Is it worth pre-closing your loan before the actual tenure?

Availing of a personal loan can be tremendously beneficial. It can be availed almost instantly by meeting a few basic eligibility criteria. The best feature of a personal loan is that it can be used for any purpose that you wish for. It could be to meet a medical emergency, paying education expenses, renovate your home or even meet a month-end cash crunch. You would know that other loans do not allow you to utilize the loan for any other purpose than the one it was intended for.

A personal loan comes without any collateral, which is why a personal loan comes with a higher rate of interest in comparison to other loans.

As personal loans come with a high rate of interest that can range between 12-25%  the EMI payment of a personal loan may feel like an added burden on your finances. Also if you have opted for a longer tenure on your personal loan the total amount of interest paid on the loan can work up to a big sum.

While there are many ways to reduce your EMI burden before you avail of a loan, the pre-payment of a loan is one of the effective ways to reduce your overall burden of financing a loan. Prepaying a loan can also help you free up your income and make you better eligible for loans in the future.

What is Pre-closure of a personal loan?

Pre-closure or pre-payment of a loan is the process when you pay back the principal portion of your loan before the completion of the actual tenure of the loan. This works as an effective way to reduce the interest burden and close a loan.

What should you consider before the prepayment of your loan?

Debt is a burden that anyone would like to close off at the earliest. Payment of EMIs can get difficult, especially in a situation like a current ongoing pandemic.

At the outset, it looks like prepayment is an excellent option to save some money. But there are two important points that you ought to consider before going in for the prepayment of a loan.

1. Prepayment penalty – RBI has allowed borrowers of loans linked to the floating rate to make part-prepayments or make full repayment of the outstanding principal at any point in time during the tenure of the loan without any penalty.

But, a personal loan carries a fixed rate of interest, and cannot be pre-paid before completion of the tenure without a prepayment penalty. Barring a handful, most of the lenders charge prepayment penalty on a loan.  The prepayment penalty could either be a percentage of the outstanding loan amount or a fixed figure.

2. Minimum Tenure of the Loan:  You should be aware that most lenders allow prepayment only after the completion of a fixed amount of tenure of the loan. For Ex: If the personal loan tenure is for 5yrs, prepayment is allowed only after the completion of 1 yr/2yrs, etc depending on the policies of your lender.

To get a better idea, let’s have a look at the pre-payment penalties and the minimum lock-in period required by some of the lenders.

• HDFC  Bank doesn’t allow pre-payment before the completion of 12 EMIs. The penalty charged is on a reducing scale at the following rates

Between 13-24 months  – 4% of the outstanding principal

Between 25-36 months –  3% of the outstanding principal

After 36 months            –   2% of the outstanding principal

 

• Kotak Mahindra Bank has a lock-in of 12 months and charges a flat penalty of 5% of the outstanding principal amount at the time of pre-payment.

When should you prepay your loan for maximum benefits?

Though prepayment comes with certain charges and a bar on when you can prepay, it can bring in enormous benefits in terms of the money saved on interest rates. But the important thing here is to choose the best time for prepayment.

The most beneficial period for making prepayment is during the initial days of your loan. But most of the lenders allow prepayment only after a lock-in period. In that scenario, the best time to pre-pay will be soon after the completion of the lock-in period. As the tenure extends, the amount saved on interest may be negligible or even lesser than the amount paid as a prepayment penalty.

Working like the one below may help you make the decision easier. Let’s assume that a personal loan for Rs 100000 is availed for a period of 5 years at 18%. The loan comes with a lockin of 12 months and a pre-payment penalty of 5%.

	Prepayment is done at the end of 2 years	Prepayment is done at the end of 4 years
Original Principal	Rs 100000	Rs 100000
EMI amount	Rs     2539	Rs     2539
Total interest paid during the tenure of the loan	Rs   52361	Rs   52361
Principal outstanding at the time of prepayment	Rs  70240	Rs   27678
Interest saved	Rs  20157	Rs     2773
Prepayment penalty charged	Rs     3512	Rs    1384
Net saving	Rs 16645	Rs     1389

 

As you can see when prepayment is done during the initial tenure of the loan, there are substantial savings that can be made.

But you would also take into account that when you make the prepayment early in the tenure, you would have to pay a much higher amount which might be difficult for everyone. In our example, you would need to shell out Rs 70000 to make a final saving of Rs 16645 while at the end of 4years the amount to be repaid is much lesser at Rs 27678.

If you want to avoid these hassles, you could also think of availing of a personal loan from a lender who does not charge a pre-payment penalty and allows pre-payment just after 3 EMIs.

Is pre-payment helpful for improving your credit score?

You must know that the number of credit accounts held under your PAN is also one of the determinants of your credit score. The more the number of credit accounts, your credit score is affected and also you end up reducing your bandwidth for availing further credit.

So, if you are planning to avail of a big-ticket loan like a home loan, you might want to consider prepaying some of your loans and close them, if you have too many on your plate. Reducing the number of loans may help you get approval on bigger loans.

Making pre-payment is a good option to get rid of some debt, but make sure you do it judiciously to make the most of it.