Are you concerned about the rising loan interest rates? Well, you are not alone. Many borrowers in India and other countries face a challenging time as interest rates have risen steeply in the last few years and may go even higher soon. An increase in the interest rate directly impacts loan borrowers as they have to repay higher EMIs. Usually, a person takes a loan considering their present repayment capacity while assuming that the interest may change slightly over time.
However, the interest rates have gone up significantly this time, and borrowers need measures to overcome the adverse impact. Prepaying a loan can be a good option in the present situation, but you need to save money for this purpose. The question is, how much should you save to prepay your loan?
Here are some important points that can help you decide how much saving can help you prepay your loan.
Check return on available investment options
You can prepay a loan using a corpus created by investing the excess funds left after regular EMIs have been paid. Investing can be viable when the return on available investment options is higher than the interest rate levied on your loan. For example, suppose the interest on your loan is 10% pa. You can invest money to prepay a loan when the return on investment is greater than 10% pa. When the return on investment is lower than 10% pa (interest on the loan), it would be better to use the available funds to prepay the loan principal immediately.
The higher the return on investment over and above interest on the loan, the earlier you’ll be able to close your outstanding loan by saving as much as possible.
Regular prepayment vs. lump sum corpus after saving
You can choose from two options to prepay your loan if you have excess funds. The first option is to prepay immediately. The second is to invest and use the corpus after a few years to prepay the loan. If the interest on the loan is higher than the return being offered by the investment, then it’s better to prepay the loan regularly. On the other hand, if the return on investment is higher than the interest applicable on your loan, you may invest the excess funds, and after a few years, use the accumulated corpus to prepay the loan.
Adhil Shetty, CEO, BankBazaar.com, says, “You should develop a habit of saving more if you want to repay your loan early. Avoid non-essential expenses to boost your savings. Evaluate your current debts and liabilities and decide how much you can comfortably set aside for loan prepayments. Besides increasing savings, you could also explore other income sources, such as employee bonuses, property sales, or maturing investments to make prepayments on your loan. Remember, even if you pay 5% extra yearly, it can make a big difference.”
Assess the impact on your financial goals
Before you start saving money to prepay your loan, you must assess its impact on your financial goal. Avoid diverting the funds you have invested in for crucial financial goals to prepay your loan. However, if you have funds remaining after meeting all expenses, loan repayments and investments, use them to prepay the loan.
When to choose a loan with an overdraft facility?
When the interest on the loan is higher than the return offered by safe investment avenues, a loan with an overdraft facility can lower your interest burden instead of availing a term loan. In a loan with an overdraft facility, you can deposit the excess fund in hand i.e., over and above your regular EMIs into your OD account. The excess fund will be adjusted with the principal to lower the interest outgo. In a loan with an OD facility, you can again withdraw the surplus fund you deposited over and above the required EMI.
For example, you are required to deposit Rs 1 lakh in the initial 20 EMIs, but you have deposited Rs 1.5 lakh, i.e. a surplus amount of Rs 50000. In this case, Rs 50000 will be adjusted from the principal till it remains in the OD account. The interest will be calculated on the adjusted principal amount. You can again withdraw the surplus fund, i.e., Rs 50000, whenever you have a requirement.
If you have availed multiple loan facilities, you should first choose the loan with the highest interest rate for prepayment. Before prepaying a loan, you must take care of its impact on your liquidity needs. Prepay a loan using a fund which is other than the fund required to meet your regular expenses. It’s better to start prepaying the loan as early as possible during the loan tenure. Even a small early prepayment can make a huge difference in longer-duration loans. Loan prepayment not only helps in saving money towards interest outgo but can also relieve you from higher EMI payments when the interest rate is going upward.