Q&A: Payment protection insurance

Yesterday the charity Citizens Advice made a supercomplaint to the Office of Fair Trading about payment protection insurance (PPI), a type of cover sold by many lenders alongside personal loans and credit cards. It said in many cases the insurance was seen as an additional source of income for the lender, rather than a way to protect consumers, and urged the Financial Services Authority to develop a basic policy with minimum standards to which all lenders should comply.

But in the meantime lenders will continue to sell these policies as an add-on to their loans and consumers will need to decide whether to buy them. If you're about to sign up for a loan read this before you tick the box for built-in PPI.

What is PPI?
It's a type of insurance designed to cover loan repayments should you find yourself unable to meet them out of your normal income, for example if you fall sick or lose your job. If your earnings stop for a reason that is covered by the policy, you can claim, and in theory the insurer will cover your payments until you are earning again.

If you're taking out a loan the cover will cost you a set amount each month, which you should be notified of when you sign up for the deal. If you have protection cover for a credit card you will only be charged if you use the card and have repayments to protect. The charge will be taken whenever you have an outstanding balance and the amount should be detailed on your statement.

Most policies are set up so that you cannot make a claim as soon as you lose your income. Usually 30 (but sometimes 60) days have to pass before the insurance will pay out. And most will only pay out for a set period of time, often up to 12 months.

What's wrong with it?
Quite a lot, according to Citizens Advice. As well as the limited period the insurance pays out for, the charity highlighted problems with the way PPI is structured and sold. It pointed to conditions on policies sold by many mainstream lenders which exclude those unable to work because of a bad back or mental health problem from receiving a payout. In some cases, as with Halifax's Creditcare cover, for example, workers cannot make a claim if they are signed off with stress.

Citizens Advice said many people were being sold inappropriate policies through high-pressure selling tactics, and when payouts were offered, the monthly payments often failed to cover the debt. It said that a borrower making a claim for a £1,000 credit card debt might only have their debt reduced by £12 over one year.

The cost was also cited as a problem. Citizens Advice said the premium paid can be equivalent to 25% of the value of the loan and was often paid for by borrowing more. This meant a borrower paying interest on the insurance payments - increasing their total debt and their monthly costs.

So is it expensive?
The cover offered by many mainstream lenders is costly. For example, price comparison website uSwitch.com has calculated that borrowing £7,000 over three years from NatWest on its fixed personal loan deal will cost you £2,324 in interest - the rate is set at 7.9% - and £1,920.82 in PPI. This means the insurance accounts for 20% of the total amount you repay and 45% of the cost of taking on the loan.

Other high-street lenders charge less for their policies. On a £7,000 loan arranged over three years, Nationwide building society would charge a total of £1,108.35 for PPI, equivalent to £23.09 a month. This is in part due to the lower interest rate on borrowing from the society - currently 6.7% - which means the monthly repayment being protected is lower. But this isn't the whole story - Lloyds TSB, for example, charges a rate of 6.4% on a loan of £7,000 but its PPI costs borrowers £31.42 a month. The £50 you save by choosing a Lloyds loan rather than the Nationwide deal is quickly wiped out if you take PPI from the lender.

This is a common problem, says Samantha Owens from financial information company Moneyfacts. "A lot of people are spending time looking for the best deal on their loan now, but they are taken in by the headline rate on that loan and do not shop around for insurance." She admits that the information given when you approach a lender "is not particularly clear", making it hard for consumers to be sure of how the policy is structured, how they are being charged and what it covers, and says borrowers should ask what they are getting if they are unsure.

Ask you lender if it will be adding the premium to your debt and charging you interest on it, how long you will have to wait before you can make a claim and for how long the policy will pay out. And ask if any of your circumstances would rule out a payment - if you are self-employed or have been ill in the past you could find that the policy is worthless.

So should I bother with PPI at all?
"With all the furore at the moment, it is important to remember that when you take out a loan, insurance cover is not is not necessarily a bad thing," says Samantha Owens. "Insurance can be invaluable, for example, should a borrower be unable to meet monthly repayments due to ill health." Alliance & Leicester's spokesman backs this up: "There is a need for people to consider the options," he says. "If they are taking out a personal loan of £10,000 for instance it's only right that we ask them to consider how they would pay that back. I think we would be criticised if that was something that didn't happen."

But that does not necessarily mean PPI is the best option. If you intend to repay your debts from your normal earnings then you might be better with an income protection policy, which pays a percentage of your earnings if you are unable to work because of an injury or illness, because it may be enough to protect repayments on your loans and credit cards too. This is what Nick White, head of personal finance at uSwitch recommends. "The fact that better value PPI is now being offered by independent brokers is a step in the right direction, but we urge people who want insurance to look at standalone income protection policies instead as they are far better value and provide better cover," he says.

Income protection policies often offer more comprehensive cover than PPI. Norwich Union's policy, for example, will pay out if you are signed off for stress or back pain. And payments on this policy continue until you reach retirement age, rather than stopping after a year. Policies can sound expensive, but offer a greater a payout than PPI and compare favourably with some of the built-in cover. Norwich Union says a 29-year-old male office worker who doesn't smoke can buy £1,500 of cover a month for a monthly premium of £24.30. The premium is reviewed after five years and could go up, but in the short term, the policy offers him far greater cover than mainstream PPI deals, for a lower monthly outlay.

Income protection policies do not, however, cover redundancy; nor do they cover all of your income so you might want to buy extra protection for your loan. If you do, consider shopping around for policies from independent brokers, rather than buying straight from a lender.

What are the advantages?
Cost and flexibility are often advantages to buying a separate policy. Peter Gerrard of comparison website Insuresupermarket gives the example of Northern Rock. Its personal loan has a competitive interest rate of 5.6%, but customers who tick the box and buy PPI from the bank will pay more than they need to for cover. A £5,000 loan arranged over three years will cost £151 a month in repayments without PPI, and £164.76 a month with the cover - a difference of £13.76 a month. If you shop around you can cover your £151 with a policy that closely matches that offered by Northern Rock, for £5.27 a month. A company called Payprotect offers a cheaper policy - £4.44 a month - to consumers who are happy to wait 60 days before they make a claim.

And that's for sickness, accident and unemployment cover. You can save further by buying only the type of cover you need. "If you're in a steady occupation and you feel safe in your job you might only feel the need to buy cover for sickness," says Mr Gerrard. "When you buy a standalone policy you can tailor it." Payprotect will charge just £2.76 to cover £151 for just accident and sickness (30 days).