Credit unions, which offer savings and loans to local communities, are to be reformed next year to encourage more people to use them.

The Government wants to make it easier for low-income households, particularly those on benefits and with bad credit records, to obtain loans so that people are not forced to turn to expensive credit cards or even loan sharks.

Credit unions are financial cooperatives owned and controlled by their members. The members are joined by a “common bond” - they may live in the same area or go to the same church. Though most unions offer good-value loans, as well as current accounts and free life insurance, they have, until now, been unable to pay any interest on savings.

Now the Government wants to scrap the “common bond” aspect of membership and allow more disparate groups to join together to form a union. It also wants to allow unions to pay interest on savings, allowing them to compete directly with banks and building societies. The proposals are due to come into effect in October next year.

There are more than 400 credit unions in Britain, providing financial services to about 400,000 members. The unions are regulated by the Financial Services Authority and covered by the Financial Services Compensation Scheme, which guarantees the first £35,000 of a member's savings if a union go bust.

A key aim of credit unions is to foster financial inclusion, by providing financial services to people who may be refused loans, or even current accounts, by mainstream providers. However, there is nothing to stop people with perfect credit records from taking advantage of a union's good deals and flexibility.

Lakshman Chandrasekera, chief executive of Southwark Credit Union, says: “Increasingly, banks are unwilling to do business with unprofitable customers. A person on benefits might not generate any income for banks and will find it hard to get a current account. Consequently, many people simply withdraw their benefits in cash and spend the money. For a charge of 95p a week to cover our costs, we give members a current account and a debit card, which allows them greater choice and control of how they spend their money.”

Many borrowers, especially those with a patchy credit record, find the unions a useful source of credit. By law unions are not allowed to charge more than 2 per cent interest per month (APR 26.8 per cent), although some are lower - Sheffield Credit Union, for example, only has an APR 12.68 per cent.

Though an APR of 26.8 per cent is higher than the average personal loan at 10 per cent, union loans are aimed at borrowers who cannot necessarily access this type of credit. Instead, they may be forced to turn to more expensive forms of borrowing, such as door-to-door cash loans. Provident Personal Credit, one of the largest of these loan companies, says that its average APR is 183.2 per cent.

People have been put off saving with credit unions because virtually no interest is paid on deposits. Instead, unions currently pay a discretionary dividend on savings, usually 1 per cent or 2 per cent a year, though it may be nothing in some years. From October next year new interest rates on union accounts should offer greater incentives for members to save.

To find out about your local credit union, go to http://www.abcul.coop.

Case Study: An invaluable service

Tina Young is a member of the Southwark Credit Union and finds its savings and credit facilities invaluable. Ms Young, who has three children aged 5, 7 and 9, has had problems with credit card debt and personal loans. But the credit union has enabled her to take out four loans between £240 and £600.

Ms Young is a member of the union's benefit loans scheme, whereby her child benefit of £43 a week is paid into an account and her agreed loan repayment is deducted, plus £10 a month for her savings. “I need the loans for things such as birthday and Christmas presents for my kids,” she says.

The union charges an APR of 26.8 per cent on loans between £100 and £800, or 13.7 per cent between £801 and £3,000. The union works out how much the member can afford and the loan must be repaid in 24 months.