A personal loan is a valuable option when you are in urgent need of money for a short period. However, the interest rate is relatively high—15-20% per annum—as the loan is not secured by any collateral.
It is possible to pay the loan in advance rather than waiting till the end of the loan tenure. Any prepayment means substantial savings in terms of interest.
Prepaying personal loan
Prepayment is when a borrower pays off his loan entirely or in part before the due date. Having taken a loan, many are anxious to pay it off as quickly as possible, if their finances allow it. However, while prepaying a loan may offer peace of mind, it may not always be the most financially advisable option.
There are two factors you need to keep in mind when deciding whether to foreclose your personal loan:
Most banks levy a penalty charge when you pay off your loan earlier than the due date. It can be a flat fee or it can be calculated on the basis of the remaining interest due. It is important to calculate what your penalty fee will be and compare it to the savings you will earn in terms of continuing to pay interest charges on your loan for the remainder of the tenure.
There is a minimum lock-in period (typically one year) during which you cannot pay off your loan. It is only after this period is over that you can consider the benefits and downsides to foreclosing your personal loan. Calculate how much you will pay in terms of the foreclosure fee and how much you will save in remaining interest charges when you pay off your loan.
Savings on principal amount
Prepaying your loan early into your tenure saves you the most money. Many borrowers who have already paid a large number of EMIs think that the interest on the remaining EMIs will be low and therefore it does not make sense to close the loan since they will not be saving much in terms of remaining interest costs. However, the interest paid on the unpaid principal amount is the same since banks calculate interest based on the reducing balance method.
Alternatively, you can make a part pre-payment. This reduces the unpaid principal amount, thereby reducing the interest component of your EMIs. However, this option makes sense only if you pay off a substantial amount of your loan amount, and you do it relatively early on in the tenure of the loan—otherwise, the pre-payment penalty might be larger than the interest savings.
The writer is CEO & co-founder, CreditMantri