What is prepayment of a loan?

In simple terms, prepayment is a facility that lenders offer allowing a borrower to repay their loan ahead of schedule. This means you can make a prepayment before your actual repayment tenure, as agreed upon when taking the loan, concludes. It’s important to note that prepayment can be done either partially or in full. Partial prepayment allows you to pay off a significant lump sum amount of the total loan, which may or may not alter the original tenure.

When should you choose to prepay your loan?

This question is complex and lacks a straightforward answer, as it hinges on various factors such as the loan type, the remaining tenure, and the costs associated with prepayment.

For housing loans, there’s generally no issue with prepaying or even fully paying off the loan early, as there are typically no penalties or fees for doing so.

On the other hand, when dealing with personal loans, the situation becomes more nuanced. Prepaying early in the loan’s tenure can lead to significant savings on interest, especially since personal loans often come with higher interest rates (averaging 14-16%). However, personal loans usually include a lock-in period of about a year, after which you can prepay the outstanding balance. So, it’s crucial to carefully consider the implications before opting for a personal loan.

Auto loans present another scenario where some banks may not permit partial payments. It’s also vital to understand the adjustments to your EMIs after making a partial prepayment. Foreclosing an auto loan near the end of its tenure might not be financially wise, as the penalty for prepayment could surpass the remaining interest on the loan.

In summary, it’s essential to carefully evaluate whether the interest savings outweigh any prepayment penalties before deciding to prepay a loan. Proceed only if the financial benefits of the prepayment exceed the costs, otherwise, it may not be worth it.

Things to remember before prepaying a loan

Your financial decisions should never be impulsive. It is very essential to understand the ‘why’ before you find out the ‘how’. A loan pre-payment is beneficial, but as a borrower, you should know a few things. And then the decision to pre-pay should be an informed, well-thought-of one.

Prepayment has a lock-in period:

Banks do not want to incur losses on the lending they do. Hence most of the lenders have a built-in lock-in period of anywhere between 1 to 3 years. , during which you are not allowed to prepay the loan. However, floating-rate loans have no lock-ins as per RBI guidelines.

Prepayment penalty:

A penalty may be charged for loan prepayment before the end of the lock-in period (for non-floating rate loans and business loans). Do check if this penalty is going to exceed the savings on interest.

The interest rate of the loan:

The interest component of the loan is calculated on the reducing balance method by most banks. This means that the interest component is higher during the beginning and reduces as the tenure decreases. A loan prepayment calculator can help you find out the exact interest you can save by following a pre-payment plan.

To pre-pay or not to pre-pay?

Choosing between prepaying your loan or continuing with regular payments hinges on several variables, including the type of loan, the interest rate, any prepayment penalties, and the loan’s duration. Additionally, policies on prepayment can differ significantly from one bank to another. Therefore, it’s crucial to consult with your bank and understand their specific terms and conditions regarding prepayment before you finalise your loan agreement.