Despite being an expensive option, personal loans are a good option for those in urgent need of funds. The disbursal is quick and these don’t require any margin, security or collateral. There is also no restriction on the end usage of the loan proceeds. Given the general aversion to debt, many people try to prepay their personal loans as soon as they have surplus funds. However, prepaying might not always be the optimum option. Here are some factors to consider while deciding to prepay or not.
Most banks and other lending institutions penalise prepayment of personal loans. For example, while SBI charges 3% of the prepaid amount as prepayment penalty, Axis Bank doesn’t penalise prepayments at all. The prepayment charges can be substantial if you make prepayments in a staggered manner instead of prepaying the entire loan at one go.
The motive behind prepaying personal loan is to save on interest charges. However, it is a myth that only prepayment in the initial stages result in savings on interest, and not those made in later stages. The reality is that interest saving is present in later stages too. Calculate your interest savings by using the online personal loan prepayment/foreclosure calculators and make sure the interest savings exceed the prepayment charges.
Impact on your emergency fund
Another important factor to consider while deciding to prepay is its effect on your emergency funds. If it is making a dent there, then do not consider the prepayment as the primacy purpose of emergency fund is to meet your needs during the financial emergencies arising out of severe illness, loss of job, etc. Otherwise, any unforeseen event may force you to opt for loans at even higher rates.
Returns from current investment
The returns from your existing investments like fixed deposits, mutual funds, insurance policies, etc., would also impact your decision to prepay your personal loan. Don’t redeem them for prepaying personal loan if they are fetching higher returns than the interest rate paid on personal loan. Similarly, don’t use your investments tied to a particular goal/purpose, especially for short-term ones. For example, if your personal loan is costing you 15% per annum and you have fixed deposits, which are earning you 6.5% per annum interest but not tied to any specific goal, then you can redeem your fixed deposit to prepay your personal loan.
Opportunity cost of not investing
Opportunity cost is the cost of choosing one alternative over the other. So, the opportunity cost of not investing is basically the returns that you are forgoing by not investing and prepaying your loan instead. This is especially true in case of equity mutual funds, stocks, etc., during market corrections, when they are available at lower NAV. Hence, don’t divert your contributions earmarked for long-term goals through mutual funds in order to prepay your personal loan.
The writer is associate director – Unsecured Loans, Paisabazaar.com