer a market-leading loan at a typical APR of 7.6%. But this is only available on loans of between £7,500 and £14,950.

Existing loan customers of Nationwide and Tesco can also borrow at the same of just 7.6% rate. Meanwhile, Tesco Loan charges new customers a slightly higher APR of 7.7% on borrowings of £7,500 to £14,999. Note that this rate is only available for a limited period until 10 November 2010 – so be quick.

Finally, the Sainsbury’s Loan for shoppers with a Nectar card also charges 7.7%. If you don’t already have a Nectar card, pick one up for free at Nectar.com.

Compare loans at lovemoney.com

More: Cheaper loans hit the market, but hurry! | Pay less when borrowing a loan